We have seen the stock market has been somewhat weak over the past couple of weeks. Rising long-term interest rates have particularly affected interest rate sensitive sectors, such as utilities and real estate, and provided support to the US dollar and dollar-linked carry transactions. Speculation has shifted from an impending recession to an environment of “sticky” inflation and interest rates that are likely to be “higher for longer.” So does the recent decline in stocks represent an opportunity to participate in the longer-term uptrend, or is it a warning to preserve capital?
Let's back up a minute.
I notice two problems among market participants. The first is to build deals without strong underlying ideas. Traders looking for “set-up” charts are especially guilty of this mistake. The second problem is generating a big picture and top-down narrative based on fundamental data, but without anchoring these themes in well-analyzed trades that provide a favorable reward-risk ratio on a shorter-term time frame. My experience with successful market participants is that they are both investors And Merchants. They generate powerful larger image ideas through unique and precise analyses And They then translate those ideas into good trades by carefully evaluating the short-term risk-reward.
In Daniel Kahneman's view, success in the markets requires deeper, slower thinking and faster, more flexible thinking. In practice, this means having consistent strategies while flexibly adapting the implementation of those frameworks based on current circumstances.
Now let's take a look at the current market:
I noticed that across the NYSE universe, we saw over 1,500 stocks hit new monthly lows and less than 1,000 hit new three-month lows. This is what we expect during a bull market correction. When one-month lows* and three-month lows are high (bear market), the next 10-day returns since 2010 have been negative. When one-month lows were high and three-month lows were not significantly high, the next 10-day returns were clearly bullish – well above average.
In short, context matters.
When analyzing market returns, it is not enough to examine a single time frame. We want to see how the shorter time frame fits into the bigger picture of the market.
Let's take a second example. Last week, looking at the world of the New York Stock Exchange, we saw quite a few stocks giving buy signals on two technical trading systems, the Wells Wilder Parabolic SAR and Bollinger Bands. These systems evaluate strength and weakness across the shorter (SAR) and medium (Bollinger) time frames. When the number of stocks giving buy signals on the SAR was weak but the number of stocks giving buy signals on the Bollinger Band was relatively strong, the next 10-day returns since 2019 were flat to negative. When we had a few buy signals on both technical systems simultaneously, the returns for the next 10 days were strongly bullish.
Again, context is important.
Through a number of these types of analyses, we see favorable near-term average returns after sell-offs in bull markets. This is the perspective from slower, deeper analyses. Now, going forward, if we see selling pressure that can't bring prices down, we can speculate that the bears are trapped, will need to cover, and we can bet on higher prices in the future. Conversely, if we see that the buying pressure is limited and/or cannot push the price significantly higher, we can entertain the idea that this time, in fact, might be different and follow this up with further analysis and perhaps completely different bets.
The most successful traders I work with look at new and different things and look at things in new and different ways. Over time, unique returns cannot come from consensus thinking.
In-depth reading:
Momentum curve
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