Tuesday, June 8, 2010

It takes a village...

Regular readers will know that while I have a bearish bias, my inner trader believed that the market is oversold and ripe for a rally, which has so far not materialized. In the last few days, there were a number of analysis showing that we are as oversold or sentiment washed out at levels last seen during the February lows. This comment from Technical Take is a typical sample:

Judging by the emails I receive, it seems to be hard for investors to grasp the idea that I view the current market environment as a "fat pitch". If we use the analogy of a card counter in black jack, I can only determine when I bet aggressively. I cannot guarantee that I will get a winning hand even though the cards should be in my favor. Nonetheless, I would always prefer to bet when the chance for strong gains is likely. This is just one aspect of the "fat pitch". The other aspect and it may be more important than all those potential gains is that a failed signal tends to portend a poor outcome for the markets. Based upon my data, I have clearly defined risk parameters, and this is what is so good about the "fat pitch" --possibility for strong gains plus the ability to define my risk.

How things might be different
It is useful from a trader’s perspective that Technical Take qualified his comments about entering a trade with “defined risk parameters” and that “a failed signal tends to portend a poor outcome for the markets.”

Having waited in vain for a market rally, my inner trader is now tilting from bullish to bearish. The primary reason is that whereas in February, when the bulls were still in control of the tape, today the bears are in control. The change in trend is evident as there are now death crosses everywhere in large cap stocks.

There are systemic risks everywhere. A contact at a major brokerage firm recently informed me that leverage is still on at hedge funds and major institutional long-only accounts are still positioned for a recovery and not a correction. As good traders know, overbought markets can get more overbought and oversold markets can get more oversold. If bearish momentum continues to carry the day, then there is still a lot of pent-up selling to be done.

What’s more, Mr. Market seems to be infected by a global contagion. Free market economists generally believe that markets are self-correcting (and therefore oversold bounces are more likely) because there are many independent market participants expressing their views. What if the views aren’t independent but self-reinforcing? Macro Man details how self-reinforcing these views might be [for the newbies, the term "spoos" refer to the S&P 500]:

"Well it’s definitely the equity markets driving this", say the FX boys, "If Spoos drop we sell Yen crosses, so they must be driving it"...

"Can't be us", reply the equity boys, "We just sell when we see the Yen rally or spreads widen"... Oooops, don't like the sound of this...

Must be those bond boys then...? "Nah not us, we buy bunds when we see Yen strengthen and equities drop and when Libor tightens".

Must be the short term cash boys then...? "Not us, we just demand more when we see Yen rally, stocks drop, bonds rally and if one of those central banks say the banks need to increase capital requirements when they can't..."
Hillary Clinton famously wrote a book called It Takes a Village detailing how interconnected people are as a celebration of community.

I am not so dogmatic as to be married to any single model of the markets. I only trade what I see. Right now, the lack of any substantial reflex rally on Monday after Friday's precipetous drop must be a concern for the bulls.

If financial markets are indeed interconnected and the whole village is arrayed against you, then it’s time to watch out for downside risks. But regardless of your bullish or bearish views, I agree with the views of Technical Take (see above). This is an extremely volatile market and it's important to define your risk parameters.

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