Trader’s Narrative

Everytime the market moves, people scramble to come up with reasons to explain why it did so. If the market went up after a certain event, like say, an economic report, then the move is attributed to that news. If the market went down and there was no news, then it may have been “a lack of buyers” or maybe the old standby, “profit taking”.

I sympathize with journalists who have to constantly write about the market and to concisely communicate to an uneducated general public what is happening. They can be forgiven for grasping at straws and giving explanations which really have no empirical legs to stand on. What else can they do? They’ve miles of white space and gallons of ink with which to fill them.

But my all time favourite is the explanation that many bandy about: “More buyers than sellers”. That is, if the market went up, it is explained by some as an unbalance between the buyers and the sellers. And if the market goes down, these same people say there were more sellers than buyers.

I’m sure you’ve heard this expression. But think about it for a second. Is it true? Can buyers ever outnumber sellers?

It may help to understand this by thinking about what a transaction is. I think of a transaction as concomitant agreement on price and disagreement on value.

In other words, I may agree with another person that my shares of Google (GOOG) should be priced at $550 but I disagree on the value of the shares. I value them less than he or she. That’s why we are able to engage in a transaction. I sell GOOG. The other person buys GOOG. But while we disagree on the worth of the shares, we do agree on the price - or there would be no transaction.

In this framework, can there ever be more buyers than sellers? No! Every single transaction needs to have both a buyer and a seller. Clearly then the explanation of an imbalance of buyers and sellers is simply incorrect. There can never be more buyers or more sellers. There must always be the same amount of shares on each side. Or all we have are bids and asks - no transactions.

So why then do prices move at all if there must always be complete congruence between buyers and sellers? Why does price fluctuate at all?

Well, it isn’t the amount of buyers or sellers but their psychological makeup. Prices move up because buyers are more aggressive in their desire to buy than sellers are in their desire to sell. And vice versa.

That’s why I cringe a little whenever I hear a trader or investor explain market moves by saying that there were more buyers or sellers. Am I being nitpicky? Maybe. This stuff will probably not make or break you as a successful trader. Although I would assume that if you are interested in the markets you would take the time to think about the underlying framework and how it all really works.

Trying to peer into the fog of future price action, I looked at the advance-decline numbers for Nasdaq. Here’s a chart of the Nasdaq along with the daily A-D numbers smoothed over a 7 day moving average:

As you can see, sharp spikes down are usually good spots for a trend reversal (a bottom, either short lived or intermediate). In the past 3 years we’ve had the following spikes (reading below -700):

• mid-March 2004 - small bounce
• May 2004 - small bounce
• mid-July 2004 - small bounce
• August 2004 - intermediate bottom
• mid-Jan 2005 - small bounce
• April 2005 - intermediate bottom
• October 2005 - intermediate bottom
• May 2006 - small bounce
• June 2006 - small bounce
• July 2006 - intermediate bottom
• March 2007 - ???

So a spike in that territory usually defines some sort of oversold. But what determines if it is a bounce or a more solid bottom?

A good tell is the % of stocks above daily moving averages. In each case of an intermediate bottom, both the long term (200 day MA) and the short term (50 day MA) were quite low. This is just a back of the napkin calculation, so what I mean by low is anywhere between 30%-20% or lower.

The only time that this didn’t happen was in last summer (June 2006). Then we had both short term and long term % stocks above MA very low but we had to wait another few weeks for the definite bottom to be carved.

Right now, we just don’t have that. The % of stocks above moving averages is sitting quite high at around 50% and 35% (for long term and short term respectively)

My conclusion after all this is that we are probably seeing a short lived bounce here. We need more capitulation to launch another leg up. So be careful out there.

One of the ways to measure market breadth is to look at the percentage of stocks above a moving average. The shorter the moving average (for example, 20 or 10 day MA) the more accurately it will measure short term extremes in the market.

Being the powerhouse research firm that they are, Lowry’s not only keeps track of such a measure, they have their own twist on it. They filter the securities out there to only include common stocks (excluding the hyper growing sector of closed end funds, preferreds, bonds, etc.) trading on NYSE, AMEX and NASDAQ.

According to Lowry’s, “a number of significant buying opportunities have been identified in the past after periods of market weakness have caused the percentage of stocks above their 10-day moving averages to drop below 10%. For example, as a result of the recent intense stock market drop beginning on February 27th, the 10-day % indicator dropped from its early-February’07 peak of 84.6% to a low of just 3.77% on March 5th, reflecting a deeply oversold market condition.”

Here’s a chart from 1990 to present showing this measure flagging (blue arrows) extreme oversold readings:

Interestingly enough, eventhough this is a short term volatility measure, it gets better the further we go in time. Measuring a 12 month return after a signal, we find that out of the 16 signals since 1990, only one of them produced a loss over that time period (-4.4% from the Sept 21st 2001 signal).

Do you remember Didier Sornette? He is the visiting UCLA professor who became a bit of a celebrity within financial circles a few years back. Sornette co-authored a paper and then a book explaining Why Stock Markets Crash. He came up with a very sophisticated model which tried to not only explain the market but predict it years in advance.

Since at the time his model was bearish, Sornette quickly became the favourite interview subject of the perma-bears. He wasn’t right of course since the market went up instead of down.

Had he been right though, you can bet he would have become a sudden celebrity, sold millions of his dry academic book, been interviewed in Barron’s, launched a hedge fund, etc.

This is what he said in an interview on March 2003 just as the market was about to launch into a multi-year cyclical bull run:

…we predicted that the stock market will go up until the first to the second quarter of 2003 and will then start a long descend until around the end of the first semester of 2004.

And here is the graph illustrating this prediction:

At the beginning of 2006 the S&P 500 was at 1270 - approximately 500 points away from Sornette’s predicton.

Now, I’m not dredging this up in order to beat up on a well meaning professor of geophysics. My point is that listening to so-called ‘experts’ is financially hazardous to your financial health. And that includes anyone on TV, radio, or dare I say it? even a blog.

Be independant and seek understanding - from that money and success will follow. There are no shortcuts in trading or in life.

If you’re interested to learn more about experts and their predictions, listen to this lecture by Nassim Taleb:

Things are not going as they should in the market. And by that I mean that the market isn’t going the way I think it should go. Intelligent tells that have worked in the past almost unanimously pointed to an oversold market that is ripe for a snap back rally. And yet the market hasn’t obliged. Yet.

We had the sentiment measures coming in as very bearish, we had put/call ratios showing a very scared retail investor, we saw a rush into the safety of ETFs and out of individual stocks, we saw spikes in volatility, an increase in insider buying, etc… the list goes on.

So what gives?

Are we really in a new cyclical bear market? having never really left the secular bear market that began in 2000? A few, like Lowry’s, have said exactly that. Only time will tell if they were prophetic.

A lot has been made of the weakness in the SOX index relative to the broader market (S&P 500) and to the Nasdaq itself. Looks can be deceiving. For each of the major intermediate rallies in the past few years, initially the SOX lagged both broader proxies. Only after the rallies were truly underway did it join in the fray.

You can’t watch the semis as a leading indicator as they haven’t been for a while now. So the double bottom thesis didn’t work out. But what about the general market?

Looking at the classic measure of market internals, the bullish percent of the Nasdaq 100 is now below the critical 30 level:

This is deep oversold levels. According to traditional bullish percent analysis, if the market can now lift up above 30 by 6 percentage points, we have a new buy signal.

Looking at the percent of stocks in the Nasdaq 100 above their 200 day moving average we see a very similar deep oversold condition:

This metric is now as oversold as it was in the summer of 2004. Will we have another summer rally? or will things continue to meander downwards?

Honestly, I don’t have much conviction either way. I would like to believe that this oversold level will be a launch pad for the next leg up. However, when I look at similar metrics for the other broad measure of the market I find them not nearly as oversold as for the Nasdaq 100.

And yet, an almost infallible (contrarian indicator) is now as pessimistic as I’ve ever seen him:

I’ve got this train-wreck button on my “Mad Money” console — the sound effects board I use during my TV show — and I feel like hitting it a bunch of times right now just to emphasize what this market’s become. It’s 2000 all over again without the snap-back because of the geopolitical stuff.