Reading the "Message of the Market?" Be Careful!

Does the market have a message?

Whether it does or not, there are hundreds of pundits who want to explain it!

There is an interesting contradiction.

If you believe that markets are efficient -- carrying a message -- then there is no edge for most of us in the investment business.  As Mr. Buffett says, he would be on a street corner selling pencils from a tin cup if markets were efficient.

If you believe that markets are not efficient -- so that you can claim to have an investment edge -- then you cannot infer a message when you have only noise!

Why is it that no one seems to realize this?  When the market is going in the direction of their prediction, people claim that "the market has learned how to interpret these rumors from Europe," just to pick one current example.

I am astonished by the current claims that the "bond market is smart" because it recognizes fears and the stock market should be thousands of points lower.  This might be true in normal times, but the current bond market is inhabited by millions of amateurs (the fearful), not the bond vigilantes of old.  Suggesting otherwise, as I hear every day on CNBC's Santelli report from the Chicago trading pits, is completely deceptive.

A Modest Proposal

I have a working hypothesis about the market message.  It is basically the opposite of what most other people think.  This is how sophisticated and experienced managers get an edge on the market.

• On the "global macro" front, where everyone has an opinion and few bother to find the best sources, the market offers great opportunity.  This is the Warren Buffett  playground -- open to the long-term investor.  Abnormal Returns has a great post on this subject.

"Let’s first stipulate that the financial markets are going to do whatever they darn well please. There is nothing any individual can do to affect the overall direction of the markets. Therefore active management is much like trying to play tennis against a professional player. This leaves the individual investor open not only to forced errors but unforced errors as well. The financial markets have a tendency to fool as many investors it can as often as it can. Can an individual investor score some points against the market? Sure, but the odds are that the market will on average return more volleys that you can’t handle."

I plan to add to this discussion, but this is really great advice.

• On the stock and sector-specific front, especially in shorter time frames, it is important to watch the market.

This is one reason that technical analysis, at least in simple forms,  provides useful information.  Here are three current examples:

1. We monitor price, volume, and technical factors through our "Felix" model.  Felix highlighted strength in home building last week.  We share these reports on Wall Street All Stars and also with those who subscribe to our reports.
2. Felix also likes health care ETFs, an interesting move in front of the Supreme Court decision.  The market is expecting improvement in health care, which actually might happen simply from eliminating the uncertainty.
3. Felix often highlights stocks in front of earnings reports.  This week Apollo Group (APOL) rocketed to a high position in our single-stock ratings. I chose not to play this in front of the earnings announcement, but Felix was right.  The point is that the market may seem to have information in front of important announcements.  Leaks?  Some people know?

It is well-established that trend-following methods are effective.  It all depends on the time frame and the setup.

Implementing the Message

Following the market trend is a staple for commodities traders.  Felix has an awesome performance in picking the Nasdaq 100, but there are some big drawdowns.  Few should take this approach, no matter how well it works.

For the long-term investor, most of what you read is unhelpful, misleading and costly.  Pretend that you are interviewing the pundit for a job.  You can ask the same question I do:

What can you tell me that I did not already read in this morning's Wall Street Journal?

The question needs to be updated, since the FT  is moving in.  The concept is still correct.

Most of what you read and hear comes from people who want to explain the day's trading as if they had predicted it.

 

 

 

Comments

[Johan Linden]

Thank you for your answer Jeff. I think you answered the question yourself when you say you have a mean-reversing method.

Of course you can find specific instruments and time-frame where trend following works but in general and in a daily time-frame trend following has lost its glory (for now). It worked well to the 80's and 90's. Many prominent bloggers have made notes and studies about this. Such as Steenbarger, Quantifiable Edges, Mark Hulbert just to mention a few.

My point is to warn about making general recommendations for how to have an edge in trading. How to control and manage risk can be generalized but trading edges will be different from one or several year(s) to another.

[oldprof]

Johan -- I only read a few trading blogs, but I have read a lot of serious work on trading systems. (search the blog for Ralph Vince or trading systems) My company has excellent model developers. We have evaluated hundreds of trading systems over 25 years, selecting only a handful for use.

I also number many successful traders among my friends. They generally like to scalp and range-trade. They do not use statistics at all. They often are playing very short-term trends, which is why I mentioned time frames. Their methods are personalized and not really subject to testing.

Those of us from Chicago are perhaps closer to Richard Dennis and the Turtle experiment, but everyone knows about it. It is this kind of evidence that I had in mind when I wrote the sentence you quoted. http://en.wikipedia.org/wiki/Richard_Dennis

I have also said frequently that there are many ways to succeed in trading and investing. We also had an active and successful method based on mean-reversion, but we are not trading it right now.

My guess is that many of the bloggers you are reading will not be around in a year -- a guess based on watching hundreds of traders at the CBOE.

Anyway, thanks for the kind words about the blog, for reading, and for raising this interesting question.

Jeff

[Johan Linden]

"It is well-established that trend-following methods are effective. It all depends on the time frame and the setup."

Is that so? Most serious trading blogs that have the slightest knowledge on statistics seems to disagree. I promise you that I show you two sources for every source you show me that says differently.

But still, this is a very good site. Keep up the good work!