Tuesday, January 3, 2012
What plagued the world politically, economically and financially in 2011 will revisit most nations and financial markets in 2012, with greater intensity. And what plagued the world in 2011 – that order of events, politics, economics, finance – will plague everyone again in 2012.
In democracies and over time in prison states like China, politics and politicians are supposed to follow the lead of the economy and its supposed servants, financial markets. Since 2007, this order has been reversed and, given the fragile state of the U.S. and world economies and the even more fragile state of equity and debt markets, it shows no sign of reverting to the Old Normal anytime soon. We are thee years into a new era of a New Normal – fractured politics, stagnant economies and volatile markets – and my point here is that it is a new era, not just a period of time. This New Normal is a new reality for investors and in 2012 investors need to accept this reality if they are to succeed in any fashion.
Madness that is more volatile, more dangerous
In 2012, this New Normal will best be characterized by a Madness of Crowds that is more instant and more volatile than in 2011. And, for those fighting it, more dangerous. This herd behavior will dominate trading in 2012 – and give investors great opportunities if they accept what the market gives them.
What will the market give investors 2012?
- A much greater ability to pick winners and losers than it did in 2011 simply because the market has learned to shrug off intraday and intraweek movements driven by Greek politicians, U.S. debt deficit negotiations, flash crashes, bankrupt commodity trading firms and the Detroit Lions making the playoffs.
- Greater volatility than we saw in 2011 as the European crisis worsens, especially in Q1. It may possibly blow out of proportion when Greece hints it may default a second time before yearend. It is supposed to default the first time in Q1.
- With a market rewarding winners and punishing losers, longer term investors can zero in on great companies and great stocks, buy them and prepare to hold with a strategy that recognizes volatility will increase.
- With a market more volatile, longer term investors will need to write calls against their holdings to generate income, to average down, to create more capital, to whatever they want to do with that cash. Speculators will be able to see faster and more profitable increases in option positions, especially put positions, as volatility creates rapid gains – and losses.
Market drivers for 2012
What will drive the market in 2012?
- Day to day, perhaps week to week, events, headlines and that herd mentality. Through the course of the year, barring a market crash, now only about a 10% possibility, fundamentals will return as a driving force behind great and terrible performers.
- What events will turn into crises that hurt the market?
- Europe has not resolved anything and has set a March deadline for itself for a new arrangement that will enable the “group” to punish nations that spend and borrow too much. Sure, right. The U.K. will not agree to this, other nations may not agree, bond markets do not like it, and a deep recession is already set in stone, reducing tax revenues, increasing transfer payments and making current national budgets moot. The bottom line is more bond market instability and that will drive trading in equity markets around the world. The European recession will also hurt exporters to Europe, especially China and commodity exporters to China other than agricultural products.
- The U.S. has its own problems currently masked by the holidays and the increasingly humorous rhetoric in the Republican primary contest, none of it remotely relevant to solving deficit and debt problems. The debate on extending unemployment benefits and payroll tax cuts must come to an end at the end of February. It will be somewhere between frustrating and meaningless and dangerous. Throughout 2012 electoral politics will push any real solutions aside and sometime mid-year it will become obvious that unless the right wing of the Republican party agrees to some sort of meaningful tax increase, the Bush tax cuts will expire. If Obama gets re-elected they expire. If he does not, the Dems kill it by vote or filibuster in the Senate, they expire. The market has yet to fully price this in. In 2012 other ratings agencies will downgrade U.S. debt, the world will shrug and Treasurys will do well given problems in Europe, the U.K. and Japan.
- Any major event – a large bank failure, Iran interfering with military force in Iraq, an Islamist coup in Pakistan – will hit markets very hard; they are very fragile.
- The direct intervention of the European Central Bank (ECB) to support bond markets in a very large way in Europe. The ECB did so indirectly last week, lending more than half a billion dollars to banks who are expected to use some of this to buy sovereign debt. The market liked it and direct intervention, which means Germany wakes up and says maybe we do have a financial crisis, would push the Dow up 1000-1500 points, at least. The problem with his event? It would be triggered by a bank failure or a large bond auction failure by Italy which would lead to a large selloff in equity markets. Probability? 20%.
- A deficit and debt deal of at least $4 trillion over ten years, which is not really any kind of a solution but would appear to be one, would push markets up and provide a floor for the bulls. The problem with this event? Right-wing Republicans would swear they will repudiate the deal if they can get more people elected in November. Probability? 5%.
- The Fed announcing QE III – It is going to do a QE III despite Rick Perry’s threats to do bodily harm to Ben Bernanke if he does so. The Fed will do it quietly unless there is a massive failure in financial markets. If it does it too quietly, markets will be disappointed. If the Fed does it with enough visibility, markets will stay the course. If it does it with a great deal of visibility, markets could go up 20% or more. The problem with this event? It will happen only because of a deepening recession or a large crisis in the financial markets. Probability? 75%.
Here are some specific predictions for 2012.
- A very deep recession in Europe, a mild one here, very slow growth in China.
- The hope for QE III and increased liquidity buoys markets and, barring a large financial crisis, they end up no more than 15% down or 15% up by yearend, depending on the scope of a crisis and the amount of liquidity injected into the market.
- Obama wins with a larger margin than anyone could imagine right now. The market begins pricing this in – with the evaporating Bush tax cuts – midsummer. The markets yawn on election night.
- Greece announces it is prepared to exit the euro. Preparations have been made in bond markets, at banks and in national capitals for this event throughout the year.
- There is a medium-sized geopolitical crisis in the Middle East – something to with a nuclear Iran or overt anti-Israeli actions by the new Egyptian government. Oil prices spike temporarily to $130.
- Great companies will do very well.
Great companies, great stocks for 2012
And what are those companies? Think of those that prospered and/or restructured during the last recession. What do I own, right now, going into 2012?
- Apple (AAPL) – Doubled in size during the Great Recession, poised to do it again in the next four years or less.
- Amazon.com (AMZN) – This is the only online company worth owning. It’s growing more than a 30% a year; what more is there to say?
- Ford (F) – people are willing to be foreclosed before they lose their car, auto sales will increase at least 10% in 2012 after a very strong 2011.
- GM (GM) – Ditto for General Motors.
- Deere & Co. (DE) – Corn production skyrocketed in 2011, farmers are flush, exports to China are replacing lost ethanol subsidies, Chinese families will give up the new moped before they give up their new taste for higher quality chicken and pork. (Own or will own it depending on when you read this.)
- The New Frugal Winners – People shopped for quality this holiday season. That means Tiffany (TIF), Coach (COH), Ralph Lauren (RL) and Nordstrom (JWN). (I sell puts against these names.)
- Cepheid (CPHD) – The world leader in molecular diagnostics, a takeover target for someone given their increasing dominance in the market. (I am in and out of this one depending on where it is in its trading range).
- Curis (CRIS) – A highly speculative biotech (I love biotech and genomics), FDA up or down in March for a new skin cancer treatment, more than 20 clinical trials underway paid for by Roche and/or the National Cancer Institute. Extremely speculative.
Best thing in 2011 – our boys and girls came home from Iraq. Second best thing? I launched two new investment services and wrote Contrarian Profits.
Best thing in 2012 – better opportunities for investors than in 2011. So bring it on.
“On the long-term weekly charts, GOOG has been in a rectangle for over four years without a successful breakout… holders should take protective steps to limit losses by selling calls or buying puts on the stock.”
I must now cancel that recommendation since GOOG has finally broken from a dramatic “W” formation with a target of $700. Cover all shorts and bearish positions and buy GOOG.
What should investors watch in 2012? As the new year dawns, there are plenty of short-term issues on the horizon, ranging from the eurozone to fiscal gridlock in the US to upheavals in the Middle East.
But amid that list there is also another, often ignored, question to ponder: could 2012 produce a repeat of the “flash crash”, the bizarre episode that hit the U.S. equity markets back on May 6 2010?
Think about it for a moment. A full 18 months have passed since the strange episode that caused the Dow Jones [.DJI 12217.56 -69.48 (-0.57%) ] to tumble 650 points in half an hour, wiping $850 billion off share prices, before rebounding. Since then, the issue has faded from view amid the eurozone drama.
But to this day, nobody has fully explained what really happened on May 6. Nor is there any evidence that the fundamental problems that caused the flash crash have been resolved. That leaves some scientists fearing that not only is a repeat of that flash crash possible, but it is probable — and next time round, it could be even more damaging.
To understand this, take a look at a fascinating transatlantic research paper published by the Bank for International Settlements. One of the paper’s co-authors is Dave Cliff, formerly a financial trader who now runs the UK government’s Large-Scale Complex Information Technology Systems project, an endeavour that analyses the risks of IT systems in sectors including healthcare, nuclear energy and finance. The other, Linda Northrop, runs a similar project at Carnegie Mellon University, which was initiated a decade ago by the US military.
In recent years, these two teams have used engineering and science skills to analyse what they call socio-technical risks, or the dangers that occur whenever complex technological systems proliferate, creating “systems of systems” that nobody understands. In early 2010, well before May 6, they released a brilliantly prescient report that predicted that a systems failure loomed.
Since then, they have continued their research, with sobering conclusions. Most notably, these researchers believe that the flash crash was not an isolated event; on the contrary, it was entirely predictable given how IT systems have proliferated to create a system of systems that is now interacting in unpredictable ways that regulators and investors cannot comprehend, far less control.
Usually, this danger is not visible to investors. After all, markets generally work well, leaving financiers in the grip of a phenomenon that Diane Vaughan, the sociologist, called the “normalcy of deviance” (based on her work on the Challenger 1987 space shuttle disaster): because people have sailed close to the wind and survived, they assume they can continue to do this — and turn a blind eye to anything that seems uncomfortably bizarre.
But the risks and near misses are rising all the time. Take May 2010. At the time, the wild gyrations in prices were deemed shocking. However, Cliff and Northrop think it could have been dramatically worse: if the systems failure had been a little later that day, prices would not have had a chance to recover before the US market’s close, which would have caused carnage when Asian [.N225 8455.35 56.46 (+0.67%) ] and European markets [.FTEU3 1011.92 10.53 (+1.05%) ] opened.
“The true nightmare scenario would have been if the crash’s 600-point down-spike, the trillion-dollar write-off, had occurred immediately before [US] market close,” they note. “The only reason that this sequence of events was not triggered was down to mere lucky timing. . . the world’s financial system dodged a bullet.”
And such luck may not be repeated. Since May 6, there has been a series of other, mini flash crashes in commodity markets. While regulators claim that introducing trading limits will fix the issue, there is scant evidence that this will really work, given the scale of this technological innovation.
Is there any solution? Cliff and Northrop offer one idea that might help: regulators and bankers should replicate what some scientists have done elsewhere and join forces to create a cross-border computing centre that is capable of extremely advanced, large-scale financial simulation. Their idea is that this would essentially replicate what is done in meteorology or complex engineering to map the markets — creating the equivalent of wind tunnels to test new financial products and ideas, and warn of looming trouble.
It sounds pretty sensible to me. There is even an obvious platform for this: the U.S. is currently creating an Office of Financial Research, which could host such a device. But don’t hold your breath; sadly, the OFR is floundering in its efforts to define its role, and most regulators still prefer to forget May 6 rather than admit in public that they are struggling to understand how modern markets really work. And that, sadly, is unlikely to change, unless there is another flash crash. It is not a comforting thought; least of all given all that is happening in the eurozone.
Back in January 2011, I pointed out that copper prices had in recent years started to track very closely with whatever the stock market was doing. But the key point about that relationship then was that when disagreements appear, it is usually copper that knows what the real story is.
That relationship continues to work to this day, with the two price plots mostly doing the same things, but with divergences usually working out the way that copper says that they should. By that I mean that if the SP500 makes a higher high but copper makes a lower high, that is a bearish divergence with bearish implications for both of them.
It is worth noting that there was a big “oops!” back in July 2011, when copper prices made a higher high as the SP500 made a lower high. In that instance, it turned out that the stock market was right, but copper worked extra hard in the weeks that followed to make up for lost time and to plunge to a lower value. Nothing works all the time.
The higher high for the SP500 going into the end of the year has not yet been matched by a higher high in spot copper prices, and that is a troubling development. But the problem with converting this observation into an actionable and tradable signal is that we never know exactly when such a divergence is actually going to start to matter. Sometimes it happens after just a few days of divergent behavior. Other times, the divergence persists over several weeks before it finally matters.
One other worry is a phenomenon I just shared with readers of our Daily Edition, which is the realization that a lot of currencies seem to undergo reversals around New Year’s Day. The end of 2011 arrives with commercial currency futures traders holding a huge net short position against the dollar. Commercial euro futures traders have the biggest net long position in the euro in the entire 12 year history of the reporting of euro futures positions in the Commitment of Traders (COT) Report. Commercial traders are also long the Swiss franc in a big way. Analysis of COT data is something that is featured every Friday in ourDaily Edition.
So what this all means is that we have a situation where an upward move for the euro (downward for the dollar) is likely because of what the COT data say, and because of the year end reversal tendency. A big drop in the dollar would be bullish for copper prices, because a cheaper dollar would mean that you would need more dollars to buy a pound of copper. So a potential big currency reversal could push copper prices upward, removing this current divergence between copper prices and the SP500. Accordingly, this relationship will bear watching closely as we move into 2012.
“Dismal” is the only word I can think of to describe the economic and political outlook for the coming year. Deep recession seems almost unavoidable for Europe. Governments in all the so-called advanced countries face mounting debt and long term unfunded entitlement liabilities, huge banking problems and negative long term demographic trends. Governments’ response will be to pillory the so-called “rich” as much as possible, levy higher taxes in a variety of ways, enact various measures of financial repression, pile on more and more regulations, print more money and ultimately continue the default process that began with Iceland and Greece. The only “good” that comes out of this will be an increased reluctance to engage in ill-advised wars (I’ll let the reader decide which recent wars were ill-advised) simply because governments can’t afford them.
• The Euro – I’ve been a big fan of the euro. The world needs the euro as a second reserve currency after the dollar. The renminbi just isn’t yet ready for prime time. And the euro makes so much sense for an ever more economically and financially integrated Europe. But the Europeans have managed to do everything wrong in response to the crisis. The list goes on and on. My recommendation was to let each nation be responsible for its own fiscal integrity. National defaults should be accepted as defaults by states and provinces were accepted for the US and Canada. That’s not what the Europeans have done. German Chancellor Merkel’s attempt to force fiscal responsibility on member states is a political nonstarter. The European Central Bank (ECB), regardless of what it says, is printing money to tidy over the Italian and Spanish huge 2012 borrowing needs. Talk German, act Italian, is the ECB mantra. The plan to do three year repos with the banks so that they can buy their home country’s bonds is a cynical repudiation of bank risk management principles, a debauching of the euro itself and to some extent a protectionist scheme that will encourage a sort of “beggar thy neighbor” approach to banking where banks only loan to their own governments. The banks need capital, not high risk lending schemes. Credit is going to be scarce in Europe in 2012.
The tax-oriented austerity schemes being adopted in Italy, Spain, Greece and elsewhere ensure that Europe will be in deep recession in 2012 and that Europe’s growth prospects longer term will be dim. There is talk of privatizations and pushing up state employee retirement ages. We’ll see. What is more likely is that the austerity packages just push Europe further down the road of more socialism and more state dominance of the economy. That is not a bright investment scenario. A further decline of the euro against the dollar would not be a surprise.
• Gold – I’ve been positive on gold and long term still am. Gold was up 10 % in 2011 and outperformed all major assets except US Treasuries. But there can be no gainsaying that since reaching a high in August gold has been tanking. Near term this downward drift may continue. My view has been that gold is an alternative to owning continuously depreciating fiat currencies. The recent quantitative easing programs suggest further future fiat currency depreciations. But of late the market has viewed US dollar assets– and not gold– as the preferred alternative to other currencies. It doesn’t make sense to me but the market makes its own decisions. Moreover, with the massive liquidity squeeze centered in Europe, people no doubt are taking profits and raising cash by selling the one liquid asset they have profits in – gold. Emerging market central banks have been buyers of gold but the recent decline of the Indian rupee has reportedly reduced Indian retail demand.
• US Treasury Securities – Just behind gold, longer term US Treasury securities rose 9.6% and were star performers in 2011. US government securities were perceived as a place of refuge. Amazing. Nobody could have been buying for yield or because of the outstanding US fiscal situation.
Let’s start with the yield. According to Irving Fisher and just about every economist who followed him, the long run the interest rate on a bond should equal the expected real rate plus the expected rate of inflation. The official rate of inflation, the CPI-U was up 3.4% year over year as of November. Ten year Treasuries yields averaged below that which means their real yield was significantly negative.
Not only that, there are a number of people – I am one – who don’t trust the government numbers. Governments which publish the inflation numbers have every incentive to understate those numbers. In Argentina it’s now against the law to publish an inflation estimate which differs from the flagrantly understated government number. In the US the calculation of the CPI was changed in 1980 and again in 1990. An advisory service called ShadowStatistics, using the earlier methodologies, comes up with much higher estimates for US inflation in 2011. Calculating the CPI isn’t as simple as it sounds and there are a number of choices that can be made. The government has every incentive to make choices that make the inflation number lower.
The point is that, unlike Japan where low nominal government bond yields have been positive in real terms because Japan has experienced mild but actual deflation, US government bonds have offered negative real yields. The US is not in deflation the housing bust notwithstanding. US government securities are a bad buy on a yield basis. Irving Fisher would never own one.
The US government’s fiscal situation on the face of it doesn’t seem any better than half the countries in Europe. (And neither does that of the British, as the French central bank has so ungraciously pointed out. But so far the British bonds get the Royal treatment as well.) Most people are familiar with the dreary US numbers so I won’t belabor them here. The size of the US deficit, the staggering total of unfunded entitlement liabilities, the growing debt load, the debts of the states, the endless gimmickry used to understate the US budget deficit – pick your statistic. And of course the Congress and the President are unable to agree on anything.
Who knows? Perhaps national muscles count in determining investor comfort levels. The US has ten nuclear powered Nimitz class aircraft carrier behemoths that can operate for twenty years without refueling and bases just about everywhere in the world. A psychic compensation for the skimpy yield on US government issues? Maybe Irving Fisher should put that in his model.
There is a good chance the US will be viewed as the ultimate refuge right up until the November 2012 elections. Those elections might be the most important in US history. Treasury securities may continue to lead a charmed life until then. If the fiscal conservatives (whoever they are) don’t sweep, then après la election, le deluge.
• US Stocks – US stocks, perhaps basking in the same refuge aura as US Treasuries, have been global relative outperformers. The Dow Jones Industrial Average, which consists of 30 generally stodgy blue chips, was up 5.5% in 2011. The broader S&P 500 was unchanged and NASDAQ was down “only” -1.8%. That doesn’t sound great especially considering the year’s volatility. Who needs a heart attack and no return? But the US was the world’s star performer. Hong Kong for example was down -19%. The trendy BRICs of Brazil, Russia, India and China were down -25%, -21%, -35% and -19% respectively (all in US$ as of 12/27, taken from The Economist). Near term in 2012, if US Treasuries are the place money is hiding and the US economy outperforms Europe, the big US stock names may continue to receive similar favorable treatment.
Still, I don’t buy the hypothesis that the US economy is making a significant recovery. The consumer remains overindebted, income growth in real terms is negligible, the states are cutting back and raising taxes and Europe is entering deep recession and Asia a slowdown. People are getting excited over the recent decline in employment claims but there could be some distortions produced by the holidays. And again – no income growth, no big recovery.
• Financial Repression The term financial repression is an old one in monetary theory, having first been used by economists John Gurley and Edward Shaw in the 1960s. More recently, Carmen Reinhart and Kenneth Rogoff, in their now seminal work This Time It’s Different as well as in follow up papers, have warned that financial repression was a likely weapon governments would use to deal with their overwhelming debt burdens. Financial repression simply denotes government measures undertaken to divert funds to themselves that otherwise in a free market would have flowed elsewhere. In plain English, that means the things governments do to screw investors in order to sell their debt obligations.
Quantitative easing arguably is a form of financial repression whereby yields on government debt are pushed down to below market levels at the expense of savers. Attempts to nationalize pension plans and force them to invest in government bonds at below market rates are another example of financial repression and such nationalizations have already been carried out in Europe. Expect to see more of this. So far the government has not touched IRA and 401K Plans in the US but don’t be surprised if an attempt is made.
Investors of the world, unite! Your savings are at risk of confiscation.
• China – Hard landing, soft landing which will it be? That’s the question the world is asking. The Chinese people are hardworking, relatively well educated, the majority relatively undivided by religious and ethnic issues and totally materialistic. Characteristics thus far largely responsible for the Chinese economic success story. Nevertheless, I believe there may be no escaping from the fact that the Chinese economic system is in need of a substantial overhaul. The Chinese economic system is characterized by a government owned and dominated financial system that misallocates resources towards real estate, capital goods and industrial commodity inputs on a massive scale. It is driven by a mercantilist policy that has undervalued the exchange rate and stifled foreign competition. It has brought significant damage to the environment. And it is characterized by crippling restraints on the flow of information, financial and otherwise. A modern economy cannot function without the free flow of information.
I tend to the view that a hard landing lays ahead, one hard enough at least to force some major reforms. That would be good. The Chinese stock market today looks cheap on a PE basis. There may be some rallies in response to government easing in the months ahead. But for China to be a good long term investment the reforms have to be made. Unlike Europe the long term future of China looks bright provided reforms are made. When the time comes to buy, stay away from state owned firms and buy real private Chinese firms that trade in New York, Hong Kong and Singapore.
• India – Three years ago the prospects for India looked bright. The ruling Congress Party had just been reelected with a larger margin and the Prime Minister was an Oxford PhD in economics who was viewed as the architect of India’s market oriented reforms of the 1990s. Indian companies and their managements are among the best in the world and, unlike China, information flows freely and in a language (English) most of the world can understand. India looked like it was fulfilling its potential at last and that it would offer great opportunities for investors. But since the election in 2009 it’s been all disappointment and the Indian stock market’s poor performance has reflected this. One reform proposal after the other has gone down in flames including proposals to allow larger foreign participation in the retail and education sectors. The one “reform” that was actually passed was an education bill that if enforced will effectively close down a substantial number of successful private schools. The Indian budgetary situation can be charitably described as precarious and inflation has remained stubbornly high. Worst of all, the Congress Party, presumably to please voters, is pushing through massive subsidy and employment programs which are bound to grow in size and present enormous budgetary challenges. The prior government, led by the Bharatiya Janata Party or BJP, had a slogan in 2004 called India Shining. The Congress Party’s slogan at the rate things are going might be India Bankrupt.
Indian equities are not interesting right now.
• A Note on Race, Caste and Fiscal Prudence It is a core view that I have elaborated on in prior letters that democracies with universal suffrage have a long run tendency to spend their way into fiscal bankruptcy and degrade their currencies along the way. Investors have to recognize this phenomenon. The so called advanced West has reached that point of bankruptcy now. Politicians pass measures to please the majority that elected them, regardless of whether the country can afford it or not.
This phenomenon becomes more politically complicated if there is some difference – be it race, religion or caste – that differentiates the recipients of the government largess from those who produce the wealth, pay most of the taxes and dominate the professional and entrepreneurial classes. Normally in these situations the recipients, who are of a different race, religion or caste, believe they cannot compete with the professional/entrepreneurial groups and regard the government largess as an equalizer and redress for current and past wrongs.
Indian democracy provides an interesting case study regarding this point. The so-called Indian masses tend to be from “lower” castes (India has a complicated definitional scheme to formally identify these groups) than the professional and entrepreneurial groups running the businesses and generating the wealth. The democratic process in India has become a mechanism whereby the lower castes, who constitute significant “votebanks” and regard themselves as having been oppressed for centuries, appropriate wealth to themselves through the (unfortunately corrupt) political system. This may be why Indian politicians, who presumably really do know better, cannot say “no” to fiscally irresponsible welfare schemes.
The same phenomenon is observable in other countries, including South Africa and Brazil and even in the US where the word “race” can be substituted for caste and to some extent welfare and subsidy schemes carry racial overtones. In the US, when the real brawling over cutting back government spending starts after the 2012 elections, the subject of race will come up. Things could get ugly. Economists and Wall Street analysts don’t like to talk about these things for fear of being labeled politically incorrect. But they have investment significance.
China on the other hand does not have this problem, partly of course because it is not a democracy in which politicians have to appeal to voters but also because ninety percent of its people define themselves as Han and its minority groups are on the geographic and political periphery of the country. The lower income Han do not perceive themselves as different from the professional and entrepreneurial groups which are also Han. In this case China’s relative homogeneity – which is sometimes criticized as an impediment to creativity –can be viewed as an investment plus.
Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.
Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.
Historical Analytics • 118 East 60th Street 5D • New York, NY 10011
The price of a futures contract is the result of a decision made by both a buyer and a seller. The buyer believes prices will go higher; the seller feels prices will decline. These decisions are represented by a trade at an exact price.
Once the buyer and seller make their trade, their influence in the market is spent — except for the opposite reaction they will ultimately have when they close the trade. Thus, there are two aspects to every trade: 1) each trade must ultimately have an opposite reaction on the market, and 2) the trade will influence other traders.
Each trader's reaction to price movements can be generalized into the reactions of three basic groups of traders who are always present in the market:
1) traders who have long positions
2) those who hold short positions; and
3) those who have not taken a position but soon will
Traders in the third group have mixed views on the market's probable direction. Some are bullish while others are bearish, but a lack of positive conviction has kept them out of the market. Therefore, they have no vested interest in the market's direction.
The impact of human nature on futures prices can perhaps best be seen by examining changing market psychology as a typical market moves through a complete cycle from price low to price low.
Classic price pattern
Let's assume prices trade within a relatively narrow trading range (between points A and B on the chart). Recognizing the sideways price movement, the "longs" might buy additional contracts if the price advances above the recent trading range. They may even enter stop orders to buy at point B, to add to their position should the trend show signs of going higher...
...but, by the same token, recognizing prices might decline below the recent trading range and move lower, they might also enter stop loss orders below the market at A to limit their loss.
The "shorts" have exactly the opposite reaction to the market. If the price advances above the recent trading range, many of them might enter stop loss orders to buy above point B to limit losses. And they may add to their position if the price should decline below point A with orders to sell additional contracts on a stop below point A.
The third group is not in the market - instead, they are sitting on the sidelines watching for a signal indicating whether they should go long or short. This group may have stop orders to buy above point B, because presumably the price trend would begin to indicate an upward bias if point B were penetrated. They may also have standing orders to sell below point A for converse reasons.
Now, let's assume the market advances to point C.
If the trading range between points A and B has been relatively narrow and the time period of the lateral movement relatively long, then the accumulated buy stops above the market could be quite numerous. Also, as the market breaks above point B, brokers contact their clients with the news – resulting in a stream of market orders. As this flurry of buyers becomes satisfied and profit-taking from previous long positions causes the market to dip from the high point of C to point D, another distinct attitude begins working in the market.
Part of the first group that went long between points A and B did not buy additional contracts as the market rallied to point C. Now they may be willing to add to their position "on a dip." Consequently, buy orders trickle in from these traders as the market drifts down.
Traders who established short positions in the original A-B trading range have now seen prices advance to point C, then decline a bit toward the price at which they originally sold. If they did not cover their short positions on a buy stop above point B, they may be more than willing to "cover on any further dip" to minimize the loss.
And those traders not yet in the market will place price orders just below the market with the idea of "getting in on a dip."
The net effect of the rally from A to C is a psychological change in all three groups. The result is a different tone to the market, where some support could be expected from all three groups on dips. (Support on a chart is price level at which buying of a futures contract occurs in sufficient enough volume to halt a decline in price.) As this support is strengthened by an increase in market orders and a raising of buy orders, the market once again advances toward point C. Then, as the market gathers momentum and rallies above point C toward point E, the psychology again changes subtly.
The first group of long traders may now have enough profit to pyramid additional contracts with their profits. In any case, as the market advances, their enthusiasm grows and they set their sights on higher price objectives. Psychologically, they have the market advantage.
The original group who sold short between A and B and who have not yet covered are all carrying increasing losses. Their general attitude is negative because they are losing money and confidence. Their hopes fade as their losses mount. Some of this group begin liquidating their short positions either with stops or market orders. Some reverse their position and go long.
The group which has still not entered the market – either because their orders to buy the market were never reached or because they had hesitated to see whether the market was actually moving higher – begins to "buy at the market."
Remember that even if a number of traders have not entered the market because of hesitation, their attitude is still bullish. And perhaps they are even kicking themselves for not getting in earlier. As for those who sold out previously-established long positions at a profit only to see the market move even higher, their attitude still favors the long side. They may also be among those who are looking to buy on any further dip.
So, with each dip the market should find the support of:
1) traders with long positions who are adding to their positions
2) traders who are short the market and want to buy back their shorts "if the market will only back down some"; and
3) new traders without a position in the market who want to get aboard what they consider a full-fledged bull market
This rationale results in price action that features one prominent high after another and each prominent reactionary low is higher than the previous low. In a broad sense, it should appear as an upward series of waves reaching successively higher highs and higher lows – or, in other words, a general upward trend.
But at some point the psychology again subtly shifts. The first group with long positions and fat, unrealized profits is no longer willing to add to its positions. In fact they are looking for a place to "take profits." The second group of battered traders with short positions has finally been worn down to a nub of die-hard shorts who absolutely refuse to cover their short positions. They are no longer a supporting element, eagerly waiting to buy the market on dips.
The third group, who never quite got aboard the up-move, become unwilling to buy because they feel the greatest part of the upside move has been missed. They consider the risk on the downside too great when compared to the now-limited upside potential. In fact, they may be looking for a place to "short the market and ride it back down."
When the market demonstrates a noticeable lack of support on a dip that "carries too far to be bullish," this is the first signal of a reversal in psychology. The decline from point I to point J is the classic example of such a dip. This decline signals a new tone to the market. The support on dips becomes resistance on rallies, and a more two-sided market action develops. (Resistance is the opposite of support. Resistance on a chart is the price level where selling pressure is expected to act like a ceiling, stopping advances and possibly turning prices lower.)
Now the picture has changed. As the market begins to advance from point J to point K, traders with previously-established long positions take profits by selling out. Most of the hard-nosed traders with short positions have covered their shorts, so they add no significant new buying impetus to the market. In fact, having witnessed the recent long decline, they may be adding to their short positions.
If the rally back toward the contract highs fails to establish new highs, this failure is quickly noticed by professional traders as a signal the bull market has run its course. This is even more true if the rally at point K carries only up to the approximate level of the rally top at point G.
If the open interest also declines during the rally from J to K, it is another sign it was not new buying that caused the rally but short covering.
As profit-taking and new short-selling forces the market to decline from point K, the next critical point is the reactionary low point at J. A major bear signal is flashed if the market penetrates this prominent low (support) following an abortive attempt to establish new contract highs.
Put simply, if the temporary support level formed at point L is lower than that of point J, odds are the overall trend will continue much lower.
In the vernacular of chartists, a head-and-shoulders reversal pattern has been completed. But rather than simply explaining away price patterns with names, it is important to understand how the psychology of the market action at different points causes the market to respond as it does. It also explains why certain points are quite significant.
In a bear market, the attitudes of the traders would be reversed. Each decline would find the bears more confident and prosperous and the bulls more depressed and threadbare. With the psychology diametrically opposite, the pattern completely reverses itself to form a series of lower highs and lower lows.
Of course, at some point the bears become unwilling to add to their previously-established short positions. Those who were already long the market and had refused to sell higher would eventually be reduced to a hard core of traders who had their jaws set and refused to sell out. Traders not in the market who were perhaps unsuccessfully attempting to short the market at higher levels will begin to find the long side of the market more attractive. The first rally that "carries too high to be bearish" signals another possible trend reversal – and potential shift back into an upward trend.
And so the market continues on shifting between upward and downward cycles...
With this basic understanding of market psychology through three phases of a market, a trader is better equipped to appreciate the significance of all technical price patterns. No one expects to establish short positions at the high or long positions at the low, but development of a feel for market psychology is the beginning of the quest for trades that even hindsight could not improve upon.
When you analyze charts, approach them with the idea that they reflect human ideas about prices that are the result and the struggle between supply and demand forces. Your attitude and ability to judge market psychology will determine your success at chart analysis. Unexpected occurrences can change price trends abruptly, and without warning. Also, some of the chart formations may be hard to visualize. You'll sometimes need a good imagination as well.
Now, let's take the first step in putting what you've just learned to the test...
This chart from the MarketClub members' area depicts a significant change in the mentality of the market. Can you indentify the 'head and shoulders' formation that has signaled a shift in trader psychology?