How To Trade When Major Events Affect Financial Markets
historical chart of the S&P or other broad indexes is really a
picture of history. Huge events have
happened in history, and their impact is reflected in the chart of averages
during those periods. There have been
world wars, depressions, booms, busts, the cornering of a critical
transportation stock, civil wars, assassinations, broad new government powers,
earthquakes, violent attacks, and countless other shocks to the free markets,
over the last 140 years or so of market data that is available.
And the beauty that such a chart shows is the incredible ability of
mankind to ultimately adapt and change to new situations and climates.
But what the averages don’t tell, is the countless stories of individuals
who did not adapt quickly enough to survive financially, as well as the
countless stories of individuals who understood the ramifications of each shock,
and were able to preserve their capital and flourish.
most important thing an investor must do when a shock hits the markets and the
economy, is analyze and strive to understand what has changed and how this
change will impact the rules and methodologies that a trader uses to capture
profits consistently in the markets.Â Without
such an understanding, traders are doomed to apply analysis that no longer is
relevant to market action. I can remember
some examples of this from my own trading lifetime.
One such example is short-interest. For
a long period of time, the analysis of short-interest provided an incredibly
accurate view of what a stock or the market was about to do.
Short interest became a very popular indicator because of its prescience.
However, when options began to trade in decent volume, lots of shorts
measured in short-interest were really offsets to option positions that were
already hedged. This ruined
short-interest as an indicator. Yet many
traders who had made fortunes using short-interest when it was successful,
continued to use it when it was no longer working.
I knew several traders who made millions using short-interest when it was
working, and who went broke continuing to use short-interest when it became
obsolete. Their mistake was not
understanding the impact of options markets on the indicator they were using.
let us look at the current terrorist shock and try to understand how it might
impact some of the tools we look at in trading the markets.
indicators. in the current market
environment. We will probably get a
pop up off of severely and broadly indicated oversold levels, but I suspect
it will be a lot less steep and a lot quicker to end than the rallies we
have seen off of oversold levels since WWII.
We have really many shocks that the market is absorbing.
We have not had a real bear market since 1972 (with 1980-82 perhaps
also qualifying, but barely). In a
real bear market like 1972-75 or 1929-32, markets are perpetually oversold
as they continue to drop. Investors
do not bounce back to confidence but get progressively more and more
negative while the market falls. We
are not at this point yet, but another leg down accompanied by more mutual
fund liquidation (mutual fund buyers on a weighted basis since 1982 are now
just 4% in the black on all their purchases — they may begin to sell en
masse if their positions since 1982 go under water), or if margin levels
fall back to more normal levels of pre late-1990s.
a much more delayed effect from economic gauges andÂ monetary variables.Â Economic
gauges show that since WWII, every time unemployment rose significantly or
any indication of recession arose, that in six to 12 months, the market was much
higher.Â That may not be the
case this time around.Â But
ancillary evidence points to the consumer retrenching in a more significant
fashion than any time since WWII.Â This
makes sense because the average American has lost more of a percentage of
his wealth since March 2000 than at any other period since WWII.Â And should reprisals by terrorists hit America again with further
attacks after the U.S. counter-attack begins, a significant element of good
feeling will be forever lost, and may be already.Â As we’ve discussed in past columns, monetary policy is already being
stifled heavily this time around, by weakness abroad and by the fact that
this bubble created a global overcapacity glut that cannot be cured quickly
or by printing money.Â Money
supply increases and lower interest rates didn’t help during the Depression
or in Japan since 1980 because confidence was dealt a severe blow and
because consumption would not return to levels beforehand.Â We have had an economy barely hanging on globally because the U.S.
consumer of last resort continued to spend despite a huge drop in capital
spending.Â But with the consumer
confidence plummeting and consumption dropping off sharply, it will likely
be more delayed and more difficult to get confidence back to normal levels.
the above indicators that normally lead to reliable signals being perhaps
undermined in usefulness by the nature of this particular economic contraction
and terrorist shock, I believe investors need to put stronger emphasis on two
types of market indicators:Â A. breadth indicators;Â and
B. leadership indications.
Breadth Indicators: Investors reading my TradingMarkets.com column since I became cautious
and cut allocations significantly in MarchÂ 2000 should note that one of the
reasons we have not gotten significantly long in the market since that time is
because our breadth indicators have never given a bullish signal.
I believe investors in global equities are well advised to wait for
leadership and two
of the following breadth indicators to signal a potentially significant
rally in stocks before allocating heavily toward the long side of global
Â Â Â Â
1) A day when up volume outnumbers down volume by at least 9 to
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2)Â Five-day up-volume is 77% or higher of the total volume for the last
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3)Â Either the 10-day A/D is 2 or greater, or the 11-day A/D is 1.9 or
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4)Â The S&P rises by 2.75%, and 70% or more issues advance
Â Â Â Â
5)Â O’Neil’s follow through days develop on several indexes at a time on a
given day and volume is clearly at a relatively high level in all those indexes;
Â Â Â Â
6)Â Either the 15-day EMA of (advances – declines) reaches +300 or higher,
or the 8-day EMA of (advances – declines) reaches +400 or higher, or the 6-day
EMA of (advances – declines) reaches +500 or higher
Leadership:Â Â Watch
the group and sub-group graphs of the TradingMarkets.com Top RS/EPS New Highs
Lists daily like a hawk!Â When New
Highs begin to expand above 20 each day, with a day or two above 50 at least each
week, you’ll know at least a catchable rally is likely to be under way.Â When a handful of stocks in leading groups begin to breakout of 4+ week
flags and cup-and-handles every day, some of which meet fuel criteria, then
trades can begin to be taken.Â Until
leadership and a plurality of leading stocks begin breaking out sound 4+ week
bases develops, give the bear market the benefit of the doubt and do not
increase allocation to the long side significantly.
we suggest extra caution, and a more gradualist approach to increasing equity
allocations than under normal circumstances. It is quite possible that the
markets will become very volatile and lead to false signals in each direction
over the coming months.Â A US
attack may appear to be successful for many weeks, but a retaliation by
terrorists could lead the market to sink to new lows.Â Uncertainty is higher, so risk is higher, and that means allocation to
stocks should stay lower until those risks recede.
investors should be watching for leading commodities to start to bottom, base,
and break out to the upside of bases.Â Watch
copper, cotton, and lumber in particular — and bonds for a top, before getting
too excited about the potential for a recovery of any lasting kind.Â Also watch for an end to the slide in consumer confidence, a turnup in
the LEI and NAPM, and some indication that the collapse in earnings is turning
there will be opportunities in the market on both the long and the short side
again.Â But in a real bear market,
investors need to remember that bear markets are MUCH trickier than bull markets
to make money in consistently.Â Shorts
that build profits for months can have those profits wiped out in a day or two
of explosive short-covering rallies.yes”>Â Pick and choose very defensively and with less than normal
allocation, until the environment improves in ways we have outlined above, to
preserve capital and be able to pounce on true highly reliable opportunities
when they return.Â