Technical Rally Could Indicate Computerized Panic Buying

There is a meaningful possibility growing that equities around the world could stage a sharp rally within the next week or so. I say this for several reasons.

First, volume is light, and appears heavily influenced by traders and, frankly, computers. A meaningful proportion of individual traders and computers alike are programmed to trade based on statistical patterns and relationships, and with these two forces apparently dominating the markets of late, the rules they follow may explain much of what we see in the overall marketplace.

Second, a commonly used trading pattern that flashes “bull market” is when short-term trading momentum dominates longer-term investment momentum. Traders use several methods to measure this occurrence. For example, traders will watch to see if the 20 week simple moving average can cross above the 40 week simple moving average. If so, past history suggests a likelihood of a new bullish market trend, and traders will react accordingly.

Point in fact, in the early part of July, the 20 week simple moving average on many US and non-US equities indexes crossed above the 40 week simple moving average. On cue, the next week equities markets around the globe staged massive rallies.

One explanation is that reported corporate earnings appeared stronger than expected, but to a purely statistics-driven trading model, earnings don’t matter. It’s hard to say how much of this month’s rally reflects earnest investments by those of us who care about earnings and earnings prospects and the like, and how much reflects a knee jerk reaction by a pack of computers and computer-like individual traders.

The low volume and curiously technical nature of this latest rally suggests participation by traders and computerized trading programs likely played at least some role.

So that said, it’s worth assuming that the market will continue to be influenced by these factors – at least until that assumption proves incorrect. Which brings me to the next point of this article, which is that a second widely used technical indicator is poised to signal a new bullish trend in equities. The 50 day exponential moving average on many US indexes is closing in rapidly on the 200 day exponential moving average.

This pattern is particularly evident with Vanguard’s Total Market Vipers (VTI), and the iShares Russell 2000 ETF (IWM). We see comparable developments abroad, as evidenced by the SPDR S&P World Ex-US ETF (GWL). In fact, certain ETFs, both domestic and international, have already seen their 50 day and 200 day exponential moving averages cross – for instance, iShares MSCI Emerging Markets ETF (EEM) and PowerShares QQQ Trust (QQQQ).

While EEM and QQQQ are often leading indicators, but are by no means indicative of the overall equities market, unlike VTI and GWL which reflect the broadest cross section of equities.

And so what if the 50 day exponential moving averages on issues like VTI and GWL cross their 200 day exponential moving averages (which may or may not happen - we're really oversold at this point)?

Well, based on what’s happened this month in the aftermath of the 20 week and 40 week simple moving averages cross-over, it is not at all beyond the realm of possibility that we could see a comparable rally if the 50 day and 200 day exponential moving averages cross over.

Computers and traders are programmed to do what worked the last time, until it stops working.

True enough, this time around, we don’t have favorable earnings news to fuel the rally (should it even materialize), but there is another far more potent fuel out there: fear of missing the train as it leaves the station. If a rally in equities continues to unfold (which, I wish to emphasize is a big “if”), we may be able to ascribe it to panic buying, more than investing type behavior.

Here's where it gets really interesting - do computers panic? If computers act like they are in a buying panic, does it really even matter?

Regardless, technical trading signals are the reality of the market at this moment, and the reality of the market being what it is, investors should pay heed. Not only to the gains that may come in short order if all the technical signals go green, but also to the eventual comeuppance that must follow when trends get far too ahead of fundamentals.

That said, one thing we can probably all agree on is that “inevitable comeuppances” can arrive years late.

Disclosures: The author holds long positions in VTI, QQQQ, and EEM.

Comments

[Wesley Mouch:]

Good article and insight. I think you have really hit on some good items here.

If Alex is right, and I think he is, we need to revise some economic textbooks on the efficiency of markets. I would suggest the following edit:

Change "Markets provide an efficient pricing mechanism" to "In the long term, markets may be efficient, but in the short term, it is far more important to have a double head and shoulders pattern with broken candlesticks under the full moon eating a muffin with an Italian Coffee, but watch your taylor series conversion."

Jul 29 08:29 AM

[Alex Trias:]

That's a great comment. Like almost everybody, I was tought to believe in the efficiency of the markets. And therein lies the problem. One market paradigm that is always true is that the market likes to disprove as many people as possible. So, once the efficient markets model universally accepted and followed, the markets will adapt in such a way as to render the model incorrect.

Another problem with the model is that it assumes that all players in the markets are investors who are concerned entirely with future earnings prospects. Unfortunately, market participants are simply not a homogenous group. Some participants care about earnings, others care about momentum, statistics, and so forth. This latter group can and sometimes does set prices. In fact, when the momentum players really get a hold on things, many of the purported "earnings-oriented" crowd start to join in and become momentum obsessed themselves. Efficiency by that time gets tossed by the wayside, because as an investment model, it's not making as much money for you as other models (like momentum) are. There are different types of participants in the market, but they all do share one characteristic: they like to make money, and the ones who are good at that will adopt any approach that makes money, and discard any approach that does not.

You make an interesting second point, which is that in the long term, perhaps efficiency does matter. My question then is, how would we know that?

Okay, one consequence of market efficiency is that nobody can beat the market's average performance over the long term. Why? Because any information they have is already priced in, so there's no way to get an edge. In fact, what we see is that most investors out there end up performing at or below the market's average. There are the Buffetts and Soroses of the world, but those are the exceptions that prove the rule. The law of averages catches up to most folks in the end, so it looks like efficiency is at work. At least that's the obvious answer. But look behind the curtain a little bit, and you'll find that there are many, many, many traders who quietly beat the market for years and years. I've drafted quite a few estate plans for guys like this who you've never heard of and probably never will. Why? They're smart enough to quit while they're ahead (or, in some cases, way way way ahead). And guess what. Most of them aren't crunching income statements and reading analyst reports, either. These guys tend to be crackerjack mathematicians, who know how to spot a trend, leverage up, and profit from it.

My conclusion: markets may or may not be efficient, but regardless, the efficient markets hypothesis isn't a tool that you can use to get rich or to stay rich. That being the case, and since running money is about making money, I'm going to say the question of market efficiency is ultimately irrelevant.



On Jul 29 08:29 AM Wesley Mouch wrote:

> Good article and insight. I think you have really hit on some good
> items here.
>
> If Alex is right, and I think he is, we need to revise some economic
> textbooks on the efficiency of markets. I would suggest the following
> edit:
>
> Change "Markets provide an efficient pricing mechanism" to "In the
> long term, markets may be efficient, but in the short term, it is
> far more important to have a double head and shoulders pattern with
> broken candlesticks under the full moon eating a muffin with an Italian
> Coffee, but watch your taylor series conversion."

Jul 29 09:11 AM

[Mad Hedge F...:]

Nothing to do here. OK, so they didn’t mention the mosquitoes, the poison oak, or the guy snoring in the next tent on the website. But I’d rather put up with all of that than the absolute dearth of trading opportunities I faced on my return. The S&P 500, the Dow, NASDAQ, the euro, the Australian, New Zealand, and Canadian dollars, gold, copper, lumber, and anything else I like are overbought, bumping up against Fibonacci’s, moving averages, RSI’s, oscillators, and any other technical warning light you want to mention. Only wheat looks cheap, the greatest growing conditions in history knocking a bushel down to the low five dollar handle (click here for the argument at www.madhedgefundtrader...). Natural gas prices are low, not to be confused with cheap, with every uptick getting smashed with a new field discovery. Only a hurricane can save NG. It’s amazing how many people have turned bullish now that everything has gone up for two plus weeks. The only thing that makes sense here is to go short, but not on my first day back. Give me some time to gird my loins and build a risk appetite. And pass the calamine lotion, please.

Jul 29 12:38 PM

[Alex Trias:]

So you've traded the risk of sun burn for the risk of market burn. Welcome back.

After reading your comment, I think the point of my article may be somewhat obscured by my writing style. I'm not suggesting everyone should be going 100% long equities. Generally, most of us can probably agree that arguing with the markets is about at smart as arguing with a hungry lion. The point of my article is that right now, what might APPEAR to be a hungry lion could very well be nothing more than a computer-enhanced mirage. If so, we could really start to see a massive disconnect between fundamentals and equity prices. And that's not good news for anyone, bull or bear. Why? Because if you cannot believe what you see in the markets, what that really creates is an uninvestable situation.

Your point about markets being oversold (I use NYMO to measure that condition for equities markets, and by golly, we're really oversold) is excellent. When short term bearish indicators are flashing at the same time as long term bullish indicators are flashing, you're looking at a pretty dismal risk/ reward situation for any position you take - long or short. Frankly, were it me, I'd go back to the mostquitoes and leave the buying and selling to the high frequency trading programs.


On Jul 29 12:38 PM Mad Hedge Fund Trader wrote:

> Nothing to do here. OK, so they didn’t mention the mosquitoes, the
> poison oak, or the guy snoring in the next tent on the website. But
> I’d rather put up with all of that than the absolute dearth of trading
> opportunities I faced on my return. The S&P 500, the Dow, NASDAQ,
> the euro, the Australian, New Zealand, and Canadian dollars, gold,
> copper, lumber, and anything else I like are overbought, bumping
> up against Fibonacci’s, moving averages, RSI’s, oscillators, and
> any other technical warning light you want to mention. Only wheat
> looks cheap, the greatest growing conditions in history knocking
> a bushel down to the low five dollar handle (click here for the argument
> at www.madhedgefundtrader...). Natural
> gas prices are low, not to be confused with cheap, with every uptick
> getting smashed with a new field discovery. Only a hurricane can
> save NG. It’s amazing how many people have turned bullish now that
> everything has gone up for two plus weeks. The only thing that makes
> sense here is to go short, but not on my first day back. Give me
> some time to gird my loins and build a risk appetite. And pass the
> calamine lotion, please.

Jul 29 04:30 PM

[JPSmith:]

I hope you're right, the sharp rally will be a good time to get out before the fall swoon.

Jul 29 05:31 PM

[Old Trader:]

I'll be the first to admit that I've only recently started employing T/A, coming from a fundamental background. The reason I've started studying and using some simple T/A, mostly to pick entry and exit points, is because so many other people do (or their computers do), and to not acknowledge the fact (and hopefully profit by it), strikes me as being short-sighted.

Bottom line, the fundie part of me is saying "run and hide", but I can appreciate the points the author's made, acknowledge the party might not yet be over, and am looking at various trades accordingly.

Jul 29 08:13 PM

[Moon Kil Woong:]

Actually, my guess is the program trade run up is over. Those generating the run up will try to hold down volatility as much as they can to close out their positions. That means trading as little actual volume as they can at the prices it wants (HFT) at the end of the day.

Don't be the sucker who buys out their position. After they clear who knows which way they will want to try to yank the price. If they want more volatitlity it probably won't be up (too hard to generate meaningful volume).

Jul 29 09:41 PM

[Alex Trias:]

Thanks for your comment, and you are making an important point. More or less right on cue, markets are staging a little bit of a rally today, which roughly corresponds to the fact that the 30 day exponential moving average for the SP500 has intersected the 200 day exponential moving averages. This timing is highly suspect, don't you think?

Your point is that what this seems like is the technical trading version of a "pump and dump". You are right. Your next question is a practical one: will we see more pumping, and when can we expect the dumping? You then opine that generating volume is tricky if you're trying to shove the market higher, so there is better volatility (and upside) pushing the market down.

Here's where I start to get a bit fuzzy on your argument. First, with low volume, I can swamp the market with orders and thereby generate PLENTY of volatility. I don't see how it matters to me whether it's up or down. If I want to generate a stampede, I LOVE low volume. And generating emotional stampedes is PRECISELY the game that is unfolding right now in the equities markets.

Point two: as a computer program designed to make money by manipulating markets higher, remember my primary trading bias. I hate shorting stocks. When I do, I get 100% upside, and unlimited downside. When I go long, however, I have unlimited upside, and no more than 100% downside. If you want to pig out on technical trades, you want a bull market. If I wanted to manipulate the market, I'd program my computer with a bullish bias.

It's in the collective best interests of those manipulating the market higher to let their winners ride, and to keep pressing the buy button. But what this amounts to is a huge prisoner's dilemma. It works as long as everyone cooperates, and nobody cheats by cashing out too much. Interesting thing is that prisoner's dilemma's can be remarkably stable for long periods of time. What will break this one will be an unforeseen random event. There is no way to predict when it will come, but it is guaranteed to come at some point nonetheless.

My practical advice for investors is probably not too far off from yours. I'm invested at the moment, but I have set targets and my finger is poised on the sell button, ready to hit it at any moment regardless of my targets.







On Jul 29 09:41 PM Moon Kil Woong wrote:

> Actually, my guess is the program trade run up is over. Those generating
> the run up will try to hold down volatility as much as they can to
> close out their positions. That means trading as little actual volume
> as they can at the prices it wants (seekingalpha.com/symbo...)
> at the end of the day.
>
> Don't be the sucker who buys out their position. After they clear
> who knows which way they will want to try to yank the price. If they
> want more volatitlity it probably won't be up (too hard to generate
> meaningful volume).

Jul 30 10:54 AM

[Alex Trias:]

Thanks for your comment. Technical analysis is a descriptive tool, and by no means a predictive tool. You can look at technical data and conclude only this much: "this is a bull (or bear market) until it stops being one." On it's own, that is not very useful information, is it?
We can probably agree that if fundamentals drive the market, technical data simply describes the market. For instance, if the Fed model suggests the ten-year earnings yield on the S&P 500 is twice the yield on a ten year US Treasury, that relative undervaluation of risk can and will drive the market higher at some point - nobody can say when. You cannot predict when that point will be, but technical analysis can indicate a probability of when the point has, in fact, already arrived. Put cheap valuation and technical strength together, you can take your finger off the sell button and relax for a little while.

My main use for technical analysis is really more as an exit strategy. Markets overshoot and undershoot fundamentals constantly, due to momentum and human emotion. How can you know when that has happened? You look for a huge disconnect between technical trends and valuation. For example, if you see a high ten-year average P/E ratio on the S&P500, and a robust technical upwards trend, you're probably at one of those points where a massive selloff is likely because markets have overshot fundamentals due to momentum and emotion. So too with the converse.

I am concerned we are at such a point now. The P/E ratio and book value of most index ETFs appear reasonable (if you smooth earnings out for the last ten years, and extrapolate average growth rates of about 7% - pretty much what we've seen over the past century). Unfortunately, thanks to the credit crunch last year, current earnings are still all wacky. Also, I'm still unclear on how the impact of deleveraging will hit earnings going forward. I cannot form any clear judgment of whether stocks are priced to perfection right now (which is what my gut tells me), whether they are cheap (if the credit bubble starts to inflate again, stocks look really cheap), or whether stocks are wildly expensive (if we are in a new era of Spartan consumption, low leverage, and pandemic global depression, stocks are insanely priced). Time will tell, but given those risks, if you see a massive technical downturn forming, it sure would be a good idea to cut and run. And if a massive technical upsurge unfolds, you need to really consider whether momentum has, as it always does, brought us far, far ahead of fundamentals.

This is a long winded way, I suppose, of explaining what keeps me up at night, and keeps my finger poised on the sell button during the day.




On Jul 29 08:13 PM Old Trader wrote:

> I'll be the first to admit that I've only recently started employing
> T/A, coming from a fundamental background. The reason I've started
> studying and using some simple T/A, mostly to pick entry and exit
> points, is because so many other people do (or their computers do),
> and to not acknowledge the fact (and hopefully profit by it), strikes
> me as being short-sighted.
>
> Bottom line, the fundie part of me is saying "run and hide", but
> I can appreciate the points the author's made, acknowledge the party
> might not yet be over, and am looking at various trades accordingly.

Jul 30 11:21 AM