Basic Probability Theory
Each day there is a (coin flip heads or tails), 50% chance the Dow Jones Industrial Average will close up, and 50% chance it will close down. Well, today the Dow has closed down for 6 days in a row, a very rare occurrence. To calculate the odds of such an event, just take 1 divided by 2 raised to the 6th power (1 / 2X2X2X2X2X2 chance) which is 1 chance in 64. To get another down day tomorrow to make seven down days in a row, the odds are 1 / 2^7 or (1 chance out of 128).
It would seem logical that if the Dow trades down early tomorrow, I should buy stocks with the anticipation we will get an up close. However, each coin flip is independent with no memory of the previous flips. It is just as likely we close down for a 7th day tomorrow, as break the string by closing up. I can only lament the fact the Dow has come up tails 6 times and the chance of heads (an up day) tomorrow is still just 1 out of 2 (50%). Probability theory would dictate that I cannot base my future buy and sell decisions on the immediate past. The story should end there, right? Wrong!
Research Shows That You Want To Buy After 3 to 7 Consecutive Down Days
Larry Connors back in January 2007, wrote a very interesting article that you can find on the internet here. According to research performed by TradingMarkets, if you see where a stock is trading a week following 3 to 7 consecutive up days, the stock is usually down. The more consecutive up days, the more negative the returns one week out. This reversion to the mean logic makes a lot of sense.
However, when it comes to buying a stock that has fallen for 6 consecutive days (like the Dow just did), one can expect for the stock to be trading 0.82% higher a week from now. If Friday is also a down day, making 7 down days in a row, then the one-week expected gain is 1.06%.
It will be fun to watch and see how the Dow performs tomorrow to see if we indeed get 7 down days in a row, or we finally get that up close. In any case, I will be long the December Dow Futures contract (YMZ4) to take advantage of a short-term relief rally that should occur next week.
The Crude Conundrum
One thing that did occur today was November Crude Oil (CLX4) finally traded below $80 early in the day, but reversed hard to the upside, hitting $85 before falling back to close in the mid $82s. If $80 was taken out, everyone was sure crude oil was doomed to drop to $75, $60, or $40. It was almost assured then that we would go the opposite way when the dreaded $80 support level was breached. Art Cashin on CNBC mentioned on Wednesday that weak crude prices were depressing stock traders, spelling weak demand, and economic doom around the world. Shale oil plays which is supporting our economic growth, needs crude oil to trade above $80 to remain economically viable.
The last couple days, traders were getting very short November Crude Oil when it traded just above $82, and making lots of money as Crude Oil fell back towards $80. As it came out of the hole today, I said to myself, I should put a buy stop just above $82.50 because if we should pop on up, the shorts who shorted between $82 and $82.50, would have to cover. I didn't trade it, but as predicted, when crude oil hit $82.50, it almost immediately exploded another $2.50 to the $85 level, before falling back to the mid $82s. Now, there will be a lot of support in Crude Oil around $82 as the big boys don't want to let any bears out of their short contracts at a profit, by falling back under $82. From the $82 launching pad, it will be fun to see how far Crude Oil can rally, which could help support the stock market. Weak Crude Oil prices have been blamed for the weakness seen in stocks, looking at decreasing world demand. The demand is unchanged but in fact it is the supply that is burdensome and knocking down prices. But right now traders are looking at weak crude prices as bearish for stocks, when in fact weak crude prices is bullish for stocks. For now, since it is working, I will forget normal logic and look at higher Crude prices as bullish for stocks and lower prices as bearish.
As long as Crude Oil stays above $82, then I will be bullish stocks. But as soon as Crude Oil again breaks under $82, then it will be time to go short crude oil with $80 likely being taken out soon thereafter. That would also be the signal to abandon any long Dow Jones futures position as the correction is over and both Crude Oil and stocks are probably again heading lower.
The thoughts and opinions in this article, along with all stock talk posts made by Robert Edwards, are my own. I am merely giving my interpretation of market moves as I see them. I am sharing what I am doing in my own trading. Sometimes I am correct, while other times I am wrong. They are not trading recommendations, but just another opinion that one may consider as one does their own due diligence.