February 17, 2016

Trading opportunities exist even though HFT and Algorithm traders are exaggerating short term moves

If you join me in the market's roller coaster ride these days, remember that it's incumbent to capitalize on the market's changing face and idiosyncratic behavior.

I get that stocks' trend, volume and momentum are all indicating that we're in a bear market, but I know that bear-market bounces are often sizable (albeit swift). I also get that 1,812 is the S&P 500's support level -- and like most players, I see that there's a resistance level as well (probably at around 1,920 on the S&P 500).

I also get that global economic growth is wobbly and on a weak foundation, and I understand the growing domestic and geopolitical risks. I know that China's banking and "shadow-banking" systems have bad-debt problems that dwarf the U.S. subprime crisis. And I also know when a hedge fund manager (Kyle Bass) vocally proclaims that nearly 90% of his fund is short China-related securities, that trade isn't likely to pay off in short order.

But this is not your father's stock market, and it's not a time to be self-confident or dogmatic in view. We must lean on the changing conditions that exist today, molding those influences to our advantage (particularly in our short-term trading activity). 

My advice:

*     Don't trust distortive near-term influences on the markets, but do embrace them as opportunities in a market that has no memory from day to day.

*     Remember that many of the normal patterns that we've taken for granted over the years have been partially rendered irrelevant in today's unusual market.

My morning missive on Friday outlined my current views. It's importance to call a trend change, as well as to watch for the emergence of extremely negative sentiment and other factors. You also need to remember the disruptive influence of gamma traders, risk-parity strategies and high frequency traders, and keep their role in mind when interpreting market moves and the opportunities that Wall Street presents us with.

Adopt Second Level Thinking

"The bottom line is that first-level thinkers see what's on the surface, react to it simplistically and buy or sell on the basis of their reactions. They don't understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how pries change. And they fail to understand the implications of all this for the route to success." - Howard Marks, It's Not Easy

But sometimes, the obvious is less than obvious and the known's are already well known, particularly in the near term. As I recently wrote, so-called "second-level thinking" often trumps "first-level thinking."

Today's Environment Dictates Capitalizing on Market Moves

My baseline case remains that the S&P 500 will show a low-double-digit loss for 2016 as a whole, although there will be wide and violent swings in the interim.

If you agree with my notion that the intermediate-term market outlook is hostile and you have a suitable risk tolerance, you should capitalize on all 5%+ upward moves in the indices (and greater rallies in individual stocks). Indeed, I think being opportunistic is now mandatory for successful trading/investing.

We'll deal with market overvaluation in the future, when distortive factors cause stock prices to become stretched to the upside (as happened some three weeks ago when the S&P 500 traveled from 1,812 to nearly 1,940).

Using the Quants to Our Trading Advantage

"This year, the S&P 500 is off nearly 15% from its 2015 high and 10.5% lower year to date (in line with my forecast of a low double-digit decline for the full year). But the differences between 1987 and 2016 are profound, as the public was more involved in the markets 29 years ago than today.

Not present back then were today's gamma hedgers, risk-parity trading strategies or high-frequency traders who generally follow algorithms that search for price momentum rather than intrinsic value. Nor did we have today's sovereign wealth funds that seem to be selling in order to support their countries' social programs. 

A lot of today's price action also reflects the reduced market liquidity that's been partly dictated by regulators. (You can thank the Dodd-Frank law, the Volcker Rule and the demise of the specialist system and the uptick rule, plus regulators who let HFT strategies to run wild.)

These factors, coupled with machines and algos, tend to exaggerate short-term trends and to some degree jeopardize the value of charts and technical analysis. Today's players often lack the sense of intrinsic value that many of we fundamentalists have. They're agnostic to balance sheets, income statements and private market values. This creates disequilibrium and bouts of overvaluation and undervaluation."  -- Doug's Daily Diary, The S&P 500 Has Passed a Critical Test (Feb. 15, 2016)

Nearly 70% of all trading is now machine-controlled. The public doesn't understand the market any more, and volatility and the political environment have poisoned the well. The result is staggering volatility and unpredictable, random moves to both the upside and downside.

Regulators are impotent and complicit in this. They've stood by as algos, 3x-levered ETFs, spoofing, the HFTs' pay-for-order flow and the loss of the uptick rule (which blocked the algos from working) drove many investors out of the market.

Meanwhile, capital goes to what I've described as "money heaven." But as I've written before, all of this is pity ... but also a long opportunity.

The above factors have reduced the role of technical analysis and poisoned our ability to interpret charts, but that doesn't mean we should ignore opportunities just because the charts "look like crap."

First, remember that many short-term moves are artificial and produced by quant strategies that have no bearing on value or fundamentals. The quants are agnostic to balance sheets, income statements and private value, as they're more centered on allocating capital based on volatility of asset classes and price momentum.

Second, you should always embrace the artificiality of the market's short-term moves, because such moves will likely be few and far between these days.

The market's near-term moves are being parsed and often mis-analyzed by artificial influences (i.e., machines and algos). In my opinion, that's stopped many market participants from taking advantage of the market's opportunities, keeping many players on the sidelines in the belief that "price is truth."

The Many Outcomes of a Policy-Dependent Global Economy

But it's not only the quants that have messed up our markets.

More than at any time in history, the markets are almost totally dependent on government policies -- mostly monetary ones (as the U.S. government has become more or less fiscally impotent). This makes markets react to the slightest changes in interpretation of the government's fiscal or monetary policies.

This dependence on government policy -- coupled with the lack of self-sustaining trajectory or escape velocity for global economic growth -- means we face many more outcomes than usual (many of them adverse).

Consider, for example, that:

*     500 million people live in countries that currently have negative interest rates.

*     The world's central bankers have collectively purchased more than $12 trillion of bonds since the Great Recession began, with little to show for it.

*     A once-relatively unknown, self-professed socialist named Bernie Sanders and brash New York businessman named Donald Trump might actually their respective parties' presidential nominations.

*     Oil prices have dropped by nearly 80% from their 2014 peak.

Again, this is not your father's stock market!

The Jan. 20 "noon swoon" provided a recent good opportunity for traders. The S&P 500 quickly followed an intraday test of 1,812 that day by a move to about 1,935.

Another opportunity for traders has arisen since last Thursday. The S&P 500 has followed last Thursday's retest of 1,812 by a tradable move to almost 1,890.

Rather than get caught up in the "dogma" of a view, I prefer to unemotionally assess the pendulum of volatility and the discounts or premiums to the fundamental intrinsic value of individual stocks, sectors or the overall market. I use that as a guidepost to my short-term trading.

Thus, I moved from a net-short position to a net-long one during both late January's swoon and last week's scary market drop, because discounts to intrinsic value widened during both events.

Catching 5%+ bear-market rallies (and even-larger moves in individual securities) might not be for everyone. But in an investment world defined by low or substandard returns, opportunistic fundamental traders shouldn't bury their heads in the sand and sit on the sidelines as these opportunities arise. Rather, flexible traders will take advantage of these moves.

The Bottom Line

Our investment journey so far in 2016 had been volatile and unpredictable, and it's almost guaranteed to remain so. But trading opportunities that grow out of the current period are plentiful and recurring. The rollercoaster ride should continue, so it's incumbent to capitalize on the unique forces that have changed the market's landscape.

I have 21 stocks on my "Best Long Ideas" list vs. 13 on my "Best Short Ideas" one. This is the highest proportion of longs to shorts that I've had since I started these lists for Real Money Pro -- and the greatest absolute number of longs as well.

Personally, I'm starting the day somewhere between small- and medium-sized net long. Am I certain of view? No. If I were, I would have gotten fully invested at 1,812 on the S&P 500 (which I didn't).

This helps to explain the ebb and flow of my net portfolio exposure from market neutral to medium-sized and back again. But one thing I am certain of: I'll use the constantly changing relationship between intrinsic value and current market prices to determine my short-term trading strategy.

via www.realclearmarkets.com/articles/2016/02/17/this_is_not_your_fathers_market_and_its_not_time_to_be_confident_102010.html