Last night we had a Key Reversal in the both the S&P 500 and the NASDAQ. If one is to believe in classical technical analysis and its followers that is a sign of exhaustion and means that we should go further down. But be aware! According to quantifiable analysis of similar patterns we have NEVER seen a major top forming this way. Statistical analysis shows that we are going to have new highs and that will be the way we will primarily bet until new evidence emerge.
Tag: stock market
In my previous stock market analysis I thought the market would make a down turn before reaching multi-year highs and then make a false break up before a big downward trend.
What happened was, as you can see in the chart below, that the S&P500 index only made a minor move down (A), before it broke up (B) and giving a false buy signal so that people would buy, then continue down (C) tricking people it was a false buy signal so that they would sell. After shaking of some weak hands of their positions the years strongest rally started (D), which was followed by the years biggest correction (E) which again landed below the previous multi-year high.
The S&P 500 was trading at 1357 at the previous analysis, while todays futures indicate and opening at 1361 (+0,29% change) in over two months time. So although a lot has happened in volatility, nothing much has shifted when it comes to valuation.
So what can be learned from this? Well, we still see that the market trying to make the most amount of people to become losers. We also see that contrarian sentiment has been reliable. It showed us the bottoms at (C) and (E), when people quickly panicked and started talking about a bigger correction down. It also showed us that the tops at (B) and (D) were not likely to give stronger long-term trend changes since people had become skeptic about the market trend.
That is obviously the reason why the market did not continue down but instead made new multi-year highs.
What can we expect next?
Most statistical signals are indicating that the market will be higher in the coming months. The risk-averse person should be out of the market while the speculative person should be buying on short-term oversold conditions and selling on overbought conditions.
What we should look for before expecting a longer change of the trend is that sentiment gets increasingly bullish while hitting new highs or that it gets stubbornly bullish while making the next correction down.
It is said be many, and I agree, that the stock market is rigged so that as many people as possible will be wrong as often as possible. This contrarian thinking is also backed by many studies which show that strategies that work are counter-intuitive.
So far it worked well for me trying to figure out the route of the market since I got active analyzing the market again last fall.
Let us take a look at my favorite scenario that I think will fool most people getting in the stock market at the worst time.
The facts are as follows:
- Since last fall we have had many difficulties all over the world
- The stock market has risen a lot
- Most people have been afraid of getting in the market
- Most ways of measuring the trend is pointing up, which is what many people like to see before entering the market
- The last movement up has been almost without any big draw-downs.
So most people now are noticing that the trend is up, they also read all the positive things happening in the economy (the bad things aren’t shown so much in media when the stock market is going up). So now people are looking at a time to enter the market. Every big draw-down now will likely attract a lot of money.
When the market finally enters a multi year high, just 2% up from where we are now, then they will throw their last dollars in desperation not trying to miss the rally. They do not even realize that they just missed a 25% move from the bottom. When that happens I think we reached a new multi-year high, maybe for many years to come.
This is just an ideal scenario that I would like to see. Of course there could be other similar scenarios or I could be totally wrong, but this would fit my expectation of the psychology and knowledge of the market.
Also note that I will short the market at a time when most of the traditional type of technical analysis would scream buy.
The Q-ratio is one of the methods to estimate the fair value of the stock market. It is defined as the total price of the stock market divided by the replacement cost of all its companies.
To put it more simply, the Q-ratio shows how much do we have to pay to buy the stock market compared to how much it would cost to build it up from scratch.
The Q-ratio is a fairly simple concept, but timely to calculate; fortunately, the US Federal Reserve provides the data on a quarterly basis.
To compare how much the companies cost with how much it would cost to rebuild them seems like a clever and objective way to measure the fair value the stock market. And looking back at “Q:s” history it has been of great value for investors using it.
The basic logic behind the Q-ratio is that if the “Q” is above 1.0, then the market is valuing the present stocks more than it costs to reproduce them; making them overvalued. If it is below 1.0, then it cost less to invest in stocks than it cost to reproduce them, thus making it more profitable to invest in the stock market than creating new companies.
On contrast to the P/E-ratio, the Q-ratio, is independent from the interest yield for comparison analysis. This makes the “Q” an easy and objective way to measure markets.
One of the drawbacks with the Q-ratio is that you have to trust the FED releasing the correct data, unless you wanna calculate the replacement cost of every stock by yourself.
Most people would intuitively think that the value of Q would be around 1 or a bit above in long-run. But its long-term value is close to 0,7. This is probably due to the fact that most firms assets are generally booked too high.
It is a shame that most amateurs in the market does not prefer to use the Q-ratio instead of P/E-ratios or dividend yields, both of which need to be compared to interest rates and other measures to be understood in their context.
Today the Q-ratio is a bit above 1 making the stock market overvalued by 40-50%.
I hope you enjoyed this article! Feel free to leave a comment.
Chart below shown for a historical view and is not recently updated
Chart from: http://mla.homeunix.com/q-ratio/
Having been a full-time poker player for a few years before I started my recent venture in finance, I have found many similarities between the two occupations.
When I read the book Poker Wizards, a book interviewing some of the best poker players of all time, I found it very interesting to see how the poker professionals reasoned and how it was related to the financial markets.
Let us look at what Daniel Negreanu, one of the most acclaimed and well-known poker players of all time, has to say about the traits of successful poker player:
- The one quality that I think is definitely the most important in being a successful player is having good people skills.
- The second most important quality is an aggressive personality.
- Third is discipline.
- The last quality is having a fundamental knowledge of the game, which is the easiest part.
I could not have agreed more about this list of qualities that makes a successful player. The interesting part though, is that the same thing goes for the players in the stock market or other financial markets. So let us look at these four qualities one by one when it comes to being a successful trader.
Most definitely one of the most important qualities! A good poker player knows that when the table is tight and people hold onto their money he should be more involved and putting his money in the pot more often. But if many players are involved most of the time, then he plays fewer hands.
The same thing goes for the stock market. When everyone talks about how good it is to invest in stocks and you hear stock tips just by visiting your local coffee shop, you better stay out. But when people loathe the thought of owning stocks, that is a good time to own stocks.
Another way of seeing why you need good people skill is to understand what drives the stock prices. In the long-run it is the earnings of a company that leads the way for stock prices, but in the long-run we might have gotten broke already.
In the short-run it is the hope and fear of people who decides where the stock prices moves. This is what we call market psychology or behavioral economics. Instead of fundamental analysis of the company itself, many successful traders try to measure and use people’s behaviour when analysing the outcome of a trade.
An Aggressive Personality
I prefer to call it an unafraid personality. If you assessed the risk of your strategy you must be willing to follow through your plan and not change it just because you are currently losing. When people panic they often take the wrong decision.
Even if you have the best trading plan in the world and make money 95% av the time, you might lose all those winnings in the last 5% of your trades if you trade inconsistently. You must also have discipline and routines to look over your trading on a regular basis to optimize results, but also take care of your well-being to not lose focus due to stress and other factors.
Another very important aspect that many people fail to follow is the discipline of game selection. Both poker players and traders alike love their game so much so they often join a game where they do not have an edge instead of waiting for the right opportunity. To sit out and not take a position is many times the right decision. Or to put it another way, to not get involved in losing games makes you a winner in the long-run.
Fundamental Knowledge of the Game
It is easy to get a fundamental knowledge of poker. Anyone can get it by reading a few good poker books. In the stock market this is much harder since there is not much scientific evidence about doing the right investment. Are value companies better than growth companies? Is it better to buy a stock with a low P/E? Many people have an opinion but if you ask them for some statistical evidence they think you are a donkey not taking their word for granted.
It is a big leak for a trader or investor who is using his common sense to take decisions instead of finding a scientific measurable edge. But just as in poker, those bad traders might win in the short-run and complain about being unlucky in the long-run. Do not become one of those people!
Differences between Trading and Poker
Finally I would like to point out two differences between trading and poker. In poker, many go with their gut-feeling when taking hard decisions. They might see something in their opponent, a tell, that looks suspicious, and take actions according to that. That is fine! People have had millions of years to evolve skills in reading other people’s subtle expressions. But traders usually do best in avoiding that gut-feeling that usually comes from fear or greed instead of the body language of their opponent.
The similarity, however, is that you should try switching of your emotional senses in both poker and trading to avoid taking emotionally driven decisions. So much money has been lost in both poker tables and in the stock market for those emotionally driven decision. But your own emotions are one of the toughest challenges to master no matter if you are a trader or poker player.
My last point regarding the dissimilarities between poker and trading is that trading and the financial markets is much tougher to master than poker. It is much harder to find an edge in trading than in poker. If you have two aces and get your money in before the flop, you are making a good investment. That is a fact. In trading you rarely find those facts.
I want to finish of with a quote:
“Poker is like sex. Everyone thinks they are the best, but most people don’t know what they are doing.” -Dutch Boyd
I hope you enjoyed this article. Feel free to comment!