Wednesday, July 23, 2008

Breadth & Helicopters: The Sequel

Yesterday’s post on Breadth and Helicopters received a slew of comments. There were many well thought out and interesting points. I don’t care to get into a lengthy debate and couldn’t possibly address all the issues that were raised, but I thought I would offer a few comments for further clarification on my thinking. I’ll also touch on a few of the issues discussed in the comments section. Anyone who hasn’t read yesterday’s post or some of the comments people made following may want to check that out before continuing.

So the June/July selloff took out two breadth indicators with “perfect” records. In my post I indicated that this didn’t sway me from treating them the same as I had previously.

I should mention that I am neither surprised nor concerned that they both “failed” at the same time. For the most part they both measure the same thing – breadth. One looks at broad market advance/decline breadth while the other looks at how broad extreme selling is in a select list of securities. Still, they’re both looking at breadth. There is no question that it became extremely negative in June. And rather than being accompanied by the sharp bounce that has been customary for the last 25 years, the market continued to slide.

One notable about both of the indicators discussed in yesterday’s post is that their history was somewhat limited. The McClellan data I used only went back to 1986 and the CBI data back to 1995. Under most circumstances, if I get enough instances that the results appear notable, I’m more than comfortable only going back this far.

Daniel mentioned an interesting event – the Crash of ’87. What traders should understand is that prior to that the market did behave differently in many ways. I discussed this in both the 7/7 and 7/13 Weekly Research Letters. From the July 7th Letter:

“I go back to the Crash of ’87 for a few reasons. First, it was the last time that strong negative breadth readings, such as the % below 40ma and the 10-day Advance/Decline EMA led to further selling, and in a big way. Second, it led to changes in the way the market is governed and monitored. Some changes, such as the implementation of trading curbs, are well documented. Others, such as the President’s Working Group, are clouded in mystery. Whatever the reason, breadth extremes as we’ve seen recently have consistently marked buying opportunities over the last 20+ years.”

To see an example of how poor breadth readings formerly failed to spark rallies, you may revisit my June 25th post. There I looked at a 10-period EMA of the advance/decline ratio. Readings such as we were hitting in late June have normally provided traders an edge over the last 20 years. Prior to that, expectations were negative to flat.

An aspect to the recent decline that provided a clue as to how bad things were getting was the persistence of the downtrend. Whereas in the past 20 years oversold was met with buying and violent short-covering rallies, it just wasn’t happening in June and early July. I first discussed this in my July 3rd post, which indicated we were experiencing a selloff unlike anything seen for a very long time. On July 7th I followed it up with another post on persistence.

So why didn’t we bounce sooner? Is it likely to happen again? Are we in a 70’s environment or was the selloff just an anomaly? Will breadth indicators remain useful?

My inclination is that we are not going to revert to a 70’s – type market where selling just begets more selling. For the market to change the way it has behaved for the last 20+ years would take a substantial change in dynamics. Has such a change occurred? Difficult to know, but I don’t think so. No uptick rule? Double-short ETF’s? The ability of retail traders to easily trade baskets of commodities via ETF’s? These are all relatively recent developments and they have changed market dynamics in some way. Enough to cause fairly reliable overbought/oversold breadth indicators to become obsolete? I don’t believe so and like I said yesterday, I’m currently just looking at it as a losing episode.

So why did it happen? I don’t know. One observation I would make is that since the Crash of ’87, the government seems to have taken a greater interest in the equity markets. For instance over the past few years there have been several times when the market appears on the precipice of something awful and the Fed arrives with an announcement that seems to spark a rally. This occurred in March. It occurred in January. It occurred last August. It occurred March of 2007. It occurred in June 2006. Those are a few I can recall off the top of my head. Each time the market turned seemingly because of a rate cut, or a bail out, or an expansion of the use of the discount window, or something.

During the recent selloff the Fed has been caught between a rock and a hard place. Whereas under other circumstances they MAY have stepped in sooner with some announcement that could help spark at least a short-covering rally, this time the anouncement didn’t come. The double-edged sword of inflation and recession was threatening and there wasn’t much they were willing to do. Also, the nature of the selloff was not crash-like. There was little panic. The mood was dour as seen by investment and consumer sentiment surveys, but not outright panic as could be evidenced by the VIX. While not immediately hailed, a temporary enforcement of short selling rules in certain financial stocks MAY have helped the recent bounce.

Perhaps stagflation will become a real problem. Perhaps the Fed will continually find itself handcuffed or the government will decide it will no longer considers the equity markets an important consideration in constructing policy. Perhaps the introduction of double-short ETF’s, commodity and currency ETF’s, no uptick rule and other things are changing the dynamics of the market in such a way that certain indicators, such as some of the breadth measures I use, will no longer be effective. I don’t believe that to be true, though and at this point I’m betting against all of that. I will continue to run studies and construct systems in the same manner I did before the latest meltdown.

Now if it keeps happening,..well…then I’ve got some things to ponder.


One last note here. There were also some observations about system development in the comments of the last post. I think it would be worthwhile to talk about some of my thoughts there some day, and I’ll try and do that. Just not today. This post is already too long. In fact I doubt anyone is still reading…


sysin3 said...

uh, I don't know for sure, but my feeling is that you are not looking back far enough.

The best analog, in my view, is 1929 - 1933

Similar credit bubble / implosion.

Possibly similar outcome.

Telecharts DJ-30 goes back that far.

Anonymous said...

I think you are right rob. The lack of panic and government action allowed the market to continue to slide. One thing I have really seen while trading is this notion of buying weakness selling strength seems to be very prevalent. gap down and its bought up and sold. really good rallies fall hard sell offs bounce sharply. i think it is the influence of proffesional traders and hedge funds

Damian said...

What Rob, you were saying something? I dosed off for a minute.

I kid!

I've got a system right now that is sucking wind - but I continue to trade it because I know that period of sucking wind are common. One thing I look at in system development is MAE and MFE - those give me the best guidelines to know when my system may have "come off the rails". Anyway, that's my approach.

I wrote a piece about the need to trust your system a while back that might interest some readers:

Anonymous said...

Wow Rob, Thanks for updating the CBI! A "0"?! Do we get a -1? Just joking... this bounce still feel like a bear market bounce... fast a ferious... don't look like a start of bull market... anyhow, thanks for great information at this blog!

Anonymous said...

Well if they keep on "killing" the shorts and stop people shorting, it will be like put a gun to their own head... because once they "clean" out all the shorts, there will be NO MORE "short cover"... so when next time the financial sector falls, it's going to be increadible... because there will be no buyer AT ALL... with short, at least there will be buyer down there, without shorts and when there is only seller, look out below...

Jeff said...

One thing that I have not heard discussed is that when people talk about systems failing, or losing effectiveness, most often they attribute the failure to the fact that too many people are trading the system.

Interestingly, that line of reasoning has not really been a large part of this discussion.

Instead, failing systems have been discussed in terms of a fundamental change in the market's structure.

I'm wondering if a fundamental change in the market structure is caused by everyone trading the same way, or the opposite, or a combination of both.

Anonymous said...

>> “..too long. In fact I doubt anyone is still reading… “

Don’t be silly Rob, you know your readers always read to the end.

Looks like our thoughts and comments provoked some thought-provoking observations out of you, which is good.

Addressing your musings regarding the “sea change” in reliability of breadth based reversal systems, in the past 25 years or so as opposed to the 1970s... since the phenomenon is objectively THERE, it must somehow be accounted for.

My own guess is that it might well be the “weak hands” vs. “strong hands” theory of equity holding strategies.

Back in the 1970s, it seems to me, more people were investors, and fewer were traders. Folks socked away money into equities, and expected dividends (anyone remember “dividends”?), which grew over time, to compensate their risk taking.

I remember John Bogle, founder of Vanguard, constantly railing against the “debasement” of the Mutual Fund concept, the way traders were turning a convenient savings vehicle into a “gambling” vehicle. He really deplored the advent of ETFs.

“Hot money” approaches cause quicker responses. Buy and hold approaches cause more reluctant responses. Hence “weaker hands” will give up a holding easily-- in fact, there are modern traders who do not even know what a company does when they buy it. The equity is simply a moving datapoint to them. “Strong hands” will hang onto a company’s shares, believing in the merits of the corporate operations.

The phenomenon in the 70s and early 80s of extremes of breadth weakness leading to more market weakness might then have been caused by a slow “unpeeling” of shares away from strong hands, a gradual process of disillusionment and giving up, which would produce a “water torture” type pattern of capitulation-- rather than the climactic patterns of rapid dumping and then re-buying one sees with “weak hands” doing most of the holding.

Also, commissions to buy and sell, back then, were a MUCH greater drag on profitability, and hence a greater deterrent to taking any action at all...

That said, since early 2006 I have been dusting off a couple of timing models created back in the 1970s, ones that “cut their teeth” in that secular bear and stagflation environment-- and they do SEEM so far to be “tracking” the realities of the last couple of years better than more modern ones.

So maybe we are in fact going to have a lengthy period of violent, hectic, heroic... and ultimately meaningless, sideways action in the months and even years ahead. Such speculations are largely fruitless-- except as a background ‘coloration’ to ones thoughts.

Damian said...

Wood - I agree it could be a change in the market - which someone else on the last thread mentioned. Also, a lot of systems fail "at the turn" - meaning that they work well during periods before and after a big swing in the market, but during that swing "get confused". I believe that's why, at the last major selloff, Goldman starting doing the opposite of what their systems told them!

Anonymous said...

I think it's mostly investor psychology that's behind the market behavior changes. People have been trained to buy at certain levels and that has yet to be beaten out of them. In the 70's it took a couple up and down cycles before the 73-74 drop could happen, and today we are only early in the second round of beatings.

Short selling has been restricted nearly every time there has been a major decline and banned outright in some so I don't think the rule changes mean much. If anything they make things worse for the longs.

Pete Birchler said...

First off, I love your blog and don't think that a failed trade is reason to abandon a system. I'm sure you are studious, but if you haven't studied a lot about demographics and market you may want to look at some of Harry Dent's work or other good sources as possible reasons for large fundamental shifts in markets.

Also, PLEASE realize that the FED is NOT a government agency in any way. It is a private bank. The history of our country has been a history of the fight for control of our money. In the best interest of you, your readers, and our democracy, please don't refer to the FED as the government. That further clouds the belief and recognition that we have the power to change our society.

Anonymous said...

Rob - I was thinking exactly the same thing: Government Interference. I went back to an indicator I developed using the ISEE sentiment index and everytime it showed excessive bad sentiment, the government stepped in and gave us a reversal. It's simply too coincidental.

Unknown said...


I'll use any indicator that ONLY works 90% of the time!

Keep up the good work, we really appreciate it.