The Big Picture

As a trader I have always been fascinated by market psychology. By its definition the process of ‘price discovery’ is intrinsically a large experiment in human emotion which is driven by greed and fear. Although the former is what brings people to the market in the first place, in 9 of 10 cases it is the latter that proves to be the basis of their financial demise. As Peter Lynch put it: “The real key to making money in stocks is not to get scared out of them.”

Of course things change profoundly when you find yourself in an ensuing bear market – but in a way things remain exactly the same. Only that the dynamics now switch into reverse, in that the ‘upside’ is the continuous slide down and that the ‘downside’ are the various episodes of corrective bull rallies. Nevertheless, many investors seem to have a psychological barrier towards ‘shorting’ stock and it is probably fair to say that an overwhelming majority have never shortened a single stock in their life. After all, it is a bit ‘unnatural’ for Joe/Jane Sixpack to grasp the concept of selling something now just to buy it back later, hopefully at a lower price. I have tried to explain this idea to some of my friends and most of the time they just give me a polite smile and hastily proceed to change the topic of conversation. As I enjoy getting invited back (especially since the food is free and the women are hot) I don’t press the issue. And finally, as I am an evil speculator I am aware of the fact that for every penny I wrest out of the market someone else out there has to lose it. It’s a zero sum game, no matter what anyone tells you.

The other aspect of investors losing money in a bear (and also bull) market is that they fall prey to their own cognitive biases. Let me suggest a few of my favorites – you can find the full list in Curtis Faith’s ‘Way Of The Turtle’ – a most excellent read:

• Loss Aversion – The tendency for people to have a strong preference for avoiding losses over acquiring gains.
• Sunk Cost Effect – The tendency to treat money that has already been committed or spent as more valuable than money that may be spent in the future.
• Recency Bias – The tendency to weigh recent data or experience more than earlier data or experience.
• Bandwagon Effect – The tendency to believe things because many other people believe them.
• Low of Small Numbers – The tendency to draw unjustified conclusions from too little information.

I guess you get the picture – people often (if not most of the time) make decisions which are driven by human emotion, not by rational analysis. The natural instincts of our deeply ingrained reptilian brain might be well equipped to staving off natural enemies and surviving a cold winter, but are completely orthogonal to the skills needed in making money in the market. Yes, we all like to believe that we are stone cold traders who can press the buy button when our instincts scream at us to start selling everything now! But evidence points quite to the contrary – most traders fail because they sooner or later fall prey to their own fears. Of course there is a good portion of people who have a trading system without a statistically reliable edge or have no trading system at all, but this is not today’s topic.

Reducing the ‘Noise’

The Internet and modern information technology as a whole has given small time investors/traders access to a wealth of data and tools that was reserved to a wealthy elite just a decade ago. I should know – I was there and remember paying top Dollar for a trading platform that does not even come close to what I am now able to enjoy for free today. On top of that I am able to access a vast amount of information and news at the push of a button, right from the convenience of my home. I can also watch financial networks covering the market pretty much 24×7 (not that I personally ever do, but it’s there). For the fundamental trader I can only guess that this is pure heaven, however for the technical trend trader (yours truly) all that data in some ways may be more of a curse than a blessing. You see, the human brain is not very good at absorbing vast amounts of information. We are good at averaging – some call that ‘fuzzy logic’, and most of us are very visual. Which is why man traders eventually embrace technical analysis. As the thinking goes – all that vast amount of fundamental data which we could not possibly hope to digest is simply reflected by one main denominator, the actual market price of the underlying equity or commodity as depicted by a price chart (remember, I was talking about ‘price discovery’ at the beginning). Add to that some time tested chart patterns like ‘triangles’, ‘head and shoulder formation’, ‘double tops/bottoms’, etc. and you’d think that trading should actually be fairly easy, right?

Well, as you probably have learned from the tribulations of life as a trader – the answer is no. We just can help ourselves it seems and sometimes – and I actually dare to say most of the times – the majority of us are unable to see the forest for the trees.

Unable to See the Forest for the Trees

There is is – the topic of today’s posting – thanks for bearing with me so far, it’ll be worth it, I promise. And in my opinion the timing for bringing this up could not be any better. What inspired me to take a step back and to write today’s intro were my own personal feelings when I learned about the FRE and FNM bailout half an hour after the market closed on Friday. I have to say admit for a little while I was very worried – but I quickly snapped out of it and actually became very excited, as we bears will get yet another chance to load up on short positions at bargain basement prices.

If you have been visiting this site for a little while it won’t be a big surprise to you that both Berk and I are extremely bearish on a medium to long term basis. And as stern proponents of technical analysis our own findings and that of people we deeply respect indicate that the market is heading towards a veritable financial tsunami. This should be readily apparent to anyone looking at a long term chart of one of the main averages. However, due to the reasons touched upon above, there is a lot of ‘noise’ and disinformation in the news as well as in the general financial blogosphere, which Berk and I sought to remedy. This was the general inspiration that lead to the birth of Evil Speculator – our motto after all can be summed up as: “Dedicated to identifying probabilities of price targets in the financial markets.”

I think so far we have been fairly successful in an extremely volatile and hostile financial environment. However, even we sometimes fall prey to our own fears or cognitive biases and fail to see the big picture. Or perhaps we take our own convictions for granted and thus fail to properly convey the larger picture many of you seek to get a grasp on.

I believe today is a unique opportunity to take a step back – to get up from your chair and walk all the way backwards until your back touches a wall. Once you’re there, look at the chart below:

The Trend is Clear.

This is a weekly chart of the last six months in the Dow. I think it is abundantly clear what I am trying to illustrate. We usually look at a lot more detailed charts as as traders we are concerned with what tomorrow brings. And admittedly the last few weeks were fairly volatile and full of whipsaw moves, right?

Or were they?

I actually beg to differ! If you look at the chart above it becomes clear that the Dow has continuously been dropping in the last month! Of course the market was whipping up/down pretty hard on a daily basis, but perhaps the key here is to do the opposite of what most people have been advising which was to focus on day trades and to take profits quickly. Perhaps, looking at the chart above and even with a rudimentary understanding of chart patterns even a 10 year old would come to the conclusion that the general trend is most distinctly to the downside. The question here is: are you mostly interested in making a few bucks trading the swings? Or is this an opportunity to position yourself for a continuation of the larger trend? This of course is something you have decide for yourself based on your personal risk tolerance, trading style, profit goals, etc.

Monday

So, will we probably get a bounce to the upside on Monday morning as the perma-bulls use the FNM/FRE bailout as an excuse to retest some of the prior support lines which are now have turned into resistance? Yes, most likely so, but it should be clear where we are heading on a weekly/monthly basis even without believing in Elliot Wave Theory or any other types of technical analysis. So, my advice for you bears would be to stick with your guns and to protect your long term short positions with hedges.

Here’s the short term forecast for Monday – this has been a long post, so I’ll make it very quick:

Retest of 1260 already in process in after market trading.

Not long after the bailout news hit the ticker the spiders were already resting at 126, so it is fair to say that we will re-test that previous support line again. Notable is also the fact that 1260 on the SPX (or ES futures) almost perfectly lines up with the 38.2% fib line. There is actually a good chance that ‘irrational exuberance’ might lead to a retest of the 50% or even 61.8% fib lines, so be prepared. Again, short of dumping your existing puts (or short positions) an alternative may be to properly hedge yourself. I already loaded up on some SPY calls but must report that they were not compensating as much as hoped. Therefore, based on the strength of the $RUT I would propose to load up on IWM calls instead.

This rally should not last more of a day or two, after which we should push down very hard, as we continue to trace out wave 3 of 3. If we keep pushing to the upside beyond 1275 on the SPX we might however have to question this scenario again, but as of now there is not reason to make any pre-mature assumptions.

Gold at psychological support line.

I’m skipping the remaining indexes as they are on a similar path, perhaps with the exception of the Nasdaq which remains to be leading the drop. As expected, Gold has not been able to drag itself much higher (not for a lack of trying) and the chart indicates that it will continue to retest its psychological resistance line at 800. I am usually not one to make market correlations easily because they only hold for limited amounts of time, but considering the bailout news it is a hgh probability that Gold will not be able to muster another try of the 850 consolidation target. It may be that even a short term market rally will be the ‘straw that broke the camel’s back’ and that we will find the precious metal way below the 800 mark on a double.

Something I have not pointed out previously is the reason for the 850 target should Gold find the strength to push up one more time. I believe that 825 should in that case a distinct possibility and if that is reached I expect the September 2nd gap to be filled as well. But again, the probabilities as of today seem to favor an immediate drop starting in late Sunday night trading.

Our interim target in either scenario remains 720. We have little doubt that Gold will reach that target and that a push up would only delay the inevitable.

Alright, if you made it all the way here you are truly an evil speculator, who however should get a life during weekends. With that said – grab yourself you favorite bottle of brew and enjoy some time with your family (or if that is not an option I would suggest you support your local nudie bar).

Cheers!