The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

16 August 2007

Market Thoughts, part 2

The market's current environment has become obviously ugly for the bulls -- but any market move that has become obvious to all has me looking for clues that the obvious move will soon reverse -- and for more than an hour or two, or even a day or two.

First, the charts have built especially ominous patterns of late, of which the breakdowns this week -- especially yesterday and (so far) today -- represent serious breaches. The auguries portend more problems ahead, although not necessarily all in one fell swoop (or plummet). Just as easily as a price correction could be a time correction, in which chart action moves left to right with lessening up and down movement, and whence the charts heal themselves; i.e, build bases rather than intermediate term tops, as is prevalent now. Too, many of the items that caused me grave concern sufficient to warn ~2 months back of an imminent market decline, now reverse positively; for example...
• Interest rates in the credit markets (to a sudden crash in yields from higher rates, which changes fundamentally albeit not immediately the dynamics for equities to increasingly positive from negative);
In addition, the strengthening today of the US$, which really is more a result of a plummet in other global currencies than outright purchases of the US$. (US$ today at a 2 month high vs the Euro, for one example -- and which, I admit, does not say much!);
• And a flight to quality, as a global search for liquidity causes selling in emerging markets and other global markets, and the newly obtained liquid assets seek a safe, non-turbulent home -- the US$ and markets, primarily US Treasury securities;
• Finally, the (too-often mentioned elsewhere) VIX index screams to multi-year highs, although a far cry (of pain?) from its all time highs set during the Crash of 1987. So while the markets' fundamental backdrop improves as a result of dynamic processes that continue, its valuation also improves, as declining prices shrivel those measures.

But let's not place too fine a spin on it. This price decline hurts us all. Is there some signal or signals traders seek that would indicate a price reversal is in the offing? Yes. First, it will be traders rather than investors who make the first stab in the dark, as their shortened time frames tend not to be direction-specific (non-directional), so what tell tales do they seek?
1) A sequence of negative (lower) closes (extreme weakness), followed by
2) A huge gap down opening (obscene weakness), which leads to
3) Short term traders (day traders, and other traders whose time frame do not endure for more than 2 or 3 days) buying that moment of extreme, obscene weakness. (This moment is very precise and specific.)

(As a paranthetical aside, the recent pattern of higher opens followed by lower closes is as bearish as they come; do not allow the markets' breathlessly up openings to gull you -- such openings are not the way markets bottom, or at minimum hit their low point.)

Traders purchasing at the moment of extreme, obscene weakeness in turn cause short sellers to cover their positions, powering prices even higher, as buying power doubles up. Then longer term traders (holding periods of days and weeks) seek their clues...
4) Do individual price bars (bar charts) cluster into 3 or more up days and 3 or fewer down days? This action would, could, and does include some horrific and terrifying down days, which lack downside follow-through. This tell is crucial, as it prepares speculators (traders, but with a longer term time frame) to step up boldly with their buy orders.

Thence come the chart readers, who rely on pattern recognition to discern their purchase opportunities. As those patterns begin to build, each investor purchases as his or her signal flares. Jack Cory shared his perceptions in part 1 of this post, which are anticipatory; other investors prefer to react to a chart's signals rather than create the signals. Each perspective is equally valid.

This recent bout of selling will exhaust itself, like a fire that burns itself out for lack of combustible material. First, note well
A) This decline occurs with comparatively and relatively little volume, which means this decline is as much a buyers' strike as the sellers overwhelming the buyers. With ever fewer numbers of buyers, the sellers crowd toward the market's exit doors; not all can get through, of course. Prices suffer declines, as the sellers scream in anguish, "Sell me out at any price!" The experienced and thus wise buyers stand aside, patiently biding their time. They know this decline too shall pass, as they always do. And that subsequent to this devastation will be screaming buys, literally and figuratively.

If you prefer to watch and wait, then watch also for inside bars -- daily price action whose high and low are inside the the bar's range of the day prior, etc; such activity indicates a cessation of selling. I admit that many investors are fooled by the 'false' signals of a chart, although I argue those false signals in fact are faulty identifications by the investor. Please be patient if your experience is not up to a professional's perceptions; this decline is a fantastic opportunity to learn and gain some valuable experience. btw, a decline of this ferocity does not simply "V" its way from high to low to (new) high.

But with so many sellers crowding into an ever shrinking window of (perceived) opportunity to sell, and with buyers stepping aside waiting with their clean out bids, prices drop due to the vacuum of a one-sided -- and, seemingly, one-way -- market. This action creates your opportunity to profit. I suspect this decline will exhaust itself within weeks, and struggle to right itself for a breakout from new bases (not new highs!) by ~15 October. But let's take each day one at a time.

A very smart person (Thank you, YKW!) noted only last night that I remind her of the real estate agents I take to the woodshed for their status as perma-bulls on real estate despite market realities. Am I guilty of the same item I chastise in others? On closer reflection, I realized (Hey, I might be slow, but I am deliberate!) that my argument is not that other people are stupid, but that they refuse to see change -- and change is what successful investing is all about.

And what drives your and my profits. So while I recognize that many stocks plummet for valid reasons, my Core Opportunities are unfairly punished. Is this runaway bullishness on my part? No, as I await change to create my opportunities to purchase and sell; I am not monolithically anything, as I await the market's clues. The Core Opportunities, as leaders, will be among the first to stop their declines and the first to rebound while the markets continue to drop or struggle. I also know that as horrid as recent days appear on the charts of my Core Opportunities, these price bars will shrivel in significance, especially when compared to the higher prices each Opportunity will achieve in the months and years to come. Of course, the future is unknowable, which is another reason I prefer only to invest in the crème de la crème; investing in fly-by-night stocks rather than excellent companies help usher in bouts of selling such as we now experience. This recent market action, bleak as it might be though, is nothing different than the typical price action of any August, only the names and reasons differ: same circus, different ring.

Change creates opportunity; for my (or your) Core Opportunities, as well as the opportunity to learn, to know -- and to profit. I hope this post helps you see the light at the end of the tunnel for what it is... And, no, it is not a speeding train!

Be well; invest well!
-- David M Gordon / The Deipnosophist


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