Confusion in the Market: How to Understand

Jun 10, 2007: 10:27 AM CST

Have you been a bit befuddled by the recent stock market action? I admit that I have, but I expect such events and have experienced various strange scenarios in my trading career.

If you are new at trading, the current market environment must be difficult to comprehend and I wanted to state a few of my thoughts on this topic.

First of all, we expect the market to be an “anticipatory vehicle” wherein stock prices reflect all that can be known about a company and the general economic/business environment. This is in line with the famous “Efficient Market Hypothesis” academics teach us.

It is also stated that the market tends to anticipate (lead) economic conditions by about six months, such that economic reports of today are parsed with implications regarding trends in the future. An example would be “If the Fed raises rates today, then businesses will have a more difficult time financing projects and their profits will decrease, leading to decreased valuations in earnings projections.” The opposite is true, of course.

While this partially explains why the market can act contrary to the current news, it’s not complete.

Case in point, the surface explanation of the recent action was confusing. The Federal Reserve announced the economy would be stronger in the near future, and the general situation is better than first expected. As a result, the market fell around 3% in the days following the announcement. Why would the market not surge on this news?

Until this point, there were so many catalysts that would suggest that the market and economy was headed for recession (high gas prices, slowing earnings, low GDP growth, international tensions, rapidly decreasing housing market, etc). Why did the market keep rallying on this news? It was confusing on the surface level.

While this is the case on the macro-level, the situation plays out in individual stocks, further causing distress and confusion to entry traders and new investors.

While news will generally “explain away” the confusion by explaining that good economic conditions increase the chance that the Fed will raise rates, bond yields rise, and that is generally bad news for a market in late expansion. This is the reason attributed to the market’s quick fall, despite good news. There are a variety of reasons, many of which you can find from other websites and news sources.

What the market pricing mechanism comes down to is the mechanics of supply and demand. Major firms and major traders (funds) often need to unload a major supply of shares onto the market and they cannot do so when conditions are poor and every trader is united in thinking and selling positions. The price would move so far so fast against them that they could be put out of business.

Instead, large firms need good news to unload their positions to the ‘masses’ of traders and need bad news to purchase large amounts of ‘inventory’ at lower prices. Such large firms (in aggregate) may comprise 10% or less of the number of aggregate traders in a market, but their actions consume the vast majority of stocks/shares and thus the volume. They must be in ‘contrary’ mode by default to unload or acquire large positions.

Professional ‘smaller’ traders try to mimic the movement of these funds and this adds to the ‘contrary’ movement in price. Such ‘smoke and mirrors’ is absolutely necessary for profit, as trading (not investing) tends to be a ‘zero-sum’ game where there are winners and losers as part of the transaction. This is absolutely true for futures and options traders, but mostly true for stock traders.

It would be great if the market moved up slowly and nicely following good news, and down calmly and slowly on bad news. Everyone would rush in to buy good news and the price would rise and we all would benefit. The market would be easy and we all would be rich, having quit day-jobs and we’d probably be trading in the Bahamas or by the beach all getting rich together. There really wouldn’t be a need for blogs or websites, as we would trade for a few hours, then go enjoy our lives.

We all know – who have traded any length of time – that it doesn’t work this way. We enter a position, it frequently goes against us, sometimes we buy the absolute high-tick of the day or week, and then when we exit the trade in frustration, the market reverses and we sometimes sell the day’s or week’s low tick. We buy at the touch of a moving average only to have ‘support’ break, but price reverse as out stop is hit.

Professionals and probability keep confusing us and we keep participating (until we give up in frustration). Either way, success comes from learning to think in probabilities, realizing that (often) half our trades will end in a (small) loss, and thinking counter to what the media and popular opinion is on a stock.

Sadly, engaging in the market and ‘making mistakes’ is absolutely necessary for success. Instead of getting frustrated when you get confused, take the experience in stride and vow to learn from the situation and realize you are one step closer to reaching your goals as a trader!

6 Comments

6 Responses to “Confusion in the Market: How to Understand”

  1. Joe Says:

    Corey,

    What is the best look back period to determine sector strength? – I know you proposed using 3 months when you described the methad with prohet.net. Have you ever conducted an optimization in this area? Is 3 months better or three weeks?
    I’ll probably be able to conduct an optimization tonight (and will post the results here), but would be very interested in your experience.

    Sorry for hijacking this thread…

    Thanks, Joerg

  2. Corey Says:

    Joe,

    I have not conducted extensive optimization on the parameters for the input, but typically will use 3 months for short-term analysis of recent trends and 6-months for intermediate or larger flow. The larger th time frame, the later the signals but the more significant the ‘flow’.

    Weekly chart analysts and position traders may do well with the one-year chart. I’m looking forward to your insights and results.
    Thanks Joerg!

  3. Stephen Says:

    Thats why you just keep trading as usual. Trade what you see, and the probabilities of your setups should remain static.

  4. Brian Says:

    Corey,

    Very good post! As you know, I trade with systems, so I just let the computer tell me what to do. This helps quiet the noise, and let’s me tune out all the stuff that I can make up in my head about what I think the market is going to do.

    Brian

  5. Corey Says:

    Thanks Brian!

    There are so many advantages to purely technical or purely mechanical trading systems. You have objective targets, entries, exits, and the mental confusion of the “why” is virtually absent. Trying to predict the market is difficult if not impossible. It really comes down to following a system – discretionary or mechanical (or combo) – with a positive edge.

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