According to the efficient market hypothesis, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.
This year has been a frustrating one for both the bulls and bears. Regardless of the lack of returns thus far in 2014, what has made it so frustrating is the lack of historical correlations and follow through. In general, market participants have always used history and patterns as a helpful guide to the markets. Although you can say that predicting the future of markets is inherently impossible, trend following and technical analysis has at its core historical precedence (i.e. the belief that the risk/reward of a chart in a bullish trend will continue to go higher based on similar chart patterns in the past, etc).
Recently (perhaps starting in 2013) traders have been scratching their heads because much of what we know about market trends, correlations, and history have gone out the window. At the start of the year, with QE tapering on the table, many people expected yields to rise; instead they have dropped. By May 15th, the small-cap Russell 2000 had fell more than 10% below its March 4 high, while the Nasdaq had suffered a 9.5% correction by April 15th. Finacials have acted poorly, biotech’s have been slaughtered, and many momentum stocks suffered large pull-backs. All the while the S&P 500 and the Dow barely flinched.
Traders have been conditioned over time to expect a spike in the VIX each time it hits a relative extreme low, especially in relation to the S&P 500 (see chart below). Adding insult to injury toward the bears, the up days have typically gone higher on light volume, while the down days on higher volume. Furthermore, there are countless divergences that began in 2013 and have continued with authority for over a year. One such commonly stated example demonstrates the decreasing number of NYSE issues making new highs just as the S&P prints new all time highs. Similar to that is the chart below where the S&P makes new 20-day highs with fewer stock participation each time. The question then becomes is this time different and I would argue that yes, it is.
This extreme ratio between the S&P 500 and the VIX has historically resulted in a VIX spike and a market pullback. 
Less and less stocks participating at each new 20-day high. 
I imagine there is a long list of reasons that the market is not following the general rules and principles that investors and traders have come to know over the history of the stock market; however, I will put forth three main explanations that I believe are responsible for the greatest impact on this current market anomaly.
1) Available information- AKA information overload – Over the last several years traders and trading has blown up over social media. Twitter, StockTwits, Estimize, blogs ad naseum are available 24/7 to anyone that has access to the internet and can read. Many of us bloggers (yes, myself included) repost the same things over and over written in a different way. Although most of these pieces are sound and based on true and past successful performance, they are no longer scarce information privy to only institutional money, insiders, or those that have put in countless hours of market study. To illustrate this point, just a couple weeks ago, Josh Brown, a regular contributor to CNBC and very respected blogger stated on CNBC that 35 of the last 36 episodes in the past 14 years where the Russell 2000 corrected 10% or more, the S&P also followed with a 10%+ correction. Within hours most traders were now in the know about this statistic as it had been on television media, posted on twitter and StockTwits, retweeted countless times and were beginning to show up in countless blog posts and investor media articles. Thus, another convincing seed had been planted to expect a 10% correction in the S&P 500 after already a plethora of reasons had been spewed since the start of 2013. Now I ask you, when was the last time we all knew something would take place in the market and it actually did?
As mentioned, in years past, that kind of information might have only been known to larger hedge funds, quant scientists, those with resources and statistical data not available to the average retail trader. However, not only do we all have free access to that sort of detailed information, but if we interact at all with social media we are force fed the information over and over again whether we seek it out or not. Therefore, I would argue, knowing this type of information is no longer providing an edge and in fact, may be acting as a detriment to ones trading. Information overflow that technology and social media have permitted may in fact be rewriting the trading rules that have been established over centuries of trading.
Circling back to the opening quote of this piece, if you believe the above proposition to be true, then is it validation to the theory of market efficiency? Do current prices reflect all information making attempts to outperform the market essentially a game of chance rather than one of skill? Taking on another viewpoint, perhaps the hypothesis of market efficiency moves in stages. Certain people (in prior years it was those with unlimited funds and resources) will find an edge to trading, but once that edge becomes mainstream the market is once again trading efficiently. Going along with that premise, it would then be fair to say that with the dissemination of information now on the fast-track, the periods of market inefficiency become shorter and shorter.
2) Psychology – AKA Sentiment – this one is purely an extension of the first explanation. I would argue that if most market participants are being fed the same information, irregardless of how well reasoned or proven the information is relative to past performance, then that information has biased the majority. Just using 2013 as an example, we saw the market grind higher day after day leading to greed and market chasing. Once it seemed everyone was bullish, the market would pull-back and bearish sentiment would pick up. The pattern repeated itself through every pull-back since at least the start of 2013. The last two weeks seems to be playing out this one sided sentiment extreme once again.
3) Coordinated Central Banks – AKA Liquidity, Liquidity, Liquidity – The Federal Reserve and prior to its establishment two other forms of central banking have set forth to build a more stable monetary system since 1771. This has largely been done through setting the discount rate and through open market operations which are the purchase of government bonds on the open market.
After the housing crises the Fed began operating under ZIRP – zero-interest rate policy. When that wasn’t enough they began unconventional approaches that had never been tried before, termed quantitative easing (QE). Included as part of their new strategy was outright purchases of mortgage back securities as well as “forward guidance,” simply meaning offering clear communication about future interest rates. Typically, the Fed had only controlled the short-term interest rate, but by telling Wall Street firms that they can borrow at low rates for a very long time, presumably those firms would eagerly lend money out to the American people also at lower interest rates. Similar central bank policies have been taken up across Europe and gaining momentum across the globe.
Without getting into more intricate details, the point is that the new efforts by central banks have pumped an enormous amount of liquidity into the money supply in what can be deemed an “experiment.” Economists, analysts, market strategist and event the Fed themselves can try to surmise how this will all end, but the truth is nobody truly can or does know. Moreover and in relation to this post, the implications it has had and will continue to have on the stock market are completely unknown. Therefore, once again I am making the claim that this time is in fact different.
Going forward – Keeping an open mind is now more important than ever. It’s fine to keep history and trend patterns in the back of your head as generally markets are cyclical, but don’t expect those patterns to repeat in the same way, especially with regard to short term trading. So yes, I am saying to forget what you know about the markets because guess what, everyone now knows. Many of us, including myself tend to make things more complicated then they actually are. We enjoy the challenge of analyzing and figuring things out. Forget about that because what the market has done 35 out of the last 36 episodes will become 35 out of the last 37 until that statistic is erased from people’s minds, replaced by a new one, or until we get a better understanding of the Fed policy implicaitons.
Feel free to check out what I offer and subscribe.
This Time ‘IS’ Different
According to the efficient market hypothesis, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.
This year has been a frustrating one for both the bulls and bears. Regardless of the lack of returns thus far in 2014, what has made it so frustrating is the lack of historical correlations and follow through. In general, market participants have always used history and patterns as a helpful guide to the markets. Although you can say that predicting the future of markets is inherently impossible, trend following and technical analysis has at its core historical precedence (i.e. the belief that the risk/reward of a chart in a bullish trend will continue to go higher based on similar chart patterns in the past, etc).
Recently (perhaps starting in 2013) traders have been scratching their heads because much of what we know about market trends, correlations, and history have gone out the window. At the start of the year, with QE tapering on the table, many people expected yields to rise; instead they have dropped. By May 15th, the small-cap Russell 2000 had fell more than 10% below its March 4 high, while the Nasdaq had suffered a 9.5% correction by April 15th. Finacials have acted poorly, biotech’s have been slaughtered, and many momentum stocks suffered large pull-backs. All the while the S&P 500 and the Dow barely flinched.
Traders have been conditioned over time to expect a spike in the VIX each time it hits a relative extreme low, especially in relation to the S&P 500 (see chart below). Adding insult to injury toward the bears, the up days have typically gone higher on light volume, while the down days on higher volume. Furthermore, there are countless divergences that began in 2013 and have continued with authority for over a year. One such commonly stated example demonstrates the decreasing number of NYSE issues making new highs just as the S&P prints new all time highs. Similar to that is the chart below where the S&P makes new 20-day highs with fewer stock participation each time. The question then becomes is this time different and I would argue that yes, it is.
This extreme ratio between the S&P 500 and the VIX has historically resulted in a VIX spike and a market pullback.
Less and less stocks participating at each new 20-day high. 
I imagine there is a long list of reasons that the market is not following the general rules and principles that investors and traders have come to know over the history of the stock market; however, I will put forth three main explanations that I believe are responsible for the greatest impact on this current market anomaly.
1) Available information- AKA information overload – Over the last several years traders and trading has blown up over social media. Twitter, StockTwits, Estimize, blogs ad naseum are available 24/7 to anyone that has access to the internet and can read. Many of us bloggers (yes, myself included) repost the same things over and over written in a different way. Although most of these pieces are sound and based on true and past successful performance, they are no longer scarce information privy to only institutional money, insiders, or those that have put in countless hours of market study. To illustrate this point, just a couple weeks ago, Josh Brown, a regular contributor to CNBC and very respected blogger stated on CNBC that 35 of the last 36 episodes in the past 14 years where the Russell 2000 corrected 10% or more, the S&P also followed with a 10%+ correction. Within hours most traders were now in the know about this statistic as it had been on television media, posted on twitter and StockTwits, retweeted countless times and were beginning to show up in countless blog posts and investor media articles. Thus, another convincing seed had been planted to expect a 10% correction in the S&P 500 after already a plethora of reasons had been spewed since the start of 2013. Now I ask you, when was the last time we all knew something would take place in the market and it actually did?
As mentioned, in years past, that kind of information might have only been known to larger hedge funds, quant scientists, those with resources and statistical data not available to the average retail trader. However, not only do we all have free access to that sort of detailed information, but if we interact at all with social media we are force fed the information over and over again whether we seek it out or not. Therefore, I would argue, knowing this type of information is no longer providing an edge and in fact, may be acting as a detriment to ones trading. Information overflow that technology and social media have permitted may in fact be rewriting the trading rules that have been established over centuries of trading.
Circling back to the opening quote of this piece, if you believe the above proposition to be true, then is it validation to the theory of market efficiency? Do current prices reflect all information making attempts to outperform the market essentially a game of chance rather than one of skill? Taking on another viewpoint, perhaps the hypothesis of market efficiency moves in stages. Certain people (in prior years it was those with unlimited funds and resources) will find an edge to trading, but once that edge becomes mainstream the market is once again trading efficiently. Going along with that premise, it would then be fair to say that with the dissemination of information now on the fast-track, the periods of market inefficiency become shorter and shorter.
2) Psychology – AKA Sentiment – this one is purely an extension of the first explanation. I would argue that if most market participants are being fed the same information, irregardless of how well reasoned or proven the information is relative to past performance, then that information has biased the majority. Just using 2013 as an example, we saw the market grind higher day after day leading to greed and market chasing. Once it seemed everyone was bullish, the market would pull-back and bearish sentiment would pick up. The pattern repeated itself through every pull-back since at least the start of 2013. The last two weeks seems to be playing out this one sided sentiment extreme once again.
3) Coordinated Central Banks – AKA Liquidity, Liquidity, Liquidity – The Federal Reserve and prior to its establishment two other forms of central banking have set forth to build a more stable monetary system since 1771. This has largely been done through setting the discount rate and through open market operations which are the purchase of government bonds on the open market.
After the housing crises the Fed began operating under ZIRP – zero-interest rate policy. When that wasn’t enough they began unconventional approaches that had never been tried before, termed quantitative easing (QE). Included as part of their new strategy was outright purchases of mortgage back securities as well as “forward guidance,” simply meaning offering clear communication about future interest rates. Typically, the Fed had only controlled the short-term interest rate, but by telling Wall Street firms that they can borrow at low rates for a very long time, presumably those firms would eagerly lend money out to the American people also at lower interest rates. Similar central bank policies have been taken up across Europe and gaining momentum across the globe.
Without getting into more intricate details, the point is that the new efforts by central banks have pumped an enormous amount of liquidity into the money supply in what can be deemed an “experiment.” Economists, analysts, market strategist and event the Fed themselves can try to surmise how this will all end, but the truth is nobody truly can or does know. Moreover and in relation to this post, the implications it has had and will continue to have on the stock market are completely unknown. Therefore, once again I am making the claim that this time is in fact different.
Going forward – Keeping an open mind is now more important than ever. It’s fine to keep history and trend patterns in the back of your head as generally markets are cyclical, but don’t expect those patterns to repeat in the same way, especially with regard to short term trading. So yes, I am saying to forget what you know about the markets because guess what, everyone now knows. Many of us, including myself tend to make things more complicated then they actually are. We enjoy the challenge of analyzing and figuring things out. Forget about that because what the market has done 35 out of the last 36 episodes will become 35 out of the last 37 until that statistic is erased from people’s minds, replaced by a new one, or until we get a better understanding of the Fed policy implicaitons.
Feel free to check out what I offer and subscribe.
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