What Makes a Market Feel Different

I’m traveling back home to Cleveland today after a ten-day trip to Asia.  This was my first time to Kuala Lumpur, where I spoke at the IFTA Annual Conference.  This has become one of my favorite annual events as it rotates to a different country every year and gives you a chance to learn about the people and their culture.

I then traveled to Singapore, where I spoke at the CMT Association Singapore Chapter meeting with my friends Jamie Coutts and Brett Villaume. 

 Action shot of me relating a mindfulness practice to a sound investment approach.

Action shot of me relating a mindfulness practice to a sound investment approach.

As a technical analyst, I’ve learned that charts are a way to understand the investor sentiment around a specific company or market.  But analyzing the chart of a country ETF only tells you part of the story. 

Actually seeing Malaysia firsthand, witnessing all the construction happening in Kuala Lumpur, and talking to locals in the financial industry- that’s when you really feel the tremendous upside in that part of the world.

In Singapore, I was asked if I thought the markets “felt” different in recent years and how that would affect the charts and technical analysis.

The short answer is “absolutely.”

The long answer…

There are three factors that could make a market feel different- a change in participants, a change in structure, or a change in conditions.

A Change in Participants

New participants with new motivations could certainly impact volatility as you now have a group of people acting with a different goal in mind.

For example, consider bitcoin.  Early adopters, I’m talking those that bought bitcoin before anyone else really knew what it was, they were not looking for a quick profit.  They were betting on a revolution in the way that people transact, and they were buying into the philosophy of cryptocurrencies.

Once awareness started to build, you had an influx of speculators who were not necessarily buying into the whole philosophy- they were just betting that the price of bitcoin would go up.  Once it did go up, they were motivated to sell for a profit.

New participations with new motivations means new market dynamics.

A Change in Structure

When I say structure, I mean a change in how investors are able to place their bets.  For example, decimalization in US stocks completely transformed the dynamics of the equity markets, shrinking the buy/sell spread and causing the industry to evolve.

Another structural change is the growth in ETFs.  Instead of investors making active bets on individual names, they are making passive bets using ETFs which usually impacts a basket of stocks.  Inverse and leveraged ETFs are a whole other beast with a potential impact that is still very much an unknown.

As an aside, I’d like to remind everyone that many ETFs have not been “battle tested” in a bear market.  What happens when fear grows and people start unloading ETFs?  Theoretically it should work out just fine.  But what actually happens and what theoretically should happen are often not the same.

I would be surprised if we don’t see some structural challenges due to ETF unwinds in the next bear market cycle.  Hopefully they are minor issues that don’t grow into larger issues!

A Change in Conditions

Bonds were in a 30-year bull market starting in the early 1980’s.  They then entered a sideways range in recent years before the ten-year yield broke above 3% earlier this year.  I would argue we have now entered a bear market in bonds that will likely last for years if not decades. 

The Ten Year Yield has transitioned from a downtrend to a sideways trend to an uptrend.

If that’s the case, then we are in a market scenario that most investors have never experienced.  That’s a change in conditions that will certainly make the bond markets feel different, and in turn will affect equity markets.

In this bucket I would also include non-financial inputs such as Trump tweets and the US-China trade war.  Unpredictability is what leads to fear and that is what leads to a change in market conditions.

Impact on Technical Analysis

As I write this article, I realize that it’s undeniable that the markets feel different due to all of the changes I’ve outlined.  So how does that impact our ability to use charts?

First, technical analysis will continue to work because the markets are driven by human emotions. 

Even with the rise of passive investment vehicles and roboadvisors, people still get nervous about their financial situation.  Traders still get overconfident and investors still display herding behavior.

These behavioral biases that compel them to make decisions are what will make charts useful for a very long time.

Second, many technical indicators actually self-correct for changing dynamics such as increased volatility.

For example, the Relative Strength Index (RSI) essentially measures the ratio of the average up day to the average down day for a specific price series.  For the statistically-minded, it’s essentially taking a Z-score of the price movements.

Note how the RSI overbought and oversold conditions tend to coincide with short-term price tops and bottoms.

This means that you can compare a bunch of stocks on an apples-to-apples basis and judge them on where they’re trading now relative to how they normally trade.  If a stock becomes more or less volatile, the indicator will adjust to the new “normal” levels and continue to highlight the extremes.

Some indicators do not self-adjust and that means the technical analyst needs to recognize and adapt to new market conditions.  For example, I still find price patterns to be extremely useful, but I think that time has become compressed with some patterns.  Moves that used to take months to evolve could now take weeks instead. 

Finally, some technical indicators do indeed become obsolete.  That is why a good technical analyst is always reviewing their toolkit to make sure it’s most in line with the investment strategy and the market conditions.

Volume is something I used regularly when I was learning technical analysis, back in the early 2000’s.  I actually remember just looking at pit volume to avoid the “noise” of what was happening off the floor of the exchange. 

The rise in electronic trading, dark pools, high frequency trading, etc. have all made volume mean something very different than it did 40 years ago.  There was a time when a large increase in volume meant big institutions were moving big blocks of shares.  Now it could mean that two hedge funds are trading a bunch back and forth. 

For me, volume no longer has the directional clarity that it used to have, so as a result I rarely consider it for individual names.  Where I do pay attention is with broad measures of volume, because I would guess that on a larger scale it can still give some color on the overall market environment.

Two key volume measures, On-Balance Volume and Volume Advance-Decline, have both turned negative.

Bill Doane was a predecessor of mine at Fidelity, where he ran the Technical Research team in the 1970s and 1980s.  He told me about following “The Generals” as a market indicator.  That is, they made an index of General Electric, General Motors, and General Re and considered that to be a good bellwether index for the markets.

To summarize…

Yes, I agree that the markets feel different.

Yes, the technical toolkit will continue to evolve due to changes in market conditions.

And yes, technical analysis is still the best way to understand supply and demand which are driven by human emotions.

RR#6,
Dave

Disclaimer: This blog is for educational purposes only, and should not be construed as financial advice.  Please see the Disclaimer page for full details.