Do Markets Under or Over React?

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  • on June 11th, 2010

To follow up on some questions from my interview with Charles Kirk, I thought I’d address how I look for edge.  I mentioned that “people underreact at the beginning of trends and overreact at the end of them.”  What do I mean by that?  How can we take advantage of that tendency?  For as much complexity as we are capable of adding, I like to zero in on the following principles of news absorption:

1) We all tend to anchor on recent memory, making us biased when addressing the introduction of new information.

2) We hesitate to act when a conflict occurs between the reaction we expect and the reaction we see.

3) We need objective tools to solve the conflict between our expectations and reality.

By recognizing these tendencies, we can come up with ways to overcome our natural wiring through the use of quantitative tools.  Call it technical analysis, tape reading, or voodoo if you want…the point is, objective tools are better than subjective ones.  Consider the following artistically challenged graphic:

Am I cherry-picking?  Of course.  But I do remember each of these instances well, and the raging conflict between my inner technician and inner fundamentalist.  By this time, I had fully converted to news reaction over news interpretation, so in each case I actually did make entries in the proper direction.  Sad to say, I didn’t have the patience or confidence to sit through what in hindsight became obvious plays.  I’d like to think introduction of ongoing measurement techniques has helped position management…time will tell.

What measures do I keep in my toolkit to gain objectivity?  I find the following most useful:

1) Distance fromVWAP since event(positive for longs, negative for shorts)

2) Cumulative Points Gained from daily open to close(positive for longs, negative for shorts)

3) Small Distance from Last High(Longs) or Low(Shorts) measured in True Range

To select candidates, I scan every day for stocks making 20+ day highs and lows on higher than normal volume.  I then zoom in to the battle by monitoring how they perform on the metrics above, both on an absolute and relative basis.  This narrows my focus down from the thousands of stocks moving in random and tandem, to a select few offering clues that an unusual move may be unfolding.

We all have different styles and time frames, be sure to know your own…my sweet spot for this style is 2-6 weeks.  This works best for me, built on observing a very defined battle in objective terms.  It keeps me acting on signals rather than noise, not to mention the benefit of reducing news shocks by acting after instead of before events.  Knowing that most participants in the stock showed up to play, and one side emerged with the upper hand, gives me comfort in both the support behind me and potential of newcomers to join in coming weeks.

I find it better to look for misreactions than overreactions.  Most of the time, the obvious is true and to gain an edge against skilled operators is nearly impossible.  Just remember that every major trend or reversion started with a small period of price action indicating that things had shifted…are we open to acting on these outliers?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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