There's Something Happening Here

• Posted by Derek
• on July 23rd, 2010

“Men, it has been said, think in herds; and they go mad in herds, and recover their senses slowly, one by one.”

Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

I can make the bear case all day long. Spiraling debt, higher taxes & regulation, real estate overhang, European austerity, Chinese tightening yada-yada.  Only the blindest of optimists refuses to acknowledge the issues at hand.  But we’re here to make money, not state the obvious.  I’m seeing signs from the “market of stocks” that tells me the market is beginning to look past these issues.

I don’t trust myself to always accept the market’s message objectively, so I measure. Everything.  Or at least I did.  Now I just measure those things that have worked for me in the past, and that fit my view of how markets operate.  I’ve mentioned these in prior posts, but to state again I track the following:

1) Distance from VWAP- good stocks should trade above their volume-weighted average price as a sign that holders are profitable. Profitable holders may do dumb things like take profits too quickly, but they don’t do desperate things like panic.

2) Distance from High & Low- good stocks should trade close to their highs as a sign of limited supply, and far from their lows as a measure of heavy demand. What makes a stock go up is unmet demand, so I look to join after signs of demand are there but before demand has been met in full.

3) Intraday Progress- good stocks tend to open weak to flat, and close flat to strong.  As long as this sequence continues, we can be confident that the demand side has not been fully met.

I’m a believer that markets are fractal, so you can apply these tools to any time frame in which you operate. However, I also believe that the “Day” and “Other” timeframes are the ones that drive the action and have the ability to trend, so extracting data from random timeframes can leave you at risk of following noise instead of signal.  For my work, I track in the 1-4 day range, the 3-6 week range, and the 6-12 month range…you may choose other frames but for me that’s where market structure offers the best guidance.

What am I seeing?  A transition over the past few weeks from subtle weakness to obvious weakness to subtle strength.  That is the right direction if you are looking to buy…I operate with the assumption that a) drift in correlation precedes b) relative strength/weakness, which precedes c) absolute price movement, which precedes d) fundamental events.  Not perfectly, of course, but I’ve seen and tested it enough times to make it my worldview.

This is a crude version of my watchlist…these are NOT entry ideas, but lists of stocks that have exhibited signs of exceptional strength(or weakness in the 2 right columns) in recent days and weeks.  The stocks on the left required a 21 day high on Thursday’s big move up, yet still blows away the shrunken list of negative stocks.  A stock that rallies only when the market goes down isn’t much of a leader, is it?

I suppose a true trend follower enters on breakouts, but my psyche doesn’t hold up in that style.  I like to enter in a quiet zone after evidence has piled up that I’m on the right side.  Think of golfers at a public course…if you want to beat the crowd in the AM, the best day is one with heavy fog.  Crowds may wait for the clouds to clear, but you’ve done your homework, telling you this is not indicative of a day-long downpour.  How thick is that market fog right now?

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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