In the Market Tells – Part 1 blog, I introduced the concept of market tells as an enduring trading edge that can be used to enhance returns over the long term. Developing the ability to identify market tells and act on these signals takes practice. It’s important to keep track of trading results to get better and gain confidence to jump on these opportunities in size when they occur.
In this blog, I first clarify thoughts on a few instances when the market tell guidelines are not met. The most important guideline for identifying a market tell is the 80% rule, which states that to consider market action as unusual (and thus providing a market tell), the usual behavior must occur at least 80% of the time. Otherwise, it’s just too difficult to associate the unusual behavior with a market tell rather than normal market gyrations. Next, I’ll review three more market tell techniques that can be used to trade asset classes. I’ll close with some thoughts on crowded trades and implementation hints.
On some days, one sector may be up while the rest of the market is down. If the behavior is explained by news, then this price action is totally normal. Even without news, this sort of divergence occurs often enough to consider it normal activity. If a security is illiquid, such as a closed-end fund, then this action might be correcting a stale price from the previous day, which is not unusual at all.
To contrast, if all risky assets are aggressively moving higher (such as when the S&P 500 is up 2%+ for the day), and one sector is flat, then this behavior is much more unusual and may be the basis of a market tell, especially if no news explains the behavior. However, we need to remember that the time scale of this edge is on the order of a day or two.
Watching how a stock or asset class reacts to news associated with a known announcement date (such as an earnings call or a central bank news release) is very difficult to use as a market tell. There is usually an enormous amount of trader attention to these known release dates, which probably means there’s no trading edge. Much of the news and all the probabilistic outcomes have been priced in before the announcement, which is another way of saying the pre-announcement price is set such that there is no edge in buying or shorting the security ahead of the announcement, or in fading or chasing the post-news reaction.
Finally, watch out for interpreting short-term market action when there’s a lot of unwinding of positions. For instance, at the first of the year, it’s best to wait a week before interpreting market action as hedge funds unwind their end-of-year trades. This sort of behavior can occur during bear markets also. This is a very chaotic time when a lot of unwinding is occurring – it’s a very difficult time to interpret market action versus any sort of playbook. Wait until the dust settles and stocks start moving in unison before interpreting market action.
Divergences and Market Tells
In discussing market tells, I’ve used the term “divergence” to describe local price action where an asset class’s price or relative strength line is diverging from normal expectations. Searching for divergences is a staple of technical analysis.1,2 In the past I have falsely interpreted a divergence as a market tell. These misinterpretations generally occurred during relatively quiet times in the market, usually during bull markets, when the 80% rule did not apply.
Ask a market strategist about divergences, and the first thing that comes to their mind is the case where the stock market is making new highs while some other risky asset class is moving lower. For instance, from mid-2014 to mid-2015, the S&P 500 was moving higher, while junk bond markets where moving lower. This isn’t supposed to happen, and such a divergence is often interpreted as a warning of future weakness in the S&P 500, leading to a convergence of the two markets. (more…)
In any competitive field, the awareness of tells can provide a significant and enduring edge. Most people think of poker when they hear about tells.1 Is a player acting strong to encourage other players to fold? Does a player seem nervous when they throw their chips in the pot? Can any useful information about an opponent’s poker hand be gleaned from these actions?
Tells occur in many aspects of life and competition. For most sporting events, searching for tendencies in an opponent’s play is an integral part of game preparation. In the home arena, parents look for facial clues when interrogating a fidgety teenager as the youngster explains what she’s doing on a Saturday night.
Tells are an important source of feedback when trading the financial markets. I call these “market tells” to distinguish between the variety of tells that occur in other forms of competitive environments (more on this distinction later). A market tell is a powerful approach to sensing moments in time when market participants are not positioned correctly.
A simple example of a market tell is a stock that’s acting strong when it should be weak. Perhaps the stock is in an uptrend when extremely bearish news is released about the prospects of the company (such as a product recall). Unexpectedly, after a momentary dip on the news, the stock price continues to go higher. That’s a positive tell for future outperformance.
Properly identified, tells can get you out of a trade much sooner than waiting for a technical trend-following sell signal. Tells can help you identify future outperforming asset classes. They can provide positive feedback that a current trade is working. No matter what your trading discipline or time scale, searching for market tells is a great trading edge.
The more you clarify and develop your thoughts around market tells, the more confidence you’ll have to quickly jump on trades and to trade with high conviction and size. I began noticing market tells soon after I started trading in the late 1990s. In 2005, I decided to be more disciplined about it by keeping track of results. When I observed a tell, I printed out a chart and documented what I expected to happen, and then slipped the paper into my “market tells” folder. I also traded on this information, and over the next four years, avoided looking at the results.
In mid-2009, I checked to see how these predictions worked. The success rates for these trades at both the short and intermediate time scales were excellent. These results piqued my interest to further investigate and refine the use of market tells in my trading. In 2014, I performed yet another trade analysis, and in 2017, I find myself slightly reshaping my views while writing this blog.
Classification of Tells
To provide a framework for thinking about market tells, I’ll review various forms of tells. (more…)
Does momentum really work? Can you outperform benchmarks by simply holding top-performing securities? I have my doubts, but I’ve decided to be open-minded and revisit this idea.
A decade or two ago, we used momentum extensively to select equity asset classes and avoid the poor performers. I lost faith in momentum somewhere in the 2009 to 2010 time frame after the premium suffered a historically large drawdown in 2009.
We turn off momentum at the beginning of new bull markets, so we didn’t suffer from this drawdown, but hedge fund assets had grown exponentially to over $2 trillion at the time, and momentum mutual funds were being introduced. The strategy appeared to be very crowded.
Momentum was a great trading edge for many decades. Now it’s just too easy to do and too popular with an enormous amount of assets implementing momentum in various forms.
Let’s define the momentum effect. The idea is that top performing assets over a 3 to 12 month time frame tend to outperform over a similar time frame. Poor performing assets tend to underperform in the near future. Momentum is sometimes confused with trend following.1 Momentum ranks recent performance among peers, such as ranking U.S. stocks among each other, or U.S. sectors among each other, or individual country stock market indices among each other. Trend following looks at absolute prices and asks if prices are in an uptrend or downtrend, and shifts to cash or shorts an asset when prices are in a downtrend. Momentum indices remain exposed to falling prices, and thus can suffer large losses during bear markets. Long-short momentum portfolios can also suffer enormous equity-like drawdowns.
A typical momentum measure is 12-month performance, although the sweet spot look-back period can vary from 6 to 15 months. For really short time periods, one month or less, there’s a short-term reversal effect where top performers typically underperform during the next month. 2-4 As the look-back period extends beyond a few years, recent top performers begin to lag the averages in the future and the bad performers tend to do better as the latter are now underowned and better valued with higher expected returns. (more…)
The massive migration of assets from actively managed equity funds to index funds has attracted a lot of attention lately.1-6 The discussion varies, including worries about the future of active managers, concerns about market efficiency, and claims that active managers are about to outperform, and a variety of social impacts caused by this trend.
The flow of assets among U.S. equities is massive and may be a sea-change inflection point in the financial markets. The transition toward indexing has accelerated in the U.S. as more and more professional investment advisors have finally acknowledged the failure of active management. New Department of Labor fiduciary rules also make it more difficult for investment advisors to recommend active managers without exposing themselves to potential litigation risk. Figure 1 from a recent Wall Street Journal article, using data from Morningstar, shows the accelerating trend.1 Similar trends are occurring more slowly among bond funds and international equity funds.
Many articles, mostly wishful thinking from those selling active stock picking, suggest the “performance pendulum” will eventually swing back in favor of active managers outperforming. John Rogers, a highly respected portfolio manager for the Ariel Funds, recently captured active stock pickers’ common sentiment about active versus passive management.
“This is going to be the decade for stock pickers. … It’s been a long trend we’ve gone through where active managers have underperformed. We know in 30 years of doing this … we have gone through these waves. Things become very popular, very hot and everyone follows that concept. What’s worked yesterday gets everyone excited and people give up on what’s not working and often that’s where the opportunities are.” 6
Barron’s seems to be hot on this idea, with multiple articles suggesting active stock picking will make a comeback.7,8 Perhaps they’re nostalgic for the investing world of the 1980s and 1990s when stock pickers were the investment stars.
A much talked about research piece out of Sanford Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism”, lamented a world where indexing dominated the markets.4 Figure 2 shows the parabolic rise in the number of indices used to track various slices of the markets. (more…)
Periods of high volatility, sharp sell-offs and bear markets create an environment rich in trading and investment opportunities for those that remain level-headed and prepared. As prices recover and the next equity bull market develops, all risk-on trades generally work. Eventually the bull market ages, and finding new trading ideas becomes a bit more challenging.
Developing successful trades in this environment requires creativity and hard work, searching for ideas that are good, yet not so well known as to be crowded, and therefore ineffective. This is easier said than done. Most traders tend to pile into similar mid- and late-cycle trades, which are often marginal with respect to an edge, or tend to be based on economic predictions and/or secular themes rather than exploiting another group of investors.
When too many traders are in the same trade, it becomes crowded. As you might expect, crowded trades lose their edge, and thus should be avoided. That is a good rule to live by, but even the best portfolio managers will occasionally join the crowd due to an extremely high conviction level associated with a trade. An asset class trader must then be aware that the price action associated with the trade will change when there are lots of fellow portfolio managers in the mix.
The concept of crowded trades has become standard trading lingo, much more so than it was 10 to 15 years ago, likely due to the growing popularity of hedge funds over that time period.1,2,3 Yet as far back as the 1960s, crowded shorts were a problem for hedge fund managers.4 In periods of limited opportunities, traders often read similar research reports, are attracted to the same outperforming assets, and in general, lack sufficient imagination to develop a new trade idea. In addition, larger hedge funds tend to implement global macro and asset class level trades due to capacity constraints.
Definition of a Crowded Trade
Whenever there’s too much money or too much attention showered on an asset type, you should expect lower returns, or losses in the case of a trade.
Pundits and fund managers throw around the crowded trade language all the time, often to justify their own positioning. (more…)