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Bottom Line: In the Short-term You Have to Bet Long

July 5, 2010

I could quote various indicators from the simple to arcane, but the bottom line is that the correct bet is to be long the markets right now in the short-term (read 1-5 days).  You would have to possess a lot of persuasive evidence  that I certainly have not seen to convince me otherwise. Ultimately from all the sources I have read or perused–both quantitative and qualitative,  the odds strongly favor a bounce from this point. So what does this mean? It surely does not mean that a bounce must happen, nor does it mean that I will be right. Truthfully any good trader realizes that being wrong is just a part of the game. The amateur is the one that takes a high edge situation and manages to mess it up by creating an alternative and unconventional game plan that defies the historical and logical odds. It makes me chuckle whenever I see people questioning whether “this time is different” etc. Let the talking heads make the bizarre and extreme market predictions that end up making a select few famous in the media and among institutions. These same talking heads will fade away after missing an entire bull market, or calling a bottom way too early at some point down the line. Personally, all I care about is the most reliable estimate of Expected Value. One does not arrive at that from reading arcane tea leaves—an expert arrives at that estimate by looking at the most reliable and unbiased evidence. Right now, the play is simple: risk an amount you can afford to lose that keeps you in the game—too much leverage at this point is not recommended. Look for a good exit, scale out on the way up in chunks if you can’t find a decisive exit point. Try to use a time stop here—a bounce should work within at most 5 days, if it does not you should definitely exit and find a better entry point.

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12 Comments leave one →
  1. July 5, 2010 10:39 pm

    Hi David,

    I enjoy and respect your work. I have a question about this post, though. Your conclusion that we are due for a bounce seems to me to be consistent with the general opinion that we are oversold. Probably most observers would agree that we are due for a bounce. If that’s the case, why should the bounce occur? Either (1) it will be a self-fulfilling prophecy (lots of people buying to profit from the bounce will create the bounce) or (2) it won’t happen because it’s already been both predicted and discounted. This implies that even though lots of people bought in anticipation of the bounce, it didn’t help, and the market is excessively weak.

    What’s your reaction to that sort of thinking?

    Thanks.

    • david varadi permalink*
      July 5, 2010 10:47 pm

      hi there, thanks russ for the kind words. i think it is a very good question. however i will qualify that the school of contrary opinion often gets taken to far: ie everyone thinks a bounce must occur so therefore it shouldn’t and vice versa. truthfully, the weakness in that argument is that profitability is not derived from the perceptions of the more sophisticated crown, but rather from the “fish” or less sophisticated crowd that operates on the basis of their emotions. i would say that most retail investors and a fair number of mutual funds that are very large tend to make up this crowd. furthermore, those that correctly forecasted a correction have to take their profits at a logical point and thus will cover their shorts and buy. this short-covering is what induced many rallies in 2008, although I think that the extreme stretch we are seeing right now is due to the introduction of circuit breakers that permit a faster realization of capitulation. as a result, this is likely what is delaying the inevitably bounce, and perhaps tommorow will be the washout day so to speak. either way the crux of the article is to make the conventional smart bet most of the time unless you have very good evidence to make a contrary bet.

      best
      dv

  2. July 6, 2010 12:41 am

    I don’t understand the point about circuit breakers at all. You say that they “permit a faster realization of capitulation” — how so? Circuit breakers have not been triggered in any meaningful way. Even if they had been, how would this delay a bounce?

    • david varadi permalink*
      July 6, 2010 9:48 am

      mp—circuit breakers prevent price discovery by capping the maximum losses within a given time interval. this slows down the rate of change in price decline, but has the effect of making downward trends slower and smoother versus abrupt and violent. after a very rapid and massive price decline there is a lot more incentive for shorts to cover and for longs to buy. even the perception that there are circuit breakers slows price discovery because large players will spread their sales over time to avoid triggering the breaker.

      best
      dv

      • July 8, 2010 1:35 am

        Totally disagree. There is no evidence that trading behavior has changed one iota after the introduction of circuit breakers. Professional traders recognize that the circuit breakers will almost never be triggered except in the case of an erroneous print.

        I don’t think you quite understand how the circuit breakers pesently work. They only trigger if an S&P 500 stock moves > = 10% in less than 5 minutes. No institutions have programs that would move a large-cap stock 10% in 5 minutes. Thus, there is no need to change trading patterns, and circuit breakers have had no role in delaying a market bounce.

      • July 15, 2010 2:06 am

        Interesting that the original post appears to have been mysteriously edited to remove any mention of circuit breakers, yet you have chosen not to respond to my second critique (from July 8)…

      • david varadi permalink*
        July 15, 2010 2:32 am

        hi dustin, no need for conspiracy theories! i simply got too busy to respond and plain forgot. i will accept your explanation, and cannot counter it at this time other than to say that high % moves are more frequent than you are suggesting. sorry for the delay.
        best
        dv

  3. July 6, 2010 1:03 am

    I just got the latest from Hulbert (http://www.marketwatch.com/story/contrarian-indicator-offers-bearish-picture-2010-07-06?siteid=).

    “According to TrimTabs estimates, which cover the week through last Thursday’s close, investors poured $434 million of new money into those ETFs that provide 3-to-1 leverage on the long side of the U.S. equity market, while pulling $355 million out of ETFs that provide 3-to-1 leverage on the short side.

    In other words, the average investor in these leveraged ETFs is betting that the stock market will soon rally. Given their dismal track record, that’s a bearish omen for the market itself.”

    • david varadi permalink*
      July 6, 2010 9:44 am

      hi russ, well I guess its an academic point now! :o) fortunately this forecaster got lucky.

      cheers
      dv

  4. eber terandst permalink
    July 6, 2010 12:41 pm

    I suggest you take a look at the last month of posts in Quantifiable Edges. The guy there has been publishing lots of studies with formidably strong predictions for an up bounce. Unfortunately, since he published the first one in mid June, the market is down by almost 9 %.
    I think that there is something that studies do not catch, something like a “market mood”. Of course, that might be another name for “this time is different”.

    • david varadi permalink*
      July 7, 2010 3:52 pm

      hi eb, i can say that many studies/indicators are often early or late in picking peaks and valleys. this has little to do with QE–but rather is an element of the uncertainty and unpredictability of the markets. this is just a part of the game—if i listed many dv2 trades there were plenty of bad ones–including recently. the general idea is that you are better off making a bet with an imperfect edge that has been quantified, versus an opinion based on disparate information that may not be relevant or useful. truthfully, even card counters make all their money on narrow 3-5% edges. that means that most of the time they look/appear foolish. conversely the typical player has a 3-5% disadvantage versus the house, and can often win due to sheer luck—but will lose in the long run. the financial markets are very much like this to a large extent, where the difference between the pro and amateur is very small. its simply a matter of extracting the fine edges consistently. Rob at QE does a good job at that and so do many others.

      best
      dv

  5. July 7, 2010 4:45 pm

    David, any thoughts on the expected magnitude of the bounce i.e. resistance levels? the nearest was 1055 which is broken (for now)… next at 1100?

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