The Market May Be Speaking. Are You Listening?

By Todd Harrison  JUN 24, 2010 10:10 AM

Sometimes you can learn a lot just by watching.


"Welcome to the future. San Dimas, California 2688. And I'm telling you it's great here. The air is clean, the water's clean, even the dirt, it's clean. Bowling averages are way up, mini-golf scores are way down. And we have more excellent water slides than any other planet we communicate with!"
-- Rufus, Bill & Ted's Excellent Adventure

Trading is a delicate balance. We must respect the past, operate in the moment and cast an eye towards the future. The market is a forward-looking discounting mechanism and at the end of the day it's not what is, it's what's perceived to be that moves markets.

We recently touched on the fatal flaw of technical analysis -- that a financial vehicle is "better" higher (say, at Gold 1260, after the breakout) and "worse" lower (a few days later with Gold 30 handles lower).

The same can be said for our other primary metrics: fundamentals (news is always best at the top and worst at the bottom), psychology (lopsided sentiment is a contrary indicator), and structural (cumulative imbalances build until they break) are all inherently flawed when viewed in isolation.

That's why I like to assimilate the metrics and rank them on a trading totem pole. At different times, different metrics matter more. Currently, I would offer psychology takes top honors, the structural metric is a close second, technical analysis is next and fundies are bringing up the rear, although they'll step up in the coming weeks.

That's the traditional mix that sets the trading table. The trick to the trade is that the last few years have been anything but traditional. You don't have to be a card-carrying conspiracy theorist to acknowledge "free markets" are a lofty ambition and a shadow of their former self. There are a lot of hands in the current stand, which has morphed our once noble profession a quest for survival.

What's my point? Ah yes, the future. Take a look at the chart below, which is the S&P but it might as well be the DJIA or the NDX. Note the "left shoulder," the "head," and the forming "right shoulder." That's what technicians call a "head and shoulders" formation -- which has negative implications -- or as we like to call it in the ‘Ville, "dandruff" (because we're quirky).

Click to enlarge

IF -- and this is a huge IF -- we traverse lower and again test S&P 1040ish, we would be wise to remember this chart. Why? Levels weaken with each subsequent test and IF that level breaks, it could be a cruel, cruel summer. In a way, a case can be made that the ability to hold that zone thus far is an ironic negative. If we didn't, a perfected right shoulder would have never formed.

Should the dandruff trigger, the impled target "works" to S&P 860, which is roughly 20% lower than where we're currently trading.  How does one calculate such things? You take the difference between the top of the head and the neckline, and subract that number from the neckline.

Two thoughts of caution: First, never anticipate the anticipator when it comes to this voodoo that we do. I can't tell you how many times I slapped on risk through the last twenty years with the expectation of front-running the technical stampede only to see it never "trigger." Learn from my costly lessons. Second, even if it does trigger, it's far from a fail-safe guarantee. That's why I use the technical metric as a context, rather than a catalyst.

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Position in S&P