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When Fighting Chaos, Intuition Beats Algorithms

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How a Skyfall situation is playing out in today's markets.

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MINYANVILLE ORIGINAL On Saturday, I skipped the usual autumn afternoon football and went with my wife to see Skyfall, the new James Bond movie. It was vintage non-stop-action 007, but I found the underlying theme of the story to be quite relevant for today's trading environment -- but not because the sky is falling. At the end of the movie, I whispered to my wife, "I think I have some material."

Without divulging too much of the plot, this movie's Bond is shown to be an aging and potentially washed up agent from the old school who has to stop a mad cyberterrorist with supreme technological intellect. It was a battle of clever instinct against arrogant genius. I thought this pretty much summed up what is unfolding in the market today: a playing field which pits the intellectual quant traders that rely on financial models backed by algorithms against the old school flow traders who rely on intuition backed by experience.

There are two basic drivers of market price action. You either have discount based on math and multiple, or flow based on positioning and sentiment. Investment decisions are ultimately a function of these two market drivers. Today investors will typically fall into one of these two classes.

When I wrote Trading the Wrong Playbook Bubble back on June 12, I was trying to characterize these two investor classes, which were represented in Trading Places by the street savvy Billy Ray Valentine and the elitist Randolph and Mortimer Duke:

I commented that instead of studying for the CFA you would be better off watching Billy Ray Valentine explain trading to the Duke Brothers.

BRV: That's a big mistake, man. You're going to get reamed on this one.

RD: Tell me just why you think the price of pork bellies is going down, William.

BRV: It's Christmas time, everybody's uptight....

MD: Could we please buy now, Randolph...

RD: What are you trying to say, William?

BRV: OK. Pork belly prices have been dropping all morning, which means that everybody is sitting in their office waiting for it to hit rock bottom, so they can buy cheap and go long. So the people who own the pork belly contracts are thinking, "Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! OK... And my wife ain't gonna make love to me if I ain't got no money!" Right, so they're panicking right now, they're screaming "SELL! SELL!" 'cause they don't want to loose all their money, right. They're out there panicking right now, I can feel it. They're panicking, look at em,.

RD: He's right Mortimer, my God, look at it.

Valentine sets the price, saying, "You'll have cleared out all the suckers by then."

I believe this whole rally in equities from the March 2009 low has been one giant clearing out the suckers' trade.

Well, it's Christmas time and everybody's certainly uptight. Only the suckers getting cleared on this rally aren't the typically duped retail investors; they are the super genius quants. As I noted on July 30 in Bernanke's Astonishingly Good Idea, the bearish camp was looking for a repeat of the August 2011 meltdown. It seemed like everywhere you looked there were charts lining up the July 2012 rally with the July 2011 rally that failed and crashed.

This week's CFTC commitment of traders report showed large speculators (aka hedge funds) remain net short for the 50th consecutive week. In fact, the last week they were net long was the first week of August when we crashed. I remarked to a friend that I didn't think the market would stop rallying until "they" get flat to long. I said they are following the 2011 analog but I was thinking more like 2006 when we saw summer weakness but the market wasn't finished rallying and after Labor Day we embarked on the final leg into the 2007 top.

Last year the speculative community was still long the QE II reflation correlation trade thinking they were going to get an extension and when they didn't it was Katy bar the door. This year they are short. If we don't crash soon when the boys come back from the beach, they may be piling in to get long before year end. It could be melt up city.

The ensuing rally wasn't exactly "melt up city," but you get the idea. After we failed to crash in August, the speculative community predictably covered and went net long as the S&P crossed above 1400. I have been sticking with this theme all year and thus far the set-up has been working according to plan. As I concluded in Rally Off 2009 Lows Flushes The Hedge Fund Shorts:

The fact that the hedge fund community would finally get long and top-tick the market above the 1370 five-year pivot suggests the suckers were finally cleared. If my thesis is correct that the hedge funds are the new crowd investor that dominates price action, the stock market could be in for a significant move lower regardless of the fiscal cliff getting resolved or QE attempting to prop up asset prices.

As we enter the holiday season and year-end trading environment, do not get caught up in all the melodramatic market commentary blaming taxes, the fiscal cliff, the prospects of a recession, or earnings growth deceleration. Those catalysts are well-known and, in my opinion, largely irrelevant. From here and into 2013, it's all about speculative positioning, sentiment, and the prospects of the QE asset reflation trade blowing up in Ben Bernanke's face.

Nevertheless investors remain focused on stuff that doesn't matter like economic data and earnings growth. Market participants are so entrenched in the ramifications of high frequency data that their infatuation with the fiscal cliff is only due to short-term economic growth statistics for 2013 -- never mind what is more beneficial for the long-term structural viability of the country. Investors want the fiscal cliff to be resolved so they can extrapolate and position for Q1 employment, manufacturing, and GDP growth rates.

In this weekend's Wall Street Journal, Tomi Kilgore seemed to sum up what the consensus believes is the cause and effect driving recent price action and the year-end trade set up for 2013. In a buried blurb titled "What Cliff? The Markets See Deal on Horizon" on page B5 of the Business and Finance section, Kilgore writes:

Volatile reactions to news about the "fiscal cliff" can distract investors, but one reality has emerged since negotiations began in earnest Nov. 16: Markets believe the parties will strike a deal.

If Republicans and Democrats can't reach an agreement, the automatic tax increases and spending cuts set to take effect at the beginning of 2013 could push the economy into recession. So it is no wonder Wall Street traders have been glued to the news, ready to sell stocks on any headline suggesting negotiations were stalling or buy on any sign of progress.

But there is a Wall Street axiom for this type of environment: Don't let intraday swings distract from the bigger trend. And at the moment, the trend for stocks appears to be up.

In today's era of information overload, there is way too much attention paid to cause and effect of headlines and price action. The market is much more complicated than what the financial media and punditry would have you believe. But it's easier for them to explain by extrapolating a market reaction to an interpretation of the news. It happens all day, everyday.

In my opinion, the violent price action is not just indicating whether or not the fiscal cliff is getting resolved. That's just the excuse. I think the price action is indicative of a market that is trying to turn and shake off the weak hands (in poker terms) that would be typical of a change in trend. In fact, I think investors who are focused on whether the fiscal cliff passes are making a very big mistake. I'm not saying you won't see a move off the news; I'm just saying it's likely to be a wiggle in the big picture.

The confirmation bias is overwhelmingly bullish, suggesting to me that if the move is up, it should be faded. The short-term trend may be higher, but the long-term trend is sideways; that suggests we are still in a bear market. The move from 2009 does not look impulsive in nature. When putting all the pieces together, it looks like the perfect ending to a corrective pattern whether the fiscal cliff gets resolved or not.

Analogs aren't just about charts that look the same; due to fractals, you will always be able to pick different time frames in history and line up similar patterns. For the set-up to be complete, the analog must also contain similar patterns in positioning, sentiment, and a catalyst.

I would venture to say that positioning, sentiment, and the catalyst are much more similar to July 2011 today than they were in July. The shorts have covered and are now long. Sentiment is bullish predicated on the assumption a deal will get done, which screams confirmation bias. And ironically, the passing of the Budge Control Act of 2011, which is the catalyst that blew up the 2011 QE reflation correlation trade due to the S&P downgrade, set up today's catalyst of the fiscal cliff showdown.

In fact, if you look at the 2011 move off the July top, you had an 8% orderly leg lower and then a violent rally that almost retraced the entire move and got everyone thinking of a QE III breakout. From the September top off the QE III fade, the market sold off 8% in an orderly move. Now we are in a violent rally looking to break out on a fiscal cliff resolution. Suspiciously, though, unlike in July, I can't seem to find any 2011 analogs.

Whether we rally to a new high on a fiscal cliff resolution is irrelevant. As I stated in How QE Is Impeding the Economic Recovery, I think we are in the late innings of this cycle and the stars are aligning for another leg lower in a larger secular bear market.
It is my belief that an ensuing bear leg in stocks will be very difficult to navigate from either side. I think there is a distinct possibility we just completed a cyclical bullish pattern off the 2009 low and that a retrace is in order that could take the S&P 500 back to the large 1160 pivot at a minimum with the potential for a deeper move that challenges 1000. However, unlike the two previous corrections in 2010 and 2011, this will likely not be swift and steep, but rather long and choppy.

Like Europe, the debt ceiling, and the election before it, the fiscal cliff is another catalyst used to clear out the weak hands who continue to try and outsmart the bear market.

During the tranquility of a bull market, the models work and technology can be a valuable tool to maximize returns. However, in the chaos of a bear market, the old rules do not apply and the only thing that matters is experience and intuition. My experience is telling me this is no time to be a hero by trading what everyone already knows, and my intuition is telling me this bear market cycle has another leg lower and it's time to get defensive and liquid.

Twitter: @exantefactor
No positions in stocks mentioned.
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