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O= 12155H= 12200L= 12022L= 12051∆= −141
Nov 2005Monthly Bar
Oct 2005Dec 2004
Jan 2004
Nov 2004
Four months of verytight balanceMay 2000
May 2003
01 May 06O=11785H=12339L=11467C=12051
FIGURE 5.6 Long-term trend emerging from intermediate-term balance period:UBS (Union Bank of Switzerland) monthly bar chart, May 2000 through May 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
opportunities, some of which can end careers. When a market sea changeis in the works, it is absolutely vital that you not only identify the comingchange, but that you position yourself correctly in order to weather (orride) the storm.
ASYMMETRIC OPPORTUNITIES AND RISKThe Efficient Market Hypothesis (EMH) embodies the theory that new information is assimilated into the market so quickly that no single personcan consistently outperform the market as a whole. This leads to the theory that the probability of a future price increase is exactly the same as afuture price decrease. And, of course, if this is correct, no one could everconsistently forecast the market—a hypothesis supported by convincingresearch. Carried to its logical conclusion, this line of thought precludesvalue investing, which is based on the idea that prices travel away fromvalue. If EMH were true, value investing would have no merit, as all prices
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would be constantly equal, negating the idea of “value” altogether. Growthinvesting, which is based on continual upward growth, would also have noutility, as it too requires practitioners to be successful at forecasting bothhigher growth and higher prices.One of the goals of this book is to provide a logical framework forreconciling these divergent ideas. The discussion of timeframes, alongwith the idea that price must only be fair in the day timeframe, enablesone to argue that the current, tradable price for any given security is, infact, the true and fair market price—given all the information availableat that moment for the shortest of timeframes (the intensely competitivenature of market participants would allow for no other possibility). However, our position is that what is fair for the shortest timeframe participant may, in fact, be viewed as an opportunity for a longer timeframeparticipant.Most of the investing world desperately wants to believe that there areexperts who can accurately forecast, and they are willing to pay dearlyfor that advice. Obviously, there would be no need for art auctions, auctions for Treasury securities, or auctions of any kind if prices could beconsistently, accurately forecast. That’s why we take a totally differentapproach—one that is not dependent on forecasting, but on assessing therisk of current auction continuation, stagnation, or reversal. For example,we may say that the risk of holding a given long position is high, and provide an assessment of the odds of continuation—but we never attempt toforecast future prices. The hardest thing to get your arms around is thatwe don’t accomplish this risk analysis with absolute numbers; we employlogical thinking to arrive at a practical assessment of risk asymmetries.We believe that identifying exact numbers and probabilities is not possiblefor any system that’s in a continual state of flux. And furthermore, oncepeople have exact numbers to cling to, their minds tend to immediatelyclose to the present-tense modulations that can utterly belie their long-termleanings.We have stated that the market is not efficient; however, the mechanism for establishing the current tradable price—the auction process—isthe most effective mechanism for allocating securities to be traded amongthose submitting bids and offers. Once the auction is underway, rather thanattempting to predict future prices, we instead observe as the market discovers future prices. We continually assess the force and health of thisauction process in order to identify asymmetrical opportunities that canprovide optimal trade location—trade location with less risk. In an upwardauction, for example, we assess whether higher prices are cutting off activity or creating increased interest, driving prices higher. If higher prices areincreasing the bidding, the risk of holding that security is low. If you areshort that same security, however, the odds of suffering a loss are greatly
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increased. Similarly, if you are long and higher prices are beginning to cutoff activity, the risk of remaining long has increased.We mentioned earlier that a bracket develops when the views of therelevant timeframe buyers and sellers are closely aligned. In a bracket, theodds of the market moving higher or lower around the bracket mean areabout equal. If the market auctions to the upper extreme of the bracketand volume decreases significantly, the odds for upward continuation havegreatly diminished. This is another way of demonstrating that not all pricesare equal. If all prices are not equal, then all opportunities—and attendantrisks—are not equal, either.Thus the market, through the price discovery process of the auctionmechanism, presents us with both symmetric and asymmetric opportunities and risks. Our primary objective, then, is to observe the market’ssymmetry—or lack of symmetry—and adjust our trading decisions basedon an ongoing assessment of the resultant risks.
LONG-TERM STRATEGY DEVELOPMENTEvery reader has his or her own unique opinion about how much stockprice movement is a result of overall market conditions, capitalization size,sector performance, or the security itself. We suspect that an acceptableanswer is “some or all of the above.” It is possible to construct a marketprofile for each of the above elements through indexes, individual securities, or ETFs. Reviewing each of these market perspectives using the process described in this chapter, and determining the symmetric or asymmetric opportunity/risk of each, will provide you with an objective view ofboth your overall portfolio and the individual elements that make up yourportfolio.This process is just one step in evaluating the risks and opportunitiesthat affect your profitability. Sometimes the greatest risk is that you aresimply wrong in your analysis—like the firm that followed the Japanesemarket. Perhaps the greatest risk of all is the risk of losing your objectivityto the point that you begin cherry-picking positive information that supports your position, and ignoring negative information that runs counter toyour opinion. The greatest investment errors I have made over the years,by far, have resulted from giving in to the tendency to acknowledge onlythe information that supported my existing beliefs and positions.Since I first discovered it in 1994, I have kept a chart entitled “Perspective on Performance” on my wall to remind me just how much sector performance can vary. The chart tracks early 1994 performance numbers for 25 different sectors, and reports that the Dow Industrial was—2.13percent, Wilshire Large Company Growth was –5.01, and the Russell 2000
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Growth was –10.09 percent. The company that produces the chart updatesand republishes it every year, and while the leaders and laggards change,the basic message remains the same. This kind of variance makes it clearthat market opportunities vary greatly—which is why it’s vital that you immerse yourself in the same kind of methodical, objective analysis for theoverall market, as well as for individual securities and sectors. Withoutcontext, the most accurate data in the world are worthless.There aren’t very many top-performing money managers—if therewere, we couldn’t call them “top performers.” By improving your performance by only a few percentage points, you can move away from themiddle of the pack where performance resembles a money toss. Imaginewhere you would place in the long-term performance battle if you couldeven slightly improve the placement and exit of every trade you make. Aswe have shown, a lot of money is left on the table (lost) because mosttraders and investors are operating with incomplete information. Like inevery endeavor, the greatest reward comes to those who recognize opportunity early; the market profile is the key to being able to act before theopportunity genie is completely out of the bottle.
ASSEMBLING THE BIG PICTURE: CONTEXTWITHIN CONTEXTThis chapter is titled “Long-Term Auctions,” but we should note that thereis no absolute definition for “long-term,” “intermediate-term,” or “shortterm”—any such definition is specific to the context of each individual investor. There is no set duration for these categories, but they are helpful inthe abstract for analyzing market activity through different lenses.In Chapter 2, we noted that fundamental information must be viewedin the proper context to have relevance. The example we used to make thispoint involved the yield on the 10-year Treasury note, which, dependingon your perspective, could be fantastic or disappointing. Market-generatedinformation must also be viewed within the proper context. The marketonly has to be fair in the day timeframe, which means there could be buyingconviction on a given day that will eventually be met with aggressivenessin the opposite direction from the longer-timeframe seller—that’s why youmust stay focused on the longer-term context when analyzing daily marketbehavior.If you consistently employ the long-term bar chart analysis that wecovered in this chapter, you will have a much better chance of keeping that“big picture” always in mind. However, as we will experience shortly, atimportant junctures even the longest of timeframes must closely monitorthe day timeframe. We said earlier that there are times when it is more
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important to be right. Nonlinear market, security, or sector moves canmake or break your yearly performance in the blink of an eye.As we head into Chapter 6, we narrow our focus and examine sometelling short-term details for the S&P as it is in the process of making newlife-of-contract highs. In Chapters 7 and 8, we then begin to combine theorywith tactics—tactics that will help you learn how to monitor the differenttimeframes in order to identify and capitalize on asymmetric opportunitiesthat reveal themselves in evolving market structure.
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IntermediateTermAuctionsComplexity creates opportunity.—Jim Dalton
I
t is May 2006, and events occurring in the U.S. stock market have coincidentally and unexpectedly converged with the topic of this chapter.We couldn’t have asked for better examples than those the market isproviding right now, in real time. Convergence is a term we employ quiteoften; it comes into play when a market is transitioning from bracket totrend, or from trend to bracket. Such convergence is always accompaniedby increased volatility as the various timeframes join the fray, which oftenleads to the kind of price movement that garners front-page news—suchas “Fed Derails Dow Record Reach,” which recently appeared in the WallStreet Journal.Before we dissect these unfolding events, however, let us first takea closer look at the bracketing process. In order to successfully navigateintermediate-term auctions, you must first understand the way they begin,develop, and end.
CONVERGENCE AND THEBRACKETING PROCESSWhen a trend is coming to an end, the market begins a bracketing process,which is the fine-tuning of value beliefs between the long-term sellers andbuyers. During this process, the market auctions up and down until a fairly77
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O= 127900H= 128300L= 127440L= 128270∆= +660
Contract highMay 5, 2006,1331
From contracthigh to low,14 tradingdays
Upside breakoutNov. 18,2005
26 May 06O= 127900H= 128300L= 127440C= 128270
Aug
Sep
Oct
Nov
Dec
2006
Feb
Contract lowMay 24,20061247
Mar
Apr
May
Jun
Jul
Aug
FIGURE 6.1 Bracket formation in the S&P: S&P 500 daily bar chart, November2005 through May 2006 (focus area).Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
well-defined bracket is eventually formed. From time to time, there maybe slight bracket expansions upward and downward. But they generallyaren’t significant until they occur on increasing volume, when a new trendbreaks out of the bracket. The difference between a “bracketing” marketand a “bracketed” market is a subtle point and vital to understanding theway shifting forces influence market activity.The tendency of markets to transition from trending to bracketing recently revealed itself in the U.S. stock market. Through May of 2006, themarket had been in a longer-term upward trend for three years. However,Figure 6.1 shows that, after recording new market highs on May 5 for theS&P 500 and on May 10 for the Dow, the long-term buying auction converged with longer-timeframe sellers on May 11, sending the equity markets down sharply and establishing the first leg of a new bracket.Claiming that a new bracket is being formed is actually a rather boldstatement, as it is too early at the time of this writing to actually confirmthat a new bracket is developing. So far, we have observed only a nonlinear,downward auction. For this auction to develop into a traditional bracket,
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or “consolidating market,” we need to see a series of both higher and lowerintermediate-term auctions, a process that can expose the convictions oflong-term buyers and sellers.In just a month, from the break after the contract high on May 5 to thelow on June 13, both the S&P and the Dow have fallen more than 8 percent,with all indices at a loss for the year. That’s a significant move—the kind ofmove that can make or break one’s hard earned track record. What followsis a review of the process that led up to this convergence, this transitionfrom trending to bracketing that became so easily recognizable on May 11(in addition, we provide an update in Appendix A that summarizes the market activity that occurred between the time this review was written and thebook went to press).
DEFINING THE INTERMEDIATE TERMEarlier, we described five timeframes: scalper, day trader, short-termtrader, intermediate-term trader, and long-term trader. We gave generalguidelines for each of these timeframes in order to provide some comfort informing a structure for understanding how markets operate. We said thatintermediate-term markets could last for months, and that it isn’t alwaysthe time, but rather the distance traveled that determines whether an auction is “intermediate.” Consider a bracket that develops over a four-monthperiod. A downward auction is met with the expected responsive buying atthe bracket’s lower extreme, and then the market auctions higher for fourconsecutive weeks before reaching the bracket’s opposite extreme. We describe this as an “intermediate-term auction” or “swing trade.” Likewise,if the market quickly reversed after nearing the upper extreme and fell tothe bottom of the bracket in just four days, this would also be consideredan intermediate-term auction. It is the distance traveled—not the length oftime—that determines the “intermediate-term” classification.The price range of an intermediate-term auction is generally greater(from the low to the high) than that of a short-term auction. Another distinguishing feature of an intermediate-term auction is that it contains severalsmaller, well-defined balance areas, which become excellent short-termtrading ranges. Regardless of what you ultimately decide to define as either “short-term” or “intermediate-term,” the key is that the auction in question begins or occurs within a bracketing period. Once you’ve identified abracket, your trading strategy should be to look for swing trades on thebracket’s extremes. In such a balancing environment, you should continueto expect a series of two-way, or “swing” auctions.It is instrumental to acknowledge that money managers who market themselves as “long-term investors,” continually advising you to stay
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fully invested, are in fact trend traders. Failure to distinguish betweentrending and bracketing markets has historically been extremely costlyto trend traders. When the market is trending, of course, trend traders doquite well, but when the market is bracketing—which we have estimatedto be in excess of 75 percent of the time—trend traders often give back ahealthy portion of what they made during the trend.
THE TRANSITION FROM BRACKET TO TRENDSIt is vital to be able to identify when a market is transitioning to a bracket,and when a new trend has erupted from that balancing range. We begin by reviewing the process that marks the transition from a bracket’sintermediate-term auctions to a trend’s directional conviction. As you mayhave already surmised, this is not an exact science.A bracketed market is a market in balance. To reiterate, within abracket there is likely to be several smaller balance ranges that developthrough the shorter-term, two-way action process. When these smaller balance areas (which will be featured in Chapter 7) begin to cluster near theextremes of the larger, intermediate-term bracket, this indicates that themarket is coming into tighter and tighter balance. While this isn’t alwaysthe case, it is quite common for this type of clustering activity to representthe final stage in the transition from bracket to trend.Figure 6.2 illustrates a tight balance range that led to an upside breakout. As a general trading principle, I have found that if the balance rangecorresponds to your timeframe, you should go with any breakout from thatbalance and then monitor the trade for signs of continuation. The wider thebalance area from which the market transitions, the greater the number oftimeframes that are likely to be involved when the breakout finally occurs,and the greater the odds that the ensuing move will be significant.If price is to remain contained within a bracket, we expect to see responsive action: participants “responding” to the advertised opportunity tosell at the upper end of the bracket, at prices above the mean (value), andto buy at the lower end, responding to price advertised below the mean.However, just the opposite happens when a market is about to transitionfrom a bracket to a bull trend; higher prices generate more upward volume, leading to an upside breakout. Likewise, in a nascent bear trend,lower prices actually attract additional selling instead of generating theexpected action—cutting off selling—which leads to a downside breakoutand trending conditions.Trending markets, at least in their early stages, demonstrate a high degree of confidence that the current price is unfair—for the seller in an upward trend, and for the buyer in a downward trend. With high-confidence
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UBS monthlybar chart
Four months of verytight balance prior toupside breakout
UBS balanced forapproximately 40months
FIGURE 6.2 Upside breakout following extended period of tight balance: UBSmonthly bar chart, May 2000 through May 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
markets, news releases that are contrary to the existing trend are likely tocause only temporary setbacks (which can provide good buying opportunities if the trend is up, for example), while releases that support the trendgenerally serve to accelerate its progress.
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Another way to define bracketed markets is that they have absorbedand assimilated all current information, and that the long-term buyersand sellers have basically arrived at an equal sense of value; the marketis marking time until new information arrives. In this state, the marketclosely resembles the textbook “efficient market.” It is not uncommon tosee a major news announcement, such as the monthly Bureau of LaborStatistics’ employment report, have a significant impact on a bracketedmarket, while having little or no lasting impact in a trending market. Amajor news release is frequently the final factor that results in a transitionfrom bracket to trend. In other words, a bracketed market is in balance,waiting for substantive new information before it begins its next majordirectional auction.
THE TRANSITION FROM TREND TO BRACKETTrends end in either of two ways or a combination of the two. The first,less-frequent type of ending occurs when volume—which is in the directionof the trend—simply dries up, as if the participants that were driving thedirectional move are “all in” and there is no one left to participate. Thetransition is relatively quiet and calm; the market just sits there, lullingmarket participants into a state of complacency and stasis.In Figure 6.3, S&P futures traded at 1,269.70, 1,269, 1,269.40, and1,269.90 during four out of five days prior to the intermediate-term auction changing direction. There was less than a full point separating thosefour highs; the buying had simply dried up, and participants contributingto the downward auction were a combination of long liquidators and newshorts. Over the next 18 days the market declined to 1,223—a 3.62 percentmove—before beginning a rally that once again failed to exceed the 1,269high-water mark. Before the initial decline was complete, the market haddropped to a low of 1,180, a decline of 7 percent.The creation of “excess” is the second and most common end to atrend. Excess occurs when a market makes a dramatic price high or low onlow volume and opposing buyers or sellers react quickly and aggressivelyby auctioning price in the opposite direction. This type of trend end is oftenstormy and sudden, which results in a state of near panic as price movesquickly and it becomes increasingly difficult to make a decision that’s notinfluenced by heightened emotion.Figure 6.4 (on the following page) shows both types of auction-endingpatterns. In the first two boxes from the left, volume simply dried up, andin the next three boxes you see the second, more violent type of transitionmarked by excess.
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1269.001269.701269.90
1269.40
May
Jun
Jul
Aug
Sep
FIGURE 6.3 Buying exhaustion, triggering intermediate-term selling auction. S&P500 daily bar chart, July–August 2005 (focus area).Source: Copyright ľ2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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Daily bar S&P 500futures contract
Excesshigh
Excessgap
Downwardauction endsas lower,rejected pricecreates"excess" low.
In these two examples,volume simply dries upending the upwardauction.
FIGURE 6.4 Selling excess, triggering intermediate-term buying auction: S&P500 daily bar chart, October 2005 (focus area).Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Following the excess high (identified in Figure 6.4), notice the creation of an extreme form of excess known as a gap. A gap (in price) iscreated when the market does not have an opportunity (time) to trade atcertain prices. This happens in one of two ways: when the market auctionsso quickly in one directions that prices are skipped altogether, or whenmarket participants have changed their perception of value so dramaticallythat they simply begin trading at a completely different price level.
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In Figure 6.4, the S&P auction ended with an excess high, indicatingthat price auctioned so high that it was deemed unfair for the buyer. Theexcess gap on the following day provided further acknowledgment thatprices were indeed too high. A gap at the end of an auction that occursin the direction opposite the most recent trend signals a reorganization ofbeliefs. As educational psychologist Frank Pajares summarizes Thomas S.Kuhn’s groundbreaking work in The Structure of Scientific Revolutions:Transition from a paradigm in crisis to a new one from which a newtradition . . . can emerge is not a cumulative process. It is a reconstruction of the field from new fundamentals . . . It changes methodsand applications. It alters the rules.In short, the laggards are finally “all in,” and the market moves withreal conviction.An excess high or low occurs on light or low volume. Most ofthe investing world, however, thinks the opposite is true. For example, many investors believe that capitulation at the end of a downwardauction—when all the sellers finally sell—occurs on heavy volume. Butthis would go against all the principles we’ve talked about. For example,a market may experience a period of healthy volume as the stragglers(Gladwell’s “late majority” or “laggards”) get rid of their inventory, but thefinal prices, manifest in the excess spike, are not made on heavy volume.The volume most people incorrectly ascribe to capitulation is actually aresult of the action in the other direction, when buyers show up in forceand the price spike down is quickly rejected. Confusion occurs due to thefact that after the excess high or low is in place, there is often a dramaticpickup in volume as part of the counterauction.
THE CONVERGENCE OF INTELLECTAND EMOTIONThe most common true end to a trend—which also signals when a bracketbegins—occurs as a result of both a reduction in volume in the directionof the trend and an excess high or low. The ending of an auction offersthe moment of greatest opportunity, as well as the moment of greatestrisk; both risk and reward are asymmetric at this pivotal point. If the trendis downward and an auction low has been established, the investor whocorrectly recognizes the low and buys has a low risk/high reward position. Sounds easy, but imagine the emotions that these “innovators” mustendure when they buy against what has been universally acknowledged
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as a bear trend. The market has been auctioning fairly consistently oneway—down—for an extended period of time, and thus a decision to buyutterly flies in the face of common (as well as expert) wisdom. It’s not easyto go against the crowd. As someone once said, being a contrarian is likecommitting social suicide. To be a successful trader/investor, your intellectand emotion must work as a team, which is easier said than done.On a tick chart, this kind of trend-end reversal looks elongated, witha final price spike that is quickly rejected. If you’ve done your homeworkand recognize that this spike is on low volume, your intellect can be saying“now would be a low risk/high reward time to buy,” but when the speedof the reaction takes your breath away, your emotions won’t always be inagreement. This cognitive dissonance can freeze your trigger finger whileopportunity slips away.The investor who is short in this example (for a long-only money manager, “short” would mean holding cash, or being under committed to themarket), and who fails to recognize that the auction is ending, must endure high risk and low reward; the ensuing rally is often sharp and fast.If you are a large money manager and your analysis hasn’t revealed theweakening auction, then once the reversal begins there is generally limitedliquidity, which can severely compromise your performance.
ACCELERATE THE LEARNING PROCESSI had always marveled at the Apollo 12 moon mission, which was reportedto have landed within 15 meters of its target. I thought it was accomplishedby a room full of incredibly smart people who created an algorithm, firedthe rocket into space, and waited until it landed on the moon. I was surprised to read that the mission was off course 80 percent of the time, whichrequired continual course corrections. Without these on-the-fly computations, the Apollo would have been lost in space.When working with the natural sciences, there is comfort and stability in the reproducibility of results, born of the constants inherent in scientific inquiry. There is a genuine feeling of delight when the mind stumbles across the “correct answer.” The human mind is hardwired to seekconcrete answers. Moreover, our tendency is to acknowledge only thoseanswers that support our presupposed beliefs, which can lead to tunnelvision, short-sightedness and, ultimately, plunging profits.The difference between the natural sciences and market-generatedanalysis is that the elements we employ to conduct our analysis are constantly evolving; the only constant we have at our disposal is change. Ofcourse, without change there would be no opportunity, and so we gladly
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welcome change. But as a result, it takes an extraordinary amount of timeand dedication to become familiar with the type of analysis we’re describing in this chapter. There is no substitute for experience in any field, ofcourse, but because of the many complexities and subtitles inherent intrading, there is no quick way to gain that essential experience. It may appear to be misleadingly simple to move from novice to proficient, as theideas we’re purporting in this book are not unfathomable. However, it takesan incredible amount of dedication to elevate your trading level from proficient to expert—and that’s what differentiates the all-stars from the herd.Think of the difference between an average professional basketball playerand the elegance with which Michael Jordan could dominate a game. Andit is well documented that Jordan trained relentlessly, studying tapes, staying late in the gym, shooting free throws after