Circus Tent in Outer Space

The last post introduced the concept of the magician, an aggregate representation of all types of induced feedback in the market. At this point, there are two distinct mechanisms of feedback in the market. The first arises from technical analysis. The second is born from the capability to steer technical patterns with subtle nudges at the right points of instability. Both have their limits, and that's the focus of the post today.

The magician (apologize for lack of an illustrative introduction) uses induced feedback. Induced feedback is feedback that has been triggered by creating the right input signal to cause the system to enter a particular state of self-propagation via simpler feedback mechanisms. Imagine a school bus full of children who are shifting their weight in order to rock the bus. By feeling the movement of the bus and using this to decide when and how much to shift their weight, the children are a simple feedback mechanism. They feed back one signal (the bus is rocking) to create another signal (rock more/less). Induced feedback was what happened when one kid got up, started rocking, and encouraged some of his friends. After the thing was rocking and it was widely perceived as fun, the storm was already in motion.

The magician in the stock market is no different. By utilizing the right stimulation to the right trading pattern, the magician has a butterfly on the end of his wand that creates a tornado. The cost of achieving these tornadoes is very low relative to the storms that are created, which continue to build through their own mechanisms in the absence of further capital input. The magician reaps the benefits. However, there are two limitations to the magicians capabilities:

• In the absence of any susceptible patterns, the magician's actions are distorted in the haze, and it costs more to create a self-propagating pattern. The profit potential is less and the stability of the resulting signal can be affected.
  
  
• Mechanisms unrelated to feedback cycles cannot be controlled by induced feedback. Unrelated influences are noise to the magician, costing him more to manifest signal stability and causing the patterns he creates to dissipate rapidly.
  

The second leads us to the showdown between our chaotic cow and the magician. The clouds of chaos are ultimately created by fundamentals. Price elasticity takes over at the boundary regions, and like a giant spring of reality, continues to pull more forcefully on a stock as it meanders into the boundary. Here, the almost random influence of the cow becomes highly self-organized and much more potent, and presents a noise signal to the magician that is too powerful to be profitably opposed. At this point, the magician must bow to the cow, reverse his fortunes, and ride with the herd.

What goes on inside the chaotic boundary regions can be likened to a circus. Complete with a ring leader, lots of people shouting, and no real method to the madness except whenever the chaotic meanderings take clear form and feedback drives them in one direction or the other. Outside the circus, whatever went on inside the circus is no longer important. The feedback mechanisms are dominated by external influences that cannot be affected outside the tent. Faced with the cold reality that the circus games can only last from one side of the tent to the other, the crowds and performers head back into the tent. The magician, having driven the show outside the tent himself, stays inside the ring and charges admission for all returning.

The clouds of chaos float just behind the curtains on the stage. The magician has his tricks. The audience gets to clap, but outside the stage the show is over, and our mystery superhero, the chaotic cow, keeps the show in check. Why do I cast the cow in a positive light? You can make money off the magician. You can make money off the cow. You can predict the movements of the cow. You can't predict the movements of the magician. The timing when stocks will move off the stage is much less certain than when they will get moved back on the stage. Follow the beef.

Illustrations on their way, but I want to keep moving through the material and doing a good illustration can take a good chunk of time.

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The Magician

This post will explain probably the most influential mechanism of stock manipulation. Long before anyone would have written the control function for the stock market or created the necessary neural network or other algorithm(s) needed to calibrate the behavior of a sci-fi trading computer, it was recognized by many that the stock market is just as fickle as public opinion would be if we had hundreds of simultaneous presidential elections going on. We try, through appreciation of human accomplishments won through logical faculty, to make rational evaluations of trading opportunities, but inevitably our social mechanics and primal nature filter in. Just like pundits and anyone with anything to gain in the political world, there are always players spinning their wheels cloak-and-dagger style, behind the cape of uncertainty and faith in the general legitimacy of society, working hard to push the right buttons at the right time to get the herd moving in some direction they can capitalize on. Collectively, this influence can be represented as the arch-rival of the chaotic cow, the magician.

Let's start with a brief introduction to social behavior. Assume you want something and recognize that lots of other people want the same thing. A viable strategy is to identify whoever looks like a strong player and follow their lead. Apply the reasoning to a cave man scenario. While on the day's group hunt, you and your party are slowly creeping up on [insert large tasty dangerous animal]. Suddenly, one of you raises up and starts running at one of the creatures. The signal hadn't been given. The guy is breaking consensus. Do you
A) rush in with him?
B) hold back, tie him to a tree after he's scared the prey off, and try again one short?
What if the guy doesn't look like your above-average hunter? Is he probably out on a limb for his ability? Now, suppose the guy is well regarded as an expert at pre-emptive cave/kung-fu. Even though the leader might not have seen the opportunity, you generally expect that this guy does. In the first case, you probably don't follow. In the second, you probably do.

Back to financial markets, are there any arenas where the elite players and gamblers mix? The answer is yes. Instruments with elevated risk and reward exist in the form of derivatives, namely stock options and futures. Stock options essentially allow you to buy the profit potential, short or long, in exchange for risk. Stock options only have a certain window of time available within which that profit can be won. This has a price, known as the time premium. Futures operate much the same way. Increased risk, increased return. Because these instruments are very volatile and dangerous, it's usually expected that big plays in the derivatives markets are made by expert players showing their hands. The reasoning is that bad plays go south, so bad players go bankrupt or get out fast.

Now, lets say that the you're a major institution or large investor and you feel/determine that there is a little bit of a wound up spring in the market if a technical pattern builds at a certain point, and you want to capitalize on that movement. You could A) get lucky or B) shove the rugby pile with a large play. Since everyone is always watching the market, all plays are visible, and one of the places that gathers a lot of attention is derivatives. A frivolous move on the derivatives market will become very costly very quickly, but making a very aggressive play that shows up in the derivatives markets is easy. The market sizes are small and the reactionary trading habits are greatly amplified. The feedback happens so fast that you can ping the spread with a single order and suddenly watch the market readjust like hyenas in a flinch-fight. One order, and the whole thing starts rearranging.

Because frivolous plays are costly, it's expected that frivolous derivatives exchanges don't happen to a large degree. However, if you're a well capitalized trader with a large position in a stock, that frivolous trade becomes cheap, and then you send the whole pack of hyenas mad in one direction. Better yet, just like our pre-historic cave hunters, the regular traders will pick up on the unusually activity of the "experts" and follow suit. If the move was made at an appropriately susceptible position, then the flurry of activity will probably be enough to push the needle over, and lo and behold the market will go in that direction, with full technical support.

This is the power of the magician. In between the boundaries of chaos, the chaotic cow is powerless, disorganized, and fickle. The magician is calculated, precise, and utilizes the emerging patterns in disorganized chaos to create self-propagating movements through technicals. How often does this happen? Ask Jim Cramer. This link goes to an interview that also aired on John Stewart's infamous clash with the poor Cramer.

The next post (barring another market update) will focus on the limited influence of the magician. Possibly an illustrated guide to the struggle that brews between the cow and the magician. Get on my RSS to be sure and catch it.

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Falling Off the Blade

This post will focus on the recent technical contention point of the broader US market and the influences that have guided what will become the new trend. Several trends were involved, some of which will emerge as the new trends for the time being. If you interpret charts enough, you can usually always find a downtrend and an uptrend. When the two connect, it's a technical paradox, with signals going both ways. It's an unstable equalibrium. Sometimes it's like a tennis ball on a hill. Sometimes it's like a needle balanced on a knife, with the slightest input causing the system to diverge decisively towards one solution. This was one of those needle on a knife moments, and this post will discuss what to do with it.

In the abscence of new economic data, it's a battle between two self-sustaining patterns, exactly like two storms colliding. The more organized flow, usually the more established trend, will usually win. In this case, we have new economic data, lots of new economic data. In fact, there's so much economic data that the dominating mechanic is unmistakably fundamentals.

The needle on the knife was a well established downtrend going back a little less than a decade. The beginning was so long ago that I remember a professor of mine using the word "megatrend." The big picture consists of the rise of oil consuming India and China (US consumption is figuratively a tautology), the Iraq war, the tech crunch, and the general doom and gloom of terrorist hysteria. All of these factors put dampers on the US economy via various mechanisms. Let's take a moment to reflect. Every great once in a while I pull out bigcharts.com when I need...big charts.


Here you have it, the history of the universe for the last thirty years. Roaring 90's, y2k bubble pop, 2001, and finally the housing bubble-bust. Notice how the first two decades of this chart show a readily identifiable curve? Then in the 90's, suddenly things went ape. In 2001 we reconnected with a "curvy" interpretation of the previous trend. Right now we're connecting with a linear interpretation of the previous trend. This is all art of course, but remember that the mechanisms of simple trends are mostly psychological, meaning that as humans who share similar psychology, we're already perfect indicators of how we visually process charts. If you've ever taken a class in trig or calculus, you have every tool necessary to be a curve fitting artist.

The last feature to pay attention to in that chart is the almost unbroken downtrend starting in 2001. What broke it? The housing and derivatives trading bubble. Bubbles pop, and in short, since reality brought the trend back in line, there was a good chance that it was still a dominant economic mechanic.

Now let's break out the microscope and look at this recent contention point:





The big question for this recovery rally from the bottom was whether to consolidate again at the bottom, letting the down trend make another run, or to have a summer rally now that the sky isn't falling. We hit that 200day moving average and almost started to head back South, but then the economic data hit and most of it indicated that the sky is in fact still well overhead. This was the wind that blew the needle off the blade, and now it's falling towards the North.

What to Do With It?

The DJIA will undoubtedly make a run back to the 50day after earnings are over. Profit taking after the flow of news slows down. At that point, the trend will take over. I would look to build positions as the earnings sink in. Any downward movement here is a buying opportunity for the summer. Pick long stocks and play their technical trends using the 20-day exponential moving average or whatever trend indicator is being consistent for that stock (more on this later.)

Short plays are a bad idea in an up market. If you're not sure the company's bankruptcy is going to happen in the next three months, look at this upward movement as the potential building of a bubble. It's frustrating to try to play a stock short that's being propped up by market movements. The simple truth is that long plays will get help from the market, so any short play is trading upstream.

What does this mean for me? I'm letting go of AMD for the time being. Yes the earnings were terrible and foreshadow the chronic failure to execute that has plagued the company, but they have enough cash to go for at the very worst several quarters, so the clouds of chaos aren't yet there.

What am I doing instead? NVDA. There's a trading gap at $14 that represents a large technical leap. NVDA is a great company with a great future. I'm sure I'll write more on this before the end of the week to give you some perspective on how I make these calls, but in the end what I'm doing is taking advantage of a stock that has a wound up technical spring and market that's poised to set that spring loose.

Ponder This

What a coincidence that the technical contention occured right around the same time as earnings. What a conincidence that most stocks' charts that I'm watching showed this same type of contention at about the same time. What another coincidence that the down megatrend occured around a huge spike in trading volume.

Computer trading started in the 80's and was driven simply by the emergence of the technology. What could have lead to the need for so much more trading activity? Let's say you're a major fund manager and you realize that the megatrend has meat in it and that investing long isn't going to pay well. What do you do? Play volume, derivatives, arbitrage, and market smoke and mirrors to take advantage of every move that occurs in the relative market stagnation.

Notice that the volume was about a billion shares per day and was fairly consistent over the last decade. Notice how it started directly coincident with the tech crunch. No, this isn't a conspiracy theory. Don't read into this line of thought too much, but I will go ahead and suggest that there was a recognized need for large trading establishments and hedge funds to generate profit from trading in the relative shortage of investable stocks.

What makes this line of thinking consistent is that the trading activity didn't continue to grow, suggesting that market fees and other limitations put a hard cap on how much profit could be squeezed out of this type of trading. Or perhaps there is an overlay of two conflicting trends. Either way, the volume spike and subsequent stagnation starting in 2000 is a little curious and I'll get back to this before the end of summer.

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Leeroy Alert

Today we have a good example of how a minor Leeroy event can threaten to completely change the stable pattern that was forming. Earnings season is very prone to Leeroy popping up, and this is why I prefer the quieter months of the year. Earnings is when excessive divergences from reality get reined in and loose ends in the minds of investors get tied up somewhat. As a whole we will correct our worst mistakes and decide where to go in the future. Well, that sounds very egalitarian, but let's focus on putting trading dollars to work.

The event I'm going to highlight is the Intel earnings report. I'm pretty sure that they beat. I'm not particularly concerned with the details. Yes, I know. Just leaving nice, solid information out on the clothes line to get bleached in the sun. But the truth is that I have my eye on a bigger ball. Within this cycle of earnings, the Dow and several individual stocks I'm watching will all be decided. What I mean is that we're on the cusp of the technical patterns diverging either north or south. A 5% move this week will probably turn into a 30% move in the next month. Check out what this little pop has done to the Dow's chart:


The Dow is unquestionably running into a well established downtrend and the only question is whether it's going to head south to consolidate the bottom or break out for a summer rally. There's always the possibility of stagnation, but doldrums neither lose or make money, so I'm typically focused on identifying the divergent behavior even if stagnation takes hold. In the previous article, it was looking pretty set in stone that traders would respond to that echo resonating in the 200-day moving average and take the market south. This one day of upbeat earnings has pushed north of the 200-day, and now we're left with a much more exciting picture. It could break either way. I say that not because the stock has simply crossed the line, but has done so on the back of plausible evidence that the economy is doing alright.



Back to AMD, we're seeing that the 20-day exponential moving average has been broken. I'm going to fast forward given what I know about AMD. The investors who follow AMD are the most rabid, underdog loving, cinderella buying lot on Earth. INTC just put out a positive earnings report. This usually bodes well for AMD stock. I'm going out on a limb to predict that without some contradicting earnings report from somewhere else in the sector, the AMD dead cat will bounce one last time. Although they're bleeding less on the income statement, note that this is only because the fab operation has been spun off. Just like the flash operation, AMD's partial stake of 44% in the fab will continue to dog them one way or another.

I'm keeping an eye on AMD and NVDA. Short AMD. Long NVDA. Depending on how they break, I'll be looking for one of them to develop into a nice profitable trade. I'm going to do a little bit of research into AMD's chips before the 20th, when AMD's earnings come out. It doesn't take a rocket scientist at this point to determine whether AMD can survive or not. Chips tend to be make or break products, with most of the money concentrated in the ability to earn the performance premium across you product line. Flagship chip prices are very telling as to how well a company is doing this. If AMD can't gain this premium, they will never return to enough profitability to have even a slight chance of paying down their massive debt and getting back in the black on the balance sheet.

The important thing to take home from this Leeroy upset is that stocks are very sensitive at the breaking point. Minor disturbances can take something that was stable and make it start diverging one way or the other. Focus on the medium-term outcomes that will result from the short term chaos. Once the pattern starts to stabalize, if it is founded in at the very least trader hope and confidence, it will usually go on to develop a solid upshot or breakdown depending on the circumstances.

The Leeroy watch has begun.

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Find Yourself a Hammock

I've been more stagnant than I want to be with regard to writing the blog, and I swore I didn't want to start making recommendations, but for one this is one of those situations I can't help but get excited about and second it's a good opportunity to start delving into -drumroll- applied theory.

Basically what you're looking at is the bottom of the recent crash and the recovery stalling at the first major resistance test. I'm going to go on my experience and say we're looking at the first indications of some major summer doldrums during which the bottom will be solidified as the market continues to weigh the impact of recent events on back-half seasonal profitability as well as long-term profitability. If Dow 7000 roles around again, I'll be about as surprised as I am about seeing a hurricane on the Weather Channel.


The second exhibit is one of my favorite trading stocks in one of my most favorite situations: the pointless breakout in an unfavorable market. In short, since I'm short on the market, the fact that I'm short on AMD has insurance. It will take more than just a minor Leeroy event to derail this breakdown. AMD, during most of its ascent and breakout, demonstrated what you call "weak buying," where the stock is bleeding a lot of red even as it trades higher, indicating that there is a lot of selling into the springback off the bottom. Basically it's a dead cat bounce that created an opportunity to dump shares, and now the bouncing dead cat is headed back to the ground.

I'll continue to revisit these two examples as I move forward into the conclusions of my model. I'm feeling pretty certain at this point I want to go back and re-approach some of the material. I've had a decent time getting my head around the material in the context of writing the book, so a little reorganization seems more than appropriate.

Good luck trading.

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