The Markets Are Changing, Change With Them

Thursday, November 12, 2009

Without question active traders have seen 2 great years of breakout-style trading. Traders that excel with a breakout/breakdown style were rewarded better than they were for years. The Panic of 2008 offered volatility not seen since the 1987 crash with the Volatility Index (VIX) registering its highest reading since it was first introduced by Professor Whaley of Duke University in 1993. From the October 2007 high in the equity markets, the Dow Jones Industrial Average fell 7,700 points losing 54% of its value. Almost 3,700 points were lost in October 2008 alone. Now, that's volatility! After bottoming in March 2009 equity markets turned sharply and rallied over 3,800 points in 9 months gaining nearly 60% in value from the lows. For those looking for range expansion, these 2 years have presented incredible opportunity.

Yet, as any active trader can clearly see, the markets are changing. Breakout traders are struggling to find profitable opportunities like they had gotten used to. More and more, traders are seeing that buying a high results in the a sharp pull-in and shorting a low finds pain in a bounce. Just as there are cycles of bull markets and bear markets, there are cycles of volatility. The VIX hit 89.5 at the height of the credit crisis while it reads just 23.5 today. The stock market is simply a price discovery mechanism and the disagreement on valuation creates movements in price. Higher uncertainty creates greater movement while complacency moderates price movement. Times of panic such as the 1987 crash, the S&L Crisis, the collapse of LTCM, the tech bubble burst and the 2008 credit crisis all caused major spikes in volatility. The times of growth and calm are shown with lower readings in the VIX given the real economic booms seen in the technology sector in the 1990s and the real estate market in the 2000s. Now, the cycle is repeating again as equity markets enter a time of greater calm. Fears of global financial meltdown are assuaging and faith in the economy is being restored.
Lowered volatility creates a different type of trading and traders must adapt. This change is happening, even if the stubborn trader refuses to admit it. And, this is likely to continue for a long time. The Morgan Stanley European Strategy desk released an excellent graph in August showing a composite of the last 19 major bear markets around the globe^. The graph presents are very clear picture of the typical scenario historically. The composite graph shows that bear markets last 29 months and register a 56% loss. The US equity markets saw a 58% loss over 17 months. The rebound off lows typically sees a 70% gain over 17 months. The US market has seen a 64% gain in 10 months. Following this pattern, the market will see a 25% correction lasting 12 months and then trade within a very large, 52% range for an average of 5.6 years. The current bear market and rebound has happened at a much quicker pace than historical averages would forecast so the correction and range trading may also be resolved at a quicker pace.
Following this line of thinking, traders must change their styles in some way. Change can come in many forms but it must come to stay in business. Some traders will choose to look for smaller price expansion. Where he expected a $2 move through lows in 2008, now he will be content with 50 cents. Some traders will focus more on a range style of trading. This trader will identify support and resistance levels and look to profit from the movement in between rather than the breakout from the defined range. Still other traders will find markets that are more suited to their strength of breakout trading. Markets such as gold, US government bonds, cocoa, and the Sri Lankan stock market all offer just such opportunity breaking out to new all-time highs recently.

Any way you slice it, traders must change with changing conditions. In order for equity markets to rally, the economy must be improving and companies must be increasing their earnings. While the economy has stepped back from the edge of a cliff it has yet to show any significantly sustainable recovery and growth as evidenced by this month's uptick in the unemployment rate to 10.2%. Therefore, the United States equity markets are likely entering a period of range action as the economy deleverages and firms retrench.

But don't fear the change! There is always money to be made in markets that move in price. But, the way those prices move will change in direction and velocity quite often over time. As Percy B. Shelley famously wrote, "Nought may endure but Mutablilty" and this is perhaps truer of markets than anything else. The only permanent thing to expect from the market is that it will change. The most profitable style of trading in US equities will be one that finds a way to capitalize on this change in action.

^Source: The Aftermath of Secular Bear Markets (via The Big Picture), Morgan Stanley European Strategy 10 August 2009, Authors: Teun Draaisma, Ronan Carr, CFA & Graham Secker, Edmund Ng, CFA and Matthew Garman.


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