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Short Term Scale - Part I

In continuation of last Tuesday's note - Long Term Scale, I offer a few thoughts on the short to intermediate time frames.

I have found the mechanics of writing to be constructive to my trading in several ways - most notably in establishing a framework of logic between more than one perspective. My market approach is objective in the sense that I am willing to argue between the poles and trade the short term nuance even if my longer-term thesis runs counter to those instincts. You could call it my respective alpha within the system.

Considering it had the potential to become another "Lehman Weekend", it seems logical - as someone who finds insights in comparative scales - to think about the financial crisis as a series of expanding proportions or even fractals in the geometric sense. The reflexes of cause and effects will continue to reverberate as the collective system digests the impacts to credit or lack there of. These congruencies and replications will be exhibited in various degrees in the charts - as noted in last week's hourly series of the SPX and in the longer term framework described in the Congruent Market Theory.

With that said, the markets continue to exhibit more forgiveness on the short side of the ledger - with the possibility that another flash-crash style event is on the backside of another technical break. This should not come as a surprise to traders since we have basically experienced a degree of intense selling/flash-crash every year since 2006.

The similarities to last year are numerous and should not be ignored - even if the timing is obvious and the kinetic relationships readily apparent.

  • Euro weakness - dollar strength.
  • Dollar strength - equity weakness.
  • Increase fear (VIX) - lower yields (TNX).

The prospect for another flash-crash has simply become an occupational hazard if you trade on a very short timeframe and attempt to position proactively on the long side of the ledger. This is especially the case if the markets have shown a particular vulnerability like they did last year. Specifically, the credit markets have been flashing hazard signals over the past month. I noted this observation in the June 7th notes on Appraising Risk.

"One such tool has been to keep an eye on a position like FCT. FCT is a close ended fixed income mutual fund that primarily invests in senior floating rate loans made to mid tier corporate borrowers. Its utility on my screen has been to appraise credit risk sensitivity."

Over the past two weeks FCT has continued to bleed lower with the overall market. Here is an updated chart of the initial contrasts of FCT, the VIX and the SPX posted in my June 7th note. You will notice that the VIX finally started expanding last week as the rubber met the road so to speak in Greece.

I find the parallels to February 2007 compelling in the sense that it was during this time period that the subprime ABX market started cracking. I have always cited this time period as the ignition point to the financial crisis. Here are a few charts (courtesy of Markit) of the price structures in the subprime market in 2007 and today. Both periods experienced intensive selling into weakness as characterized by the waterfall price structures.

An un-teachable instinct in successful trading (which typically covers the majority of skills a trader acquires) is knowing where your respective edge has prescience and where it does not. Semantics I suppose towards successfully managing risk. You can read about the mechanics and behavioral psychology behind trading - perhaps even get an advanced degree in finance - but you will never grasp when to adjust your respective approach to the market until you experience the spectrum of conditions many times over. Maybe its 10,000 hours as Malcome Gladwell referred to in the Outliers - it is likely a much greater investment when it comes to the markets because the variables are so numerous and the conditions so disparate.

Recently, the impacts on behavioral finance have been extremely atypical - in the sense that we knew of several catalysts within plain sight that could potentially have broad influence over the system:

The telegraphed conclusion of QE2 and the sovereign debt travails in Europe.

This is likely the reason for the constrained conundrum in the VIX going into last week. While although market participants have been anticipating the prospect of volatility - the difference between the description of the event and the act itself is akin to the difference between reading about the mechanics of war and actually being in it. They are worlds apart and often indescribable until you find yourself immersed within it.

We are now immersed within it.

For the past several months I have had a very good read on where the markets will likely trade and it has been reflected in the frequency (high) of trades I have executed, the duration of exposure within the market (short) and in my P&L statement. Over the next several sessions I will likely do more watching than trading for the purpose of recognizing any anomalies that may be perceived as insightful towards spotting a low.

Recognizing a market low is a much clearer discipline than determining tops. From the geometry of price to the emotional response echoed within the market - they are typically a "you know it when you see it" event. Bear markets take that dynamic and slowly erode it away over the course of each successive low. It remains to be scene whether we are on that proportional course, but we should be approaching a low sooner rather than later.

Sentiment continues to be constructive towards further downside action - in the sense that the majority of traders are chasing that low. That was reflected in this past weeks increase in optimism of retail investors that see stock prices higher six months from now. Granted they were from historically low levels (from 24.4% to 29%), but the negative divergence is still noteworthy.

More to come in this line of thinking in Short Term Scale - Part II, tomorrow.


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