The First Principle of Context

The First Principle of Technical Analysis, Context

Human nature impacts everything we do and everything we do in life involves a choice, therefore an amount of risk. You make a choice, and it opens one set of doors and closes others, you get married choose a career path, you decide if you are going to college or tech school or none of the above.

As an observer of human behavior when it pertains to the equity markets, the decision to buy and sell stocks, futures or commodities runs a repetitive emotional cycle. Obviously, that course can be very long term 60 plus years or it can be a smaller swing of several months or it can be a very near-term cycle like day trading.

The sooner you pick a career, the higher the chances are you will do well at it, as a rule.

When a new product breaks onto the market, like the iPod, to date it back for a little perspective, who wanted to pay up for a pocket-sized record player, many people are cheap and wait until the price comes down; and they wait for the assumed bugs to be worked out.

By the time the iPod cycle is over and the iPhone is on the market, a device that can play music and double as a phone. So the laggards still may not even be aware of the new gadget called an iPod!

However, this SAME bell shaped curve reflects the mental point of view of investors and traders as they go through a typical bull/ bear market cycle.  The context of the market or where it is in terms of its cycle is the key to knowing the meaningfulness of both buy and sell signals independent of the kind of strategy used. The term cycle is always relative to the time horizon of the trader but the behavioral phases are the same.

We have all heard how the market climbs a wall of worry, or when CNBC pundits are caught off forecast a rationalization regarding why bad news is good news.

However, in real time, from the beginning of a bull market cycle to the end of the bear market that follows is a human behavior cycle where each phase provides background or context for reaction to monetary and fiscal news events.

1. Cycle price low, most recent long term example March 2009 - Beginning phase, there is an Aversion and Disregard for the market. A bull market starts when prices are depressed and investors hate stocks. I will use stocks in this report but any market is interchangeable. The headlines read with all the reasons why the market has come down so much. The industry has massive layoffs of brokers and margin clerks, who will never re-enter the industry again. The public will never buy stocks again but a minority, smart money - will see that as an opportunity to buy before others regain their consciousness. This is the beginning when media new events are exaggerated to dooms day.
2. As prices climb out of their hole, Cynicism and Doubt constrains investors. Risk is still high. The market could still fail.Investors try to decide whether what they have left should be invested in a safe haven, such as a money market fund. For early investors (adopters) they are proud of their courage buying stocks and tell a few friends of like personalities and they should buy the stocks. Media News at this stage is bullish when it is bad news and to keep the market guessing, good news is bad for market prices.
3. Cautiously optimistic: For most of 2015 and 2016 no one has trusted this bull market.  Most remain cautious, but prudent investors are already drooling at the possibility of profit. American Association of Individual Investors (AAII) Sentiment Survey this past June 2016 posted the number of bulls beneath the long-term average of38% for 32 consecutive weeks dating back to the fall of 2015, to reflect this general mistrust of the bull market. The best advertisement for equity prices is price action itself, as the advance continues, people begin to talk. Media News begins to stop the doom and gloom headlines and transitions from bad news means good and good news means bad to the more common or positive interpretation of news events.
4. Confidence! The regular investor has caught up to prices As stock prices rise, investors' feeling of mistrust changes to confidence and ultimately to enthusiasm. The majority of investors (both individuals and institutions) start buying stocks at this stage. Now the uptrend in stocks is more than clear to the majority. Now the public thinks they know the reason “why” they should invest. The media begins to focus on the economic recovery and the rationalizations for it.  Good news means a positive reaction in higher prices and bad news is ignored. The Brit-exit vote is a good example.
5. Overt enthusiasm, what Greenspan called back in the 90’s “Irrational exuberance.”During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realize that the bull market is becoming mature; and is providing a large and broad enough pool of late adapters to sell into by the early adapters, SMART MONEY. At his point the economy news is caught up with the market. Reaction to good news is positive, that is prices go up on good news and the market ignores bad news, the most recent occurrence was the mini panic low November 9 -2016.
6. The peeking phase is earmarked by greed and a conviction that easy money is here to stay.Investors' enthusiasm is followed by greed - often accompanied by numerous IPOs. As the market finally is making its peak, what was an ambitious market has now become a greedy one. So broad in its participation that even NYC taxi cab drivers and home makers are bull day trading and making money. Good news is exaggerated and bad news is ignored.
7. After a top is in place there is indifference reflected by the public and media.Buy dips is programed into behavior. However, smart money, the early adopter uses the volume of new entrants to sell into.  As the decline starts to pick up steam, the late majority average down their cost buying more. Good news stops getting positive follow through in prices higher as demand is overcome by supply and good news is leading prices lower.
8. Dismissal:As the market declines, investors show a lack of interest that quickly turns to dismissal. And as prices sink below the people’s 200 day moving average they begin to worry. and good news is leading prices lower and bad gets false rallies.
9. Denial:The market reaches the denial stage, where they regularly affirm their belief that the market definitely cannot fall any further. The last stage before the low is near. You hear “I can’t believe this” and the finger pointing begins. Good news is ignored and bad news is reacted to negatively.
10. Fear, panic and contempt:Concern starts to take hold; fear, panic and despair soon follow. The market is now capitulating, investors and traders throw away the asset at any price, some by forced by margin call liquidation. The average investors again start scorning the market. Once again, they vow never to invest in stocks again.  For the investor, trader who has the ability to stand above it all, the low is a work of art, more beautiful than a Michelangelo. Major bad news and the largest high to low range is witnessed.

There is nothing cynical in the above,like you hear from the guy who fires you, "It’s nothing personal, its business." The markets are not socialized, except to the extent that the centralized government will step in, if needed, to save the financial system e.g., QE1.

And the cycle starts again, hourly, daily weekly and so on depending on the time horizon you are trading.

You have a choice. You can be a Contrary Thinker AKA an early adapter or you can be an every-man, a laggard or nothing at all.

Your logic will always take you - the trader, the strategy developer or the composer of strategy portfolios to ask the key question. How do I thrust my buy and sell signals today? At the core of the answer is CONTEXT.

The above market cycle helps gives life, a real time example, to help demonstrate the meaning and impact of context. In order to determine what cycle phase the stock market is in, the challenge is to identify the prevalent background behavior of the news media and the public response they report.

When the market goes up on what is assumed to be good news, ignores bad news and declines for no foreseen reason you are late in the bull market. What the media pundits refer to as “good means good” phase.

There are ways to take the same behavioral phases and apply them to smaller time frames but that is not the goal in the above report.

As a collective of traders and strategy developers, Contrary Thinker's objective is to get you to think independently of what the industry is purporting and its media proxies are expecting. It certainly is important, to stand above the mob, the crowd and see more objectively.

Contrary Thinker's goal is to demonstrate in additional ways the importance of “CONTEXT.”  Events occur, that can be price based, monetary based, socially based or economic based. It does not matter.  They can all have the same value in a vacuum but put them into a different back drops, a different environment - and the market’s reaction will be different.

Context no matter the data used for your trading system, the context in which that data is streaming is more important than predicting direction. If you get the context right, you will apply and or accent the correct strategy and the streaming data through that strategy will take you into the trade.

If the above statement gives you a mind cramp and you just don’t get it and you prefer to forecast direction as primary goal, a good system that takes you into the opposite direction will cause you great consternation.