Computers do not have psychology

In previous posts, I discuss equities investing or stocks using technical analysis (TA) to guess the market (see here, here, here and here). One common form of TA is known as Elliot Wave Principle (EWP) which depends on the collective psychology of investors charting price patterns over time into 5 distinctive waves. Over the last couple of years as I have dabbled in stock investing I have attempted to use EWP unsuccessfully with the New York Stock Exchange indexes. EWP came to my attention in the 2007-2009 crash as the price action followed the 5 waves. If it was true then, it must be true just a few months later? I have come to the conclusion that TA including EWP is not very effective at the current time in US stock markets because of how the market's composition has changed even in a brief period. It has to do with investor psychology (or lack of) and other outside influences.

I will give a brief history of how the US stock market changed over the last couple of decades. In 2001, markets began to trade stock in $0.01 increments in a process known as decimalization. Prior to this, all stocks were traded in fractions of (n/16) fractions of dollars. One advantage of fractions was the fact stock brokers with ask and bid prices at the increments. The slight (n/16) difference between the bid and ask price was the amount a stock broker could make buying and selling blocks of stocks for customers. The second innovation was the market switched to partially computerized operations in NYSE operations and is fully computerized in the NASDAQ market. In a nutshell, the pits with traders buying and selling stock are gone. The price action mostly occurs within a giant computer.

This "modernization" of the markets led to new kind of investment strategy, computerized trading at a quick speed. Basically, picture supercomputers directly connected to the exchange computers through a high speed Internet connection. Why would anyone do that? It is capitalizing on the same trade strategy as day traders. Buy and sell millions of stock simultaneously of just a few pennies of profit and the pennies turn into hundreds of thousands of dollars quickly. Add in the ability to trade put in quotes and cancel transactions before they are processed, one has quite a money making strategy. This process is known as high-frequency trading (HFT).

How does this influence TA? As stated before, TA is based upon investor psychology and the desire to hold stock over various lengths of time from hours up to years. Traders make buys and sells in a response to price movement creating the distinctive TA patterns. HFTs buy and sell stock within a matter of seconds. HFTs can even move millions of stocks down to milliseconds time frames! The HFT responds in a near instantaneous, mechanized manner to stock movement. The resulting trade psychology does not appear on the stock price charts. If HFTs were a small minority in the stock community, it would not directly influence TA. This was partially the case during the 2007-2009 crash with HFTs being ~40 % of the market's participants. EWP traced out the 5 distinctive waves. Currently, HFT represents ~60 % of all trades made on the US exchanges and can account for ~70 % on light trading days. Since this represent the majority of trades, the price action is not driven fully by investor psychology making TA less effective. I believe TA is useless over short periods of time.

One other factor distorting the markets are US government authorities. The government's stimulus and various Federal Reserve programs (TARP, TALF, POMO and etc) are putting money into investors hands in indiscriminate, unequal ways. The "free" money ends up being investing in the market in unorthodoxy manners.

The aha moment I had last night was using TA to avoid these unwanted outside influences into the markets. The only market to my knowledge that is too large ($100s billions per day) for authorities to significantly manipulate are foreign exchange markets (FX). These markets are based upon converting money into different currencies worldwide and HFTs would also have no interest in these markets. What FX markets can follow using TA are carry trades and whether investors are seeking risk or are seeking a safe haven for their investing.

The wave of pain

In previous posts, I gave a brief outline of Elliot Wave principle and how it pertains to investor psychology in stock markets (click here and here for the postings). I also spoke about the sovereign debt crisis in Greece along with the problems of the PIIGS. This post will bring together these two concepts and what is currently happening on the US stock exchanges.

Today was a massacre. The three major indexes (Dow, NASDAQ and S&P 500) all fell more than 3%. One major factor roiling the market is the continued debt crisis in Europe. Even after ~$1 trillion USD bail out a few weeks ago from the European Central Bank (ECB) and the International Monetary Fund (IMF), the European Union (EU) is still not economically stable. More debt does not solve Europe's fundemental marcroeconomic issues. The country that is the focus of attention is Hungary. Hungary is not part of the EU, but the former communist block country received significant amounts of loans from EU based banks. Hungary is threatening to default and the potential massive losses to those EU banks are both enormous and destablizing. The jobs report for May also came out worst than expected. These events contribute to the main stream media's story to why the market sell off occured.

Was this sell off predictable? It is impossible to determine the exact movement or level of the stock market on any given day. Anyone who says they can is a liar or an insider. Insiders can only predict with a certain stock for limited amounts of time (insider trading is illegal). For us average folk, it is possible to approximate the direction and pattern a market may take using Elliot Wave principle (EW) which is a technical analysis method based on the Dow Theory. EW prescribes potential outcomes. The EW community tends to believe we are in Primary wave 3 of a secular bear market. We are a heavily indebted society with a debt bubble that needs bursting. Accordingly, I believe we are at this stage in the bear market as of today:

Cycle 3 of 5 (Primary wave 3)
Intermediate 1 of 5
Minor 3 of 5
Minute 3 of 5

Remember, each wave is further divided into 5 subwaves in the repetitious fractal form. The minor 3 of 5 represents the largest 3rd wave of a fractal. I was skeptical about any waves smaller than the minors, but the last couple of weeks made me a believer. The 3rd wave is also the most violent in action. The sell off today represents the sudden movement expected in this bear market stage.

The answer for the predictability question is yes. The massive sell off was predictable being limited to approximate dates and amplitudes. I was prepared by going long on inverse ETFs or funds that respond in an inverse manner to the market movement (represented stocks go down, fund goes up). This current downturn should continue on for a least a few more trading days.

Europe stops fiddling while Greece burns!

This post is a combination of several other past blog topics. It will cover economics and the stock market.

In March, I discussed the economic crisis in Greece in the post The slippery slope of Greece. In the post, four options to Greece's crisis were presented:

Option 1: EU bails out Greece with emergency loans at low rates and Greece implements austerity budget spending.
Results: If the money comes in from the other EU members, it will give Greece a little breathing room to fix problems. This requires the most powerful EU member's, Germany, blessing. If the money does show, I rather doubt Greece will do more than superficial changes to government spending. Greece has cheated on its obligations in the past, thus, why should it change now? EU members know this. The cash influx would last about 6 months and nothing structurally would have changed. Greece would be where it started. Even if the austerity measures were fully implemented, Greeks make is a national past time to protest. The economy would face a decline in productivity resulting in further economic problems.

Option 2: Bailout from the US Federal Reserve in low rate loans
Results: Same as in option 1. The advantage of this scenario is it could be kept secret. For Europeans, it is the best option since Europe do not have to pay. American taxpayers get the bill when option 4 below occurs.

Option 3: International Monetary Fund (IMF) steps in and gives emergency loans to Greece.
Results: Same as option 1 again. Two negative aspects loom here. One, I believe this would break terms of the EU. Other EU states would retaliate, dumping on Greece in various ways. Greece might get thrown out of the EU. Two, the spending restrictions the IMF imposes during its assistance programs are harsh. Greece will enter into an economic downward spiral as socialist union workers shut the country down from mass protests.

Option 4: Greece defaults on sovereign debt
Results: It is impossible to determine what will occur after the actual fact. Greece would enter into a severe depression though. The key is membership within the EU. Will it remain a full or partial EU member? Will it keep the euro as a currency? I am guessing the IMF would step in here and impose their will. Greece would have to accept a bitter pill.

It appears as if a variation of Option 1 won. The ECB announced last night along with aid from the IMF a $955 billion rescue fund for the entirety of the EU states dependent upon the Euro. The plan is bailing out all of Europe! The intention of the rescue was to defend the value of the Euro. Really, the plan is nothing more than printing money and providing it to banks across Europe. In the long term, it is going to devalue the Euro even further. It does not directly address the crisis in Europe and especially Greece, too much debt.


In two previous posts, Markets and psychology along with Market observations, I present Elliot Wave Theory and how equity markets are driven by investor sentiment. It is time for a Dr. Coffee's Market Update.

In February, I was predicting that we had begun Primary Wave 3, AKA the Ponzi wave. The market had a mind of its own and recovered after the sell off in January and February. It continued on the ever appreciating march to the moon. Primary Wave 2 had not yet finished and had me fooled into a sudden crash as expected in Primary 3.

Well, things have changed. The sudden drop and high volume accompanied with the sell off starting on April 27 is more characteristic of a 3rd wave. Last Thursday had the Dow Jones Industrial Average briefly drop almost a 1000 points! Today, after the European bailout was announced, all of the US indexes shot up over 4%. This is typical of a bear market rally and indicates that Primary 3 has launched. I believe this is where we are at within the wave structure:
Cycle 3 of 5 (Primary wave 3)
Intermediate 1 of 5
Minor 2 of 5

If this is true, expect significant downside to the US stock market. If not, the market may fool me again!! I reserve the right to be wrong.

Market observations

In a prior post, Markets and psychology, I mentioned a market theory known as Elliot wave principle. Elliot wave principle states the markets move in five wave fractal shapes dependent upon investor sentiment. It is a tool based upon probabilities estimating future outcomes. The theory gives investors windows of buying and selling opportunities.

I have encountered difficulty using this theory within the last week. If one examines stock charts over long periods of time, the wave can be easily identified in the data. Sometimes, the waves are not clear as they are being formed. For example, on February 9 I predicted we were on this step in the current Cycle:

Primary = 3 of 5
Intermediate = 1 of 5
Minor = 2 of 3
Minute (not sure)

After about a week of market action, this stage in the Cycle has yet to be fulfilled. My current guess as of today's close (2/17) is:
Primary = 3 of 5
Intermediate = 1 of 5
Minor = end of 2
Minute (still not sure)
I was assuming the Minor 2 of 3 was unfolding as we had entered into the 3rd Minor wave. Further market action completed a nice rebound 2nd Minor wave demonstrating we were not that far into the overall wave structure yet. The 3rd Minor is coming at a later date.

What went wrong? Two things come to mind.
1. I had my investments ready for a 3 of 3 Minor movement. My bias.
2. Other more experienced bloggers I follow came to the same conclusion. The waves were unclear as they were being traced.

It is now obvious what the wave patterns are, not so in real time. Stock market investing in general follows this unknown path. Mr. Market will move as Mr. Market chooses. As Yogi Berra said, "It's tough to make predictions, especially about the future."

Markets and psychology

This post covers a topic of interest to me, the stock market. I mentioned in a previous post, driving with the rearview mirror, about some basic concepts of the stock market. Several months have passed since my last market posting. Accordingly, I have been studying and stock trading resulting in both failure and success. The more I watch the market, the easier it is to understand that investor psychology drives the market.

One technique that I am studying is Elliot wave principle (EWP) developed in the 1930's by Ralph Nelson Elliot. Elliot observed that markets move in 5 distinct sets of waves according to prevalent market psychology. When in a bull market, impulse waves move the market up. In a bear market, impulse waves move it down. Waves 1, 3 and 5 are the impulse waves, while 2 and 4 are the corrective waves. Impulse waves are further subdivided into smaller sets of 5 fractal waves. Corrective waves have an a-b-c wedge like pattern and are also subdivided into smaller waves. The time span of the waves are from decades to hours on ticker charts. To be honest, the larger waves on the order of days (Minute) up to years (Primary) follow this pattern making distinctive patterns on ticker charts. Time spans greater than several years and less than several days tend not to fit into exact scenarios. It is just wishful thinking putting noisy or irrelevant data into such a pattern in my opinion. The take home message is Elliot wave principle follows what truly drives a market, investor sentiment.

Elliot wave principle is a loose theory, it has multiple outcomes during any given situation. Market timing and wave amplitudes are based upon Fibonacci numbers. Exact values fit into a range. Here is where EWP is useful, it tells us approximately when the market will turn and to the approximate degree a rally or sell-off will carry a market. It determines buying or selling windows ahead of time. I suggest using other technical indicators (MACD, stochastic and etc.) as complimentary tools when waves are not clear, which often waves are unclear. Investigation of the stock's price movement (who owns it and why) will further help an investor.

In practical application, I believe as of February 9, 2010 we are in a bear market at the following point in a Cycle. This means the overall market movement is downward.
Primary = 1 of 3
Intermediate = 1 of 5
Minor = 2 of 3
Minute (not sure)
Using this, I made a successful and unsuccessful trade. The unsuccessful trade occurred because of undesired price movement premarket. My blunder even as the stock moved in the desired predicted direction. This is why the system is not going to make anyone rich without following good trading practices.

I will post further on this topic to see if my evaluation and Elliot wave principle holds true.