How To Trade When Major Events Affect Financial Markets

A historical chart of the S&P or other broad indexes is really a picture of history. Huge events have happened in history, and their impact is reflected in the chart of averages during those periods. There have been world wars, depressions, booms, busts, the cornering of a critical transportation stock, civil wars, assassinations, broad new government powers, earthquakes, violent attacks, and countless other shocks to the free markets, over the last 140 years or so of market data that is available. And the beauty that such a chart shows is the incredible ability of mankind to ultimately adapt and change to new situations and climates. But what the averages don't tell, is the countless stories of individuals who did not adapt quickly enough to survive financially, as well as the countless stories of individuals who understood the ramifications of each shock, and were able to preserve their capital and flourish.

The most important thing an investor must do when a shock hits the markets and the economy, is analyze and strive to understand what has changed and how this change will impact the rules and methodologies that a trader uses to capture profits consistently in the markets.  Without such an understanding, traders are doomed to apply analysis that no longer is relevant to market action. I can remember some examples of this from my own trading lifetime. One such example is short-interest. For a long period of time, the analysis of short-interest provided an incredibly accurate view of what a stock or the market was about to do. Short interest became a very popular indicator because of its prescience. However, when options began to trade in decent volume, lots of shorts measured in short-interest were really offsets to option positions that were already hedged. This ruined short-interest as an indicator. Yet many traders who had made fortunes using short-interest when it was successful, continued to use it when it was no longer working. I knew several traders who made millions using short-interest when it was working, and who went broke continuing to use short-interest when it became obsolete. Their mistake was not understanding the impact of options markets on the indicator they were using.

So let us look at the current terrorist shock and try to understand how it might impact some of the tools we look at in trading the markets.

1. Overbought/oversold indicators.  I would advise most investors to put less stock in oversold indicators like TRIN, VIX, put/call ratios, etc., even including sentiment indicators, in the current market environment. We will probably get a pop up off of severely and broadly indicated oversold levels, but I suspect it will be a lot less steep and a lot quicker to end than the rallies we have seen off of oversold levels since WWII. We have really many shocks that the market is absorbing. The first is that this is a real bear market. We have not had a real bear market since 1972 (with 1980-82 perhaps also qualifying, but barely). In a real bear market like 1972-75 or 1929-32, markets are perpetually oversold as they continue to drop. Investors do not bounce back to confidence but get progressively more and more negative while the market falls. We are not at this point yet, but another leg down accompanied by more mutual fund liquidation (mutual fund buyers on a weighted basis since 1982 are now just 4% in the black on all their purchases -- they may begin to sell en masse if their positions since 1982 go under water), or if margin levels fall back to more normal levels of pre late-1990s.

2. Expect a much more delayed effect from economic gauges and monetary variables. Economic gauges show that since WWII, every time unemployment rose significantly or any indication of recession arose, that in six to 12 months, the market was much higher.  That may not be the case this time around. We need to see how significantly consumption has been hit, as well as consumer confidence.  But ancillary evidence points to the consumer retrenching in a more significant fashion than any time since WWII. This makes sense because the average American has lost more of a percentage of his wealth since March 2000 than at any other period since WWII. We doubt that consumers will buy like normally crazy any time soon, because the resolution to this crisis is likely to take a long time. And should reprisals by terrorists hit America again with further attacks after the U.S. counter-attack begins, a significant element of good feeling will be forever lost, and may be already. As we've discussed in past columns, monetary policy is already being stifled heavily this time around, by weakness abroad and by the fact that this bubble created a global overcapacity glut that cannot be cured quickly or by printing money. Money supply increases and lower interest rates didn't help during the Depression or in Japan since 1980 because confidence was dealt a severe blow and because consumption would not return to levels beforehand. We have had an economy barely hanging on globally because the U.S. consumer of last resort continued to spend despite a huge drop in capital spending. But with the consumer confidence plummeting and consumption dropping off sharply, it will likely be more delayed and more difficult to get confidence back to normal levels.

With the above indicators that normally lead to reliable signals being perhaps undermined in usefulness by the nature of this particular economic contraction and terrorist shock, I believe investors need to put stronger emphasis on two types of market indicators:  A. breadth indicators;  and B. leadership indications.

A.  Breadth Indicators: Investors reading my TradingMarkets.com column since I became cautious and cut allocations significantly in March 2000 should note that one of the reasons we have not gotten significantly long in the market since that time is because our breadth indicators have never given a bullish signal. I believe investors in global equities are well advised to wait for leadership and two or more  of the following breadth indicators to signal a potentially significant rally in stocks before allocating heavily toward the long side of global markets:

     1) A day when up volume outnumbers down volume by at least 9 to 1

     2)  Five-day up-volume is 77% or higher of the total volume for the last five days

     3)  Either the 10-day A/D is 2 or greater, or the 11-day A/D is 1.9 or greater

     4)  The S&P rises by 2.75%, and 70% or more issues advance

     5)  O'Neil's follow through days develop on several indexes at a time on a given day and volume is clearly at a relatively high level in all those indexes;

     6)  Either the 15-day EMA of (advances - declines) reaches +300 or higher, or the 8-day EMA of (advances - declines) reaches +400 or higher, or the 6-day EMA of (advances - declines) reaches +500 or higher

B.  Leadership:  Leadership becomes clear and leaders begin breaking out of sound bases with plurality. Watch the group and sub-group graphs of the TradingMarkets.com Top RS/EPS New Highs Lists daily like a hawk!  When New Highs begin to expand above 20 each day, with a day or two above 50 at least each week, you'll know at least a catchable rally is likely to be under way. When a handful of stocks in leading groups begin to breakout of 4+ week flags and cup-and-handles every day, some of which meet fuel criteria, then trades can begin to be taken. Until leadership and a plurality of leading stocks begin breaking out sound 4+ week bases develops, give the bear market the benefit of the doubt and do not increase allocation to the long side significantly.

Finally, we suggest extra caution, and a more gradualist approach to increasing equity allocations than under normal circumstances. It is quite possible that the markets will become very volatile and lead to false signals in each direction over the coming months. A US attack may appear to be successful for many weeks, but a retaliation by terrorists could lead the market to sink to new lows. Uncertainty is higher, so risk is higher, and that means allocation to stocks should stay lower until those risks recede.

Economically investors should be watching for leading commodities to start to bottom, base, and break out to the upside of bases. Watch copper, cotton, and lumber in particular -- and bonds for a top, before getting too excited about the potential for a recovery of any lasting kind. Also watch for an end to the slide in consumer confidence, a turnup in the LEI and NAPM, and some indication that the collapse in earnings is turning around. 

Certainly, there will be opportunities in the market on both the long and the short side again. But in a real bear market, investors need to remember that bear markets are MUCH trickier than bull markets to make money in consistently. Shorts that build profits for months can have those profits wiped out in a day or two of explosive short-covering rallies. Conversely, bear market rallies that look like the real thing can take the profits away from weeks of longs in a day. Pick and choose very defensively and with less than normal allocation, until the environment improves in ways we have outlined above, to preserve capital and be able to pounce on true highly reliable opportunities when they return. 

Click Here To Learn How Mark Boucher Has Been Successful For The Past Decade