Old trading axioms, “the trend is your friend” or “never bet against the trend,” are more useful today than ever before.
The day-to-day action on Wall Street has been commandeered by a small group of investors and individual investors are getting left in the dust.
Despite it all though, there is one small group of investors turning one very big trend into profits. Here’s how you can join them.
Staying One Nanosecond Ahead of the Jones’
Billions of shares exchange hands on any given trading day. Even during the summer, when trading volumes are historically low, volume is still exponentially higher than it was a few decades ago.
The increased volume is due in part because there are more investors than there were a few decades ago. We talked about this and the wealth effect of a rising stock market when 70% of American adults have some exposure to the stock market. Most of the increased volume, however, comes from the big “quant” funds.
The increased volume is from quant funds and programmed computers which execute trades in nanoseconds. According to Tabb Group, a financial research firm, computer-directed trading now accounts for 73% of all stock trades on the major U.S. exchanges.
The computers use sophisticated algorithms to spot micro-trends – very small price movements and patterns – and then jump on the trend. Then the fun really begins. A computer starts buying, the price of stock ticks up, and the trend is reinforced. Then another computer catches on and jumps in too, thereby reinforcing the trend. Then the cycle begins again.
This is how computer trading has played a big role in the surge in cyclicality of different sectors.
But here’s the deal, 27% of the trading is not directed by machines. And that’s where the profit opportunities are found.
One Big Advantage
We’ve watched Wall Street’s “black box” trading machines in action over the past couple of years. And we’ve witnessed them take a greater share of the market with each passing.
We’ve been able to spot when they get “bored” with a trend and move onto something new, and how average investors are destined to lose because of it. Here’s why.
Most investors are at a fundamental disadvantage to the computer-based trading platforms. Obviously, the computers are much faster and can catch bounces of a few cents. Emotions don’t get in the way of computer-directed trades either.
Those are not the biggest advantage of these trading systems. The true advantage of the computers is they act on, and profit from, random market movements. There doesn’t have to be a “reason” for things to happen. The trading systems react to the markets rather than following a specific story.
This is a tremendous advantage and puts them in far better position than most investors.
You see, the demand to figure out why something happens is an inherent human trait. That’s why we look at all the daily headlines, which sound reasonable at first, but don’t make any sense when viewed against each other.
A Tale of Two Headlines
Here’s one classic example from the past year. Last July, one headline said, “$140 oil drags markets down.” Oil did pass $140 and the markets fell.
Was rising oil prices really the cause of the decline?
If so, it would make sense that rising oil prices were bad for the markets.
Now jump to a year later. Oil prices have had some big swings, but they’re nowhere near last summer’s bubble highs. Still though, one Wall Street Journal Headline earlier this month proclaimed, “Falling oil prices drag on markets.”
Now, falling oil prices are bad for the markets?
That can’t be true…just last year high oil prices were bad. Now high oil prices are good.
It doesn’t make any sense. But it does help provide people the reason “why” the market moves up and down from day to day and its information they so desperately crave.
In the very short-term, the markets are random, but here’s why it plays into the hands of the computer driven trading programs.
Man vs. Machine: The Winner Is…
Over the past few years we’ve watched the hot money jump from sector to sector every two months or so. No one really knows where it’s going next, but we see the impact of it near the top and get ready to profit when they move on to another sector.
Look at what has happened over the past six months…
At first, it was infrastructure stocks which got all the attention. Infrastructure stocks started to rise from the ashes of last fall’s market downturn. For whatever reason they started going up. Then they continued to go up as the computers caught an uptrend, jumped in, and continued to pile in. Next thing you know, infrastructure stocks were up 50% to 100% across the board.
This rise got a lot of attention from the mainstream press. The reason for the rise was the coming “stimulus” bill and all of its infrastructure spending.
We poked quite a few holes in the questionable theory about infrastructure stocks and avoided the inevitable downturn. In due time, the computers pulled out and infrastructure stocks came back to reality. Many investors who wanted to “get their piece of the stimulus” and bought in when it all made sense certainly paid the price.
The same is true for education stocks. If you recall, back in January there wasn’t a hotter sector than for-profit education stocks. They were going up and the computers were piling in. Then the herd created the “they will benefit from Obama education spending” thesis. Everything has to happen for a reason. Again, the computers moved on and the herd that created a reason to explain why some stocks were moving took a beating.
Then a few months ago it was precious metals stocks. It seemed like these stocks were off to the races…gold was making another run at $1,000…and the herd was jumping in “before it’s too late.”
The results were the same.
Use This Trend to Beat the ‘Bot Today
Don’t get me wrong, in the examples above there are some great long-term opportunities in some of those sectors. Others, there’s not much. The key here is to understand what’s going on in the markets in the short-term and use it to your advantage.
That’s why, now more than ever, a contrarian investment strategy is more important to have. If you get caught up running with the herd and buying in when there’s an obvious “thesis” in place, you’re going to constantly be one step behind the markets.
Sure, you’re stocks may hold up briefly, but it won’t last long. The computers chase action. And once they’re all in, there’s not much action left. As a result, the stocks level off or start to dip and the herd comes piling looking for more gains and the computer-driven trading programs move onto the next sector.
From a trader’s perspective, you can catch some decent trading opportunities on the way up and on the way down by keeping an eye on these trends. From an investor’s perspective, it’s much easier to see the sectors which are completely out of favor and look for opportunities there. By doing that you’ll get in lower and your upside potential is higher.
There’s no reason not to expect the growth of computer-based trading to continue. Sure, Congress will vilify speculators and hedge funds, but computer-directed trading is here to stay. So it’s not something to get overly concerned about, it’s just another market reality which successful investors will use to their advantage.
By Andrew Mickey