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Secrets for thriving in a hedge fund dominated market
- 1. Secrets for Thriving in a Hedge-Fund Dominated Market Joe Bell Senior Equity Analyst Schaeffer’s Investment Research, Inc. September 11, 2012
- 3. What to Expect • Our Trading Philosophy • Herd Mentality • Market Sentiment • Sentiment Indicators • Adapting to Market Environment 3
- 4. Expectational Analysis ® A TE NT CH ME NI DA CA FUN L L SENTIMENT 4
- 5. The Ashe Experiment 5
- 6. Fashion 6
- 7. Herd Behavior 7
- 8. Stock Market Crowds 8
- 9. Humphrey B. Neill “The crowd is most enthusiastic and optimistic when it should be cautious and prudent; and is most fearful when it should be bold.” 9
- 10. Four Stages of a Rally and Decline Euphoria (bearish) Euphoria (bearish) Disbelief Acceptance (bullish) Acceptance (bearish) Disbelief (bullish) Despair (bullish) 10
- 11. The Wisdom of the Great Sanhedrin 11
- 12. Sentiment • Anecdotal – Media, blogs, Twitter, friends & family, magazine covers • Surveys/Forecasts • Quantitative – Option activity, option open interest, put/call ratios, implied volatility, short interest, analyst ratings, inflows/outflows 12
- 13. Probably the Most Famous Contrarian Magazine Cover 13
- 14. Do Not Buy Commodity ETFs 14
- 15. “If everyone is thinking alike, then somebody isn’t thinking.” 15
- 16. Potash (POT) 16
- 17. Agriculture ETF 17
- 18. Same Day as the Market Bottom in ‘09 18
- 19. Within Hours of a Major Market Peak 19
- 20. Sentiment Surveys • AAII Poll • NAAIM Poll • Investors Intelligence Report • Bloomberg Strategist Allocation 20
- 22. NAAIM 22
- 23. Wall Street Strategist Allocation 41.50% 23
- 24. Analyst Buy Ratings 24
- 25. Incorporating Bearish Analyst Ratings 25
- 26. Incorporating Bullish Analyst Ratings 26
- 27. Fading Option Speculators Stock TOL= $25.00 27
- 28. The Unwind $27 $28 $26 $25 28
- 29. Trade Example – 6/18/12 29
- 30. Sentiment on TOL • Several analysts still doubt stock • SI/Float = 9% • June 26-strike put = 7,500 puts 30
- 31. TOL August 22 call - $10.00 $4.40 31
- 32. Contrarian Quote “When someone yells ‘fire’ in a crowded theater, a contrarian is the person who first checks to see if there really is a fire before rushing to the door.” 32
- 33. Short Interest 33
- 34. Where is the Retail Trader? -$325 Billion 34
- 35. There They Are! +$911 Billion 35
- 36. Applying Ratios with Hedge Funds Involved • Buy-to-Open Individual Equity P/C Ratios • Puts on ETFs are popular hedges • VIX calls are popular hedges 36
- 37. 10-Day Equity BTO P/C Ratio 37
- 38. VIX BTO Call/Put ratio 38
- 39. A Contrarian Technical Analyst? • Be Aware of “Obvious” Set-Ups • Popular Moving Averages • Indicator Defaults – 95% don’t change them • Confirm on Multiple Time Frames 39
- 40. Think Like a “Sentimentician” • Don’t always follow the herd • Look for stocks or ETFs that have low expectations • Low expectations translate into potential buying power • Success comes from buying low expectations, not “low prices” 40
- 41. “If you don’t have time to do it right, when will you have time to do it over?” 41
- 42. Follow Us on Twitter @joebell_trader @schaeffers @ryandetrick 42
Notas del editor
- My name is Joe Bell, I have worked on the trading desk at Schaeffer’s Investment Research for almost 6 years. Today I want to focus primarily on human behavior, herd mentality, and sentiment. For those of you unfamiliar with sentiment, we are going to break it down to really understand how human behavior, moods, and feelings not only reflect but also affect the stock market. I will also offer several different types of indicators that can be used in your trading.
- Our company has been around for more than 30 years. Our monthly Option Advisor, is the nation’s leading options newsletter and the company’s flagship publication since 1981 We offer real-time option trading services to investors, as well as print and media educational offerings, including daily, weekly, and monthly newsletters. Our website provides financial news and commentary throughout the market day, plus stock screens, filters, and many other option tools Traders Blog & Market Observations from traders, TraderTv segment from Ryan & I
- Intro to Trading Philosophy: What sets Schaeffer’s apart from the crowd? It’s Expecational Analysis, a three-tiered methodology for analyzing stocks, sectors, and the market as a whole Herd Mentality & Group Think: Talk about the human behavior that defines herd mentality, along with a look at how we find this type of group think in all facets of our life and some of the theories and research behind why this phenomenon exists. Market Sentiment: So we see herd mentality & group think in all facets of our life, so it makes sense that we would see it in the financial markets as well & we will dive into market sentiment and discuss what it is and examples. Sentiment Indicators: So once we have defined it, I want to go to through different types of sentiment indicators that you can use for your analysis & even go over a trade example. Finally, we have seen the retail trader flee these markets and it seems as if they are dominated by hedge funds and institutions. We will go over some broad market indicators and perhaps a different way to look at traditional sentiment indicators given the changing market environment. Adapting to Market: Finally, I will discuss how certain indicators may need to be viewed differently as markets change, especially with a decline in participation from the retail trader and hedge funds dominating.
- Fundamental Analysis: The segment most people are familiar with. This is the popular form of analysis that colleges and masters programs teach. It involves valuing companies based on future earnings growth and revenues. Obviously analysis also includes a look at the competitive environment and the supply/demand for the industry and products or services of a company. With options and trading, we are often focusing on the short-term as well though. Some of the things from a trading perspective that can’t definitely effect the short-term include Earnings revisions, new products, new management, share buybacks, mergers and acquisitions. Technical Analysis: This is becoming more and more popular and is essentially the study of the direction of prices through the analysis of past price action and trading volume. It can included price level support/resistance, volume, momentum, overbought/oversold indicators, breadth, price patterns, as well as quantitative systems based on back testing and buy/sell signals. Now Sentiment is the 3 rd piece of the puzzle that we think is not as widely used as the other two. If I had to pick a couple major things that we focus on at Schaeffer’s it would be options and sentiment. Sentiment is the general attitude of investors toward the anticipated direction of the market. It is the moods, beliefs, and feelings of the crowd. These emotions and feelings can be effected by a variety of things. The most accurate indicators reflect what a group of investors are actually doing as opposed to what they are feeling or saying. Our methodology is contrarian. One of the most important tenets of this approach is that the power of the contrarian indicator is much greater when underlying sentiment runs COUNTER to the direction of the stock.
- Before I start a discussion on Sentiment, I want to really dive into the human psychology behind herd mentality and group think. This is something we can observe in all walks of life and is important to understanding exactly why sentiment can be so powerful as an indicator. This clip is from a 1962 Candid Camera episode titled “Face the Rear.” It is based on study done back in the 1950’s by Soloman Asch which are known today as the Asch Conformity experiments. SHOW CLIP: Behind this humorous clip is a really interesting and real phenomenon, our capacity for groupthink and herd mentality. Studies have shown that it takes only 5% of a crowd to influence the crowds direction – and the other 95% follow without realizing it. All you need to do is see what those around you, like you, are doing. And it’s a shortcut to deciding what you should do in a situation. Studies have shown that members of group think later admit that they would rather do what the group is doing than face ridicule or get singled out. Others have given answers that they believe the group of other people are smarter or more informed…if everyone is doing it, there must be a good reason and most likely right.
- Herd Mentality is one of the most commonly occurring phenomenon effecting our lives each and every day, yet one of the least explored and talked about. Fashion Trends are one of the most common examples that is so normal we don’t even think about it. We follow the latest trends because magazines tell us, actors & singers, those around us show us. Early 1960’s - bright colored clothes, the bikini came into fashion, mini skirt was invented. 1960’s -1970”s – You also had the hippies, they even had trends. Tie Die, unshaven, long hair, bell bottoms, flowers, body piercings, tattoos. Although they were often rebelling against middle class and traditional values and culture, they embarked and created there own herd that had own trends. 1970’s Disco – Mini Dresses, Hot Pants, Bell Bottoms, Disco Clubs, Platform shoes, bright colors and bright clothes] 1980’s – Big Hair, bright colors, spandex, glam rock, men and women began wearing looser shirts and tighter pants. Mustaches became popular, as did long hair. The popped collar, had to be late 1990’s early. Pink shirts and raised collar. Really? Hipsters, skinny jeans and all types of different styles and trends. We see these trends come and go, but the one constant is the groupthink and herd mentality involved.
- So, let’s take a look at Herd mentality. The term “herd” generally creates an image of animals in our head and that’s for good reason. In Africa, this a familiar scene; a herd of Zebra grazing by grass, peacefully. And then there’s a predator on the stalk. One of the Zebra senses it and takes a leap. Next thing you know, the entire group is on the run when only one zebra is the one who saw the predator. We see it in birds, where they flock together in very neat patterns Now this is a group of Wildebeasts, often found in Africa as well. They actually are commonly found in groups with Zebras when they are grazing. Lions, Cheetahs, Wild Dogs, and Hyenas are common predators. The logic behind it is that larger groups decrease the chance of being hunted or standing out for the predator to see. Grouping together also creates a larger open area around the herd, making it easier to spot the predator. Tribes trying to survive migrated in groups. It is easier to gather food and your less likely to be singled out or preyed upon. Early 19 th century, we started getting people studying group behavior in other forms, mob mentality. This was after The Vancouver Canucks lost the 2011 Stanley Cup Final to the Boston Bruins. 140 people injured, 4 people stabbed, 9 police officer hurt, an more than 115 arrests, cars flipped, burned, etc. Obviously one person alone wouldn’t react this way, but put with a group it can morph into something entirely different. It’s not just when fans are angry though. In Lexington, Kentucky fans rioted after bearing state-rival Louisville in the Final Four last year. In celebration, they burned clothes, burned & flipped over cars, burn couches, even gun shots went off, injuring fans. It’s not just sports fans either, we’ve demonstrated how a good deal or sale will get the crowd going too. On Black Friday, each year, people get in long lines, camp out and take off work just to go shopping so they don’t “miss out” on the deal everyone else is getting. Even if its not a good deal, if everyone gets excited about a product the crowd gets going. The iPhone has become huge and people will jump in lines. Yes, it’s a good phone, but are people standing in long lines the first day because they really need to have the phone a week or day before others? It has become the “cool” phone that is the “must have” if you want to be part of the crowd. So, we no longer need to group together to avoid predators, but we find similar tendencies for different motivations. People are shamed or singled out if they are not part of the crowd. So, to avoid the stress of being singled out, labeled as wrong, or to “fit in” we will take the steps necessary to avoid this stressful situation.
- Tulip Mania – generally considered one of the first recorded speculative bubbles. In Netherlands, during the Dutch Golden Age of 17 th century, Dutch trade, science, military, and art were amongst most proclaimed in the world. At the peak, February 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. At one point, 12 acres of land were offered for one Tulip. It had a different look than a lot of flowers and could tolerate the harsher weather conditions of certain parts of the region. Also became a status symbol of the elite, where they had elaborate flower gardens surrounding their mansions with tulips as the center piece. Begin to have futures markets for tulips and created mini exchanges and contracts at taverns. Tulip Graph – Collapse began in a City, where, for the first time, buyers apparently refused to show up at a routine bulb auction. Only sellers existed. At the time, the city was effected by Bubonic plague and may have been contributing factor. Traders tried to prop up demand, but within weeks the market plummeted 90%. Roaring 20’s – a period of economic prosperity. After World War I, era saw wide use of automobiles, telephones, motion pictures, and electricity, accelerated demand for consumer demand and aspirations, and significant changes in lifestyle. It was a time of Wealth & Excess, many believed stock market would rise indefinitely. Dow Jones was up 400% over a 6-year period. Great Depression – It all came to an end in October 1929. Black Thursday (10/24) – lost 11% of value, Friday Wall Street Bankers put bid on large shares on blue chip shares to halt the slide. News of the events surfaced over weekend, and Black Monday (10/28), Dow lost 13%. Black Tuesday, Dow lost 12%.. In today’s market, that would be like the a 4,300 pt decline in the Dow over a 4-day period. Over next 3 year period, the stock market lost 90% of its value. In today’s market, that would put the Dow at around 1,300 in August 2015, that is 80% below the March 2009 lows we experienced after financial crisis. NASDAQ – In more recent memory, we had the tech boom in the late 1990’s and the bubble in 2000-2001. Low interest rates, Internet was becoming mainstream, you saw companies with no revenue trading at huge premiums expecting future earnings, Everyone wanted in on the action and it eventually burst like all those before it. Housing – home values soared, houses didn’t stay on the market for long and usually had several bids at or above the ask price. Mortgage lenders were pushing mortgages on consumers and consumers were buying houses with potentially risky loans. These loans eventually were packaged and sold and you had a flood of supply on the market. All the signs were there, everyone was flipping houses and writing books on how real estate was the best investment. Like all other bubbles, the crowd became euphoric and people never thought housing would decline. Obviously they were wrong and we are still struggling with the aftereffects of this crisis today. So, we have talked about a few booms and busts. They have involved flowers, internet, new products, housing, technology. Perhaps very different industries, but the characteristics of all of them are the same. During the tops people get euphoric and happy and sooner or later end up with on the wrong side and experience, despair and negative emotions.
- All of these examples can be pretty much summed up by a quote from Humphrey B. Neill. He wrote the book “The Art of Contrary Thinking” and this is a quote from that book. Read Quote – This sentence sort of defines every major bubble and bottom in the market.
- We have seen several examples of Euphoria, Despair – When you see everyone hating the market, magazine covers are negative, everything is doom & gloom, sentiment polls are at sentiment extremes. Can generally be bullish, because from a supply demand perspective everyone demonstrating this negative sentiment has already sold. So When this happens we start to see buying pressure overcome the declining selling pressure. Disbelief – Now once we get a bounce, all the doubters are coming out. You hear “this is just a dead cat bounce” and we heard a lot of stuff back in the summer of 2009. Slowly the trend continues as there are a lot of naysayers. Acceptance – The market then starts to pressure these short sellers and naysayers out of the market and attract more and more people off the sidelines. This is the portion of the trend where “the trend is your friend” and you can make a lot of money. Ideally, you want to get in these trends in the disbelief stage and/or early in acceptance. All the sideline money comes in, able to make a lot of money. Euphoria – This is when everyone loves the stock market, and the demand for the market is reflected by the extreme positive sentiment. We saw this in the tech bubble, the housing crisis and all the bubbles throughout history. Positive magazine covers, headlines, holiday and water cooler talks about the market, extreme optimism that leaves little more buying power available to maintain the rally.
- August 13, 1979 bearish cover. The Dow closed around 875 that day. Preceded a multi-decade generational bull market. Next 20 years, the market returned about 18 percent a year. Today you hear things about “The Cult of Equities is Dead” by Bill Gross, so just some interesting comparisons. People not trusting the market and thinking its “rigged.”
- Encouraged readers to read about “America’s Worst Investment.” July 2010.
- Whenever I see bold statements or headlines like this on magazine covers or news outlets, I think of this statement by Patton. If everyone is short, than there is no money in being short unless you were first. If every trader is long, than there is no money in being long unless you were first.
- This is a chart of Potash, an agricultural stock that just a few weeks later was offered $39 billion by BHP Billiton to buy the company, this was at a 27% premium. Important, because when companies within the industry, that know their companies and industries the best, are willing to go out there and make big time purchases, its probably a good sign.
- Continuing on this theme…now remember, they didn’t call out POT specifically. They Said “DO NOT BUY COMMODITY ETFs” So what happpened? You guessed it…the DBA, Agricultural ETF, pretty much went straight up. The ETF gained about 35 percent during the next 8 months, the magazine came pretty close to picking a multi-year bottom.
- After the financial crisis, the market was incredibly volatile and there definitely wasn’t a shortage of extremely bearish headlines.
- We see it on the opposite spectrum as well. This was actually right before the financial crisis began and S&P 500 had just made a new all-time high. Market preceded to lose nearly 50% over the next 12 months.
- AAII – Surveys its members and asks them what their outlook on the stock market is for the next 6 months – bullish, bearish, or correction. NAAIM Poll – Survey of Investment Fund Managers, asks them what their exposure is – answer can range from -200% short (fully leveraged short) to +200% long (fully leveraged long). Investor’s Intelligence Report: Staff reads & evaluates more than 100 market newsletters and assess reach author’s current stance on the market: bullish, bearish, or correction. Bloomberg Strategist Allocation: Survey of major Wall Street sell-side market strategists where they ask them what their current recommended allocation to U.S. equities is.
- AS OF 08/29/12 We have identified a couple extremes on this chart. Generally, when bulls goes above 55% it has tended to be a bit of an optimistic extreme. The interesting thing I noticed on this chart was actually ahead of last week’s breakout. With the SPX trading back near its early 2012 high, we actually saw less bulls than we did during the previous peak…so, people were less optmistic. So, where did these bulls go to? Remember, they can be under the category of “bears” or “correction” also. Looking at this second chart, we saw an increase in the total number of bears. So, although market was trading near same level, we had a decrease in optimism and an increase in pessimism. I viewed that as a positive for the market.
- As of 08/30/2012
- This is the Bloomberg strategist allocation. * Last week, the recommended allocation was actually 41.50%, which is actually lower than it was back during the March 2009 bottom. Pretty incredible one here.
- We have seen the analyst buy ratings decrease during the recent rally. Historically, analyst ratings with increase with the trend and reach an optimistic extreme during market tops. This isn’t what we are seeing.
- Just an example of how fading option speculators can sometimes pay off. In this example, TOL is trading at $25 and we can see big put OI at the $26 strike. These are slightly in-the-money options, using some of our data from exchanges we can see they are buy (to open). Now, when they buy these options, the market marker will generally create some sort of short position to hedge themselves and remain neutral.
- Now Let’s say the stock starts to rally. What happens to this 26-strike put option. It might have been a 0.60 delta option when it was purchased, but will start to decrease and move to 0 once it becomes OOTM and moves closer to expiration. This decrease in delta, means market maker doesn’t need to be as hedged so they may start reducing their short position which could boost the shares. The big unwind could also come because these speculators may feel they are wrong at some point and look to close their short position. Any short position the market maker has at this point would be closed as well, so you get this boost to the shares.
- Now, you can’t see this from the chart, but housing data has actually been one of the strong points of economic reports during this year. TOL also had a recent history of beating earnings expectations. The first thing you notice from chart is that the stock is in a nice uptrend. Shorter moving averages above long-term moving averages.
- Short Interest discussion Interesting thing to me is that we see total short interest up near similar levels as we experienced last summer, despite the fact that the pullback wasn’t anywhere near as sharp or large.
- Develop a plan before you trade or do it over later with more frustration and less cash.