Friday, April 1, 2011

the Congruent Market Theory

As a guide, I typically size up a trading environment and isolate markets with like qualities (i.e. fundamentals, technicals, sentiment). Certainly, no two markets are the same or follow a harmonic trajectory. However, they can provide a historical study of how a market reacted to similar conditions and where the inflection points may arise. Finding patterns in the charts is one aspect of that. However, I find it is only useful if it is placed into a broader context and applied to a market environment that is similar to the one that I am trading in. Here is one example of how I used historical charts, applied appropriately to a similar market environment - to determine the higher probable outcome. 

In December of 2008 as the market was reflexively trading higher out of the November lows, there was a great deal of chatter by traders about "the" low being made for the cycle. And while the selling pressure was tremendous in both October and November, and the market was up by more than 20% from the lows by the end of the year, I wanted to look for another perspective to see if there was any evidence to the contrary. I found it in the VIX while reviewing similar market environments in 2002 and 1990. 

As you can see below in the charts, both bear markets found their exhaustion points at lower highs in the VIX. Considering the market back in December of 2008 was trading out of a higher VIX print in November, it constructively colored my expectations for the beginning of that year.
The current trading environment is still loosely following the reflex reflationary trade from 2003 to 2007. However, as we are all keenly aware of, the stimulus and monetary response from the Fed is much greater this time around. For this reason, the fractal analogy still applies, albeit the proportions have expanded. Considering we are currently trading (or feeding) in the trough monetary response by the Fed (just as we were in 2004) you could use the market environment back then as a useful reference for future expectations. Let's just call it the Congruent Market Theory. It dovetails rather nicely into my previous piece on the corporate credit market then and now (see here).
I am not going to go through all of technical similarities to 2004 in fear of being overly verbose (already there), but reducing it to its basics you could look at the Golden Cross that was made in the previous week (SPX) as a reference point to back then. Broadly speaking, you could say the Golden Cross on the weekly charts is analogous to the Fed successfully turning the battleship that is the US economy and achieving reflation within the market.
Further diving down the timeframes to the daily charts, I would expect the market to loosely follow the script from 2004 - in that it basically traded sideways for the remainder of the year as traders wrestled with the notion of a less accommodative Fed and what that meant for stocks, commodities and bonds. 

Ultimately, and assuming this time is no different (how ironic), the market should receive a positive psychological boost that we are in fact stepping away from the brink (for now) and headed towards a  trading environment that is driven fundamentally by positive, rather than negative feedback.

Ignoring the constructive seasonality that is April, I am looking for the market to transition to a more defensive and trading range environment like it was in 2004. I believe you may have seen aspects of that transition today as managers alter their asset allocation strategies on the first day of the quarter to reflect a mix of less "stuff" and more stock. If and when the commodity complex begins its descent back towards the historical mean, it will likely have a disruptive effect towards market liquidity in the short term.

As a trader, I would look to short the indices in the short to intermediate time frames as either a hedge or a trade itself. As a loose framework, I would still utilize the SPX highs from February as the top of the range (and a stop) and the the lows from early March as the bottom of the range.