Rocking the golden boat

September 3, 2015 09:00 AM

People often ask, “Why does the market go up?” The answer is simple. There were more buyers than there were sellers. And why does it go down? The answer is equally simple. The sellers outnumbered the buyers. Price action is that straightforward.

Knowing what moves the market isn’t worth much unless you know why. The next logical question to ask is, “What makes people become buyers or sellers?” Initially, it is news. Many retail traders think that information will make them rich and most live on the cusp of the next great report and then faithfully follow it once it is released. The trouble is that there are always enough news, reports and economic indexes to prove almost anything — especially after the fact! 

Instead, we should turn to what the market actually tells us about its overbought/oversold condition and its relationship to its perceived mean value. Probability signals that develop as the price action pulls away from the mean and the amount of liquidity in the market at any one time are the ultimate indicators of accurate market prognostication (see “Retracement rules,” below).

Price action is not determined by the hoped-for profit from the development of some new product or a “forward looking statement.” Never mistake news with trading expertise. If you are going to be successful as a trader, you do not need the world whispering in your ear about what others think is supposed to happen six months from now. Instead, place your trust in what has already happened and what the market freely tells all who will listen. 

Mean value

As we try to interpret any market, too much cannot be said about the perceived mean value of the stock or futures contract being traded, as well as the relation of the overbought/sold condition of the last price paid for it. The foundation of every stock or futures contract is found in its perceived mean value, as traders alternately give more or less than that price. Every stock or futures contract will eventually attempt to bring the overbought/sold condition of the last price paid into agreement with this value. 

The perceived mean value represents the market’s worth according to institutional traders. An example is the widely recognized 200-day moving average used by many on daily price charts. The perceived mean is normally a long-term simple moving average, and each stock or futures contract has one that is unique unto it.

The market of a stock or futures contract becomes overbought or oversold, it normally exceeds the perceived mean value by too much for institutional comfort. When it does, the institutional money will almost always come into the market and bring the price action back into line with its perception of that market’s actual worth.

Therefore, every time that price action pulls away from the mean, pressure develops for it to retrace. And anytime we have a normal preponderance of one over the other, it will cause the market to seek equilibrium between the last price paid and the perceived mean value (see “Wheat moves,” below). “When” is always open to conjecture; however, a deviation between a momentary extreme and the markets’ perceived value cannot continue forever.

At any point in time, there is just so much money actively trying to find placement in the markets. As that pool of money expands and contracts, the buyers and sellers constantly fight over it. Every traded market always develops into being either oversold as it engages in profit taking and short selling, or it is overbought as it sops up the money available in traders’ accounts.

Counting money

At the time of this writing, M2 money supply (the total amount of money in circulation plus savings deposits, retirement accounts and deposits of less than $100,000) is approximately $7.725 trillion. Of that total, there is approximately $139 billion being traded on the New York Stock Exchange each day, against a total market cap of approximately $14.085 trillion. 

However, it must be recognized that this $139 billion pool of money is broadly dispersed across the entire market. Roughly speaking, an individual stock can be defined by the pool of money used by traders who follow that particular issue. This pool is often referred to as its market cap, but it is actually more. If you trade stocks, the market cap is easiest to understand if you recognize that the market cap of a stock is analogous to the annual usage of a commodity. 

In the case of futures, this can be roughly defined by the historical usage of that particular commodity. For instance, the world’s approximate annual demand for soybeans is 250 million metric tons, and the futures price is determined by the world’s likelihood of currently producing that amount vs. the supply that is available to satisfy the worldwide demand.

The golden boat

Visualize a boat. Keep in mind that for a boat to remain stable in the water, physics require that the weight of its cargo always must be distributed fairly evenly on both sides of the keel. The keel is analogous to the perceived mean value of the issue or contract being traded.

Let’s say that our boat has 100 passengers; however, there are only seats for 80. These seats are equally divided, with 80 of the hundred passengers comfortably settled into their seats in the middle of the boat with 40 seats on each side of the keel. Because their weight is fairly evenly placed in the center of the boat, the captain of the boat usually has no problem with the 80. 

Unfortunately, the remaining 20 passengers are a drunken, unruly lot! Members of this crowd constantly run from one side of the boat to the other to see the view. When they do, they shift the center of balance of the boat. As time goes on, this group begins to accumulate at one side of the boat as something attracts their interest. At the same time, some of the seated passengers now begin to leave their seats and join them. When a sufficient number of passengers gather at one side of the boat, the boat lists and becomes nearly unmanageable. 

The combined weight of the collected passengers now drives the gunnels of the boat downward toward the surface of the water. If all the passengers were to rush to one side of the boat, they would cause the boat to capsize, but there are always a few seated passengers—on both sides of the keel—who are not going anywhere. Their unwillingness to get excited provides the boat with a certain degree of stability. 

As all of this occurs, water begins to slosh into the boat and the “terrible 20” plus those who had joined them become frightened and begin to rush to the other side of the boat. The center of balance shifts again, and the boat becomes even more difficult to control. As it does, shaken passengers look for vacant seats for security, and the boat acquires a degree of stability. Once all the seats are again filled, the scenario gets ready to start all over again.

These “terrible 20” are always looking ahead toward the next approaching vista. Once one is sighted, they will again rush to position themselves at the side of the boat for the best view when it arrives. 

If we pursue this little analogy to its finality, we would find that every subjective market, no matter the time frame, will always have a distinctive trading range that depends on whether the last price paid is overbought or oversold (see “A closer look,” below). In our example, this is akin to the gunnels of the boat. As the larger market surges ahead, the price action normally swings from one extreme to the other as it moves across the market’s perceived mean value. 

Price action always moves from being overbought to oversold, then from oversold to overbought, and then back again. In other words, the price action always travels back and forth across the markets’ perceived mean value. Catching the price action at its extreme as it begins to correct is a way to consistent trade profitability. That said, don’t fall into the trap of thinking these extremes are impenetrable boundaries; markets can and do exceed them, sometimes for extended durations (see “Pushing the envelope,” below).

In most cases, and certainly over time, it is not productive to consider opening a long position if the market is already overbought, any more so than it is smart to go short if the market is oversold. To achieve maximum profit consistency as a trader, it is best to be positioned contrary to price extremes. That does not mean that we should never reach for tops and bottoms as we evaluate our trades, only that we execute before the retail investors see a retracement developing.

About the Author

Bill DeBuse has been engaged with the markets since 1959 and is presently a proprietary trader for a family foundation.