Saturday, 26 July 2014

How trends end - part 2 and shifting tectonic plates

Type 2 End of Trend

Treacy, in Crowd Money, points out that although the trend which ends in acceleration is relatively easy to spot, the unfortunate truth is that it is a rare event. Other reversals do not display the same regularity and finding them requires more head scratching.

The way this type of reversal plays out is based on where stops are set by participants. The process is a little
counter-intuitive. The market has been happily trending upward with a series of higher highs. Now we begin to see upward movements becoming less successful and the market spends more time ranging (i.e.flat). Most of the money in the market still feels safe because the movement is still upward albeit at a slower pace.

Momentum has subsided. The losers are those who try to make extra money on the upside by buying when the market breaks upward. In earlier times when momentum was strong they could rely on the upmove to bring them short term profits. Now they are regularly knocked out of the market with a loss. On the other hand short traders who sell these rallies are starting to make money.

It becomes clear that there is declining demand above the market. Participant will start to lose interest and start to look for alternative markets that offer better prospects. Long term traders will have their stops at a recent low so they can pull out when the trend is proved to be ending. But above them shorter term traders and those who are leveraged will have their stops higher up. With each upmove followed by a reaction a growing number of stops will be sitting at each reaction low and will be hit as the market moves down.

Once the market hits the point where there is no more demand - the last upside buyers have lost their nerve -  the market drops abruptly taking out all the stops of short term traders and eventually the stops placed at the previous big reaction low by long term holders. There is no longer any support for the market and it crumbles with no immediate cause. It is a bolt from the blue.

A changing world

I would like to quote, verbatim an analysis that I found extremely revealing. It summarizes perfectly something I have been thinking but have felt unable to put into words. Treacy does it beautifully:

Where once it was assumed that the risk in emerging markets was clearly more acute than so-called developed markets, the delineation is no longer so cut and dry. Since the year 2000 alone , China has emerged as the second-largest economy in the world. Brazil has evolved from hopeless debtor to a creditor and host of both the soccer World Cup in 2014 and Olympics in 2016. The Philippines has become a creditor to the IMF rather than a perpetual supplicant. At the same time European countries, long lauded for the integrity of their institutions and stability of their democracies, have had to go cap-in-hand to the IMF for enormous bailouts. The USA, which has long been vaunted as a bastion of free enterprise , capitalism and the rule of law has gone through two massive busts in a decade and is the largest debtor nation on earth. When characterised thus, we need to ask ourselves if there is a disconnection between our perception of risk and where the risk actually lies.

Treacy, Eoin (2013-10-07). Crowd Money: A Practical Guide to Macro Behavioural Technical Analysis (Kindle Locations 3379-3386). Harriman House. Kindle Edition. 


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