How the stock market makes sense
Posted by Danny on March 7, 2016
Stocks kept climbing and on social networks a lot of investors are shaking their heads in disbelief, complaining that this market makes no sense. Just when they started feeling safe going short in a down market in a weak global economy the markets climb more than 10% in a few weeks… Huh, where is the logic? More on that below.
Let’s start with a look at the current Nasdaq chart:
Nasdaq Composite has climbed above 4700 without looking back. Three weeks ago it was still testing 4200. This is what I warned for two weeks ago: pullbacks have been very short and shallow because too many traders are looking for a chance to cover shorts. Is this rebound now done and over with? Maybe, maybe not…
Technically the fast Earl (blue line) has turned down, but the market is not coming along. The slower Earl2 (orange line) and MoM are still going up with further room to rise. This market may easily have another good week in it and by then the Earl2 and MoM will probably start to flatten out at high levels. Above 4700 the next major overhead resistance for the Nasdaq is in the 4800-4900 area, and that’s how high it could go before we see a meaningful pullback. Best approach is to go with the flow as long as my MoM indicator keeps pointing up. Once it turns down I would take some profits.
So, what’s the logic of stocks going up in a weak economy? Well, people who expect the economy and the stock market to behave in an easy logical way are going to be disappointed over and over again. We want the market to be logical, because when something is logical it is to some extent predictable, and when something is predictable it feels safe. Wouldn’t it be nice if stocks always went up on good news and down on bad news? We would all be rich fairly soon, just waiting for the daily news and doing our buying or selling based on it. Who would need a job if the stock market was that logical?
But clearly, that’s not what’s happening. It is very common for stocks (or the market) to go up on bad news, or down on good news. And it will keep happening… Here is why.
The inner logic of the stock market is not that it goes up on good news (or good economy) and down on bad news. The deeper logic of the stock market is that it is a zero sum game where you always must have a buyer for every seller. You cannot buy 100 shares without somebody else selling/shorting 100 shares. The implication is that the stock market cannot be logical in a superficial way. If stocks always went up on good news, then it would become an obvious edge that is too easy to exploit for every teenager with a TV or a computer connected to internet. A zero sum game doesn’t allow such easy edges to exist for very long. Traders will use that edge until it disappears, which means the market must stop acting logical based on incoming news. So it becomes chaotic and at times crazy, because it has to, and that tends to frustrate a lot of traders who expect their economic logic to work all (or most) of the time.
To trade well we must stop being “slaves of logic” and start accepting (and even anticipating) the apparent craziness that must emerge regularly in a zero sum setting. That’s why I like to say that there is always some madness to my method. There has to be because there is always some madness to the markets.
I called this site lunatictrader not only because I use lunar cycles, but also because I like to explore and study the crazy aspects of the stock market.
More on this topic on a next occasion.