Bulls, Bears and the Permanent Versions Thereof

Today’s post is about market bias.  Market bias is a trader’s opinion about the long term direction of the market.  If you’ve been learning what this blog is trying to teach, you first question should be “which market?” because there are many.  While it’s possible to hold a bias about any of them, the most interesting market are the “risk on” markets which are those that are positively correlated to the economy – stocks and commodities mostly.

Biases are traditionally expresses via two terms – “bull” and “bear”.  A bull thinks the market will go up.  A bear thinks it will go down.  The origin of the terms are lost to history but the most plausible explanation I’ve heard relates to the fighting tendencies of the two animals – bulls thrust upwards with their horns, bears claw downward.  What is certain is that the metaphor has stuck, going so far as to create a cottage industry selling tacky bull and bear statues for traders’ offices.

Statuary aside, market bias is interesting because of the effect it has on speculators’ behavior.  It’s very hard psychologically to take a position that contradicts your bias, regardless of what other evidence argues in favor of that position.  This is odd, because at first blush it doesn’t make much sense to have a bias at all.  While markets are not in fact random walks, their behavior appears very much like a random walk until analysis is applied.  And a random walk leaves little space for an opinion about market direction since the next move is, well, randomized.  So at first approximation, having no bias is a more rational position than bearishness or bullishness.  That said, it’s not to difficult to do enough analysis to form a meaningful bias.  For example, you could do the following:

Start with a neutral bias.  If the S&P 500 closes 13 consecutive weeks (one quarter) above the 40 week average price, change your bias to bullish.  If it closes 13 consecutive weeks below the average, change your bias to bearish.  Maintain your bias until it closes 13 week the opposite direction, then switch.

If you run this against historical S&P weekly data, you will find that the weeks where you had a bullish bias were on average much better in terms of price movement than the weeks in which you had a bearish bias.  In other words, if you had traded your bias by going long the S&P when bullish and short when bearish, you would have made money.  This effect is very statistically significant, and in fact is the core of a functional if not exceptional trading system.  But the real point I want to get across is that it’s not TOO hard to gain rational information about likely future market direction.  What’s interesting about this method of determining bias is the one quarter delay – this means that no matter how bad things appear to be in the market, you wait a relatively extended period of time before deciding that the world really is going to hell.  And once you decide it is, you persist in that belief even as some seemingly good news comes in.

Many market participants, especially novice speculators, do not follow this advice.  They switch their views on market direction on the basis of very short term events – days, not quarters.  If you test these faster bias switches against actual market data (perhaps by speeding up the average and reducing the delay time in the above method) you will find that the new bias no longer predicts the market’s behavior nearly as well.  It’s too easy to get suckered when you change your opinion too fast.  The efficacy of a long delay is probably closely related to the concept of false breakouts – a delay allows them to play out in either direction without affecting your opinion.

The flip side of changing your bias too fast is changing it too slowly or not at all.  This, as far as I’m concerned, is simply irrational.  Historically, there have been long periods of increasing price, and long periods of decreasing price.  To the extent that I want to have a bias, it would be fighting history if I was only willing to bias one way.  Yet numerous traders do this.  I’ve coined them “permenant (bulls|bears)” or perma-(bulls|bears) for short.  Both phenomena exist, both are intersting, and both are irrational.

Perma-bulls are probably the less common of the two.  They tend to appear towards the end on long bull markets, and are frequently extremely inexperienced speculators.  The heyday of the perma-bulls was the late 90’s in the US, when it appeared that US stocks simply could not go down.  The whole phenomenon was fueled by publications like the original Motley Fool book that in essence claimed you should perpetually speculate on the long side of DOW stocks.  As you might expect, no sooner had they gotten the book published then the continual bull market of the 90s ended, and their core “Foolish Four” strategy went from a big winner to a big loser.  Which goes to show that timing is everything both in the market and in book publication.  Regardless, that book exhibited the mentality of the perpetually bullish speculator very well.  It is worth noting that while perpetually bullish speculation is rarely a good idea, it does sometimes make sense to buy and hold an investment.  If the investment continues to yield well and one one offers you an exorbitant price for it, there’s frequently no reason to exit your position.  This is sometimes referred to as buy-and-hold.  But the Foolish Four was not an investment strategy (it didn’t care about yield), it was a speculative strategy with built-in yearly churn.

The last 10 years have made the perma-bull a rare creature.  Three major market collapses (.com bust, 9/11 and the housing crisis) and a decade of zero overall returns have beat all but the most resilient of perma-bulls into submission.  But every once in a while you’ll still spot one in the wild.

More common now than the perma-bull is the perma-bear.  For whatever reason, many speculators fall in love with the short side of the market and refuse to acknowledge evidence of a bull market no matter how robust that evidence might be.  These are the people who were short in March of 2009 and are still short today 600 S&P points higher – possibly with brief breaks to re-capitalize their battered account.  I can intellectually understand how someone gets to this point – the news cycle unquestionably prioritizes bad financial news over good news.  If you simply listened to the press without observing market price, it would be easy to become convinced the market perpetually goes down.  Failure is noisy, fast, and easy to talk about.  Success is quiet, slow, and frequently there’s little to say other than “yup, things don’t suck right now” which doesn’t make for much of a news piece.  The strongest bastion of perma-bear though is zerohedge.com – perhaps the most poisonously negative financial site on the internet.  I don’t recommend you spend time there, except perhaps to go and gawk at how the other half lives.  I find it more sad than entertaining though.

Ultimately, a lot of speculation doesn’t really require a bias.  I trade both the long and short side of the S&P on a daily basis without worrying about where it’s going to be 6 months from now.  But it’s pretty hard not to form an opinion.  And for longer term speculation, it’s highly unlikely your trades will come in winners if they go against broader market movement.  So there bias is very important.  To the extent that you do need an accurate bias, I would strongly suggest determining it using a method that has an appropriated delay to avoid being fooled by very short term events and false breakouts.  Most importantly, avoid falling into the trap of permanent thinking.  If there’s one constant in the market, it’s that price can both rise and fall.  Putting on blinders and assuming it will only go one way is a recipe for failure.

 

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