Don’t Be a Pattern-Hungry Trader

When I was a wee lad, no more than six years old, I distinctly remember being given bike-riding privileges for my neighborhood in our quiet, college town in Virginia.

I was excited because it meant that, even at such a young age, I could ride my bike to Van’s – the neighborhood store only three blocks away.

Van’s wasn’t like modern convenience stores. It was truly a one-of-a-kind, family-run establishment.

While most of its patrons perused the aisles at Van’s for a few items to carry them over until their next trip to the grocery store, I was there for one reason – they had candy.

Lots of candy.

It was heaven for a young boy, like myself.

There was just one problem.

I didn’t take any money with me on that first bike trip.

With my little bike parked outside the small store, I sat on the bottom step leading up to the front door, pondering my situation.

Not much time went by before an older woman came out of the store with a small bag of sundries.  As she tucked her folding money and coins into a small change purse, she looked up and saw me.

I must have had quite a sad look on my face because she asked me what was wrong.  I told her my problem – I had ridden here on my bike, but didn’t have any money.

She reached into her still-open coin purse, pulled out a nickel and said, “That should make you feel better.”  I thanked her – loudly – before I bounded up the steps into the store with an ear-to-ear smile.

Back then, five cents bought a lot of candy.

I had struck pre-adolescent gold.

A few times a week, with memories of licorice whips and Bazooka Joe bubble gum dancing in my head, I would sit on the bottom step outside of Van’s waiting for an act of kindness from a stranger to bestow delicious treats on me.

It never happened again.

But that didn’t stop me from expecting it to happen. I was so caught up in both the memory and the desire for it to happen again that I couldn’t understand why I never had that good fortune shine on me for a second time.

As investors, the same thing happens to us in the markets.

Random but memorable events happen that cause a great deal of confusion for investors.

Just look at the two recent, big down days on consecutive Thursdays that happened on August 10 and August 17.

Ever since, I’ve had two questions tossed at me over and over again…

  • Does it mean the market is topping?
  • Should we “Beware of Thursdays” and avoid trading on those days?

I wish I was kidding about that second question…

But, to be honest, that “Beware of Thursdays” mentality reflects the same “random but memorable” event bias I dealt with as a child.

That’s why we are going to spend some time today digging into this common bias…

This way, we can make sure you don’t let it trick your pattern-seeking mind into making a potentially disastrous decision.

And after that, we’ll spend some time answering the first question. I’ll be sharing some deeper insight on the market to figure out if we’re seeing topping action or not.

Let’s get started…

Coincidence – I Think Yes

Thursday, August 10 and Thursday, August 17 were only the third and fourth times that we’ve had a 1% down day in 2017.

More so, these two Thursday selloffs did have a decent amount in common…

  • Both featured big down days for the four major indexes: DIA, SPY, QQQ & IWM
  • Both were triggered by geopolitical events: North Korean bluster two weeks ago – tragic and senseless terror in Barcelona last week…
  • Both saw very modest Friday morning rebounds…

That alone was enough to give us a case of Déjà vu.

But the similarities ended there.

While all four major indexes were down big on both days, the August 10 pullback saw the Dow drop less than 1%. It then carried its “consecutive trading days without a 1% down day” streak to 63 before being down -1.2% on August 17. That was still much less than the S&P500 (-1.56%), Russell 2000 (-1.83%) and Nasdaq (-2.04%).

In addition, on August 17, all nine S&P SPDR sectors were negative. That’s only the 3rd time that has happened all year. It happened 21 times in 2016 and 38 times in 2015.

Which makes them memorable, especially if you have money on the line. But it doesn’t mean this is a pattern or a repeatable trend.

Our brain’s natural tendency is to try to notice patterns in the world around us.  This is a trait that has helped human beings survive and even thrive over the centuries.

The important thing to remember is that sometimes things that look like patterns are really just random coincidences.

There is certainly nothing special about market action on Thursdays.

That’s why, if we want to combat the “random but memorable event” bias, we have to examine a large sample of similar events before assigning any importance to the event at all.

Here are a couple of examples of when a type of event warrants further investigation:

  • Consecutive down Thursdays in August = no need to even think about a pattern.
  • Thousands of data points showing stocks and indexes rebounding more often than not when they hit extremes? Hmmm – now that’s worth investigating.

The bottom line: investors need to make sure they don’t let a “random but memorable” event trick their mind into making an unwarranted decision.

That’s the beauty of our The 10-Minute Millionaire system. It strips emotion from our trading decisions – letting us avoid this potentially disastrous bias altogether.

Now, let’s move on to our remaining question: Do these two consecutive down days tell us that the market is topping?

An Aging Bull

This has been an unusual year in the markets.

I’ve used the term “grinding bull” to define the market action.

I think that’s an apt description.

Markets that grind higher also tend to be the lowest volatility markets.

That’s because investors and traders get lulled into a complacent state by a market that has had no meaningful pullbacks all year.  There are still more than 4 months left in the year, but so far, we’ve seen historically low levels of market movement.

As I said above, we’ve only seen four days this year with a 1% or bigger down move in the S&P 500.

And as additional proof of the low volatility, we’ve only had three days with a 1% or higher up move in the S&P!

Here’s an interesting list that shows how those numbers stack up to other years dating all the way back to 1928…

As I’ve studied volatility more and more this year, the three periods I’ve circled in the Pension Partners list above leap out as the historical standards for low volatility: The mid-1960s, 1972 (the calm before the storm) and 1995.

If we take a quick look at the charts for each of those times, we see a striking resemblance.

I’ll use monthly bar charts so we can see the overall movement of price with fewer “in-between” wiggles:

Here we see 1963, 1964 and 1965 as the essence of a continuous grinding bull market, though 1965 did have a mid-year pullback.

This chart shows the relentless bull of 1972 that culminated in a blow-off top before the market had a two-year drop of almost 50%.

And in 1995, we see the essence of a grinding up move that was a continuation point for one of history’s longest bull markets that most analysts date back to 1982.

So why is this volatility lesson so important?

Because it informs us on what we can expect going forward.

Which brings us back to the original question: With two consecutive, big down Thursdays, should we be worried about a topping market?

The short answer is: Not yet.

Trying to pick a top in a grinding bull market has been a historically bad idea.  Just refer to the charts of the 1960s, 1972 and 1995 above.

If you feel a compelling need to turn bearish, at least wait for the price to give you some idea that a pullback has started.

Last week, I gave some useful support zones for that exercise.  However, until then, we have to realize that grinding bulls can grind higher and for longer than “normal” market analysis would dictate.

Prudence dictates that we have risk management tools in place for the possibilities of a major market drop.

But it is also prudent not to jump out of the boat when we’re in a period of historically smooth sailing.

Great trading,

D. R. Barton, Jr.

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