Lately I have been writing an article for CME Group’s Spring magazine. In my head it is titled “The Social Markets Hypothesis” (note: NOT Social Market-ING). That term, to me, is an extension of the Adaptive Markets Hypothesis by Dr. Andrew Lo which in turn is an extension of the Efficient Markets Hypothesis which has been the reigning paradigm for so long. It happens to also be the bridge between the arguments of EMH and Behavioral Economics or Finance.

The “thing” that is different about both this hypothesis and my way of looking at the markets is this. I begin my thinking with the question of “what are they or will they be doing”? In other words, I always ask the human question FIRST.

I do this for a couple of reasons. 1) It is actually the only thing we care about – except 99.85% of the traders and investors never think of it. 2) Recent research shows that “Theory of Mind” (the ability to understand the other) is a more applicable skill to market prediction than thinking in probabilities.

Now I have almost 15 years of trading experience and I learned from a tape reader (btw …what is tape reading but “reading” what “they” are doing), so I can look at my screens and unconsciously come up with a good answer to the human question. But it is totally fair to ask me to deconstruct it?

For example, the $TICK and the Adv/Decline line or chart are both revealing what traders in the NYSE cash equity markets are doing. Now, who trades those? Basically you have two maybe three groups – the vast retail public and the hedge funds (and prop desks). It used to be that the S&P futures would lead the cash market but it is my experience that in recent years, this “cash” leads the futures. I attribute this to lots more short-term trading by hedge funds.

2nd – the Naz and Russell are different animals from the S&P 500 – so I consider those traders/groups as a different group of people. If they are turning the ship in the exact same way at the exact same time, then the boat is going to move. If they are pulling in a little bit of the opposite direction, then the boat won’t go so fast. It might even do a 180. When I look at the VIX (which I haven’t lately but not for any great reason), I consider that a 3rd group – the equity option people. Same ideas though.

Now all of this can be labeled under convergence/divergence but I like to have my decisions be based on the most irreducible analysis which in the markets is always people – i.e. it can’t get any simpler than that.

So take elements like volume. Well now, what is volume but a representation of how many people traded how many contracts in a given period or at a given price? (which is why I like the market development/market profile method) You can count on the price coming back to a high volume area or an area that everyone knows (yesterday’s low) and being defended. Why do gaps work? Well… because there are less trades there to be defended – and because now we all expect them to work. In other words, real people who bought or sold at a certain price – or who had the opportunity to get in or out at a price but didn’t – will react when the market gets back to that price again. Some will be adding to defend and some will be adding out of relief (it works short or long).

You can also ask questions like “are there as many people selling at this price now as there were this morning or did that huge volume bar just wipe out all the shorts” – at least until a group of real people have time to recover and re-load.

So… do I use probabilities? At this point, I really only use them intuitively. Do I think they are valuable? YES but nevertheless, the real clue is that the numbers (and the bars and lines they draw) are only a clue – not the real answer.

Hope that helps – DKS

Columnist and author Jason Zweig writes in his weekly The Intelligent Investor column that “Much like the choice of whether to invest in stocks at all, rebalancing is a bet about the future“. Forgive me but this should be self-evident – particularly to anyone who reads the WSJ on Saturdays.

The more critical point that Zweig fails to mention and most investors and traders never realize, overlook or forget is that any investment or any trade in any timeframe and based on any analytical method is a bet on ONLY ONE THING – that some other human being is going to be willing to pay a different price than you paid at some moment in the future. Markets are no more and no less.

This may seem self-evident or unimportant to some – after all, we have our fundamentals or our technical analysis and we really only need to bet on the numbers! Really? So how did betting on those things work out in the past 18 months? How did all those hedge funds do using their historical volatilities going into September 2008? Or, those day-traders with fixed stops?

See the numbers – whether from a chart or a projected cash flow – are only a reflection of or proxy for what another human will decide in a given set of circumstances. Take this example, after the run on BSC a year ago this coming week would it have been that hard to imagine that one of the other banks could go down altogether? Would it have been that hard to imagine that Paulson could buckle under the pressure and let someone who had lots of credit-default swaps go BK?

Not if someone paid to predict the markets stopped looking at the numbers, put their feet up on the desk and said … hmmm… let’s think about this purely from human behavior for a moment.

It works in much shorter time frames too – like yesterday afternoon when the ES was trying to make new lows but the speed of the downdraft had slowed and the NQ wasn’t moving down… you see that and you can be sure people are still getting short ES and there is about to be a huge short squeeze. But… if you dont’ think about the other trader’s behavior, your numbers and charts may have said shorting again was a good idea. Especially because your brain defaults into expecting the same result out of the next decision as it got out of the last – another fact that Zweig doesn’t fully articulate even if he did write Your Money & Your Brain.

Everything.

I said it on the Cavuto show on Friday November 14th – “they will come back to buying the assets because the market needs a bid. It has to find a bid somewhere and nothing will be fixed until it does.” I have said it before in this blog but since getting the &#)@)#? tag cloud to work correctly is one of techno road blocks of my life, I can’t find the exact post. (probably user error I admit).

Anyway – these markets we trade are auctions. If there are no buyers, the price either keeps going down or the seller withdraws the item. Since withdrawing the CDO’s and CMO’s isn’t an option, the auction is always open…and waiting waiting waiting for a bidder/buyer to show up. It isn’t one iota different in process than what happens in a rapidly directional ES or YM move. Not one iota.

Oh yeah, the timeframes are different and the product’s complexity is greater but the underlying idea that a human somewhere needs to be willing to pay something for the asset – i.e. bid on it – is identical.

The reason I bring it up is because essentially thinking through what has happened with these assets and how they have been handled is a slow-motion object lesson in the same high-frequency trading we do everyday. That might sound odd… but think about it and let me know…

I have been wondering since mid-October when they were going to give in and do the basic thing one needs to do to stabilize a market – provide a deep-pocketed bid!

In fact, I said it on the Cavuto show and have said many times since, until the Treasury starts bidding for some of these so called toxic assets, the banks would be stuck. It isn’t that I am SO smart – it is just the basic way auction markets work. Buyers bid up and sellers sell – if one of the other is lacking the price just keeping moving into the vacuum left by the lack of buyers or sellers.

It really doesn’t matter if it is on a one minute timeframe in the ES futures or for homes in Las Vegas…. auction markets need bids in order for the prices to stabilize.

We still believe this is the best way to read price action. In fact, we would go so far as to say that it is the best way to integrate the ideas out of behavioral finance into a way to actually trade the markets. Put simply, being able to easily see the areas of congestion versus thin trading gives you a clear picture of what other people are thinking – and doing. This is really all you need to extract alpha out of the market. It is also where most traders (and portfolio managers) miss out. It is all too easy to think of the market as a series of numbers or bars… but it really is a series of human decisions which are simply reflected in the bars.

The crisis (gee that word is getting really old) that we are in now is a great example of how the series of human decisions, some based on numbers and some based on fear, cause an asset to be priced at what it is – at least until a new series of decisions ensue. If you want to judge how much is rational and how much is irrational, does it really help? What you need to know is where others think there is value – and auction market theory allows you to do that.

The trick is what tools best assist in understanding human decisions? We all have essentially the same data – but how we choose to interpret it and what we choose to do with the interpretation – is the harbinger of our results.