What Most Investors Missed in Last Week's Selloff

The 80’s classic, “Wall Street,” has been quoted more times than probably any other movie, certainly within the realms of financial commentary. One of the lesser used quotes from Michael Douglas’ iconic character, Gordon Gekko, is “the most valuable commodity I know of is information.”

If that statement was true in 1987 when the film was released, it's exponentially more true today. There is nothing more prevalent today than information.

The other side of that coin is that there is nothing more prevalent today than bad or irrelevant information.

As traders trying to navigate the complex global financial markets, it's imperative that you have a process for gathering and processing information. The media’s response last week to the price action across markets was a reminder to us that most people focus on the wrong information and that leaves the rest of us with a considerable edge.

By the end of last week, the majority of the headlines across all types of media were discussing bear markets, recessions or both. I’m not saying that a 6% weekly decline in the US equities isn’t an event worth paying attention to. But what I am saying is that most market participants find it difficult to see beyond the immediate event to determine how that event impacts the future probabilities of various scenarios.

If you buy in to my concept of information, then you can understand why I believe that as a trader, I’m nothing more than a processor of information. The better and more efficiently I process information, the better trader I will become and the better my risk-adjusted returns will become.

 

Information Processing

There are several key criteria to processing information more effectively. First, is distillation. In this day and age, a large component of being able to better process information, is knowing what information not to pay attention to.

You have to have a very fine filter on your information sources.

I’ve said it before but just from an economical data perspective, there may be 100 different data points that come out in a given week, of which, only 2-4 will actually impact asset prices for longer than 12 hours. You need to be a master distiller of information.

For instance, markets get all amped up for the monthly US ADP employment and non-farm payroll numbers. I’m not saying these reports aren’t important but the fact is that the weekly unemployment claims report has historically provided a much more accurate picture of the US labor market. I won’t geek out and bore you with talk about information ratios and the like, but statistically I can back up my perspective.

I’m not trying to imply that you need to go out and back-test every economic indicator across the world to determine which are important and which are not. It’s a matter of finding information sources that are consistent, objective and allow you to articulate a detailed perspective of the financial markets at a given point in time.

Second, be present. Stay with me, I’m not going to launch into a sermon about mindfulness.

If you focus your attention on better understanding what is happening right now,  that makes you a contrarian and puts you on the opposite side of most market participants, which is a good thing. Everyone and their mother is either looking in the rear view mirror at data from last month or last quarter, or they're trying to forecast earnings, S&P 500 prices, etc, 3 months in the future.

Processing information effectively is not about forecasting the weather for tomorrow but rather noticing that it's raining today. When it comes to price action, I am constantly looking for ways to look at information in a way that is different than everyone else.

 

At The Margins

While everyone is discussing the selloff in equities and how the Fed has made a huge mistake, something else occurred last week that no one is discussing. The event was subtle but will have a much more profound impact on markets going forward than 1 week of price action.

Did you notice what happened on Friday in response to the latest US jobs data that blew away the market’s expectations?

The labor data was released at 8:30 am and when the market opened at 9:30 am, the S&P 500 traded up around 65 basis points from the Thursday’s close. What happened next is the most important development from last week.

Literally 5 minutes later the market reversed and began to decline.

The S&P spent the rest of the day making a series of lower highs and lower lows, finally closing the day down over 1%. What’s 1% in the context of a 6% decline?  Not much. But that 1% decline and Friday’s reversal tells us a lot more about the current state of market participants' psychology than the 6% decline.

Since the end of the crisis, the better part of 7 years, bad economic news sent risk assets rallying. Investors were trained by the world’s central banks that bad news meant that there was an increased chance of the banks bringing more punch to the party. Even last year, this type of Pavlovian response to bad data continued because bad data decreased the likelihood that the Fed would tighten and left a sliver of hope that they might join the rest of the world and go back to an easing policy stance.

Few economic releases are more anticipated than the monthly release of US jobs data. And just like every other data point released, the jobs data is evaluated as good or bad based on how it comes in versus the expectations.

The fact that a jobs report that crushed expectations couldn’t even rally the S&P that was down almost 5% for the week is a very telling sign into investors' mindset. This type of anecdotal information flies in the face of what the crowd believes and that is generally overlooked by everyone else can provide you with a better picture of the present, and that clearer picture of the present gives you an edge over other market participants.

 

Play The Weirdness

A market that I have liked on the SHORT side for the last 4 months is US Small Caps, specifically iShares Russell 2000 Market Index (NYSE: IWM), the exchange traded fund that mirrors the Russell 2000 index.

Fundamentally,  US growth has been slowing and I know that global growth is slowing. US small caps significantly underperform other areas of the equity market with that type of fundamental backdrop.

From a quantitative perspective, IWM has been making a series of lower highs and lower lows since last June. It made an attempt to breakout of this downtrend in November but was unable to do so, resuming its slide in the last month of 2015.

The fundamental and quantitative factors are both favoring a SHORT in IWM.

Friday’s loss pushed IWM below a significant price level at $107, which can now act as a risk price if you’re inclined to initiate a SHORT trade idea. In decision making, uncorrelated inputs are more useful, but they take more cognitive work to process.

We naturally tend towards information that confirms our biases for a particular market or economy. The real edge over other investors comes from being able to do the work that others are unwilling or incapable of doing.