Rev Shark: Flat Market Action Isn't What It Used to Be

 | Mar 17, 2017 | 7:39 AM EDT
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"Everything takes time. Bees have to move very fast to stay still."

-- David Foster Wallace

Over the past year, one of the most significant patterns in the market has been long periods of very flat action. Last summer and fall, the indices set records for tight trading ranges and in January of this year there was another long stretch of very tight action.

Tight trading ranges and limited volatility in the indices aren't anything new, but there is one big difference about the action in recent years -- it impacts almost every stock in the entire market. Prior to the Great Recession in 2008-9, many traders I was associated with would look forward to days when the indices had limited movement. What would happen is that there would still be some very good tradable action in a few stocks, and that action would stand out and be easier to catch. Traders would gravitate toward the "hot" stocks and would help to create pockets of strong momentum. Some of our best days of trading would occur when the indices barely moved.

That no longer occurs to the degree it once did. These days, when there is flat action it hits the entire market and the pockets of momentum do not stick out. There are always a few things that make outsized moves, but the action is much more challenging for human traders, because nearly all stocks are moving in lockstep.

There is no big mystery about what has changed. First and foremost, the market is now driven to a much greater degree by the indices and related ETFs. The index ETFs are the tail that wags the dog. When the indices trade in a tight range, all the underlying stocks that make up those indices move in lockstep and do little. There are limited pockets of momentum, because it is the indices that are determining the movement, rather than the characteristics of the individual stocks.

The computer algorithms, which trade most of the volume these days, don't need high levels of volatility to make money. They trade massive amounts of volume and are happy to extract a few pennies of profit on each share. They are like bees that are making so many small movements so fast that they look like they aren't moving.

This is the reason why some of the major brokerage houses can go months without a losing day. They have an advantage of both great size and great speed. They control the flow of price action and have an advantage when they can benefit from a movement of a fraction of a penny.

Flat action now can be just plain boring for human traders, who are trying to find some "heaters". They must be much more selective and they run a much higher risk of being caught leaning the wrong way when a buy or sell program hits and causes the entire market to react.

Despite this dynamic, individual stock picking is still the best way to produce superior market returns. It just is more challenging and requires more patience. Traders need to be aware of this dynamic and need to tolerate days like yesterday, when there was hardly any movement at all.

Traditional technical analysis teaches that the longer a base, the bigger the subsequent move. That no longer works like it once did. Human traders tend to grow very frustrated with flat action and react by becoming more and more anticipatory. When the market doesn't move much, it is hard to resist the temptation to make a prediction about how we are on the brink of a huge move. Much of it is simply a desire to escape boredom and be more active, but it can cause bad decisions when we become impatient and restless.

There are two things to keep in mind as you contemplate the market today. First is that these tight ranges tend to last longer than we might anticipate. The idea that we are setting up for a big move is of great appeal to traders and can cause us to act prematurely, but flat action tends to led to more flat action.

Second, the flat action requires much more selective stock picking. The days of holding a large number of positions and producing superior results are over. It is necessary to be more selective, concentrated and to manage things tighter. You are fighting the indices that are diving the bulk of the action and need to change the way you handle individual stocks.

Early indications are flat once again, and while it is easy to make arguments that a big move is coming soon, the likelihood is that we have to contend with more dullness first. I'm not expecting the indices to do much today, but I'll be working hard to find some individual stock picks.

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