Rev's Forum: Applying 'Coin Flip Logic' in the Face of Old Mo Is a Risky Game

 | Oct 12, 2017 | 7:24 AM EDT
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"Man plans, God laughs."

--Yiddish proverb

If you flipped a coin 20 times and it came up heads each time, what are the odds it will come up heads on the next flip? It is still 50-50, but most people would say that the odds are very high that the streak of heads would come to an end.

The flaw in the logic is that each coin flip is independent of the previous one. The fact there was a long streak of heads has no bearing on what will happen next.

The stock market is different because each day is not totally independent. What happened the day before does have an impact on what will happen next. When there is positive action one day, that increases the odds of positive action the next. That is how momentum operates, and that is how market players tend to think.

Too often, folks who fight the trend think of the market like a coin flip. Certainly, the odds of another positive day, after we have had so many, are much lower. Statistically, coin flips always will be 50-50 if given enough time.

That is the thinking that drives many bears. They know the market eventually will revert to the mean and the odds of that seem much higher when an index such as the Russell 2000 has gone up in a straight line since mid-August.

Unlike coin tosses, trends in the market have persistency, and you must think about them in those terms. The greater the momentum, the greater the odds it will continue regardless of whether it is extended. That is why trying to anticipate turning points is such a dangerous game.

You do not need to predict what happens on the next coin toss in the market in order to be a winner. You just need to identify when a change in trend is starting. So far, there are no signs of a trend change.

The bears are yammering over tax reform and central banks once again but the market shrugs. Technicians are focused on overbought patterns, light volume and the strength of the momentum, but the market refuses to weaken.

The odds that the market hits a turning point today are not 50-50. The odds favor continuation of the uptrend, but we really don't need to worry too much about that. The price action will give us a hint about the change in the market trend, and that is what matters most.

We have some minor weakness in the early going as Citibank Inc. (C) and JPMorgan Chase & Co. (JPM) kick off earnings season.

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