One of the most significant changes in the stock market in recent years is the dominance of algorithms and computerized trading. These programs control the majority of volume in the market and have had a great impact on the way the market moves.
The primary impact of the computers is that they disrupt the normal ebb and flow of the action. Markets are typically a reflection of the humans that trade them and their emotions are constantly shifting. They are fearful one day and greedy the next, and this causes the market to go through cycles of ups and downs.
Computerized trading is designed to take advantage of typical human emotions. They are programmed to act counter to simple logic, which tends to produce action that doesn't seem reasonable to a normal person.
After a market has gone down or up for a number of days in a row, the average person begins to think that it is reasonable that there be a change in direction. Technically inclined traders have developed a number of indicators such as stochastics to try to gauge when a market may be overbought or oversold. This is just an attempt to determine when things may have gone too far in one direction or the other and a turn is likely to occur.
Recently we have seen good examples, in both directions, of how the market can trend far longer than seems reasonable. There was the decline that started in October and continued into Christmas Eve, stunning many people as it seemed relentless. The S&P 500 dropped eight straight days starting on Dec. 13 and went from oversold to even more oversold. It felt unreasonable to many traders, but they suffered some pain when they tried to trade on that feeling.
Since Christmas Eve, the indices have gone in the opposite direction. There has been more than a 10% bounce in the indices and they have been up eight of 10 days. Suddenly the market is now very overbought and it seems reasonable that it should rest.
The problem for human traders is that we run into trouble when we start to think about what is reasonable for the market to do. Much of the market is programmed to take advantage of that sort of simple thinking.
The best way to deal with this tendency of the market to go from one extreme to the other is to be less anticipatory and more reactive. Trying to guess when a trend will turn is fraught with peril. We are far better off to wait for a trend change and then act rather than try to guess what the future holds. Of course, there may be false signals when we are reactive, but we do reduce the risk a bit.
Here on Thursday morning we finally are seeing the market rest a bit. It is exactly what is needed to help build conditions that will support more upside, but we have to wonder if the computer algorithms will go to work and produce another surprisingly strong trend.
Interestingly, this turn is coming as the market seems to have run out of positive news catalysts. The Fed has made it clear that it has shifted its bias from hawkish to dovish and the China trade negotiations are on hold again after some recent progress. The government shutdown is starting to matter more as both sides are dug in and the pause in operations is starting to be felt in places.
We still have a week or so before earnings season starts, so the lack of positive news makes for a good excuse for a rest. We shall see very quickly if the computer algorithms are going to be aggressive to the downside again, so it is important to make sure you protect capital. It has been a good bounce and now it's time to make sure we don't give much back.
We have a weak open and much talk about the government shutdown.
