Capital Rotates according to sentiment and risk. The market basically is a set of financial decisions in the long run driven in the short run by emotions and the long run by certain wants and needs.
Emotion can bee seen by investors, trend traders, swing traders, or even day traders if you learn to "see the code".
From Justin Mamis "Nature of Risk"
So it looks a little like this:
The thing I noticed is near the oil peak where oil hit 140 a barrel, that all these no name trashy stocks came out of nowhere to produce multiple hundreds of percentage points of gain. That along with the teachings of many, particularly the "option addict" helped me to realize this was actually quite normal and is about the risk appetite the market takes which occurs in a predictable cycle. To vaguely paraphrase Niccolò Machiavelli, history repeats because the passions of man go through the same cycles of emotion.
I learned to go beyond and "see" that not only did individually assets go through this type of phase where the worst of the stocks performed the best near the end, but that it had an entire cycle that was predictable and "fractal". Even in larger cycles a similar concept occurs and you can equate what's happening to "emotion". Fundamentals also change so the perception of "what is quality" may change as well but this process of shifting up the "risk" ladder can be phrased in a number of ways.
See, the experienced traders recognize that they personally as well as many others have a certain tolerance for sitting in names that aren't moving and so what they will do and what institutions will do is when the market is beaten down and they want to try to pick a bottom, they will only go with the names where "quality" has started to form. That means low beta, lots of support, strong fundamentals, strong trend, strong dividend, mega market cap and so on. IF the market sticks and the stock sticks and a higher low is made (in the discouragement phase), then they might go after the high growth and momentum stocks that can really run for weeks. Then if they suspect "aversion" they will want to be in the stocks that can take a hit or already have. That means those that are already at great valuations, but have been neglected. Once those start to take off and market is in a full confirmed uptrend they have confidence and the bears are weak. So they are going to attack the high short interest plays to try to squeeze the shorts out and force them to buy back their shares to "cover" which will send stocks even higher. Now when the short squeezes have taken off, that puts you in "returning confidence" and even euphoria. That is when I would start to add in "hedge" into the equation.
At that point, there is no other place to attack except for the very small market cap delisted stocks or those on the path to being delisted that have basically the worst relative strength but maybe have consolidated near their lows. They might be the over the counter penny stocks and stocks under $10, but they also might just be a stock like JCP or some of the gold miners under $10 which have chronically underperformed for years. Much different then the laggard which has yet to go, but on a long term basis still hasn't been in constant decline. These stocks are more illiquid, but with the major upswing EVERYONE wants in on the rotation of capital and the next phase is to sell to the average joe on the sideline who gets caught on the mania and will buy any "hot stock tip" of a very bad investment. So they buy up all they can of anything and everything, and with a market cap that small it doesn't take much to cause it to double in price.
Once the "turd" stocks start hitting new 52 week highs and really taking off and moving 15% or more in a day, that is when you have to be careful, because everyone who wants to buy finally buys even at ridiculous prices and that is when you get the "rug pull" so switching to "defensive" names that you can sit in for years such as coca-cola and wall-mart and other dow stocks start to be a place you may want to consider, if not cash and bonds.
For the most part institutions drive capital flows among sectors and industries, if they are not blind sided by an even larger international mega institution that take an entire ASSET class rotation approach (think global governments, sovereign wealth funds central banks and perhaps even the primary dealers). The institutions are required to beat benchmarks to keep their job and will have to go with what's working. They do not have time to stick with the undervalued laggards that has not began an uptrend unless market is taking off. They won't stand in the way of heavily shorted names unless the market is really breaking out and they know the shorts are as good as dead and will soon be forced out if the rally continues. And they certainly won't go for bankrupt names unless they have no other choice and all the other assets have reached a "saturation point" in which they can no longer provide average gains on average risk.
But I have come to learn how to "go beyond" this understanding. You see I start to get a "feel" for what the market is looking for. In other words, lets take a situation where market is declining. You want to look for positive signs such as the russel and nasdaq getting hit a lot harder than the dow and S&P first, followed by an oversold signal and a McCllelan reading approaching oversold. Then maybe even a dow and S&P up with russel or nasdaq down. This is when the quality starts to lead. Individual stock picks are mostly out at this point, HOWEVER, the "feel" the market has is going to be to go into "quality", I KNOW specifically what stocks will probably do well, not just what type.
You gain an even greater advantage by knowing what the quality names are and where the greatest focus will be.
That also involves KNOWING how the sector rotation is basically a sentiment or risk cycle for INVESTORS through the credit cycles as Financials get hit the hardest and offer the greatest value, then as economy gets moving and trade starts to occur, the transports will pick up. Then economy will start to improve and the latest technological breakthrough that can transform some of the old ways of doing things will start to lead. Then Capital Goods and industrials and consumer services will all go closely together as economy is rebuilt, housing and infrustructure is rebuilt, and consumers start spending. As the economy starts to overheat the materials become scarce and there is a huge demand for miners and the like, and ENERGY output starts to hit cycle highs as the cost of energy and need for it starts to pick up and scarcity of oil occurs. Then the stocks reach their saturation point and raw commodities such as gold as well as defensive stocks like consumer staples and drugs and utilities start to become the only area to rotate into, as market declines the rotation OUT of stocks as an asset class and into bonds, and even eventually just CASH or even foreign currency may take place.
See investor cycle charts below:
You can identify quality by passing a visual test. The visual test is identifying stocks that LOOK like the market, particularly the DOW on a longer term basis, but START to act differently on a short term basis (such as making higher highs and/or higher lows on a intraday chart while market makes lower lows and/or lower highs). This is a "divergence" that is bullish and means that particular individual stock is starting to act higher quality than the market and will likely lead it higher. That is basically the "confirmation" If you know what asset specific stock is likely to lead by knowing which sectors are strong and which specific stock is in favor, THAT will be the confirmation that it is starting to be TIME for a move. "QUALITY" means the stocks have established a solid trend which means they have been in favor for awhile and means the relative highs and lows are typically higher than the previous ones. The sector rotation may require you to go back a couple cycles when identifying quality. For example, recently we have been seeing industrials outperform a bit, yet financials... particularly goldman sachs (GS) has been the "quality" play to buy when you are trying to grab a stock in a rough market that has been declining over most of the past several days, but you think is nearing a bottom (swing trader's low within an uptrend). I suspect that using the cyclical investing chart that AUTOS will likely be next as a name like WMT is more "defensive" and may lead even before a name like GS or GM will, but won't make much of a move in either direction. Housing is not currently a bad bet, but the long term chart shows no signs of market correlation, which makes it more of a laggard.
You can identify sectors or industries as a whole in terms of how the perform, but also what sector they are in, and where you are in the cyclical/sector rotation. Momentum is basically the equivalent of the sector or industry that is currently outperforming and the "laggard" should be the focus on what was supposed to have gone but hasn't, or what is next on the plate. "short squeeze" is the sector that everyone has been underweight that is breaking out and basically the "returning confidence" phase. The "floaters" is basically the "desperation play" when people HAVE to buy whatever they can, but will focus on whatever is left that hasn't been bought yet. In the terms of a credit cycle that may be real estate and leveraged buyouts going nuts but also will be the energy, materials, and raw commodities. These are basically derivatives OF the economy as the "floaters" are derivatives of the stock industry groups, or sectors. That means they are those that are somewhat independent from, but still derive from that sector. In other words, gas is derived from oil, and the rally in "floaters" is derived from the capital rotation into the sector. Similarly, energy derives it's boom as a result OF the economy booming, rather than focusing on what is being produces as a result OF the economy, you are at this point focusing on one of the things that it uses (as an expense) in order to produce). The reason this works is the BOOM brings all sorts of new economic activity and eventually drives up oil demand to it's peak and starts producing explosive earnings. Finally, you have the derivative of the derivative... which is an entirely new asset class in commodities. The energy producers and material producers and miners all eventually compete when their sector booms until it gets crowded and the competition eats into their margins, particularly as the rest of the economy is oversaturated and will have no place but to decline as their earnings go negative even as they continue to try to produce profits and burn up resources in the process. At this point, even the energy companies get oversaturated and the only thing that can go up is the raw commodities until the negative earnings starts to drive people out of business and the success stories turn into horror stories that start to drive everyone away. At that point, people go to cash and bonds and you see a rotation into defensive stocks such as healthcare+biotech (more independent and non correlated from other stocks), consumer staples and utilities.
But as I said before, the major institutions are still victims to the capital rotation of the MEGA players (global governments, sovereign wealth funds, central banks, pension funds, primary dealers).
The motivations they have and what they are capable of doing is entirely different. See, those with trillions of dollars of value to protect can't just go out and buy an individual 100M market cap stock. They have too much money to move. They have to go with ENTIRE asset classes. They have to focus on the MOST liquid until it becomes over saturated, or until fundamentals of the particular debt market changes.
Right now, the US debt market is the largest at over $17T in debt. It also is the world reserve standard and made to expand in order to accommodate demand. If there is a need for liquidity that is where central banks must park their capital. Due to decisions made by Washington and the US central bank (federal reserve), this could change. In that case, initially there would likely be a shift from a longer dated maturity on the bond (such as 30 years) to intermediate and eventually shorter term. They then might rotate globally according to
1)Liquidity (the larger the market the better)
2)Safety and Stability (the more capable a nation is of paying it's bills and honoring the debt the better)
3)Interest rates (the higher the better)
A market such as the YEN or the YUAN or the EURO could eventually come into play, but ultimately the default source of liquidity is still the dollar because it is more fundamentally structred strongly and since it is the global reserve currency the primary dealers and other central banks will gladly accept it.
As mega wealth makes decisions to shorten maturity eventually they can only shorten it to zero (cash), and in the meantime they will be rotating into perhaps the corporate bond markets. Corporate bond markets have a risk cycle of their own. If both those markets are out, they could consider rotating some of it into the stock market. Because of the size, the sovereign wealth funds basically must be diversified as some markets are too large to sell completely. A a result they typically want INCOME from their investments since they don't want to deal with the hassle of selling and finding a buyer (which since their size, that will cause markets to move down as they try to get rid of their shares) So in stocks, if they rotate there at all, (mostly just the primary dealers who broker the debt but can use depositor money and leverage as investment banks to buy a very large amount of stocks) they will only look for the highest quality, largest market cap, or just S&P futures.They may also consider commodities as an asset class or investing in banks debt backed by real estate in order to get some real estate exposure in a more safe and stable manner.
What they do has consequences. If they rotate into mega cap stocks the price will go up. As this happens institutions will likely sell and rotate into medium or small cap stocks and individual investors as well. This creates an entire risk ladder where everything is compared on a relative basis to everything else.
Everything can be adjusted and priced on a relative basis as interest rates change, and it will have consequences. With interest rates near zero, dividends must be driven down by driving up the price to obtain an equivilent risk/reward. In other words, since stocks present more risk, they should have more reward, but the nature will not get too carried away as if it ever offered too much reward, people would buy it until it's the same. If people bought it up too much, it would be more vulnerable to a decline as capital seeks "equilibrium" ( a fancy term for "balance). Low interest rates will eventually force people out of money markets as pensions will start to go bankrupt unless they seek higher yields. So the federal reserve can lower interest rate as a tool to boost returns in the long run at the expense of savers. However, there is a serious lag and other factors that determine what is "fair". Each asset class has it's own set of risks that will change as the way the countries change. Pensions will likely kick off a rotation of capital into corporate bonds or longer dated treasury, but given the political environment and risks, they may actually determine that the interest rates for a 5 yr or 30 yr or any government debt is too risky. At some point it will also seek higher return and move out of treasuries and into corporate bonds and even high quality high yielding stocks. At any given time, an asset class could be ignored offering superior return at reduced risk in relationship and when that happens eventually capital will be repelled from other places.
But asset classes acts a lot like gravity in that it obtains more momentum and attracts more capital the more mass (capital) it accumulates. However, eventually it reaches a "saturation point" where the momentum cannot continue as other assets will be ignored for too long. It basically is similar to how water reaches a boiling point as temperature is increased. First little movement in the water, then a bit, and then it explodes into bubbles and gasses into the air. It is at this point that a company that has parked a ton of money can now SELL without dropping the stock. You see those with tons of capital cannot sell because there aren't enough buyers at the price. They would have to drop the stock tons of points before they could get out so it's unreasonable for them to do anything but collect dividend. But in a parabolic run up top, those that PARK their money HAVE to sell, and in doing so they will choose to rotate, and dictate a trend of capital elsewhere, while the masses exploding into a buying frenzy will have run out of new buyers interested in paying that price. At this poit nearly EVERYONE in the stock all ends up under water and the least amount of selling pressure will cause the stock to collapse as there simply is the least amount of buyers left. Now is when you can see the parabolic top manifest in a collapse as all those underwater now have felt pain and want to exit. This is like a spring. The capital reached the point where it had completely coiled the spring and now the slightest bit of those exiting or unable to continue to put any more pressure on the spring now causes it to uncoil rapidly and now rather than ATTRACTING more capital it REPELS it.
Since the long term investor has so much more time that they will have to sit in an asset, they are only looking at the very long term nature of things, and this provides a much longer and slower rotation that may last decades for a full cycle. If the long term mega wealthy institutions have been sitting in an asset collecting a dividend and watching it eventually go exploding higher, they HAVE to get out then or they will never get out until the next cycle. In other words, the liquidity is where they need it to be, the dividend has been pushed way down as a result of the increasing demand, the valuation has no longer become attractive and there is nothing else for them to do but sell.
So now you should be able to understand the two natures and drivers of market action, the institutions and the soverign wealth and mega institutions, and of course emotion, and the cycle it goes through. Actually, I will speak briefly of a cycle that lasts for multiple lifetimes. Entire nations will also drive the fundamentals by the current government type and global setiment for a particular government type and the result it has on the public treasury or debt markets. That cycle exists as well as described by Alexander Tytler (1747-1813):
"A democracy will continue to exist up until the time voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by dictatorship.
- From bondage to spiritual faith;
- From spiritual faith to great courage;
- From courage to liberty;
- From liberty to abundance;
- From abundance to complacency;
- From complacency to apathy;
- From apathy to dependence;
- From dependence back to bondage. "
A more direct democracy ultimately reached it's end in ancient Greece, and Marxism and the rotation to communism eventually results in financial catastrophe as capital rotates towards the free nations and away from those who will take away the incentive to produce and attempt to flatline the business cycle. Then you have your dictators and despots take over and rule by war, but eventually historically you run out of the ability to produce weapons or eventually the war is ended one way or another and economically the nations one way or another will have to reform. There are many other causes, but the cycle is probably too long term to really verify that it exists, although I will say the nature of spending and creating dependency seems consistent with the nature of mankind and thus I believe it exists even though if there is really nothing to do to capitalize off of it, I find it interesting.
If you take the time to connect the pieces and pay attention, you should be able to see WHAT particular asset class, what particular sector, and what particular stock is on deck and next to move. You can also look at what HAD moved recently to see what is likely next. This is a tremendous advantage, and when you combine it with an incredible knowledge or skill set on technical analysis and/or fundamental analysis and learn how to manage your own psychology, this is a tremendous advantage.
I will cover more on this later.
update: Speaking of psychology, check out this post titled, Wired to Lose: The Psychology of Trading
