Saturday, February 16, 2013

Where have all the trend traders gone?

The broad market advance from the 2009 lows, despite the periodic volatility, reminds us of the late 1990s bull market.  The only thing missing is the presence of the retail investor.  That is to say, the typical “trend trader” of the ‘90s and earlier 2000s is nowhere to be found.

What’s ironic is that the stock market environment of the past few months has been ideal, even textbook, for trend trading.  Indeed, the methodology based on identifying upward trends in actively traded stocks via trend lines or moving averages and then riding those trends has been perfectly suited to the trading environment of most of 2012 and 2013 to date. 

So why have retail traders remained mostly on the sidelines, missing most of this impressive rally? The main reason for their absence is the long-term fear engendered by the historic 2008 credit collapse.  Psychologists tell us that it takes the average investor about 3-4 years to recognize a reversal of the major trend.  Based on those numbers, it’s not surprising that many small time traders and investors are only now recognizing the enormous gains that equities have achieved since 2009.  This partly accounts for the recent liquidation of safe haven investments like gold and bonds – the two areas that investors flocked to after 2008.

Yet there has hardly been a major rush back into equities of the kind we witnessed in the late 1990s and mid-2000s.  The fact that trading volume on the NYSE has been relatively low considering the magnitude of the rally is telling (see chart below).  The diminished volume trend over the last couple of years overwhelmingly suggests that the public hasn’t bought into this rally.

Diminishing volume suggests the public has missed this rally.

Another point to consider is a phenomenon known as “trading range trepidation.”  This is a term I coined several years ago to describe the angst that many traders and investors experience whenever a long-term trading range ceiling is reached by the major indices.  Whenever a trading range top is being tested by, say, the S&P 500 (SPX), instead of investors getting excited at the possibilities of a breakout above the ceiling, you can always expect to see an increasing reticence to buy.  This is one reason why the market often backs off several times after reaching a major trading range ceiling before finally punching through it.  Many investors use this test of the trading range ceiling as an opportunity to take profits and reduce long commitments instead of increasing them.

Note that in the 10-year monthly chart of the SPX shown here, the market is once again testing what could be described as a major long-term trading range ceiling.  Knowing what we do about the psychology of trading ranges, this would partly account for the reluctance of retail investors to enter the market right now.

Trading range trepidation
Psychologists also inform us that it takes the average retail investor anywhere from 5 to 10 years – or even longer – to recover from the psychic effects of a major financial collapse.  The more an individual investor lost in the crash, the deeper and longer-lasting the psychological scars tend to be.  Painful memories of the 2008 credit crisis have undoubtedly kept many a retail investor from re-entering the equities market as a participant.  Yet we also know from studying behaviorism that rising prices will eventually attract the more skittish investors.  The thought of missing out on an historic opportunity can entice even the most reluctant investor to enter the market fray. 

There are some who believe that this cyclical recovery won’t end until the public rushes in en mass as buyers.  There may be some truth to that, but the market doesn’t necessarily need the return of the retail investor (or trend trader) to put in a major top.   Trading today is dominated by institutions, HTFs and hedge funds.  The market has obviously done just fine without the public’s participation and can probably continue doing so without it.  For clues as to when the market’s next major top is in traders need not focus on the retail investor.  Instead, look to the technical and fundamental data, i.e. to the market itself for clues.  

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