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One of the age-old questions is “why should any pattern work?” In this case, we’re not simply talking about patterns on charts, but we could ask the same question of any fundamental, technical, or quantitative pattern: why should there be a seasonal effect? Why should low P/E stocks outperform on some timeframes? Why should some pairs of stocks exhibit mean-reverting behavior? Though there are many answers, I think that many of the patterns we see are driven by groups of trapped traders, and there are a few questions we can ask to protect ourselves and to capitalize on these movements.

The Efficient Markets Hypothesis (EMH) is one of the cornerstones of academic finance, and is the basis for many of the risk management and allocation models used by practitioners in the financial management industry, and has been adopted by the passive management crowd as a key part of their marketing strategy. Unfortunately, EMH does a rather poor job of describing some aspects of real world market behavior. ((It is dangerous to summarize a complex body of theory to a bullet point, but the EMH essentially says that all available information about any asset is incorporated in the asset’s price and that, therefore, asset prices are always “correct”. It is a simple extension of the theory to see that, if the theory were true, it would not be possible to find any opportunities to outperform the “baseline drift” of the averages. If the theory is true, we should all be indexes. These are probably the critical points of EMH for traders and practitioners, and is what most asset managers (i.e., indexers) would have you believe.))

In particular, EMH assumes that investors always make rational decisions in their own best self-interest, but is this true in any area of human experience? Do people avoid emotional mistakes and always make the best decisions for themselves based on a careful analysis of the available information? Of course not! This seems to be obvious, but many of the people telling you how to invest are using models and theories that do not allow for humans to be irrational. Even Eugene Fama, High Priest of the Efficient Market Hypothesis, has admitted that “poorly informed investors could lead the market astray”, causing stock prices to become “somewhat irrational.” ((Hilsenrath, John, Stock Characters: As Two Economists Debate Markets, the Tide Shifts. Wall Street Journal, 2004.)) In other words, markets are not always efficient.

Behavioral finance has provided better models of asset price paths shaped by investor psychology. To paraphrase an argument: investors do rational analysis and attempt to make rational decisions; in fact, they usually do make rational decisions, but they may be led into making emotional decisions at some times. At these times, asset prices reflect both a component of their rational analysis and their emotional reaction to price movements themselves. (Good reading from Andrew Lo here and here.)Richard Wyckoff (1873-1934) created a model of markets that depended on understanding the action of different groups of traders and the emotionally-driven mistakes they might make, and his work stands out above much of the usual work of traditional technical analysis. One of his key ideas is that sharp moves in markets are often driven by trapped traders. This does not just apply to trapped daytraders driving sharp intraday moves–it also drives price direction on the glacial scale of years and longer.

It’s pretty easy to see a situation where a market makes a short term fakeout move above a previous high that encourages breakout traders to buy, and then to see that market reverse when there’s no real support for the move. This may create one of the trading patterns I use (the failure test), but also consider the many allocators who have been “trapped out” of stocks as they’ve rallied off the 2009 lows. Never underestimate the pain (or business risk) managers incur as they watch markets edge higher while they are “underinvested.”

How many arguments have we heard over the past five years for why stocks “can’t go higher” or “shouldn’t be at these” levels, and how many times do you hear people nearly deny the reality of the rally? These are emotional expressions of traders who (in most cases) have not been positioned with the market; once you start thinking like this, you will parse blogs, social media, and major media a bit differently–there is valuable information there.

Consider what a sharp rally in stocks would do to the many traders who assume a vicious bear market has started. How about a meltdown in gold and gold stocks? What about a sharp selloff in the dollar that then reverses into another roaring trend leg up? Can you see these moves driven by mania and panic, the frustration of traders trapped on the wrong side of these moves, and needs of traders trapped out of the market, looking for any reason to jump on board a moving train? Can you imagine how these patterns might manifest in the markets? Can you plan for how you might trade them, and how market volatility might change as the moves develop?

I’ll write more, over the next few weeks, on how to think about markets like this, how to protect yourself from these mistakes (short answer: it’s not always possible. Sometimes you will be the trapped trader, but it’s important to know when you might be on the wrong side of the market), and how to find trading opportunities that essentially capitalize on the errors of other market participants.

(Portions of this blog were published in an early Monday morning research note I wrote for Waverly Advisors.)