Ever since the tripling of the VIX index at the end of August, trading has settled down into a consistent decline that has assuaged the fears revealed by the correction. Over the past two months, a falling price channel has developed as the volatility index falls almost -64%. Meanwhile, the index levels fell well below the 50-day simple moving average and recently below the 200-day moving average. Those crossover points represent short-term volatility lowering below long-term and mid-term levels. Investors should be more bullish and continue in that fashion, but we still see intraday fluctuations and pared gains (and losses). If volatility is dropping, group psychology should suggest that buying pressure should overcome the market, but it has been stemmed by an equal amount of selling. Where is the fear coming from if it isn't coming from volatility? The answer may come from the research of Daniel Kahneman, one of the leading behavioral economists doing research today. His theories summarized by prospect theory cite the importance of doubt when individuals take on risk. Conventional economic theory says that individuals will not discriminate between bets with varying risk that have the same expected value. For example, a person is given the choice between two bets: a 50% chance of winning $100 and a 10% chance of winning $500 (both have an expected value of $50). Orthodox utility theory suggests both bets should be chosen equally, but Kahneman has shown otherwise. Instead, he showed that the introduction of more doubt makes that option less likely to be chosen. Consider this example. a person is given the choice between two bets once again: a 100% chance of winning $99 and a 99% chance of winning $100 (same expected value of $99). Kahneman's premise of the overbearing power of our lazy intuition suggested that participants would choose the sure option more than the less sure option (even though it is only 1% less sure). This comes from a risk-averse mindset that infects our minds. We hate losing, so we seek the option that reduces the possibility of a loss at all costs. Kahneman also showed that participants were willing to take a premium for more certainty. For example, participants might choose a 100% chance of winning $80 instead of a 90% chance of winning $100 (first option, expected value is $80, second option, expected value is $90).
These ideas about risk taking and betting can be taken to the current condition of the stock market. Imagine the average investor choosing between the options of trading with a higher expected value but more risk and the certainty of money in an uninvested state. Because most individuals are loss averse, the typical buy might go away. In a market which is clearly improving volatility-wise but becoming increasingly uncertain about which way to move, investors are surely being scared away from committing to a position. Instead, trading short-term margins has been more evident with the small fluctuations in the day-to-day trading. In the current bull rally, we've seen the most effect from contrarian indicators that saw energy and consumer good sectors rebound, but other than that stocks have had slurred performance. Typically, when equities confidence becomes fuzzy, traders flock to bonds, but even there Fed policy has convoluted the future of interest rates, teasing bondholders. Once again, today's trading reflects the hourly whipsaws with little convincing movement as advancing and declining stocks balance each other out. The Dow Jones initially dropped but has stabilized to a -0.02% loss. The S&P 500 flew down then up and finally centralizes at midday with losses of -0.19%. Even the Global Dow shows similar fluctuations with an intraday high and low both 6 points higher than the current middle to which it has trailed off. The sector that has been most affected by global convolution is the energy sector which continues to shuffle the overall demand and supply levels for energy with the continuation of murky data. Analysts from different firms and the EIA in the U.S. constantly produce contradicting data and reports that predict production and consumption figures in the near future but may have very little merit at all.
Chinese GDP supposedly grew 6.9% in the third quarter which is just 0.1% less than what the target was. Although it seems like a pretty clear figure, observers are not trusting this number, and it has limited its effects on the global outlook. The chart above demonstrates the aimless WTI benchmark that cannot find a direction in which to move. After two clear moves, one bearish and the other bullish, the past two months of trading has elicited a continuation pattern for the past two months. Today, WTI contracts lose -1.00%, but still no definitive trading activity has overtaken the market. Investors continue to bounce between the 50-day and 200-day moving averages, hinting at some rebound that could be in the positive direction. Going forward into the end of the year, investors should look for clear information into what way the market will turn. Time after time, I stress that misinformation and unclear situations will almost always be dissolved by bigger organizations like the Fed. Earnings season is providing individual stocks with fundamental adjustments, but the trend is not broadly-based. For traders looking to establish a long or short position, my suggestion is to start looking at sector performances as they may be more directional at the moment. After that, find a stock with fundamentals that are likely to be proven strong as technicals are proving to be very muddled at the moment.