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December 1, 2005

How Markets Really Work" (book review), Thur., Dec. 1, 2005, 4:33 PM

Earlier today I wrote that trading is about numbers, not fashion. Since you don't create fashion, sell it or end it, you are at a disadvantage if you trade by following it. If you do; you will always buy high and sell low. Rather, I have always said, you need to understand that your edge is in the numbers.

Larry Connors and Conor Sen, of the well-known California independent investment firm called Connors Research Group, has published the proof of concept. Their book is called: How Markets Really Work " A Quantitative Guide to Stock Market Behavior" (2004) US$49.95 at Amazon.

By testing 15 years of trading data, Connors Research proves that successful trading involves buying into weakness and selling into strength.

In their words: These conclusions were confirmed many different ways, by comparing multiple-days' highs to multiple-days' lows; comparing multiple days of the market rising to multiple days of the market declining; comparing multiple days of the markets rising higher intra-day to declining lower intra-day; looking at the days when the market rose strongly to the days it declined sharply; studying days when advancing issues were much stronger than declining issues; looking at the put/call ratio, and studying the effects of prices when VIX stretched to extremes. The test results, many using over 3,500 days of trading, all point us in the same direction—it has been smarter, wiser, and more profitable to be buying weakness and selling strength in stocks, than vice versa."

So Connors proved it; I have been saying it. Moreover, how many times have readers been shocked when I would recommend a sell on say SNDK (a company I really like) after a strong run up in stock price, or a buy on the golds and the oils after extreme market weakness that existed in the first two weeks of May-05.

You know of course that (i) I am not bigger than capital markets where I can just wave a Wizard's broom to achieve success soon after, and (ii) I am not rolling dice or flipping coins. But I am here to say that precisely what Connors has published (i.e., the mathematical data) is what I have known for many years.

To some of you, this revelation is more than a mild shock. Some of you have actually started to follow my blog to try to understand the discipline. Well the Connors book might be a place to start.

Before you do, I want to say that this is not a wordy text. It makes very few statements, but then backs them up with proof. So if you happen to be somebody who needs convincing, go buy the book.

I see that Connors also offers a costlier service called Special Reports, which they make available at $200 each or three for $500. You can find further info at www.TradersGalleria.com.

Report #1: Applying this knowledge to SPY, QQQ and SMH
Report #2: Applying this knowledge to the Options Market
Report #3: Applying this knowledge to the E-mini market

After I test the Connors system on options and ETF's, I'll write up a subsequent report.

Back to this book, here are some nuggets I jotted down as I went through it:

1. "Prudent money management and portfolio management (risk control and position size) is a must. In fact, they may be as important if not more important as any trading strategy."

2. "If you believe that markets move from overbought to oversold, and oversold to overbought, you will want to structure your entire thought process around this. This means looking to be buying the times when the market has had a statistical edge to the long side and looking to exit when the edge is exhausted. This is especially true in bull markets, meaning markets that are trading above their 200-day moving average. And, if you short stocks, you should be looking to be a seller when the market has shown strength, especially when it's trading below its 200-day moving average."

3. "Having multiple signals indicating the same thing will likely improve the performance of many of the indicators. We gave you the results of indicators as they stood alone. We encourage you to use them in combination."

4. "Corporate fundamental analysis may improve results but what has always been interesting to us is the fact that fundamentals are probably one of the easiest areas to test, as the information is vast. Yet in spite of the fact that Wall Street research (both from the brokerage firms and the independent research firms) is overwhelmingly fundamentally driven, there still remains today little quantified evidence that their research actually has a statistical edge."

5. "Once again, the stock market moves from overbought to oversold and vice versa, over and over again. The statistics prove this out. It's happened in one way or another for the past 100 years and in our opinion, it will happen for the next 100 years. The key from here is to "properly identify" when the market really is overbought and when it really is oversold. Hopefully, this book solidifies the process of getting you there."

In my view, this book is better suited to academia than say Random Walk Theory of Prof. Burton Malkiel, which was (is) a piece of nonsense I dismissed immediately after I read it many years ago. This book is based in mathematical research. Traders can get their heads around this material.

But if you're looking for an Art Laffer or Larry Kudlow piece of blather, this book is not for you. It doesn't tell a story; it is the story. It is how markets really work.

Posted by Posted by Bill Cara on December 1, 2005 04:33:10 PM | Category: Trader Tools

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