Art Cashin, a UBS stalwart and CNBC commentator from the NYSE floor, is a dear friend and marvelous and sensitive gentleman. He is revered by those who know him as the dean of the investment university called the American stock market. Art was kind enough to give us permission to share his morning missive (September 9, 2020) with readers.
Below is Art Cashin.
David R. Kotok
Chairman of the Board & Chief Investment Officer
Email | Bio
Date: September 9, 2020 at 9:11:30 AM EDT
Yesterday’s comments appear at the end.
The overnight whipsaw in the averages continues, which I think tremendously underscores the thesis I explored yesterday about the dominating influence trading against sell stops and momentum players. Several of my widely read friends have honored me by asking permission to reprint it because after seeing it, they recognized the clarity of explanation it provides. You see again this morning two things to underscore it. First, a whip back in markets after the heavy sell-off yesterday, without any major news. Secondarily, the disparity within markets, in which we see things like the Chinese markets weaker. Yet the bounce-back rally continues in the U.S. So, the actions are somewhat internalized here and we will have to continue to watch out for how that trades. The election may soon begin to press its influence, although the polls remain vague enough that there is no real sense of how things may be moving.
Please remember that sell stops may be behind some of these swings and at least that will provide some backdrop that eliminates the sense of mindless trading and how the market seems to be positioned. We will explore how condition changes may adjust this in coming days.
Stay safe.
Arthur
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We are in the midst in what we old fogeys tend to call a sell-stop avalanche. It happened before in history and most of them look like this. I know there are several theories about what has been causing the recent sharp weakness, but based on over six decades of time on Wall Street this one looks pretty clear to me. So, let’s discuss how such a thing sets up and you will begin to recognize its familiarity.
Sell stop orders have been a key feature in markets for probably over 5000 years, since the ancient Sumerians began trading futures on their grain crops each year. And, the idea, as we said, was to protect you from a deep reversal. There is some belief that sell stops may have even been a factor in the great tulip bulb bubble that burst, but I cannot find any strong evidence either way. If you want to read how sophisticated the market was, see if you can find a copy of something called Confusion de Confusiones. It was a book written in Latin at the time about markets and tulips, etc.
Anyway, back to our topic. So, now you have both amateurs and professionals for their own separate reasons trying to capture the momentum of this particular sector or the market and follow it up with sell stop orders. As I say, stop orders have been around. They really blossomed in the late 50s and early 60s, when a professional dancer named Nicolas Darvas wrote a book about how he took a couple of grand and turned it into over two million dollars. The book was a major sellout and then burgeoning brokerages at the time were forced to grapple with the emergence of a new factor – huge influxes of sell stop orders that caused high volatility. The exchanges at the time scrambled to try and find new rules and procedures that could cushion the blow. Even though Darvas’s theory never caught on completely, it still remains, and anyone will tell you the best way to play momentum is to follow with trailing sell orders. How tight you make the orders depends on what kind of sell-off you are worried about. You want to keep with the trend but you don’t want to be there if the trend is going to reverse so you will probably check on some technical pattern and, say markets are okay, unless they reverse 3% or 6% or whatever and, therefore, based on that technical theory, that’s where you will put in your sell stops.
Now, you must remember there are hundreds of people elsewhere doing all this stuff so there are going to be stop orders all over the specialist book and that’s what helps make for the avalanche when they start to get interactive.
The process quite frankly begins whenever the market begins to zero in on one sector, whether it is techs or energy or whatever, and those groups seems to keep going up and up and up, and money managers begin to look at it and begin to say, I think they are overbought but I’ve got to participate or my fund is going to underperform. At the same time the amateurs are looking and saying, the energy stocks just keep going up and up. So, everybody then decides to try capture the momentum. Even though stocks look probably overbought in the sector, they begin buying, and what they do to avoid being caught deeply off base is to follow their purchases with trailing tight sell stop orders. In essence, if the market trades to 50, they bring their sell stop up to 48. If it then goes to 52, they bring it up to 50, etc., etc.
Frequently, before the phenomenon ends, there is usually a new wrinkle called going parabolic, in which the stock that has been rising relentlessly suddenly begins to move up, almost in a straight line, looking like a parabola.
Now, sometimes the reason for this is just very simply that everybody finally decides to join the pack. Don’t fight them. They are winning. XYZ goes up and up and up. I might as well get in.
Sometimes it can be a news-related event like the recent series of stock splits that we saw, which caused rounds of short covering and mini-short squeezes as people have to go out and buy more stock to replace or reset the stock that they had borrowed when they first got involved in shorting. The shorts being forced to cover was a recent event or you had people saying I can’t win; I might as well just join the pack. In either case, it brings in new buyers on top of the others and that causes the stock to get up nearly in a straight line called going parabolic.
Going parabolic quite frequently occurs as the cycle is shifting toward its end phase. The difficulty is that people cannot time that shift. More than a few people have shot themselves in the foot, saying, it has gone; I’m going to short it here. When it collapses, I will buy it back.
The market can stay irrational longer than you can stay insolvent.
By my recollection, more than half of these sell stop avalanches end in pretty much a washout and that is because they quickly interact so fast that they take it to a level no one had placed previous stops at.
This morning looked like it had some potential as a possible washout. Declines beat advances over 8 to 1. Usually washouts begin at 9 to 1, all the way up to 15 to 1 or more, but the market quickly tried to correct itself. And, while price-wise it is still showing significant losses, the breadth of the market has healed up a little too fast to make you feel that what you are seeing is ‘throw the baby out with the bath water.’
So, we may have to watch for a bit more. I hope I have not bored you with my recordation of what I remembered from 6½ decades.
Stay safe and we will look again tomorrow.
Regards,
Arthur
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