Momentum Versus Mean Reversion

*** The following is an excerpt from Alex’s weekly Market Note ***

The Nasdaq is 3 standard deviations above its 200-week moving average. The trend has only been this stretched a handful of times over the last 30-years.

Fund flows into tech are nearly 2.5 standard deviations above their 12-month average. A point at which has marked intermediate tops over the past 3-years (red highlights below).

Breadth in the tech sector has been narrowing but is still not at levels that typically precede large-scale weakness. Though that could quickly change.

The latest BofA Global Fund Manager Survey (you can find the report hung up in the Comm Center #Research channel) had the largest percentage of respondents call Long US Tech & Growth the “most crowded trade” in the survey’s history.

The only other instance that comes close is “Long US Dollar” in February of 2015, which happened to precede a top and 5-years of sideways chop.

But… while the trend is stretched, the trade crowded, valuations high, and short-interest at record lows. The path of least resistance remains up — at least for now.

The Nasdaq is in a buy climax and buy climaxes last longer than anybody expects them too (see 99’-00’, the last time Nasdaq was this far above its 200wma.

The bullish thrust off of the March lows has been incredibly strong and is dominated by large bullish candles. The tape reflects a large imbalance between demand and supply, which the bullish trend is working to correct.

Strong thrusts such as these tend to go through a distribution phase (a topping process) that plays out over a couple of weeks before we see a change in trend. It’s during these times that we see breadth materially deteriorate and the tape chop sideways. The Nasdaq made new all-time highs this week and though breadth has weakened it’s not yet giving a sell signal.

In an old research paper (link here), Michael Mauboussin recalled a study titled “Crowd Synchrony on the Millennium Bridge” that was published in Nature. Michael wrote:

On June 10, 2000, the Millennium Bridge opened to the public with great fanfare. London’s first bridge across the Thames in over a century, it had a sleek design—the architect wanted it to look like a “blade of light.” However, when thousands of people stepped on the bridge that day, it started to sway from side to side so much that people had to stop or hold on to the rails. Fearing for the public’s safety, officials closed the bridge two days later and, following a retrofitting, it reopened in February 2002.

What led to this high-profile failure? People exert a small amount of lateral excitation when they walk. Normally, these excitations cancel out when a group crosses a bridge. However, the Millennium Bridge initially had insufficient lateral dampeners, which allowed a little swaying when a sufficient number of people were on the bridge. That swaying forced people to change their gait by widening their steps, leading to greater lateral excitation and more swaying. The wobbling and crowd synchrony emerged simultaneously.

The crucial insight is the existence of a critical point. Simulations show that roughly 165 people can walk on the bridge with little impact on the wobble amplitude (see Exhibit 1). But adding just a few more pedestrians causes the amplitude to change dramatically, especially as the feedback between gait adjustment and wobble amplitude kicks in (see the dashed line in Exhibit 1). For the first 165 bridge crossers, there’s little wobble and no sense of any potential hazard even though the bridge is on the cusp of a state change.

The study helps illustrate how critical tipping points are reached in complex non-linear systems, of which the market is one.

Recursive action drives feedback loops which leads to amplification and eventually tipping points from critical states.

The current trend in the Nasdaq can be looked at through this lens. The stretched trend and the increasing absence of sizable dips show that the primary rule “buy dips, buy highs” is becoming more widely adopted. More agents (traders and investors) are adopting it because it’s been profitable to do so.

At some point, adoption of this rule will reach a critical mass and the lack of rule diversification will set the stage for the feedback loops to run in the other direction.

We’re not there yet but we’re getting closer with each passing day. Until then, play the trend until it bends.

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Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.


Investing & Personal Finance

AK is the founder of Macro Ops and the host of Fallible.

He started out in corporate economics for a Fortune 50 company before moving to a long/short equity investment firm.

With Macro Ops focused primarily on institutional clients, AK moved to servicing new investors just starting their journey. He takes the professional research and education produced at Macro Ops and breaks it down for beginners. The goal is to help clients find the best solution for their investing needs through effective education.

Tyler Kling

Volatility & Options Trader

Former trade desk manager at $100+ million family office where he oversaw multiple traders and helped develop cutting edge quantitative strategies in the derivatives market.

He worked as a consultant to the family office’s in-house fund of funds in the areas of portfolio manager evaluation and capital allocation.

Certified in Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

Alex Barrow

Macro Trader

Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Macro Ops’ research has been featured in Forbes, Marketwatch, Business Insider, and Real Vision as well as a number of other leading publications.

You can find out more about Alex on his LinkedIn account here and also find him on Twitter where he frequently shares his market research.