Lately I have been writing an article for CME Group’s Spring magazine. In my head it is titled “The Social Markets Hypothesis” (note: NOT Social Market-ING). That term, to me, is an extension of the Adaptive Markets Hypothesis by Dr. Andrew Lo which in turn is an extension of the Efficient Markets Hypothesis which has been the reigning paradigm for so long. It happens to also be the bridge between the arguments of EMH and Behavioral Economics or Finance.

The “thing” that is different about both this hypothesis and my way of looking at the markets is this. I begin my thinking with the question of “what are they or will they be doing”? In other words, I always ask the human question FIRST.

I do this for a couple of reasons. 1) It is actually the only thing we care about – except 99.85% of the traders and investors never think of it. 2) Recent research shows that “Theory of Mind” (the ability to understand the other) is a more applicable skill to market prediction than thinking in probabilities.

Now I have almost 15 years of trading experience and I learned from a tape reader (btw …what is tape reading but “reading” what “they” are doing), so I can look at my screens and unconsciously come up with a good answer to the human question. But it is totally fair to ask me to deconstruct it?

For example, the $TICK and the Adv/Decline line or chart are both revealing what traders in the NYSE cash equity markets are doing. Now, who trades those? Basically you have two maybe three groups – the vast retail public and the hedge funds (and prop desks). It used to be that the S&P futures would lead the cash market but it is my experience that in recent years, this “cash” leads the futures. I attribute this to lots more short-term trading by hedge funds.

2nd – the Naz and Russell are different animals from the S&P 500 – so I consider those traders/groups as a different group of people. If they are turning the ship in the exact same way at the exact same time, then the boat is going to move. If they are pulling in a little bit of the opposite direction, then the boat won’t go so fast. It might even do a 180. When I look at the VIX (which I haven’t lately but not for any great reason), I consider that a 3rd group – the equity option people. Same ideas though.

Now all of this can be labeled under convergence/divergence but I like to have my decisions be based on the most irreducible analysis which in the markets is always people – i.e. it can’t get any simpler than that.

So take elements like volume. Well now, what is volume but a representation of how many people traded how many contracts in a given period or at a given price? (which is why I like the market development/market profile method) You can count on the price coming back to a high volume area or an area that everyone knows (yesterday’s low) and being defended. Why do gaps work? Well… because there are less trades there to be defended – and because now we all expect them to work. In other words, real people who bought or sold at a certain price – or who had the opportunity to get in or out at a price but didn’t – will react when the market gets back to that price again. Some will be adding to defend and some will be adding out of relief (it works short or long).

You can also ask questions like “are there as many people selling at this price now as there were this morning or did that huge volume bar just wipe out all the shorts” – at least until a group of real people have time to recover and re-load.

So… do I use probabilities? At this point, I really only use them intuitively. Do I think they are valuable? YES but nevertheless, the real clue is that the numbers (and the bars and lines they draw) are only a clue – not the real answer.

Hope that helps – DKS