How Markets Really Work: Book Notes

This post contains my personal notes from the book “How Markets Really Work” by Larry Connors.

The essence of the book is as follows:

Buying short-term weakness has outperformed buying short-term strength over the past 15 years.On a short-term basis, oversold markets tend to move higher over the next few days and overbought markets tend to move lower on a short-term basis over the next few days.Technology changes, but market behavior rarely does, especially short-term. Markets are made up of individuals, and individuals are driven by the same emotions no matter what decade or even century they’re in. Yes, intelligence has greatly expanded but decisions are still driven by fear and greed, especially at market extremes no matter what the time frame. In  spite of the incredible technology, product and global expansion in the markets, they still behave the same way over and over again.

Now let us see how we can practically use the information in the book. Unless mentioned, the strategies will work when used with an index ETF or fund. It is best to use these strategies as foundational principles of a broader investment strategy.

1.The greater opportunity and edge lies in being a buyer as the market makes a new short-term low versus buying when it makes a new high. This is applicable if the market is above the 200 day moving average.

Practical application: When the stock market is above the 200 day moving average, buying when the stock market reaches a 5 day low, 10 day low or 21 day low and holding for the next 1 day, 2 days or 1 week results in an above average profit. The opposite happens when you buy 5 day, 10 day or 21 day highs, especially when the stock market is below the 200 day moving average.

2. The greater opportunity and edge has been from being a buyer as the market has made lower lows versus buying when it makes higher highs irrespective of whether the market is above or below the 200 day moving average.

Practical application: When the stock market has made lower lows for 3, 4 or 5 days in a row and you hold for 1 day, 2 days or 1 week it results in an above average profit. The opposite happens when you buy the higher highs, especially when the stock market is below the 200 day moving average.

3. Waiting for a market to decline multiple days in a row is better than buying into strength. 

Practical application: If you buy the market after 2 or 3  down days and hold for a week, on average you will outperform the market.

4. It has been better to be selectively buying the stock market when market breadth has been poor versus when market breadth has been strong. 

Practical application: If the declines/advances ratio is >2 or >3 and you buy and hold for a week, you will on average outperform the stock market. If the declines are greater than the advances for 2 or 3 consecutive days and you buy and hold for a week, you will on average outperform the market.

5. In looking at volume as a stand-alone indicator, there does not seem to be an obvious edge. 

Practical application: Don’t base your investing strategy on volume.

6.  Large market drops are often followed by immediate snap back moves. This is especially so, if the market is above the 200 day moving average.

Practical application: Buying the stock market after 1% decline and 2% decline and holding for 1 day, 2 days or a week outperforms the market on average.

7. A lower HILO index outperforms over the short run.

Practical application: HILO index= Number of new 52 week highs minus Number of new 52 week lows. If you buy the market when the HILO index makes a new 1 week low, 5 week low or 10 week low  and hold for 1 week to 2 weeks you will outperform the market on average.

8. Using put/call ratio does not give an edge.

Practical application: Do not use put/call ratios for your investment strategies.

9. Static numbers do not work when it comes to the VIX. You have to use a moving average.

Practical application: When the VIX has closed more than 10% above the 10 period moving average, buying outperforms over the next 1 day, 2 days or 1 week. When the has closed more than 5% below the 10 period moving average, buying underperforms over the next 1 day, 2 days or 1 week.

10.  The 2-period RSI has a very good edge in investing for the short-term.

Practical application: When the 2-period RSI is less than 5, buying outperforms over the next 1 week. When the 2-period RSI is greater than 95, buying underperforms over the next 1 week.

11. Low volatility stocks outperform high volatility stocks.

Practical application: Calculate the 100 day historical volatility for each stock in an index. The volatility is the standard deviation and can be measured using Excel. Divide the stocks into 5 quintiles. Buy the stocks in the 4 quintiles with the lowest volatility. Do not buy the stocks with the highest volatility. Hold for 1 calendar year or 252 trading days. You will outperform the market.

Some other things to consider:

  • Do not use these indicators blindly. Prudent poistion sizing and risk control are essential.
  • Never buy sort term strength gain or sell into short-term strength weakness.
  • Use multiple signals.
  • Rather than use static exit, you can exit when the stock goes above a moving average.
  • Markets do not absolutely move in one direction, neither short-term or long-term.
  • Trade when the stock market is above the 200 day moving average, the stock is above the 200 day moving average, the stock has gone down atleast 2 days in a row, the stock is oversold(RSI less than 15) and has low volatility( less than 35).
  • These principles are for short-term trading( 1 week or less)
  • Slippage, commisions and taxes may erode this outperformance.
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