• How to read the markets

    The objective of this document is to explain the different forces that move markets and how to somehow measure/read them.

    1. Central banks

    These forces are the most influential and the most unpredictable. Central banks decisions can influence the flow of money for long periods of time. A shift in policy will have wide repercussions on the markets for two reasons: overall Government debts are very high/unsustainable and "independent" central bankers act in order to preserve price stability, full-employment and in general avoid financial chaos.

    By order of importance, their tools are:
    - Interest rates (Discount rates, rates on reserves, overnight rates, etc.)
    - Open Market Operations (QE, Overnight repo and reverse repo operations)
    - Currency debasement
    - Buying corporate bonds/equities (The Fed is silent about this, but The BOJ and the ECB are active players.)

    The hidden hand conspiration theory: The FED manipulates gold/oil prices for political purposes.

    As far as I know, these central banks manipulations cannot be confirmed by anyone. What has been confirmed is that some large banks/commodities trading desks have been actively helping price discovery. Fortunately, these manipulations have been uncovered, "heavily" reprimanded and will never occur again thanks to the SEC's active watch.

    The End of Quarter Reverse Repo operations

    These operations are used mostly for window dressing operations of the largest US banks, which need to show better ratios. You can see that these operations are getting smaller. The link is below.


    The Rates on Excess Reserves

    As we can see below, QE Infinity has provided much excess money that was parked at the Fed against a 0.25% fee.

    Since the end of QE Infinity, excess reverses have slowly been moving back into the markets.

    As we can see below, the Fed's decisions on interest rates can greatly influence the excess reserve flows of money and hence the equity markets.

    The rate hike of December 16 forced money out of reserves and into the markets, while the increase of the excess reserve rates on January 1rst drained liquidity out of the markets and almost crashed equities.

    The link is here. It is updated weekly, but with some delays.


    Currency Debasement

    The US$ is the reserve currency. Its main use is hence to help international trade because countries need to settle exchange of goods mostly in US$. A decrease in oil prices is hence bearish for the US$ because while an increase in oil prices in bullish of the US$ simply because countries might adapt the level of their US$ reserves.

    Most oil exporting countries (Saudi Arabia) had to use its excess US$ liquidity to buy US treasuries. Most recently, the Saudis had to sell US Treasuries in order to finance their budget deficit. This is US$ bearish, as the proceeds of US Treasuries selling were exchanged into Ryal.

    However, China and Japan have the largest stock of US Treasuries. It is believed that China is selling some of its US Treasuries in order to be able to fight capital flight that is caused by the Yuan's continuous devaluation policy.

    Japan and Korea are in a political and economical competition against the Chinese tiger. They therefore want to "help" their own economies by a combination of rate decrease and currency intervention. This is US$ bullish.

    The move of the US$ is hence very difficult to predict because of its status as reserve currency and its wide use. A smaller currency, such as the Australian $ is influenced by a smaller number of market forces (The country's GDP/discount rate, China and price of commodities.)

    2. Interest rates differentials

    The Interest rates differentials between US and Japanese 10Y Treasuries is a powerful tool for detecting possible S&P500 trend changes. A higher rate differential means that US assets are more attractive to Japanese investors (Japanese pension funds.) The same analysis can be done with German rates.

    The Tickers to use on StockCharts.com are below:


    I always keep a close eye on the Large Effective Volume (LEV) pattern on US 10Y Treasuries in order to detect changes of mood.

    On the RT EV, subscribers can use T5, T10 or T20 as tickers to pull the specific 5 Years, 10 Years or 20 Years US Treasuries Figures.


    Why are interest rates differentials more important now than even one year ago? The reason is NIRP.
    In the past, when the US rate was 5% and the Japanese rate was only 3%, the rate differential also was favoring carry-trade activities (The carry-trade consists of borrowing in a low interest currency/country and investing in a higher interest rate currency/country.)

    When one country turns to NIRP, it means that pension funds of that country cannot earn any money by buying local bonds. Hence, they need to turn to either riskier investments in their country or to bonds abroad. This is simply a life and death situation. NIRP is sure to bankrupt them in the mid to long term.

    The behaviour between Carry-trade investors and NIRP refugees is very different: Carry-trade is a short-term activity, while NIRP refugees is long-term. Now, considering that Japan wants to push the Yen down, investing in US assets looks the logical way to go for NIRP Refugees.

    3. The Mammoth Stocks

    I have selected the 10 most traded stocks of the S&P500 in terms of Money exchanged (Price * Volume.) I have calculated the Weighted LEV * Price evolution for the whole group with the objective of detecting what the big funds are doing.

    Indeed, these Mammoth stocks have zero probability to go bankrupt, while offering attractive dividends and also often growth prospects. This is the reason why some of the money coming from NIRP refugees must also find a home in Mammoth stocks.

    We can see below that even though signals have not been accurate, positive divergences (Green arrows) on a market pullback is a good indication that money is moving back into these mammoth stocks. On the other hand, price weakness seem to be following sell-offs of the Money Flow below the zero level (Red arrows.)

    This chart can be found here: http://www.effectivevolume.com/content.php?3178-nq100

    4. The E-mini (S&P Futures)

    The E-mini is the most liquid leveraged way to operate a short-term trading activity in US markets.
    This instrument is used by most professionals and some retail investors. However, this is not an instrument attractive to longer-term investors such as pension funds, except maybe for specific hedging reasons.

    Here is a comprehensive explanation regarding this instrument.


    E-mini traders will use all the tools at their disposal in order to detect market liquidity. When QE was in full force, market liquidity was telegraphed through the planned daily operations. These days, large investors have developed liquidity detection algos probably similar to 20DMF that I am using.

    The 20DMF

    As a small reminder, the 20DMF is a sector based indicator. It measures the twenty days flow of money into 114 equally weighted sectors (Hence, sector rotation should have no influence of the indicator.)

    We can see below that before the bounce of February, the 20DMF was already showing a positive divergence. Currently, the 20DMF shows a negative divergence: each new S&P500 high corresponds to a lower high in the 20DMF. In itself, this is not a short signal, as far as the 20DMF stays above 0, because the 20DMF is an oscillator.

    However, when it falls below zero, it has a clear meaning: the money flow for the past 20 days is negative.

    In other words, I believe that US funds are selling equities into the liquidity provided by Japanese pension funds. I believe that US funds are buying/selling individual stocks on the basis of value metrics (PE ratios, sales, etc.) Japanese pension funds are less sophisticated and hence will limit themselves to buying the market (ETFs) or the largest stocks.

    The Cumulative Tick

    The Cumulative Tick is a good tool to detect an indiscriminate flow of money into the market.

    As Steenbarger explains it , "The NYSE TICK represents, at any given moment, the net number of stocks in the broad market that are trading at their offer prices minus those trading at their bids. When the NYSE TICK becomes very positive, it means that traders are lifting offers in the broad market: buyers are quite aggressive. When the TICK becomes very negative, it means that traders are hitting bids in the broad market: sellers are very aggressive."


    I myself use the 1200 Minutes average to judge when the accumulation pattern changes.
    We can see that last Friday, the Cumulative Tick turned down below its average line.

    The E-mini LEV Pattern

    Positive/Negative divergences on the E-mini's LEV pattern also offer critical clues regarding the underlying liquidity move in the cash S&P. This was the pattern in early February 2016, just after the BOJ NIRP.

    The VIX Futures' EV pattern

    The VIX is used for short term hedging activities. Fear would result in VIX spikes, because instead of having to sell right away a position that could be taking water, traders would Hedge that position by buying puts (VIX is a volatility measure based on different types of options.)

    I find it very interesting when a VIX spike is not bought. Why would be the cause of such a behavior?
    I see two reasons:
    • The first reason would be that investors are very confident that markets will move higher. In such a case, why bother with hedges?
    • The second reason would simply be that the VIX is not the right tool for hedging one's position. This is especially true if you are a pension fund whose investment time frame is much longer than the VIX. As we all know, pension funds use diversification instead of hedging tools.

    Hence, my opinion is that the poor VIX accumulation pattern is an indication that the current market liquidity is provided by NIRP refugees.

    The Overnight Price gains VS the Real-Time hours price changes in the E-mini

    I want to point again to Peter's excellent work regarding the analysis of the E-mini price gains as a function of market opening hours. The discussion is below


    The typical Figure that Peter produces shows in Green the E-mini price changes during the real-time hours, while in Yellow, we have the overnight trading.

    We can see that the current RT hours price gains are now in a steep uptrend line that started just around the BOJ NIRP decision while the overnight trend is definitively down.

    This pattern is easy to explain: NIRP has forced Japanese pension funds to invest in the US markets. This can be done in the cash market (Not in the Futures) and only during opening hours because this is when liquidity is available. The E-mini trading algos detect such liquidity in the cash market and just follow it, but they make sure to book their profits after the cash market closes.

    When will this pattern change? Difficult to say. Peter has drawn some arbitrary trend lines. In the past, when the RT hours gains broke their trend line, it was a sign of a pullback.

    For now, it is difficult to know in advance when the BOJ will change its NIRP/Yen debasement policy and/or when Japanese fund will decide that the have enough US markets exposure. I am pretty sure that this indiscriminate buying is "malinvestment" on a grand scale, but as far as we believe that the Fed will continue supporting the markets, then US equities are the best dirty shirt to wear.

    My second opinion is that since the Fed wants to decrease its balance sheet, it should take advantage of this buying frenzy to offload US Treasuries. This would put upward pressure on rates without having to increase rates themselves. It would be a reversed QE.

    5. Oil and distressed debt

    Here is a comment written in March 2016 regarding the oil market and distressed debts.


    Oil has reached the target price of $50 and now seems to be pulling back.

    Both junk bonds ETFs seem to be under selling (HYG more than JNK.)
    I believe that what needed to be refinanced will have been refinanced before the Summer.
    This means that there will be little need to keep oil prices high after bad debts will have been refinanced.

    6. Gold and the PM sector

    Gold is a tiny market. Hence, when gold moves, it is the equivalent of a mosquito bite: either it is not relevant or Mr Market has just contracted a major disease. This means that we need to track this sector for the specific signals that it may carry and spread.

    The signal is important when gold starts to diverge from the US$'s traditional inversed correlation.
    This is what is being shown below: when gold moves up together with the US$, this means "market fear"

    For now, this fear originates from a possible Brexit. Since polls show a very tight situation, equities will probably drift lower until results are "in the voting box".

    7. The SP500 and its 5MA

    I found it interesting to track the S&P500 compared to its 5MA. After an uptrend, when the HOD is below the 5MA, this indicates a probable trend change. This is what we got on Friday and means that bounces up to the 5MA can be shorting opportunities.


    As you can see, markets have become interrelated and very complex. I do not believe that it is safe to trade these markets without having a good look at the different instruments that follow liquidity.

    If you have new ideas regarding aspects of the markets that I have not discussed here, please use the comments section to make suggestions.

    I deliberately did not write about Support/Resistance and momentum. These subjects are well known tools but do not provide liquidity per se. I will keep this Article at the top of the list of weekly article, as a reference paper for newcomers.
    Comments 2 Comments
    1. Normand's Avatar
      Outstanding “Putting it all together" article Pascal. Thank you. Normand
    1. admin1's Avatar
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