Bias and Self Validation

It's important to look at the markets without bias. Beingunaware of one's own bias can result in at least missedopportunities, or worse, swimming upstream with a poorrisk/reward profile. For most, it's tough to avoid a "bullish"bias. This is, of course, the predominant "retail investor"perspective. This perspective on the markets believes that theonly way money is made is for prices to rise. "Buy low and sellhigh." At least as far as most accounts go, that's true. Fewinvestors are aware of inversely correlated funds, and there'sdefinitely no way they would short the markets. This perspective is very one dimensional. Instead of just askingthe above questions, it's worthwhile to approach yourtrading/investing with some "devil's advocate" style thinking -even if your account doesn't leave you tools to profit from abearish scenario. Instead of just asking the question, "whatshould I be buying now" - look at the perspective, "is this agood setup to short?" Self validation is even more dangerous than bias. Having made adecision, the investor faces the mind numbing onslaught ofself-validation. We've all experienced this - and it's easiestto see third hand. Picture your friend who just bought a newcar/house/computer/etc, and now wants to explain to you whytheir decision was superior to the alternative productsavailable. You may agree - or you may perceive their argumentsas a shield for buyer's remorse. Self validation always affects investors - those who havealready bought in, tend to focus on the data that confirms theirlong position. Those investors out of the market will tend todownplay the former's data and focus on bearish analysis. Thisdoesn't seem like a big deal when you're "right", ie: the marketis confirming your analysis. This is where complacency can setin, because the market's trend will not last forever.Eventually, you'll become "wrong" - the market will start tomove opposite your position - and it's here we must beware ofthe trap of self validation. It's OK to change your mind, acceptnew data, and reanalyze the situation. The point of this is toprevent your small losses from becoming big losses. "Don't fightthe market" goes the platitude. The challenge is to understandyour margin for error - your pain tolerance. Now that I've discussed those concepts, I'm a stationary targetfor accusations of personifying either. Last week, both the Wilshire 4500 and the S&P500 recoverednearly all the setbacks from earlier this month. Both bouncedcleanly off their 50 day moving averages (twice), and look tohave established a floor of support. The question is whetherthere's a ceiling of resistance waiting next week. If these indices top their highs of early June, I'll be back instocks due to the following: * The NYSE Bullish Percent is (currently) still on offense. * Support has been confirmed at the 50 day MA. * The market will have shown buying interest above the previoushighs. However, given that I'm currently out of the market, therisk/reward profile is not conducive to me buying inanticipation of the last point above. There is much evidence toshow supply is overpowering demand: * 4 of 10 Stockcharts.com's sector bullish percents have movedto defense, including Finance, Health Care, Materials, andUtilities. * The NYSE weekly advance/decline chart broke below its 50 dayMA. I discussed the significance of this in an earlier post. Seethe sidebar chart for the latest. * So far, the market hasn't topped the highs of earlier thismonth. In fact - Friday's market rose quickly to just short ofthose highs, and then started a slow steady decline. The more likely scenario in my mind (here come the accusationsof self validation), is a retest of the 50 day MA next week. Ifthat happens, I think supply pressure would be sufficient to putthe S&P bullish percent on defense. Either way, I've got agameplan.