"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
Sun Tzu

Wednesday, April 30, 2008

Pre-Fed Thought: Market Singularities

There are days, when it is absolutely impossible to predict the markets. One of these days is today with the FED interest rate decision. In a mathematical sense, the market creates a SINGULARITY.

A singularity "i
n general is a point at which a given mathematical object is not defined, or a point of an exceptional set where it fails to be well behaved in some particular way." {Wikipedia}

Singularities exist in space (black holes), mathematics (functions), engineering (e.g. bouncing ball) and I also see them in the markets.

A singularity is not an issue for the long term investor, since the data point is small compared to his usual investing time frame. It is also not an issue for the day trader, since he stops trading before and starts again after the singularity. It is an issue, though, for the swing trader, who holds positions for a couple of days. The singularity can seriously damage his performance.

So how can the swing trader deal with that phenomenon? Mathematicians sometimes "remove" the singularity by just defining a finite value at the critical point. The swing trader can do the same: he just hedges his portfolio during the singular point by for example open a short term S&P short position if his portfolio is predominantly situated on the long side.

So: guess that's what I'll do today.

Good luck

Sunday, April 20, 2008

Game Plan Week of April 20: a Quick Look Back into History

Better than expected earnings obviously caught the market by surprise and stocks rallied. The question of course is: is the market due for a consolidation. Let's look what the market did in the third quarter of 2007 to maybe get some insight. The DOW broke out of a consolidation zone and even reached the upper bound of his trading channel. The Stochastics oszillator indicated overbought conditions:

The market kept rallying for another four weeks and thus staying overbought. Note the declining volume, which indicated a upcoming change in sentiment:

So here is the latest DOW price action. Let's see if history can repeat itself:

We are just 20% in the earnings season, so maybe there is more room in the next weeks to stay overbought. A lot of funds still maintain heavy cash positions, so there is room to run. Gold, BTW, has been a little bit disappointing in recent days. Are money managers moving back to riskier assets?

Nevertheless, the market will concentrate on the FED meeting end of April at one point. What if we won't get a rate cut? 25 base points are already priced in. I wouldn't be surprised if the market would take that as a positive: "Earnings are strong and the FED has some room to manage inflation" could be a comment we'll read in two weeks.

So, as usual: how do we play this? The present rally is driven by multinational companies, who benefit from the strong dollar and booming foreign economies. Since I do not like to swing trade a stock over earnings, I'll probably trade some DOW index ETF to capture the move of US large caps with international orientation.

Saturday, April 12, 2008

Game Plan Week of April 13: Slow Down or Not?

Well, we had a nice rally which ended at the upper bound of the 2008 trading range. Unfortunately, I reversed my SHORT positions from beginning of last week to LONG due to some emotional actions, which cost me some percentage points.

When I read newsletters and market comments, I detected a major theme: "the economy will rebound in the second half of the year". The market obviously priced that in. But there are quite some individuals who predict the opposite: George Soros is one of them. Also: in my opinion, the economy can only rebound if housing prices reverse up. But all predictions are to the downside until 2010.

When the market tanked on Friday, it wasn't because of GE's earnings miss. It was because of GE's low guidance for the rest of the year and its global business. Suddenly, the market woke up from the "rebound later this year" dream and got a little nervous.

Where do we go from here?
To be honest, we have to wait and see how the other Dow stocks report the next two weeks. More of the low guidance and we'll see the January lows again pretty soon. At this point, I'm mostly in cash, some Gold LONG and some S&P SHORT. I try to resist to build up significant LONG positions before we've seen more earnings reports.

A nice chart was posted from Bespoke Investment Group and I post it here again because it is a nice guide for the next weeks:

Thursday, April 3, 2008

Trading Summary Q1 2008

The first quarter of 2008 was a successful, yet challenging one. Compared to my benchmark, the S&P500, we did pretty well:

Trading Performance Q1/2008: +4.7% (S&P 500: -10.9%)

During the first quarter, I wasforced to do more trades than desired due to high market volatility. Trading performance would have been better by 160 base points when not taking transaction fees into account. Still, I am quite satisfied with our results. One of my goals is to reduce trading frequency in the future, though.

The biggest winning positions:

Countrywide (Short) + 29%
Yamana Gold (Long) + 15%
Toll Brothers (Long) + 15%
S&P500 (Short) + 13%
Goldman Sachs (Long) +11%
Blue Nile (Short) +11%

The biggest loosing positions:

Suntech (Long) -13%
Pulte (Short) -9%
Clearwire (Long) -9%
Homebuilder Index ITB (Short) -8%
Financial Index IYF (Short) -8%
Mastercard (Long) -8%

Further analysis reveals that many of the losses stem from short trades in the homebuilders sector. I recognized too late that this sector reversed its downtrend. I still can't see an improvement in underlying fundamentals, but for now, we go with the flow and trade the homebuilders from the long side.

Despite significant short positions in the financial sector, I could have benefited more from the downturn in that industry. Two times during Q1, I was set up to benefit from a potential market crash, which didn't happen due to FED interventions. In turn, I had to quickly close short positions, which resulted in loosing trades.

Multiple long trades of the GOLD bullion resulted in nice winning swing trades during the period.

Inthe first quarter, I implemented the following changes in my trading strategy:

1) "Market first": a very rigid top-down analysis approach
2) Using the VIX indicator to gauge market sentiment and find possible reversal points
3) Scale in and out of positions to manage trading anxiety

Experience with these changes, especially with 3) have been very positive so far.

Outlook & possible trading themes Q2

Going into the second quarter, the market sentiment has changed dramatically in my opinion: the credit crises seems behind us and stocks climb even on bad news, which indicates that a lot negativity (and possibly the notion of a recession in the US) has been priced in. It looks like the
market is betting on a economic recovery in the second half of the year. Therefore, I plan to touch equities dominantly from the long side, at least in the first half of the quarter. Should the market come to the conclusion that economic (and housing) recovery won't happen this year, we possibly could come back to the Q1 lows.

In terms of trading themes, I'll try to put on swing trades in the following areas:

- Technology (RIMM, AAPL) LONG: Recession seem to be non-existent for Research In Motion.
- Euro/Dollar SHORT: Europe is behind the US in the business cycle. With easing inflationary pressure and slower growth, the EZB will be forced to lower interest rates later in the year.
- Exchanges (NYX, ICE) LONG: High trading volume in the first half and market space consolidation make the exchanges attractive
- Housing LONG: go with the flow as long as the market favors them. I'm ready to switch sides, though.
- Aerospace LONG: I like Boeing (BA), 787 negativity possibly priced in. Airlines need to upgrade their fleets due to high oil prices. Wait until the sector comes into favor again. The market might not like a possible democratic president after November.
- Biotech (GENZ,DNA) LONG: Not affected by weak economy, great pipelines, good relative strength.

- Commodities SHORT: it looks like funds are shifting back money from commodities to stocks. I'm closely observing that development.