"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

Thursday, August 27, 2009

Feb 27 2007: What can we Learn from History?

The current market reminds me a lot of the beginning of 2007. At that time, the market was moving in a similar fashion: climbing the "wall of worry" on low volatilty.In fact, it took the market seven months to move up about 18% from the bottom. On February 27, the market finally declined over four percent in a day. The move was triggered by a big decline in Chinese stocks and negative economic numbers in the US (Check out the CNN market report of that day).

Prior to that decline, experts were warning of a significant pullback for months due to economic expectations. We are in a similar situation right now with several analysts predicting stocks to decline. Yet, the S&P continues to make new heights on low volatility.

Was there a way to predict the date of the selloff from various (sentiment) indicators in 2007? On the chart I plotted several curves, such as NYSE Advanced/Declines, New Heights/New Lows, VIX and MACD. None of them predicted the selloff. You could maybe argue that the momentum divergence of the MACD showed decelerating upward drift. However, the MACD accelerated again in Jan/Feb and thus gave you a false signal (As you might know, I consider these classical technical indicators quite useless anyways). Bottom line is that none of these indicators predicted the downturn. Drawing trendlines or Moving Averages also didn't help.

So let's assume, you were a short term oriented trader at at that time and you would have known that stocks will sell off at some point in the future. What would have been a successful strategy?

a) you could have gotten out of the market during the uptrend and simply waited for the sell off to re-enter.
This strategy would have been profitable if you would have sold after November, so almost three months before the sell off . Psychologically, you would have had a tough time between December and February: you needed to watch the market go up from the sidelines and be disciplined enough to not get back in.

b) you could have played the price swings: buy after a pull back and sell on a new height, which is actually my style. Problem with that strategy: You might have bought the days before Feb 27 because the market actually dipped slightly. In order to play this strategy successful, you should have sold everything in the morning of Feb 27 and aggressively opened short positions to play the downside momentum. That day was actually a trending day, so you had a good chance to get back some of your losses of the last swing.

A third, more advanced option would have been to use options to hedge the portfolio and benefit from rising volatility/premiums.

So, here we are two years later. I think that we will see a similar selloff before the end of the year. It is totally unpredictable when exactly that will happen. As we have seen in 2007, trends can run a long time and it is impossible to pick the top.

I'm leaning towards strategy b), but there will be days in September when I cannot monitor the markets all day, so I will probably move to strategy a).

Friday, August 7, 2009

Some Trading Themes

Just briefly wanted to list some themes I try to benefit from in my trading:

- Dollar Decline leading to rising commodity prices. Looking to trade metal & agriculture stocks.
- Inflatation fear. I'm watching gold, but still don't believe it will break $1000 despite compelling fundamentals. I keep observing. Might either change my mind soon or even short it.
- Natural gas: straight decline. Looking for signs of bottomning. Compelling Oil/Gas price ratio.
- Financial outperformance: see my last post. Favorite since last week: Citigroup. Glad to see Cramer finally got behind that as well :-).
- Germany: (I'm a little bit biased, since that's where I'm living: looks like recovering faster than US as a result from export orientation of the country. Stock market so far has not outperformed the US. I might buy into an ETF after some consolidation. Could put more pressure on Greenback BTW.
- China: play the long term up trend.
- Solar: sector out of favor and quite rocky, so I'm careful.

Please note that I'm not holding positions YET in every one of the themes. Looking for good entry points.

Thursday, August 6, 2009

Visualizing Sector Rotation

I regularly look at relative sector performance as part of my weekly routine to detect shifts in market sentiment and themes. Each industry gets assigned a relative strength value between 0 and 100%; some smoothing is also applied. It is a quite interesting exercise to look at a chart of these values: When you look at the tech sector (green) for the last half a year, you can observe that stocks in this area have been quite strong. However, Tech lost its leadership in recent weeks. Financials (red) and Technology seem to play a dual role: if one of them is weak, the other is strong and vice versa. In fact, the rise of Financials to become the leading sector started almost two months ago. We are in a momentum market and it looks like that the hot money is moving from Tech to Bank stocks. It doesn't make much sense to me, but as a momentum based trader, you need to follow the money flow.