The Small Cap Sell-Off

It was quite interesting the last days to observe the nature of the recent sell-off: large cap stocks held up quite well. While the Russel 2000 was underperforming for quite a while, its decline really accelerated this week. The lower curve on the following charts depicts the ratio of small (Russel 2000) to large cap (DJ) stock prices. While the ratio was declining for the entire rally, it shot up in the last four weeks:

So the decline is one one hand a sign for risk aversion, but might also be an indicator for a healthy longer term rally: we are seeing a normal sector rotation from risky small caps to more conservative large caps (who BTW benefit from a weaker dollar, because large companies tend to be more export oriented.)

In any case, I don't expect the decline to be over. We propably will see a bounce soon due to oversold conditions, but I expect stocks to be under pressure for some time because of missing catalyst. The wild card, though is the Dollar. The chart shows us a stable downtrend so far, you might could argue for mild momentum (MACD) divergence as a sign of stabilization:

Anybody Interested in Joining a Virtual Trading Group?

I would be interested in establishing a "virtual trading group" in order to have more targeted interation with mind like traders and bring our trading "to the next level". Check out Dr. Brett's post about the topic. I think it would be great to form a group of 3-5 investors with similar style and experience. The group would regularly (2-3 times a week) discuss trades, the markets, successes and failures. In order for this to be beneficial to everyone, it would be important to have similar backgrounds/philosophy.

So here is what I'm looking for:

- Trading US equities on a short time frame (2 days - 4 weeks)
- At least three years experience and solid knowledge about technical analysis, risk management and trading psychology
- Style influenced by Alexander Elder (not a must)
- Located in Europe (makes it easier with the time difference, not a must either)
- Part time traders OK (or even preferred, because that's what I am)

So if you are interested, shoot me a mail.

S&P 500: this chart makes me nervous - VERY nervous

As traders, we are constantly questioning our own positions and looking for signs why we might be wrong. Despite the fact that I am (was) very bullish recently, I have to acknowledge that the S&P 500 chart doesn't look bullish at all. You might be surprised, because a superficial look tells you that prices keep going up. Let me focus your attention on some observations:
I would like refer you to a tool, which was introduced by Dr. Alexander Elder: the Force Index (FI). The FI is basically price change multiplied by volume. I use this index to visualize divergences between volume and price action. Higher prices without participation of volume indicates upcomming trend reversals.

Lets look at this relationship for the last 8 months: we can identify three distinct periods:

- Marked with (1) on the chart: right after the ultimate low in March, the market put in a strong reversal and kept climbing for almost two months on declining volume. Look how nice the divergence shows up in the chart.

- (2): The divergence (1) indicated upcoming weakness. In fact, the S&P went through a consolidation phase in June. Note that we actually had a bullish divergence during phase two (green lines).

-(3): The market responded after the bullish divergence (2) with higher prices. Upside volume has become increasingly weak and divergence (3) has been shaping up.

- (4): This is the point that concernes me most: during phase (3), we had three minor pull backs. Each of the pull backs was stronger in size and volume, as you can see when looking at the Force Index (4). So it looks like the bears are gaining strength on every dip. Divergence (3) shows that bulls are running out of steam. The big price jump beginning of July was triggered by the beginning of the earnings season. Guess what: Q3 earnings season just started and the chart looks to me more like prices getting exhausted.
I'm really contemplating closing all my long positions and start going short. S&P price target at least 950.

Buy Semiconductors After Intel's Quarter?

Intel reported a blowout quarter yesterday evening and the question arises if one should buy semiconductor stocks in anticipation of more positive earnings news from companies in this sector.

Let's take a look at what happened in Q2, when Intel kicked off the semiconductor earnings season on July 13:

We had a similar situation: Intel surprised to the upside. It was a profitable trade to buy into the momentum and trade a semiconductor ETF (IGW). Even if you got in at the new relative high around $39, you were able to book a 10% gain after three weeks. Since market conditions are comparable, I think we could see a similar move now. The risk reward ratio is the compelling feature of this trade: even if you did put a stop at the breakout point around 38, your ratio would have been 1:4.

BTW, I prefer the leveraged version USD for this trade.

Market Acting Tired

Despite my bullishness, I have to recognize the fact that the market is acting tired. Divergences all over the place. Earings really need to kick butt to keep the rally alive.

Weekly Game Plan Oct 12 2009

It seems like the most common question these days is "what the heck is going on with the market?" No one is understanding, why we keep going up despite questionable economic numbers. A nice quote I read the other day summarized the current state: "stocks will go up until nobody is surprised anymore that stocks go up". It is only two and a half months until the end of the year and a lot of money managers have been sitting on too much cash and are jumping in on every little pull back. This game can go on for a while.

But there might also be a fundamental reason: we are at the beginning of earnings season and many market observers state that "top line results have to improve to further fuel the rally". I do not agree: stocks can go up if companies keep beating earnings on cost cutting. The catalyst here is that analysts simply underestimated how much costs companies are actually able to cut. They are using technology to replace processes, which were predominantly executed by humans. Or why is the techonogy sector so strong?

So with money managers being underinvested, strong earnings season comming up, a lack of investment alternatives (besides maybe gold), the prospect of additional stimulus packages and a recent up tick in housing prices (potential housing bottom) in some areas, there are plenty of reasons for the market to run up until the end of the year.

The game plan remains simple: stay on the long side, buy the dips & sell the rips.

Swing Trade Idea: RIMM

I generally like to trade stocks AFTER they reported earings. One "surprise factor" has been eliminated and we can sometimes exploit the overreaction of the crowd. (As I keep repeating like a broken record: to a certain extend, you need to bet against the crowd to be succesful in short term trading).
So RIMM reported on Sep 23 and earnings outlook disapointed. To make that clear: they presented a positive outlook with future Q3 revenue to be around $3.6 -$3.85 billion. Analysts expected $3.9 billion, though. So the company is still projecting significant growth.
Looking at expectations explains, why the stock came down so hard: out of 44 analysts following the stock, only one had a "underperform" (not even a sell) rating. 66% of the analysts rated RIMM a "buy". A classical case of too much optimism, which sets up for disapointment. From a fundamental stanpoint, RIMM is trading around 18 times earnings, which is cheap when considering a projected earnings growth of over 35%. So we have a positive long term fundamental picture. Since we are looking for a short term trading opportunity, we need to take a look at price action after the event:
Price came down to a major support level at $65, which gives us a nice landmark for a stop-loss of our swing trading postion. Next we need to find out, if RIMM is likely to brake that level short term or if buyers are coming back in. let's take a look at a 15 min chart: We can observe two developments: first, price tested the $65 level succesfully three times, which is quite bullish. Second, we can identify a "falling wedge" chart pattern, which indicates declining selling pressure. Should we break this wedge to the upside, we will likely see more upward momentum.
So here is the trade:
- buy RIMM either on a break of the pattern or another succesful test of the low@ $65. Based on current dynamics, we expect the break to happen in the next two trading days.
- Once you are in the trade, you put a stop - loss slighty below $65 and sell half of your position around 69.50 to cover your costs.
- Final price target @$72, which roughly gives you a risk-reward ratio of overall 2:1 and makes this an interesting trade.

Update - Sector Watch: Financials Look Interesting

Just a quick note: Goldman came out this morning with positive comments about US banks. So here we have another explanation for the technical picture I described in my last post. This is a very interesting lesson: technicals often lead fundamental events, such as upgrades and you need to monitor both to put the puzzle together.

Happy trading

Sector Watch: Financials Look Interesting

OK, the market has pulled back for the last two weeks, but at this point I consider the recent decline just a correction of an uptrend. Analyzing relative strength of major sectors reveals some interesting insights into the current mood of the stock market. Please note that I compare relative prices of major sector ETFs for this analysis:

(Chart of 6-month relative stock market performance of major US sectors)

Particular interesting is the raise in relative strength of the Financials (red line): uptrend is a little choppy, but they have been quite strong for the last three months. I actually expected Financials to lead the market decline, due to the difficult situation in US consumer financing, defaulting loans, housing demand, etc.
The steep Yield curve is probably reason for the strong Financial sector. It will be very interesting to see if they can lead the market higher if we should see a rebound.

Defensive sectors (grey dashed lines) have been on the rise for the last two weeks, but I would expect more strength if the recent market decline would have been more than just a correction.

The analysis shows how important it is to visualize any kind of financial data. The human brain is generally strong in pattern recognition (and BTW weak in number crunching, computers outperform us here).

Bottom line: I'm still bullish, but looking out for warning signs.