"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, October 27, 2010

Intermarket Analysis: One at a Time, Please

It is quite interesting to study intermarket relationships these days. It looks like we are currently experiencing a orderly rollover-process among various asset classes. Bonds, Gold, Dollar and stocks seem change their trajectory just one at a time. Bonds started first, Gold followed, the Dollar (plotted inverse) came next and it looks like stocks will be last:

Thursday, October 21, 2010

Market Commentary: Switching Market Themes?

As part of my trading strategy I try to identify  “dominant market themes”, which are responsible for the latest market action.These themes usually play out within various asset classes. The latest stock rally for example was fuelled by the "QE2 theme", hope for additional quantitative easing was/is pushing the Dollar down and lifting equity prices.

Themes can change very fast and result in entirely different price action. Crazy things can happen. For example: market participants could start to see QE as negative for stocks or decide that its impact on the economy would be limited. Suddenly, "hope" would be replaced by "fear".

However, I do not think this is the most likely scenario. This morning, Caterpillar announced earnings and gave a positive outlook on the global economy. What if the hope for strong global recovery suddenly becomes the new "dominant market theme"? Some fundamentals currently support the notion: besides earnings, I would argue that strength in certain commodities, especially Copper, can be attributed to a strong global recovery. German PMI numbers were quite positive this morning, which is an important indicator because of the country's export orientation.

If the theme would indeed switch, certain asset classes would act differently: the Dollar could rise while US stocks move up as well. Treasuries would fall. Gold could underperform as long as Mr. Market doesn't get afraid of inflation.

I'm looking for these signs. So far I haven't seen them, but indications could change every day.What is true at this point: the QE2 theme starts running out of steam. The market needs a new driver to push him in either direction.

Sunday, October 17, 2010

Buying Google after a 10% Upside Gap?

Google Inc. was one of the big earnings surprises last week. The company reported record earnings and the stock gaped up over 10% higher. Does it make sense to still buy Google at these levels?

II went back until 2004 when the company went public to find out what happened when Google gaped up in a similar fashion (> 10%). In every case, the stock moved higher for several weeks after the event:

Oct 2004
Apr 2005
Oct 2005
Oct 2006
Apr 2008

The monthly distribution of the gaps hints that earnings releases were the catalyst.
Conclusion: you might have an edge when buying Google after blowout earnings.

Wednesday, October 13, 2010

Trading Strategy: Short Interest and Analyst Ratings as a Filter

My trading style is a blend of technical and statistical analysis.Two of the "filters" I apply to technical setups are short interest and analyst recommendation ratios. CXO Advisory recently summarized some research done by Drake, Rees and Swanson in 2010, which found that the combination of high short interest and bullish average analyst ratings actually has bearish implications for a stock. The recent decline of Equinix Corp. is a good example for these conditions.
Because their findings are so important, I summarized the different combinations  (high/low short interest, buy/sell rating) in the following table, which every trader should have in the back of his mind:

Obviously short sellers are ahead of the curve when analysts are too bullish.
Before  I take position in a stock, I always check these numbers on Yahoo Finance.

Covestor Model Portfolio Commentary: Riding the Trend

Market strength has been impressive in the last weeks. At this point, my model portfolio is 130% long and I am more inclined to reduce exposure at this point instead of expanding the long book even more.
Stocks I currently own are:

Apple Inc.: could rally into earnings in two weeks. One of the few stocks I would even hold over the report.

Amerigroup Corp.: Strong healthcare company.

Blackstone Group LP: Private equity benefiting from improving investing environment. My strongest position in the portfolio.

Bancolombia SA: Benefiting from outperforming South American markets.

Coach Inc.: Retail has been outperforming the broader market. I like China exposure.

ETF DBB: Benefiting from rising metal prices. Very Dollar sensitive, so I might close this position soon.

ETF UGL: Small Gold position. I plan to keep this one even if we see a pullback.

Harley Davidson Inc: High short interest by analyst expectations relatively mixed. I'll probably close this one before earnings in two weeks.

Hill-Rom-Holdings Inc: a medical equipment play. Rallied over 300% since March 2009.

Principal Financial Group: Insurance & asset management.

Potash Corp: Expecting a higher bid. Limited downside risk even if deal falls through because other stocks in this sector up a similar amount since BHP's offer.

Royal Caribbean Cruises:  another consumer play.

YUM! Brands Inc.:  very positive earnings report last week. China growth story.

I'm following various trend/themes to decide when to reduce positions

1) General sentiment
Believe it or not: sentiment is not overly bullish, even after the strong rally of the last weeks. Mark Hulbert commented on this observation today.Also keep in mind that many (hedge) funds are still in catch up mode
because they underperformed so far in 2010. The chase for performance could push prices higher.

2) The Dollar
The Greenback is reaching key support levels and might be in for a bounce, which could put a damper on equities and commodity prices. What would cause a change in the Dollar's direction? A strong earnings season could be the catalyst. On the other side, the "QE2" theme seems very strong and I wouldn't be surprised to see the Dollar decline until the November FED meeting. At that point, the "sell the rumor, buy the fact" rule could reverse the Dollar's direction.

3) Earnings season
Statistically, a run-up into earnings season results in a weaker market during the season. Again, a "buy the rumor, sell the fact" phenomenon. I'm therefore more inclined to scale back in the coming days than increasing my long exposure.

4) Financials
Didn't participate at all in the recent rally. However, expectations are low and Bank stocks could surprise to the upside during the current earnings season. It would be bullish for these stocks if longer term bond yields would reverse direction and result in a steeper yield curve. The flattening of the yield curve has been one of the reasons why bank stocks underperformed. This is maybe the only sector I could buy for a short term momentum trade.

In summary: I'm ready to close positions quickly, but also aware of the need to ride the trend. It is a tricky balance and kind of a "musical chair" task.

Friday, October 8, 2010

Market Commentary: QE2 and Dollar Crash

It is absolutely amazing to currently see how much markets are interrelated to each other. Basically all asset classes are driven by the same theme: the US economy is supposed to be weaker than expected, which will prompt the FED to engage in more "quantitative easing" ("QE2") soon.

As a result, the Dollar has been tanking:

which inflated commodity prices:

especially Gold:

but also put pressure on Bond yields and pushed up bond prices:

and finally increased the value of US stocks:

One of the tools I use to evaluate market themes is Google Insights, where you can access search statistics. The latest chart for "QE2" underlines, how much this topic is currently dominating pubic interest:

However, Google Insights displays the following chart for the search term "Dollar Crash":

Obviously, a "Dollar Crash" scenario is not on the radar of the public. It was though at the end of 2009, when the Dollar Index traded at similar levels:

It is quite odd to see that the public doesn't seem to be concerned of the Dollar, meaning the Greenback has more room to fall. There could be a Tsunami brewing here since we are still far away from "panic mode".

Gold: Trading Review and Outlook

Yesterday, I closed the Long Gold position in our Covestor Model Portfolio.
The yellow metal had a good run and the sharp intraday reversal could indicate a short-term top. From this point on, I'm looking at two scenarios: prices either correct for a couple of weeks and move prices back to the area around $1250 - $1300, which would be at most a 5% correction. Note that we can find Fibonacci levels as well as key moving averages in this area:

In my second scenario, prices would consolidate only for a couple of days and we would experience price action similar to what we saw in April 2006:

Should this scenario materialize, I will be very quick in aggressively going long again. As you can see on the chart above, the final short-term top occurred three weeks later.

Gold has the ability to go parabolic. The current fundamentals might support such a move. This could be the "trade of the year" in 2011.

Wednesday, October 6, 2010

Equinix: Lesson to Learn

Equinix, Inc., (NASDAQ: EQIX) a data center company, issued a earnings warning after the close yesterday. The stock declined over 25% in after hour trading. The stock was NOT part of my model portfolio. However, I it is important to review its characteristics to minimize the risk that my stocks experience similar blow-ups.

Let's begin with the chart:

The chart looks fine: stable uptrend, good relative strength, higher volume on up-swings. A lot of swing traders probably loved this on.

Another look at key statistics:
  • 20% of float held short, which is a very high number. Bulls were probably arguing for a short squeeze, however, we have to keep in mind that short sellers are usually very sophisticated investors and might be up to something.
  • Trailing P/E: 90, 2011 forward P/E: 40. PEG ratio: 4. Wow, these are Internet-bubble like numbers! First red flag.
  • 25 of 30 analysts covering the stock had a buy rating. No sell ratings on the stock. Average price target: $120. Second red flag: analysts are extremely bullish going into earnings season.
Lesson learnt: even if you are a technical oriented trader, you have to look at some basic fundamental numbers. The high P/E ratio, coupled with high expectations of analysts sets up for disappointment. Especially right before earnings season, it is extremely risky to trade these high-expectation-stocks.

Again, analysts have proven to be entirely behind the curve.

Tuesday, October 5, 2010

Price as Supply/Demand Equilibrium and What it means for a Trader

I would like to present my understanding of price and its consequences for a short-term oriented trader. Let's start with a simple question: why did AAPL close at $278.64 yesterday? You could argue from a fundamental standpoint and say that e.g. this price reflected the company's intrinsic value. Or you might be a "Technician", who would argue based on support levels or Fibonacci ratios. The question has to be answered on a more basic level: AAPL closed at $278.64 because at that price, neither the buyers were willing to pay more, nor the sellers were willing to accept less. So the $278.64 level represents a supply/demand equilibrium. Of course, this is not a new thought.

Who are these potential buyers and sellers? At any given point of time, there are thousands of them looking at the stock price. Believe it or not: most of them are very smart people and have performed very thorough analysis of AAPL. Both sides have their valid arguments on why the Apple stock is either too cheap or too expensive right now. The reason why AAPL might go up or down tomorrow is because one side gets slightly stronger or weaker so that price can move.
If there wouldn't be number of good bullish arguments, prices would crash immediately. We saw that on September 28, what could happen to price if a strong bearish argument suddenly comes up: the stock lost five percent in not even a minute.

Now what does all that mean for a trader?

If I recognize that my view of AAPL, whether its bullish or bearish, is only one of two very valid ways of seeing the stock, I become more comfortable in cutting my losses and closing the position if it should go against me. Maybe I'm smart, but I have to understand that there are many investors out there how might be even smarter than me and right now are on the other side of the trade.

Second, be careful of over-analyzing stocks. Even if you analyze the stock to death and you come to a bullish conclusion, there have to be good bearish arguments. Otherwise, the stock would probably cost an infinite amount of money.

So analysis of a stock actually means to investigate shifts in the supply/demand situation. Technical analysis can be one tool . Fundamental or sentiment based tools have more an implicit effect on stock prices: for example: changes in the number of analyst buy/sell recommendations create more demand for the stocks over time.