"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

Monday, January 31, 2011

Global Equity Markets Decline: What do Egypt, Chile and Columbia Have in Common?

There is an old saying on Wall Street that "the news doesn't matter until it matters". Global equity markets declined last week, supposedly triggered by the riots in Egypt. However, weakness in the so called Frontier Markets has been broad based since the beginning of the year or -relative to US stocks- even since the end of November. Take a look at the chart of the Guggenheim Frontier Markets ETF (Egypt contributes 13% of weight to the fund):

The largest country in terms of weighting in the fund is Chile, contributing over 32%. The country ETF has sold-off by over 10% so far in January:


Have you heard of any riots in Chile recently? I haven't. Yet, the media blamed Egypt for global market weakness last week. The truth is, underlying weakness (and the related theme) started much earlier.Obviously, something else is going on. Chilenean stocks by the way fell because Chile's central bank pledged to intervene in the currency market and increase their foreign reserves. 

Let's take a look at the second largest Frontier Market ETF country contributor: Columbia. Their stock market lost 20% at the beginning of November 2010, again strongly underperforming US stocks since then:

Egypt is a just a puzzle piece in a much bigger picture of frontier (and emerging) market weakness, which is starting to spill over to developed markets. I don't think market conditions will change even if the political situation gets resolved. So the question "Can Egypt Take the World's Markets Down" has to be answered with a "no". Instead, bigger forces can lead to a substantial market decline. Obviously, investors started to pull their money out of risky assets, such as emerging markets and US small cap stocks (see my other posts on this topic this month) long before the Egypt crisis took a front seat in the daily news.

Friday, January 28, 2011

Market Breadth: Performance in 2010

To put my last post into some historical perspective: there have been two incidents last year when market breadth (measured by the percentage of stocks above their 50 day moving average) diverged from the S&P 500 after rallies. In both cases, markets declined significantly shortly after:

Market Breadth: This Chart Makes me Nervous (and I Don't get Nervous Very Often)

Market breadth still continues to deteriorate. Fewer and fewer stocks are participating in the rally: the number of S&P 500 companies, which trade above their 50-day moving average continues to fall. Divergences show up not only on an intermediate time frame (Oct 2010 - Jan 1011), but also during the January rally (lower chart):

Thursday, January 27, 2011

My Favorite Sectors Based on Relative Strength Charts

I prefer to trade sectors, which show improving relative strength. Since I believe that markets are in a constant mode of sector rotation, I like to find areas, where strength is just starting to improve. Some interesting industries:


Medical Services:



Real Estate:


Disclaimer: Covestor Model Portfolio is long ITB

Relative Strength of the Consumer Discretionary Sector a Reason for Concern?

The Consumer Discretionary sector has shown weak relative strength over the last two months, prompting some commentators to call a market top.A look at strength vs. the S&P 500 reveals that Consumer Discretionary stocks had several "weak" periods over the last two years (May/June 2009, June 2010). The longer term trend is up and I see recent action more as a sign of sector rotation than shift in general market sentiment:

Wednesday, January 26, 2011

Small Cap Underperformance: Some Historical Perspective

Recent underperformance of small cap stocks concerned many market participants - including me. Putting the recent price action into historical perspective might give some insights:

The following chart is showing the relationship between large (upper panel) and small caps (lower panel). The curve in the middle is the ratio of small to large cap stocks over a 20 year period:

The red box marks periods, where prices were rising and small caps outperformed. Green indicates bullish phases led by large caps. Some observations:
  • Over the last ten years, smaller companies have outperformed larger peers, which is inline with  academic research.
  • However, Russel 1000 stocks can lead rallies for an extended period of time. Note how big companies pulled the market higher from 1194 to 2000 - a six year period.
  • It seems like small caps tend to outperform after bear markets. At one point larger companies are taking over the lead.
  • Underperformance of small caps during bull markets doesn't seem to be bearish sign.

Within this larger picture, there always have been periods, where large caps took over the lead for some months. 1996/97 illustrates this behavior:

Smaller companies sold off in July '96 and Russel 1000 stocks took the lead for almost a year (the Russel 2000 played catch-up in the third quarter).

A look at the current action:

Obviously, the Russel 2000 has been outperforming in the current bull market. But even the price action this January hasn't reversed this trend so far. The green lines indicate short periods large cap outperformance.

the market might be in a transition from small to large cap leadership. It will be interesting to keep monitoring relative performance of both groups. I believe that the Russel 2000 underperfromance is not a sign that the bull market is over. Should larger companies indeed lead the market going forward, I'll keep looking for trading opportunities in that group.

Sunday, January 23, 2011

Weekly Game Plan: a Major Sell-off Coming?

The S&P 500 lost 0.8 pct last week, which barely can be considered a sell-off. In fact, if you take a look at the price chart, the index hasn’t even broken its uptrend. It is more important to “look under the hood” and I don’t like what I see: leading stocks had a major sell-off after (decent) earnings disappointed. F5 Networks (NASDAQ: FFIV) pulled down the entire “cloud” sector after missing forecasts by a penny. Apple (NASDAQ: AAPL) declined after record earnings.  Weak reaction on positive news is always a bad sign.
Other signs of weakness: the Technology and Consumer Discretionary sector have underperformed the broader market for weeks and in fact seem to be in a major transition from up- to downtrend, based on the charts. Small cap stocks continue to be weak. Two weeks ago, I was short the Russell 2000. Unfortunately, I was stopped out of the position. Last week, I opened the short again.
One interesting development was the decline of the Dollar, which probably was responsible for the good relative performance or large cap stocks: the DOW recorded a small gain in the last five days.
Next week, I’m carefully monitoring if weakness can spread to the overall market. Note that major market declines are often preceded by a transition process. Unfortunately, the market has been playing by the books so far: in December, divergences showed up in various breath indicators: fewer and fewer stocks were participating in the rally. Beginning of January, small cap stocks started to underperform, indicating less risk appetite of investors. Analysts were actually UPGRADING price targets in the weeks prior to earnings season, setting investors up for disappointment.  Note that I discussed all these developments in my prior posts. Finally, last week leading sectors, such as cloud computing stocks, showed heavy declines.
So what does that all mean for a short-term trader and for my Covestor model portfolio?
Last week, I closed almost all my equity long positions. The only remaining one is Annaly Capital Management (NYSE: NLY), which I intend to keep holding for a longer period. The 14% dividend is too compelling.
Besides the Russell 2000 short, I’m not intending to short individual stocks. Yet, we might get interesting setups in some of the stocks that were pulling us down last week. At this point, it is important to not overtrade and patiently wait until the picture becomes clearer.
My short in Gold is working out well. However the position is small, with just 5 percent of the account invested in the double-leveraged Gold ETF GLL. I intend to buy more shares on weak rallies. Rising real interest rates are a poison for the yellow metal.   

Friday, January 21, 2011

Gold: Scenario for the Next Two Months

I'm looking for the following scenario in Gold for the next two months:

the yellow metal has been showing a "three push" intermediate term topping pattern and is rapidly approaching the 61.8% Fibonacci retracement level.So I expect a bounce in the coming days.
Covestor Model clients have been short Gold for the last two weeks with a small position and I plan to sell more shares on a potential rally. Ultimately, Gold could target the 38% retracement, which would mean a further 7% downside from current levels. Gold has been on a decline because of rising real interest rates:

Sunday, January 16, 2011

Weekly Game Plan: Riding the Train

In my my last weeks game plan, I discussed how hedged the Covestor Model Portfolio with a short position on the Russel 2000. On Friday, I was stopped out of this trade, so I'm back to 90% long again. My only short position at this point is Gold, which has been moving down nicely in the last week.

Even though sentiment keeps staying at extremely bullish levels, the market refuses to turn lower. Conventional wisdom is that extreme bullish sentiment acts as an contrarian indicator, ultimately leading to lower stock prices. However, various recent quantitative research from bloggers I follow as well as my own relatively simply studies have shown that bullish sentiment is not necessarily a signal to sell stock. It seems like the method has more value when looking at bearish extremes.

Only price pays, like Brian Shannon often says and leading stocks keep pushing higher. Take a look at charts of companies like Apple, CF Industries or Cliff Natural Resources and you know what I mean. Since there is no technical reason to short these stocks, I have to keep playing them from the long side and keep stops tight in case the market turns, which it always can in a blink of an eye.

As usual, I'm careful ahead of earnings season and I will sell at least part of winning positions a day before release.

Since I'll travel to Asia for business next week, I can't play hard ball with respect to stocks. If you are able to follow your trades full time, the current environment should be a perfect one to enter aggressive swing trades.
Still, the Covestor Model has outperformed its benchmark by 110 basis points since the beginning of the year and is up 4.5 percent for 2011. 

Monday, January 10, 2011

Some Data Snooping on Mean Reversion: Buying After 4% Declines

In statistics, you have to avoid data snooping. However, it sometimes helps illustrating underlying market structure. As you can see from the following chart, it has been a good idea to buy stocks in the last two years after the S&P 500 declined four percent within a 15 day period as a result of "mean reversion". Also note how it was almost guaranteed in the three months after prices increased by six percent that the S&P would decline by four percent within 15 days.

Conclusion: patiently wait for a market pullback We did always get it in the current rally.

Weekly Game Plan: Be Careful

In the first weeks of the year, the S&P 500 added another 1% and stocks seem to be in bull-mode. However, short-term pullback risks are rising and I took partial profits in some of the positions of the Covestor Model Portfolio: ATML, CLF, F, KOL and MDR had great runs and  I'm waiting for a pullback to add shares again.

I currently see mixed signs for stocks: on the plus side, charts of many leading names are looking bullish. Well known momentum plays, such as BIDU, VMW or even AAPL, resumed their uptrend after consolidating in the last weeks. Other stocks keep making new heights. Consolidation seems to be a unknown term for these names. Take RVBD or AA as an example.  Strong leading stocks are a healthy sign for the market.

However, I also see some negative developments. Currently weak market sentiment and breath has has been widely discussed by various market commentators. The latest action in Small Cap stocks prompted me to hedge the portfolio towards the end of last week: Russel 2002 stocks not only started to underperform the broader market (which by itself wouldn't be overly negative), volatility also has been on the rise since the beginning of 2011. The following chart illustrates the observation:

A similar development took place in April last year, right before the major sell-off. Volatility sometimes leads decline. Also, note how a couple of high-volume distribution days preceded the decline. Obviously, institutions sold into market strength:

As a result, I put a position in TWM, the leveraged inverse Russel 200 ETF. I don't expect a major trend reversal, this trade is supposed to simply benefit from a possible 3-5% pullback. I will be very quick in closing this position.

So what could act as a catalyst for lower prices? Maybe the upcoming earnings season. According to Bespoke Investment Group, analysts have been raising earnings estimates in recent weeks. So expectations are high and companies need to exceed these high estimates for their stocks to keep raising.  What's interesting is that we saw similar action in January 2010: Net-earnings-revisions was positive in the weeks before earnings season, companies couldn't meet higher expectations and stocks started to sell off in the third week of January:

I'm not predicting that this will happen again. It is just a scenario to be aware of, especially in the light of overly bullish sentiment and decreasing market breadth.

Thursday, January 6, 2011

Covestor Position Review: Cliff Natural Resources (NYSE: CLF)

Cliff Natural Resources is currently my favorite position in the Covestor Model Portfolio. I own the stock since December 15.  Even though my trading time frame is usually shorter than a month, I can see CLF being a position, which I will hold for several more weeks.
Note that I entered the trade after CLF already had a significant run:
The position is a momentum trade in its purest form: price is accelerating, relative strength vs. the overall market was and still is looking positive.
The flooding in Australia was not part of my rationale when I entered the trade. However, CLF's price action in the last days indicates that the stock might benefit from the disaster. Iron ore producers are expected to benefit from rising prices and huge China demand.
Cliff Natural owns mining operation in Australia, so one might expect negative impact from the flooding. Another company, Australia-based Macarthur Coal issued a profit warning this week due to mining issues in Queensland. However, CLF's iron ore mines are located in the Western part of the continent - no floodings there.
Let's discuss some technical aspects of the trade: I sometimes like to analyze the "momentum potential" of a stock. How strong have momentum moves been in the past? I usually look at the rate-of-change on different time frames. In this case, four weeks, three months and a year:

For example: CLF's maximum rate-of-change over a month has been around 30% in the last five years (let's forget the 2009 crisis period for this analysis). Over a three months period, CLF has shown to be capable of making 70% moves. Over a year, the stock was capable to make 250% moves. Here is the catch: I believe that CLF has much more room to run in 2011 based on these numbers, thus making the stock an interesting investment even at these levels. Sure, the rally could be over tomorrow and I would close the position if it goes against me. Strong fundamental shifts simply have the potential to significantly move this stock.

Stay with trend and get out when it ends.

Tuesday, January 4, 2011

A Nice Opportunity for a Quick Short-Bond Trade

Longer term interest rates are rising, bonds have been showing a nice downtrend recently. The daily chart of the 20+ Year Treasury Bond fund ETF TLT is a perfect example for a trending asset. Note how multiple "bear flags" offered interesting entry opportunities for short-term swing traders. Recently, TLT has set up another flag, which could act as an entry point with compelling risk/reward ratio

A possible price target can be derived from the longer term support at $88.5:

At $88.5, I would at least take 50% off and then let the rest run to capture the longer term trend.

Monday, January 3, 2011

2004: a Possible 2011 Scenario

Last 21st of March, I wrote a post on my previous Wordpress blog "The Stock Market of 2003/04: a Playbook for 2010?". I compared the situation seven years ago with current market conditions in order to find out what could trigger a broader consolidation today.

The US economy was in a similar phase of the economic cycle: America just left a recession behind, interest were low, unemployment relatively high and the stock market had been rallying for almost a year:

A broader consolidation started when the March employment report came in surprisingly strong. Before that, stocks climbed "the wall of worry". The FED started tightening three months after the job report.

The big question today is of course how long can the current market rally run? If 2004 is giving us any guidance, stocks could climb until we would see significant job creation.

Let's take this concept a step further and look at performance of key sectors in 2003/2004:

Note how the rally was supported by all of these sectors - Energy, Financials, Technology and Industrials. However, the later two started to fizzle out first, indicating market weakness. On the other hand, Energy never really broke its uptrend. Stocks in this sector turned out to be a good investment in 2004, supported by higher Crude prices throughout the year.

The same chart for 2010/11:

All four sectors have been participating. So far, I don't see a reason for concern. However, I'm monitoring Technology and Industrials since they underperformed in December.

Also interesting: a look at interest rates in 2004:

Longer term rates started to climb three months before the FED started raising rates, around the time of the strong job report. Short term rates (upper pane) of course started to move when the FED started tightening.

Again, the current picture:

Obviously, long term rates already started to move.

So here you have my playbook for 2011, which I see as a replay of the 2004 action. I expect the rally to pause once (lagging) data confirm a stronger economy. Jobs might be the trigger.