"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, August 31, 2011

Visualizing the Rise of Germany in Europe

The following chart shows the relative performance of the Germany ETF EWG against the Italian EWI. I found it quite interesting to see how German stocks have been outperforming Italian equities for the last five years:

The combination offers an interesting pair trade if you believe that the economic differences will keep widening, which is what I think. An investor, who would have gone long Germany and short Italy five years ago would have raked in a 37% return without a single negative year, even during the financial crisis.The return for this year so far would be positive even though both ETFs are down for the year.

Disclosure: Covestor Model Portfolio is short EWI.

How I Trade Europe in the Covestor Model Portfolio

Even though I'm short-term bullish (see my last post), I have a close eye on Europe. One of the positions in the Covestor Model Portfolio is a short trade of the Italy ETF EWI, even though I accumulated various long positions in US stocks during the last week.

Europe has the potential to kill the QE3-hope-rally in my opinion. As usual, I'm looking at relative strength against the S&P 500 and Italy doesn't look too good with this respect. In fact, the ETF didn't participate in the recent rally at all:

Unfortunately, Germany doesn't trade any better:

What really doesn't fit the picture here is the performance of the Euro, which held up quite well in recent weeks. Sorros was speculating about a "secret buyer" of the currency the other day. The question however is if we are seeing  Euro strength or Dollar weakness. The later one might be the case:

 Overall, I'm planning to stay short Italy until I see some relative price strength.

What the Lessons from the 2000 - 2003 Bear Market Mean Today

My general investment hypothesis these days is that stocks entered a bear market. I'm not alone with this outlook: Peter Brandt, a very experienced trader whom I respect, talks about the same notion in his blog. Even though I agree with Peter's views, my investment conclusion differs. Some of the differences arise from the fact that he is a position trader who applies longer holding periods while I'm trading short-term swings.

My view is that even in a bear market there can be significant rallies, which are short-term tradable. Let's take a look at the 2001 - 2003 decline to illustrate the point:

Even though stocks clearly acted in bear market territory, the S&P 500 pulled off three 20 percent rallies over the two year period. If traders simply bought stocks right after the major sell-offs, they could have achieved significant returns even in a long only portfolio. Obviously, markets were volatilie over the entire period. I believe that we could experience a similar highly volatile pattern in the coming years. Holding short positions for sure makes sense, but investors might have to stay in these trades for several months while stocks are rallying -  psychologically a challenge for inexperienced position traders.

The scenario is the reason why I took several long positions in the Covestor Model Portfolio last week. I believe that the bear market will continue, but right now investors are hoping for more QE3, which could fuel stocks for several months.

Finally, here is a similar chart for the most recent period. As you can see, volatility has indeed picked up in the last two years:

Sunday, August 28, 2011

Volatility Cluster & Decay: Indication of Higher Prices Ahead?

It is well known that volatility tends to form clusters over time. Adam Grimes of SMB explained the phenomenon in a very practical way here. Bottom line is once you have a volatility spike, large price moves tend to persist for some time. So you need to adjust your trading. However, that's not the topic of this post.

One observation I made during the last years (and I should quantify the these observations) is that the decline of volatility after a spike (I call it volatility decay), seems to be a non-exclusive criteria for higher prices ahead.

Take a look at the following chart:

Even though markets were initially not rising, declining volatility (measured by the Average True Range "ATR") declined during the bottoming processes in early 2009 and Summer 2010. As can be seen from the chart, the ATR has already started to move lower after the recent volatility spike in August. Does that mean the market reached a bottom? Maybe. However, volatility decay was more a process of months instead of weeks. So the development of the last days doesn't mean much. It is more important to keep observing the action: lower prices on declining volatility could be a bullish sign going forward.

The Two Waves of the August Sell-off and What They Tell us About the Markets

I was analyzing August price action this weekend and found some very interesting points. When looking at an index chart (Nasdaq Composite in this case, but other indexes are highly correlated) we can identify two waves of selling so far. The first one obviously was much stronger than the second wave:

A remarkable divergence occurred when considering the number of new 52 week lows (lower pane). The Nasdaq Composite recorded new price lows, but fewer stocks obviously participated in the decline, a bullish sign short-term. 

What's more interesting is to look at individual stocks.  This weekend, I was browsing through all the charts of S&P 500 stocks and I found that it is possible to classify them into three basic categories:

1. The strong Comebacks
These stocks have rebounded strongly after the first wave. In fact, you wouldn't notice that there even was a second wave of selling in the market. Certainly, stocks in the defensive sectors are showing this characteristic. A positive is that some offensive names, such as AAPL can be classified in this category. To look for these stocks, simply search for names that trade above their 50 day moving average:

2. The Endangereds
These stocks didn't really participate in the second selling wave. However, they are in a dangerous position, because their charts are forming bearish continuation patterns, such as wedges or rectangles:

3.) The Loosers
The loosers fully participated in the second wave and recorded lower lows during the second half of August. To find these companies, I simply ran a scan for stocks that traded lower on Friday than 14 days ago:

The interesting observation is that every stock, independent of the category, sold off during the first wave. The market saw some sort of differentiation during the second wave. Obviously, the first selling was kitchen sink type action, maybe coupled with some forced hedge fund selling. Everything had to go. It seems like the market got more rational during the last two weeks and market participants tried to pick stocks, which were taken down without reason. The decline in new lows, which I discussed above support this point.

What does all that mean for a short-term trader?
One possibility could be to start buying category one members. However, stocks are still volatile and this is clearly not a bull market (group one is fairly small, especially when taking out Utility stocks). So I will look at cat. two and in particular three for potential short candidates. I'll keep an eye on the bearish patterns of the second group as an indicator where markets might be going.

Thursday, August 18, 2011

Vacation Canceled: Back to Work

Unfortunately, I had to cancel vacation this week due to a tragic loss in my family. The good news: I'm back to trading and the opportunity that presented itself during the last days was simply to compelling to ignore. Three days ago, I presented the idea of an intraday declining wedge on chart.ly. At that point, I started to set up short positions in the Covestor Model account. Since equity asset classes have been extremely correlated recently, I focused on individual sectors and took modest short positions in Basic Materials and Financials (XLF, XLB). In retrospect, I could have been more aggressive with my shorting since the markets presented an almost perfect setup. At least I'm happy to be on the right side.

So when will I cover the shorts? I believe we will at least test August lows again. That's when I plan to start scaling out. As usual, the plan is subject to change every day.

Sunday, August 14, 2011

On Vacation the Next Two Weeks

Since I will be on vacation (visiting family in Michigan) the next two weeks, the Covestor Model Portfolio is now doing the same and went to 100% cash. It was an important trading lesson some years ago to really not have any short-term trades running while taking time off or not being able to follow the markets all the time. Once we went on Summer vacation during earnings season and one of my stocks reported earnings and blew through the stops while I was laying on the beach. I tried to stay connected to the markets but believe me: it wasn't really a vacation.

The great Jesse Livermore stated: "Every once in a while you must go into cash, take a break, take a vacation. Don't try to play the market all the time."

I would add: there will always be  new opportunities in the market. Who knows. Maybe Gold becomes a great short or whatever.

Wednesday, August 10, 2011

Yesterday's Reversal and Fibonacci Levels

I'm not really using Fibonacci Levels to make trading decisions. However, I'm occasionally following the topic because it's quite fascinating.

If the market indeed bounced yesterday (and we would need to see at least one higher high/higher low week), it would have done so exactly at the 61.8% Fibonacci retracement level on the weekly chart:

Let's take this concept a step further and check how high the market could bounce based on Fibonacci levels:. As can be seen on the 30 min intraday chart, there is not much room: the first major retracement is at 1194 for the S&P 500 or 1.9% above yesterday's close. Given the current volatility, the market could reach that at the open. So trading a snap back rally really doesn't offer a compelling risk/reward ratio at this point:

Tuesday, August 9, 2011

Covestor Portfolio Commentary

I'm posting portfolio commentaries a little bit more frequently here to keep Covestor clients updated in the light of market volatility.

Equity Put/Call Ratio: Finally Investors Getting Bearish

It sounds obvious in the light of recent stock market declines, but bearishness is finally showing up in the sentiment indicators I'm following. That was different at the beginning of the month if you remember my last post on the topic. The equity put/call ratio is now moving into "panic territory", which is good news.

Friday, August 5, 2011

Very Simple...

It is 10:30 pm ET and there is nothing in the charts that suggests going long would make any sense. Very simple: as long as the SPY is trading below the falling 5 day moving average, you'll find me on the short side or in cash:

10%+ Declines: Not So Uncommon

US stocks lost over 10% in the last two weeks. Reason for concern? Not really. As can be seen from the chart below, "10% bombs" have been not unusal in the last two decades. In fact, I counted eight events in the last 18 years; granted they have been unevenly distributed and seem to demonstrate cluster characteristics. It might be too much of a stretch, but one could argue that once a 10% drop occures, expect more to follow:

Covestor Model Portfolio Commentary

August 4 was a brutal day for the markets. Fortunately, I was positioned on the defensive side so that the Covestor Model Portfolio actually showed a slight gain for the day in the magnitude of 0.8 pct. Going into Thursday, I was 30% in cash, 25% long and 45% short.

Tuesday, August 2, 2011

Investors Still too Optimistic

Two of my favorite sentiment parameters are still showing that investors are not really concerned about the possibility of further declines, even though the S&P 500 is at very critical technical levels. Yesterday, the index barely made it to close above the 200 day moving average. The indicator is important because it often acts as a line in the sand for institutions.