"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

Saturday, March 31, 2012

What Volatility Pre Clustering is Saying About the Stock Market

I wrote about volatility clusters in earlier posts. Another phenomenon, which I observed in the last years is what I call "volatility pre clustering". A fancy term for a simple pattern: prior to intermediate term market tops, volatility started to rise for two or three weeks while prices turned sideways. Take a look at the following chart:

I measured short-term volatility using a 5 day average true range (ATR) of the daily moves. Note how ATR started to rise before major sell-offs in January and April 2010. It is almost like a car hitting a bumpy road before falling off the cliff.

This is probably not an exclusive structure, so declines can happen without pre clustering as well. However, its occurrence would send a strong warning sign. As you can see from the following chart, volatility hasn't risen so far, so no red flag from this pattern:


Thursday, March 29, 2012

CAT: When a Loosing Trade is Still a Good Trade

One of the stocks I was trading in February was CAT from the long side. The investment is a great example why a loosing position can still be a good trade:

I bought CAT right after the breakout from a bullish wedge formation. In general, I try to buy momentum stocks after certain consolidation patterns. This trade was a little bit untypical, since it required to buy relatively high in the moving average channel. The risk/reward seemed favorable, since I put my mental stop below the breakout point. Relative strength vs. the S&P 500 was still positive on Feb 21.

However, nothing happened after I got into the position. Relative strength declined and CAT triggered the stop a couple of days later. I closed the position with a small loss.

Even though this was a losing trade, CAT was a good trade. I followed my rules and got out immediately when cracks appeared. The stock actually dropped substantially in March.

Around the second week of the month, CAT even offered a nice shorting opportunity, which I missed. One could have even shorted right when I closed the long trade: failed moves tend to create strong moves and the decline from $114 to $106 verifies this point.

Wednesday, March 28, 2012

2012 = 2011?

Say what you want, but the first months of 2012 look exactly like the beginning of 2011 from a market breadth standpoint: fewer and fewer stocks are participating in the rally. The same pattern led to a 5% correction in March last year:

The tricky part: this could go on for another month; picking an exact top is impossible as you know.

Why is Bernanke so Pessimistic?

I was surprised of Mr. Bernanke's comments on the economy last week ("too early for victory on US Recovery"). The statement reversed the recent rise of US interest rates and pushed stocks higher. Various commentators agreed and argued that the recent decline in the Citigroup Economic Surprise Index indeed indicated slowing positive momentum.

I have another interpretation. Not that it matters since I'm a trader and not an economist, but I believe that the FED has to do everything to keep interest rates low for a single reason: US mortgage rate resets. During the housing boom, many new homeowners took loans with adjustable rates. Most of them have been starting to float in the last year, so consumer discretionary spending is now extremely sensitive to these rates. Resetting of course also works in the positive direction. Since rates have been heading lower in 2011, US spenders had more money in their pockets, which explains the surprisingly high level of consumer spending.

Rising rates would therefore be catastrophic for the US economy. I'm surprised that the ARM reset topic is not on front of the magazines anymore. 

Tuesday, March 27, 2012

Shorting Spain Again

My portfolio is loaded with long positions, but I took one short position today in EWP, the Spain ETF. Price has been moving sideways for the entire US stocks rally in recent months and therefore underperforming the S&P 500. The chart looks extremely weak and suggests a price breakdown soon. Someone recently questioned on Twitter if Spain would be the next Greece since Yields are rising. The topic is definitely not on top of the radar of media and investors.


Monday, March 26, 2012

Small Caps Outperforming in March

Small caps had been the trouble maker in February: the Russel 2000 underperformed the S&P 500, prompting pundits to predict the end of the rally. Things have changed in March: small caps  regained strength and pulled the market higher - overall a bullish development:

In recent weeks, I hedged long positions in the Covestor Model Portfolio with TZA, the inverse leveraged small cap ETF. The hedge didn't play out and I closed the trades with small losses - no big deal. At this point, I'm almost 100% long.

Thursday, March 22, 2012

Dr. Copper's Recent Track Record & Outlook

"Dr." Copper is supposed to have the ability to predict stock prices. The following chart shows his track record during the last three years:

The green circles indicate when Copper started to rise before stocks did so. Red circles indicate negative divergences, so Copper declined prior to stock price declines. Obviously, all three prior "forecasts" turned out to be accurate and stocks followed Copper with a lag of three to five months.

From that standpoint, Coppers outlook for the next months is negative: a divergence has built up since the beginning of the year.

I'm currently fully long in the Covestor model portfolio, but I will close positions quickly should they go against me.

White Paper for Download

I recently wrote a White Paper about my trading method for the Covestor Next Invest conference. Click on the cover to download:

Tuesday, March 20, 2012

Yields Still Trending Down - Long Term

In case you made some money on the short side of Treasuries, here is a quick reminder: it will take a lot to reverse the 20 year+ downtrend in Treasury Yields. What we've seen in the last weeks is just a mean reverting move. Interest rates would need to rise above 5% before even thinking about a trend change:

Disclosure: Covestor Model Portfolio is long TBT.

Why I Closed the Small Cap Index Short

Yesterday, I closed the the TZA portfolio hedge with a small loss after opening the position on Friday. I'm currently waiting for a setup to occur before committing again to this trade.

One important concept in trading is the idea of market structure. Corey Rosenbloom discussed this in one of his posts. Here is how I see current structure in Small Caps:

IWM is in a stable uptrend on the intraday chart as indicated by a series of higher highs and higher lows. It would be foolish to go against this trend unless some signs of deceleration emerge, which actually happened last Friday:

The chart suggests that it would actually be a better idea to trade IWM from the long side and buy the intraday swing retracements. So any weak pullback to 83.50 could be an entry with good risk/reward.

Sunday, March 18, 2012

Sorry, I'm Not a Storyteller, I'm a Trader

I wish I could tell stories. I mean when someone asked me about my short positions in Silver or Treasuries, it would be great to tell him why I believe that these assets are overvalued and where they will go. I think, I could even make up a story, but honestly, I don't care. I'm not paid by CNBC, I'm paid by the markets and they require me to be unbiased every day. Stories tend to bias your thinking: "Silver should go down because of this and that." The risk of stories can be that they are based on economic textbooks. The steep decline in housing prices was not forecasted by pundits who grounded their predictions on textbooks.
Instead, I'm looking at data, correlations and (most important) patterns. It is boring to talk about them. "I am short Silver because it broke important support and tends to be inversely correlated to the US$, which just put in a trend reversal. I have no idea how far Silver prices can drop and I do not want to even forecast a target price. I just go with the flow and close the position when the asset stops moving." This is not a compelling story. Trading is boring. Get used to it, stop watching CNBC and start to make money.
Disclaimer: Covestor Model Portfolio is short SLV

Saturday, March 17, 2012

Hedging Again

A couple of divergences developed over the last days and I took a short position in Small Caps (long TZA) last Friday to hedge the portfolio:
IWM not only lost momentum, small cap stocks have also underperformed since March 10. The Russel is trading right at resistance, so the short trade offers a nice risk reward ratio. Intermediate term I'm still bullish, but this clould be just a trade for one or two days.

Friday, March 16, 2012

Why I'm Still Short-term Bullish

The market has been on fire the last seven days so is time to take profits or even start hedging again?

Wednesday, March 14, 2012

Top Individuals Outperformed Top Pros on Covestor Last Year

Covestor is not only a great investing platform, it is also a big real-time experiment to find out if individuals or professionals are the better investors. Conventional wisdom says that money managers should perform better than the retail crowd.

Monday, March 12, 2012

Some Interesting Covestor Model Characteristics

I did some scatter plot analysis of the Covestor Model Portfolio monthly returns last weekend. The first chart are model returns plotted with monthly S&P 500 performance for the last four and half years: 

Swing Trading Setup: Failed Breakout

Here comes another setup from my trading playbook: the Failed Breakout.

Sunday, March 11, 2012

Why I Like Consumer Discretionary Stocks

Last week was odd: on Tuesday, stocks sold off only to resume the rally until Friday. Individual sector performance was quite diverse and it was easy to lose money if one was positioned with the wrong industries: 

Friday, March 9, 2012

Stocks Outperforming Gold Since Sep 2011

In case you are not aware: US stocks have been outperforming Gold since last September, another sign of the current "risk-on" environment. This is why I haven't been trading the yellow metal lately:

Thursday, March 8, 2012

Was This It?

Futures are coming in strong this morning and the obvious question is: was this it?

Wednesday, March 7, 2012

A Short-term Bounce is Very Likely

One of my favorite tools to evaluate short-term market overbought/oversold conditions is the McClellan Oscillator. Yesterday, the indicator closed below -80, which has led to a bounce 6 out of 7 times during the last two years. I marked occurences on the following chart.  

The Recent Trend Transitioning Process

Trend changes and market tops are often a process. Price action of the last weeks hasn't been any different. The following chart shows what happened "under the hood" since beginning of the year. The vertical line indicates the highest asset price during that period:

The weakness in small caps had been all over the media and in fact, they topped out around Feb 6, together with Transports. Next in line was the US Dollar. Note that I plotted UDN, the inverse ETF for consistency. The Greenback showed some strength around mid February, but managed to decline again. A bottom was put in at the end of February. Finally, weakness spilled over to the general market during the last two days.

Intermarket analysis is a valuable tool to evaluate the overall market health. Unfortunately, there are no strict rule. Tops will look different each time, but looking out for divergences is always highly recommended.

Monday, March 5, 2012

Why I'm Careful Right Now

There is currently one reason to be careful when it comes to US equities and certain commodities: the US Dollar, which is usually inversely correlated to these assets.

The Dollar Index chart shows that prices are in a process of creating a "double bottom" chart pattern (red lines), which would be bullish for the Greenback. In addition,  this bottom would mark a series of higher hights and higher lows since August 2011, so the Dollar is developing an intermediate term uptrend.

Even if you are "just" trading US stocks, it is important to follow these intermarket relationships. At the end of the day, it is all just ONE big trade.

Thursday, March 1, 2012

Market Commentary March 1

It was a very weak session yesterday. Even though the S&P 500 just lost 0.47%, more damage has been done "under the hood". A key index right now is the Russell 2000, which has been weak since the beginning of February. Small caps can be a good indicator of for the risk on/risk of trade. Fortunately, I build up a significant market short position two days ago by going long TZA The hedge was not enough to compensate all the losses from my long positions yesterday, but I expect further declines. At this point, they should be limited, so I wouldn't be aggressive on the short side. I closed most of my long positions yesterday, though.

A new short for me yesterday was BBY, which created an "inverse double dip momentum" setup from my playbook. I probably will discuss this play at a later post.

Silver got totally killed. I have a position, but I entered this long early, on January 17. I took profits yesterday and reduced position size by 50. Depending on the price action today, I might even close the trade entirely.

The market has some room to fall because it got too extended. Declines usually happen fast, so stocks could correct in just two or three days. The key indicator I'm watching is the McClellan Oscillator, which  currently trades at -34. Stocks reversed during the last years at readings below -80.