"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

Tuesday, May 29, 2012

Why TOL Could Gain Another 20 Percent

I like homebuilder stocks. In fact, I believe they could be the "trade of the year" in 2012. My favorite one is Toll Brothers (TOL), which I own for the Covestor model portfolio.

Below is a long term chart of the stock. Note how TOL has been trading in a range for the last five years. Last week, the stock broke out of that range to the upside on good relative strength and volume.  Next major resistance is coming up around $35, which is about 20% higher than current price. I think that's where we're heading this year: 

Another Buy Candidate: Chipotle Mexican Grill (CMG)

CMG is another stock on my buy list with compelling trading characteristics: as can be seen from the weekly chart, long term momentum is intact. The stock has been outperforming the broader market for the last years:

The daily chart shows that bears are running out of steam: the stock declined 10% during the last six weeks, but each selling wave was accompanied by less volume. On the other side, upside volume seems to have picked up recently: bulls are getting stronger, so I'm happy to join them. In addition, relative strength vs. the S&P 500 improved in recent weeks:

In order to find a good entry, I look at the intraday chart. CMG seems to be in a transition process from downtrend to sideways/uptrend. Two possible scenarios here: A) price breaks resistance around $410, so I would buy the intraday breakout with a stop around 400. Scenario B assumes further weakness and CMG becomes a buy on strong rebound from support around $390:

Fundamentally, the stock seems expensive, which others obviously have already figured out: CMG is heavily shorted with 16% of float held short. Analysts are neutral: only 14 of 27 analysts rate the stock a "buy", which is good since it leaves room for upgrades. The combination of high short interest with neutral analyst rating has no negative implications according to this piece of quantitative research.

Thursday, May 24, 2012

Time to Buy AAPL?

Apple, Inc. (AAPL) is always on my watchlist and I find recent intraday price quite bullish. Let’s discuss:

The company presented a blowout quarter on April 24 and opened almost $60 higher the next morning. However, prices declined in the following weeks, partly because of market weakness. As can be seen from the chart below, these declines came in on relatively low volume. Did big funds just use the opportunity to take some profits and reduce exposure by trickling out some stock? In any case: $555 was/is an important support level and AAPL broke this barrier on increased volume, only to reverse back up. So far, this action created a pattern from my trading playbook: a “false breakdown”, which I tend to trade from the long side. These breakdowns are often (not always) followed by rapid moves up, because many investors were caught on the wrong foot and have to close or even reverse their positions. I find it quite telling that the recent rally was accompanied by good relative strength against major indices. Price action of the entire period – gap up, low volume decline, shakeout and strong reversal – looks to me like big traders just waited for price to close below 555 in order to trigger some stops and then go into heavy buying mode. 

AAPL is now at a critical juncture, where price is about to break the downtrend of the last two months, which would also be my buy-point. I wouldn’t put a stop too close since the big guys will probably try to engineers some fake moves to have some fun, but a (mental) stop around 555 to 560 should be fine. Especially with AAPL, you can’t use hard stops anymore these days. (Peter Brandt explained the dynamics in a recent post.)

Disclosure: Covestor model is NOT long AAPL yet, but I'm planning to buy soon.

Wednesday, May 23, 2012

Waiting for Declining Volatility

I consider volatility one of the most important indicators when it comes to identifying market bottoms. Investors usually use the VIX to look at implied volatility. However, as I discussed in an earlier post, there is not much difference between implied and actual volatility. So I’m using a short-term “average true range” (ATR) for my analysis.
Volatility spikes or “clusters” occur frequently and can indicate a normal correction. These “normal” volatility spikes are marked green on the chart below. During these periods, ATR rises to moderate levels around 20 to 25 for the S&P 500, which means that the index fluctuates on average 2% from close to next day's high/low on a daily basis, assuming the S&P trading around 1200.
The (violent) second class of volatility spikes are marked red on the chart: these are the crashes and panic sell-offs. Note how ATR recorded at 80 during the peak of the financial crisis while the S&P traded below 1000, so the index was fluctuating around 10% per day from clos to next day's high/low, an unbelievable volatility.

Now look at the right edge of the chart: obviously, volatility has been on the rise in recent weeks. It is quite surprising to me that the ATR is still relatively low. Will we see a violent spike or a “normal” correction spike? I don’t know and there is no data available that will let you predict the outcome.

The good news is: you don’t have to make a prediction. In recent years, declining volatility has been a (necessary) condition for higher stocks prices ahead. As you can see from the following chart, a strategy, which went long after the volatility spike when the ATR started to decline would have been quite profitable. So one just has to be patient and wait for calmer markets before committing capital aggressively on the long side:

Monday, May 21, 2012

How to Trade a Possible Market Bounce

There is a lot of speculation about an "upcoming bounce" because of oversold market conditions. I'm usually not a fan of trading bounces against a higher time frame trend, because profiting from a potential 3-5% rally with compelling risk/reward ratio is not easy, believe it or not.

Looking back into recent market history gives us some guidance on how to trade such a bounce, if one really wants to be aggressive: the last time markets sold off was around August 2011:

On August 9, the S&P 500 recorded a "single day reversal" on high volume. Buying on the close of that day would not have been a good trade because stock rallied just 2% after the reversal, but the downside of the trade at 5% (assuming stop at low of the day) resulted in more risk than potential gain.

A better approach would have been to either start scaling into the long position during the selloff when RSI (2) was still below 10 or wait for the re-test of support on August 10. Also, one needed to sell as soon as momentum declined four days after the reversal.

The other question is what to trade. Since correlations tend to be high during major selloffs, trading individual stocks is often not necessary and a analyzing them a waste of time. Usually, the weakest sector gains the most during the rally. Since the Euro has been the driving force behind recent declines, one wants to buy sectors, which are highly correlated to that currency, which are Energy and Basic Materials. Here is how the later performed during the 2011 decline:

Note how XLB outperformed after August 9 and gained 10% from the August 8 low but underperformed during the decline.

Here is the same chart for Basic Materials, but for April/May 2012. Conditions look similar, so it might be worth to look into the trade using a leveraged ETF such as UYM:

Saturday, May 12, 2012

Equity Put/Call Ratio Signaling "BUY"

Finally, investors got bearish: the smoothed equity put/call ratioreached levels last week, which have been followed by heavy buying in the last three years. According to the principles of contrarian investing, the best time to buy is when everybody thinks that prices will keep falling. This in turn also means that all the weak hands have already sold and no sellers are left to fuel further declines.
At the end of the Financial Crisis in 2009 however, stocks kept declining after high put/call ratio readings. So the indicator had a win rate of 5/6= 83% in the last three years:

Friday, May 11, 2012

What's Strange About the Market

Have you recently looked at the charts of e.g SPG, TOL, DIS or or ALL? They are looking great! Very clean up-trends, low volatility. Did somebody forget to tell them that it's cooking in Europe? In addition, the S&P 500 refuses to break below 1340 and the VIX remains at modest levels despite all the negative macro news.

There are two options: we are actually seeing some underlying market strength or investors are incredibly complacent and ignore Greece, which could be extremely bearish. If Greece would indeed fail, the unexpected would hit wrong positioned investors on the wrong foot.

Frankly, I do not know, which position to take. There are arguments for both sides, so I play it from the technical standpoint as usual : buying the strong stocks while shorting the junk, keeping positions light with high cash levels.

The intraday charts of major indices look horrible BTW, but that's another post.

Disclosure: Covestor Model is long SPG & TOL

Thursday, May 10, 2012

Not my Typical Trade: Long Metalico (MEA)

Yesterday, I went long MEA, a small cap stock of a company in the metal recycling business. If you look at MEA's chart and know my philosophy, you will notice that this position is not my typical swing trade. Here's the idea behind the move:

There is guy whose financial podcast I'm listening quite frequently: Frank Curzio, a small cap value guy and publisher of a monthly newsletter, which is the only such product I have subscribed to by the way. Frank is doing a lot of fundamental research on the companies he recommends. My idea was to use his fundamental picks and trade them using some parts of technical strategy. MEA was one of his recent picks.

The stock has been hitting $3, which is a long term support level for the stock. I'm trading the bounce from that level, even though MEA is trending down. Volume action has been positive in recent weeks, which supports the thesis that sellers are exhausted in the shorts term. The position is fairly small to compensate for the risk of the highly volatile stock.

Wednesday, May 9, 2012

Why I Shorted Silver Yesterday

Silver has been in a difficult technical position for the last months. Yesterdays, the metal broke $30, an important intermediate term support level. Intermediate term support can be found around $26, so Silver could be in for a quick 10% move to the downside:

The longer term picture looks even worse. Silver has been building a top for the last 1.5 years and a potential breakdown from the $26 level could result in a move to $20.

It is likely that some demand will come in after the initial drop, so I expect some choppy action once Silver hits $26. A rebound could become a good opportunity to load up on the short side in the next months.

Disclosure: Covestor Model Portfolio is short SLV.

Monday, May 7, 2012

The Most Important Chart Today

... is obviously Euro vs. Dollar. The currency has been holding above 1.30 for the last months, but downside pressure has increased steadily as can be seen by the descending triangle pattern on the daily chart:

A potential price target in case the Euro breaks support would be around $1.24.
The currency traded below 1.30 this morning but managed to bounce back above that level. The intraday chart will tell us today, how strong Euro bulls really are. The fight for 1.30 will go on for while, so keep this one on top of your watchlist:

Since the Euro has been a acting as a "risk on/risk off" indicator recently, its direction will be telling for various global markets.

Thursday, May 3, 2012

Green Mountain Coffee: Useless Analysts

So GMCR missed earnings yesterday and the stock tanked 40%. A surprise? Not really. GMCR displayed a combination of factors, which has been identified as bearish by academic research (Drake, Rees, Swanson, 2010): "we find abnormal returns (1.11 percent per month) from a zero-investment strategy that 1) shorts firms with highly favorable analyst recommendations but high short interest and 2) buys firms with highly unfavorable analyst recommendations (sell signal) but low short interest (buy signal).".

In the case of Green Mountain, 9 out of 12 analysts had a buy rating on the stock (according to Yahoo Finance). Only one rated the coffee company a "sell". Short interest on the other hand was extremely high: 23% of stock was held short according to finviz.com.

I'm amazed how much analysts are often behind the curve and frankly, I do not understand why. 

Tuesday, May 1, 2012

Gold: a Sharp Move Coming?

Gold is currently in a very compelling technical position. On a weekly price chart, a symmetrical triangle can be identified. A breakout from this formation should result in a sharp move. Technically, it is not clear whether to expect a rally or a selloff. My feeling is that prices will head north and follow the long term trend. Especially, since Gold has a relatively strong negative correlation to the US Dollar, which recently showed some weakness and is about to complete a similar pattern - to the downside:

I'm contemplating going long Gold at this point and might start to put up an initial position this week with a tight stop below $1,600.