Morning Thoughts

Good Morning, 

Since I'm located in Germany, I figured I have quite an early bird advantage because of time difference. So let me see if I can setup a regular series of brief morning posts to communicate some thoughts and what I'm seeing in the markets. 

Looks like we'll get a nice pop this morning from Europe's overnight news. I wonder though how long this will last. My feeling is that Q2 earnings could be the focus moving forward and estimates could be still way too high. NKE disapointed yesterday after the close and pulled down LULU after hours. RIMM was a disaster.

Various MOMO stocks basically got killed in recent days. Not a good sign. Most of them based on rumors. It the markets want to go down, they find a reason. I actually went short LULU and CMG in the morning and would increase these positions on weak rallies. 

Silver, which I'm also short, is in a difficult position. Everyone is watching the $26 level like a hawk, so expect some sell stops to be hit once we get close. The metal might rally this morning, but if the intraday trend turns south again, traders could get a nice entry point on the short side. 

Homebuilders are rocking and my long position in LEN popped over 2% yesterday. I continue to believe that this sector could be the "trade of the year". We'll see...

Happy Trading

Is CMG a Short?

I lost some money yesterday with a long position in CMG. I bought on Tuesday because of the tight consolidation after some encouraging price/volume action of the last weeks. Even though I lost money, it was a good trade because I followed my rules.

After yesterday's action, CMG looks rather like a short than a long. Momentum stocks can decline very rapidly if they fall out of favor and Chipotle might be in such a position. Should weakness continue and the stock moves below $390 in the coming days, I have no problem shorting the stock. $300 offers an attractive price target based on long-term Fibonacci levels, which would be a 30% decline from current levels. CMG is expensive, trading at a generous 53 times trailing earnings and is heavily shorted with 15% of float, so there are others who think the rally could be over.

For comparison, here is the chart of another former momentum leader: GMCR. Not how the Fibonacci levels played out nicely and how relative strength was the key measure to give the sell signal:

How I Plan to Trade a Potential Pullback

As discussed in my earlier post, this is a good entry point for a short-term market trade on the short side and I plan to implement this trade today. I will focus on the Russel 2000 small cap index, since it is the cleanest way to trade risk on/off events. The idea is to benefit from mean reversion characteristics and therefore close the trade when prices pull back to the 20 day moving average. Note how taking the opposite position would have been a profitable strategy when the index was trading at the channel boundaries in recent months:

One of the issues will be timing: I hope that prices will not move too much pre-market. Otherwise, risk/reward will loose its appeal.

Why I'm Expecting at least a 3% Pullback

One of the most reliable indicators in the last years has been the McClellan Oscillator. Readings above +/-80 were followed by short-term reversal of market direction. The following chart displays the signals. Successful bull signals are market with green circles; bearish points are market in red. Black are failed signals. 17 out of 19 events had been successful, so the indicator had a win rate of 89% over the last 3 years. Yesterday, McClellan closed above 80 again, so I'm expecting the market to decline at least 3% from here, which is what he has done historically:

During the last two days, I took partial profits in my winning long positions and might put up a short-term hedge this morning.

Wanna buy AAPL? Keep this in mind:

I like Apple. If I would be a long-term investor, I would have it in my portfolio. But as a short-term trader, I need to keep an eye on the stock's individual trading characteristics. For AAPL, it is very typical to consolidate gains over relatively long periods and at one point surprise everybody with a rally. These consolidation periods can take more than half a year. So far, the stock is just two months into its recent gains digestion, so I would actually be careful chasing the stock at this point on strength. Alternatively, it can make sense for position traders to scale into the trade:

Buying now? Here is why you are too late

... at least if you are a swing trader. Let me explain.

Of course one could argue that markets should rally now after Greek elections. But as a swing trader, whose strategy is built on the concepts of short-term mean reversion and intermediate-term momentum, it becomes time to at least take partial profits on long positions.

From a practical point of view, the idea is to buy pullbacks to the mean (a short-term moving average) and sell when prices reach the upper limits of its price range (or "channel" in a technical sense). We had seen a lot of positive price action last week and one stock that behaved textbooklike was Ross Stores (NASDAQ: ROST). The optimum buy point was two weeks ago around $62. As can be seen from the following chart, the stock is becoming extended and is trading close to its upper channel boundary. Note how the stock was trading in a similar region at the beginning of May before it pulled back:

Disclosure: Covestor Model is long ROST.

How to Trade QE3

Expectation for QE3 is a major theme that continues to drive markets: in a recent survey CNBC found that 58% of all participants expected further action from the FED. So let's assume QE3 is indeed on the table, how could one trade it?
Looking back to the last easing round in 2010 gives some guidance and is a great example for the old maxim "buy the rumor, sell the fact". QE2 was announced on November 4, 2010. The S&P 500 started to rally two months before the announcement in anticipation of the event.
The following chart shows what was going on. In addition, I added key summaries from the daily market outlook archive of Briefing.com:

It is interesting to follow the comments and to see how QE2 expectation built up over time. The announcement itself pulled in the last remaining investors from the sidelines only to consolidate gains over several weeks in November. The December rally was then driven by various positive economic comments/numbers out of different parts of the world.Guess what: Europe was one of them.

Lessons learnt for trading QE3 today: you do not need to predict the event, the market will guide you to it. If the FED would indeed get active, sell into the excitement. 

Time to Buy Gold?

Technically oriented traders might recognize a "declining triangle" topping pattern on the price chart of Gold:

However, a different interpretation is that the metal has simply moved within a broad trading range since last year. What's also interesting is that May price action looks somehow similar to what we had seen in December 2011. Gold had a strong rally to almost $1,800 after that double dip:

Will history repeat itself or at least "rhyme", according to Mark Twain?

Currently it is still possible to setup a trade on the long side with compelling metrics. Assuming you buy Gold at $1,640 with a price target of 1,770 and stop at 1,600 would still result in favorable a 3:1 risk/reward ratio:

Disclosure: Covestor Model Portfolio has no position, but I intend to go long Gold soon.

A Difficult Market - Really?

I keep reading posts and tweets where authors express that current markets were "so difficult to trade". I agree with this statement if one does not apply technical analysis. However, if one is into technicals, it doesn't get any cleaner than this. Take a look at the following chart of the S&P 500:

Patterns have been lining up very clearly. It is easy to identify the market top, the recent bear flag as well as 1300 as an obvious support level. The price action we have seen in the last months is textbook-like.

So if an investor relies on technical analysis and still looses money these days, it can have two major reason in my experience:

1) there is a big difference between identifying a pattern and put up a good trade with a compelling risk/reward ratio. It doesn't mean that you are a good trader when you are a great analyst. However, the opposite is true: you need to be a good analyst in order to be a great trader.

2) psychological biases: the charts speak a clear language, but if one follows the news, commentators or other investors, headline stories are often still positive, prompting investors to not pull the trigger and second guess the message of the charts.Remember: the markets are a discounting mechanism, where news are often priced in months before the headline occurs.

Trade Review: TOL

There have been a couple of posts recently about my thoughts on Toll Brothers. Let's review the trade since I closed it last Wednesday. TOL it has been a typical transaction. Even though I offered a long term perspective, I am a short-term trader.

I entered the position on May 21. TOL was setting up a "double dip momentum" structure from my playbook. I scaled into the position by adding shares on May 22. When TOL reached its upper channel boundary, I went into selling mode and started to sell part of the position last Tuesday. I kept the rest in order benefit from the longer term move and expected the stock to turn around soon. However, at the end of the day, volatity had increased significantly and TOL actually underperformed the market, a sign of declining leadership. I therefore finally closed the position on May 31 with a small gain. Going forward, prices have to set up again. The risk is that TOL does fall back into the long term trading range, which would negate my bullish case.

Overall, the trade did not gain much, but I'm happy with it, because I followed my rules. You could argue that it would have been better to close the entire position at the upper channel boundary, but I'm trying to compromise between short term mean reversion type trading and intermediate term momentum.

Analysts!

I was looking into MS this morning for a trade on the short side. What caught my eye was the incredible incompetence of certain analysts. Of course, that's nothing new and normally shouldn't surprise. I just find it unfair that these people receive decent salaries despite being highly incompetent. I'm an engineer by education and engineers would never ever find a job again if their designs would fail.

Some illustration for entertainment purpose: JMP Securities initiated coverage of Morgan Stanley in April 2009 with "market perform" after the stock outperformed the S&P 500 for several months (I don't even want to know why they dropped coverage earlier).
One month later, MS was upgraded to "outperform". Ironically, that was the time when MS started to underperform the S&P 500. JMP kept recommending to buy the stock until this month: on May 21, JMP downgraded MS to "underperfrom". Well, MS had underperformed for the last three years. Why the downgrade now?

I marked JMP's rating changes on the following price chart:

The question at this point is if JMP's calls have to be inverted to profit from them: so when they say "underperform", go and buy; sell on the outperform rating.

I like to look at analysts as a group: I want the majority of analysts bearish before making the bullish case. Roughly 50% of them still rate MS a "buy" according to Yahoo Finance, so there is more room for downgrades.

What is a Setup?

Traders frequently talk about "setups". But what actually is a setup? Why at they so important?

Since I'm writing this post on an iPad (on a train ride to the Netherlands), let's pull up the built-in dictionary for a general definition. According to my device, a setup is "a play or pass in a ball game intended to provide an opportunity for another player to score". Apple's dictionary offers multiple definitions, but I liked this one best when it comes to trading. It involves two factors that are also relevant for the speculator. The "play" often relates to multiple players and "opportunity" implies probability, actually an increased probability or "edge".

Trader are often technically oriented and rely on (chart) patterns. Is a pattern a setup? I don't think so. In my definition, a setup is much more. Maybe it involves a pattern, but most likely multiple patterns of interrelated markets. Trading is a 3 dimensional puzzle and its pieces often fit with certain probapbilities. Trading simple chart patterns such as a "head and shoulders" pattern, is like trading in just one dimension. This is why it is so difficult to statistically validate classical chart patterns. A simple example: a certain stock just broke down from a H&S top, but the underlying index finalized that pattern two weeks ago and has become deeply oversold. Is it a high probability trade to short the stock? I guess it's not. Another example is the process to look at multiple timeframes all at once: maybe one pattern occurs on the daily timeframe, another one on the intraday. My favorite setup for illustration: I like to trade pullbacks to the 20 day moving average on the daily timeframe while an breakout occurs on the intraday chart, so this setup involves basically two patterns (there are other factors involved, such as relative strength, so it is not that simple).

Since setups involve propabilities, they also include risk/reward ratios. The breakdown from a H&S top might become a setup when the short position is entered after a weak rally, simply because risk/reward is better defined.

Trading is challenging from the psychological standpoint. Most traders fail because they fall prey to typical problems like fear to miss a trade or the inability to get out of loosing trades early. Mark Douglas suggests in his book "Trading in the Zone" to "think in probabilities" in order to manages these psychological challenges. Setups are an important component here because they minimize the emotional factor.

On a final note I think it is benefitical to work hard on documenting the setups one, collect statistics, examples and of course become an expert in these structures. Each trader should publish his own "Trading Playbook" with all this information, even if nobody else will ever read it.