"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

Thursday, August 23, 2012

A New High/Low Volatility Pattern in Equity Markets

In the last four years, equity markets have been showing a very interesting cyclical pattern, which I haven’t seen in the years or even decades before: volatility “shocks”, followed by strong low-volatility rallies.  The following chart shows how this pattern occurred after the Financial Crisis. Note how each of the two phases takes several months to play out. While transitions between high to low volatility areas happened smoothly, changes in the opposite direction were quite dramatic. Most notable was of course the transition that ended in the Flash Crash in 2010:

The lower pane of the following chart shows short-term volatility over a 20 years period. Without looking into too much detail, it becomes clear from the ATR distribution that this extreme high/low volatility cycle did not occur prior to 2006. Of course, volatility shocks happened, but the difference between high and low was much smaller than in recent years:

Finally, here is an example from the rally between ’95 and ’98, showing no volatility shocks at all:

It is not clear why this pattern has been so obvious in recent years, but the 2010 Flash Crash hints that the high degree of algorithmic trading is one of the culprits. As we all know, markets always change. And that’s the reason why I do not like automated trading strategies. It is quite obvious, why a strategy that might have worked in the nineties probably doesn’t work anymore. It is much easier for discretionary strategies to adapt to changes in market structure.   

Tuesday, August 21, 2012

How to Justify a Channel Trade in Silver

What if you are a channel trader and want to buy Silver because of its strong move yesterday? Since price is now close to the upper channel boundary, you cannot get into this trade from the long side:

Here is an alternative: just trade that thing on a higher time frame and use weekly charts. As you can see, there is enough room for Silver to run. Only drawback: the wider stop will create a smaller position due to risk management, but it can still be a trade with a good reward/risk ratio. 

Discussing my Latest DIS Trade

Disney has recently been a poster child stock to swing trade: clean moves, trending characteristics, small gaps only. There are some interesting lessons to learn from this trade. Note that I still own the position in the Covestor Model Portfolio.
I bought DIS on July 17 after a complex pullback, which I call the “Double Dip Momentum” setup. So this has been a fairly long swing trade so far. I held the position for two trend legs and was able to lock in partial profits at the upper channel boundary on July 30. Momentum was still strong, so I increased the position again on July 8, when I was able to buy in the middle of the channel.
Price action has now become interesting: momentum has weakened in the last days and DIS actually underperformed the broader market. Is it time to close the position?

This is where I usually look at lower time frame action to get a better understanding on what’s going on: the 30 min chart is actually looking promising and a bullish ascending triangle formation can be identified. The lower time frame triangle gives me the reason to stay in the trade and to even encrease the position on a break out. However, should this pattern fail, I would consider to get out of this trade entirely. It is these inflection points, where trading edges exist.

Explaining My Current AAPL Trade

AAPL had a tremendous run during August and so far I was able to catch most of the move. I indicated in my yesterday's post that it would be time to take partial profits. Let's take a look at the trade:

I entered on August 3 on a setup, which I call "Single Dip Momentum" and where the stock consolidated rapid gains in a tight range. I entered a little late, so this was not a perfect trade: AAPL was already moving quite high in the Keltner channel, which I use to identify areas of emotional extremes. Second, another setup occurred 5 days earlier: a "Earnings Gap Reversal", which I explained here. From a swing trading perspective, it was fully justified to go long around $580.

In any case, the idea of channel-based trading is to sell when a long position reaches the upper channel boundary and when investors are most excited. It can be shown that these areas are often turning points.

In strong markets I try to find a compromise between playing the short-term mean reversion and intermediate term momentum, which is why I need to take partial (30 -50%) profits in a position once the stock reaches an emotional extreme. It doesn't mean that I'm bearish on the stock, it is just part of my trading plan. Should a longer term trend establish, similar to we saw during the first months of the year, I can still benefit from the move.

Monday, August 20, 2012

VIX Below 15: Bullish for Equities

Frequent CNBC guest Doug Kass recently claimed on CNBC that "Over history it’s very rarely paid to buy equities when the Vix is as low as 14”.

Besides publishing his track record before making comments to retail investors, Mr. Kass should maybe take a look at history: as can be seen from the chart below, there had been two extended periods in the last 20 years, when the VIX traded as low as 10. Stocks rallied during these periods (1993-1996, 2005-2008).

Why I'm not Concerned About China

Recent lagging performance of China stocks has been a concern to various commentators (e.g. Global Macro Monitor). Let's take a longer term perspective and look at the S&P/Shanghai Composite relationship of the last 20 years:

Long term correlation has generally been positive, which doesn't come as a surprise. However, there had been a couple of extended periods,where US stocks rallied while China stocks underperformed significantly (blue boxes on the chart below). It is interesting, though, that the Shanghai Composite turned around sooner or later and followed US stocks up north. Obviously, the US stock market has been the leading market during the last two decades. If history is any reference, this is rather the time to buy Chinese stocks instead of selling them.
The S&P has even been leading in the opposite direction: the US market was the first to move lower after the Internet bubble, China stocks followed in 2001 (red box).   

Sunday, August 19, 2012

Market Commentary: Follow the Trend, but Watch Out

The S&P is about to run into multi-year high territory in the next weeks. Should you sell your stocks? As a trader, you of course want to stay with the trend as long as possible but watch out for signs that this trend might change. History is always a good reference although one has to make sure not to fall prey of “recency bias”. When stocks hit new highs beginning of this year, market character changed and the ride got bumpier: stocks entered a transitional phase, where momentum weakened and major indices printed an intermediate term top as can be seen on the chart below. It is by no means guaranteed that similar price action will occur again, but (as always) it will be important to watch out for signs of distribution in the coming weeks. Until then: enjoy the ride and ignore the news. 

Apple at New High: Should You Buy?

AAPL has been hitting a new high on Friday and one might ask if this is still a good time to buy the stock. As can been seen from the chart below, AAPL was able to keep momentum when a similar setup occurred in the last three years and the stock appreciated between 15 and 50% after hitting a new high. If history repeats or at least "rhymes", it is not too late to buy some shares. Covestor Model subscribers have been long since August 3 and I do not intend to close the trade. Some partial profit taking will happen soon, though.

Thursday, August 9, 2012

S&P 500: Some Observations

The S&P 500 is showing some very interesting characteristics and price action in the coming weeks will determine longer term direction. Obviously, the S&P is entering a major potential resistance zone around 1400. In the last months, price has printed a regular upward sloping zick-zack pattern. So the obvious short-term direction at this point would be south. However, markets tend to surprise the majority of investors and continuation of the zick-zack pattern would be too obvious; especially at major resistance. 
Another observation is momentum: price seems to be in acceleration mode, so the S&P has been gaining strength in the last weeks. 

So what would surprise most people? If resistance would turn out to not be a major obstacle at all. We'll see.

Investors Favor High Beta Again

The following chart shows the ratio of SPHB, an ETF covering high Beta stocks and DVY, a dividend-focused fund. I'm watching this chart to get some insights of investor's risk appetite. Note how dividend stocks had outperformed their high beta peers since March. However, something might have changed in the last weeks. Investors are seeking beta again, a positive sign. The trend is still young, though, and it is not clear if we see a new trend or a simple reversion to the mean.

Thursday, August 2, 2012

Russell Underperformance: a Big Warning Sign

Recent underperformance of the Russell 2000 Small Cap Index is has been sending out warning signs for quite some time and is currently my biggest reason for concern. Temporary weakness is not a big deal, but take a look at the following chart:

As you can see from the red curve, there have always been relatively short (2-3 months) periods, where small caps didn't perform. This time however, the Russell has been underperforming the S&P 500 since October 2011, so almost for a year! A similar setup occured in 2007 before the stocks completly broke down.

Let me be clear: I'm still 90% net long (large caps only, of course), but I keep watching the developments very closely.