Monday, November 30, 2009

Gold/Oil Ratio and Pairs Trade Examples

As part of a further evaluation of the context of gold prices (and hence monetary inflation concerns and outlook for the US dollar) I decided to look a bit into how gold prices were relating to other inflation sensitive issues. Oil was the one that I thought would offer the most interesting comparison. The idea I wanted to explore was whether the ratio of gold prices to oil prices was informative on the future price action of either of the two.

After doing some charting I looked for some historical data on the ratio and found the useful chart below. It is not a truly long-term chart, but does go back several decades and shows probably a good sampling of the range that the ratio swings back and forth in.

Click on Chart to Enlarge

The chart above shows the gold/oil ratio in standard units oz/barrel. The chart goes back to about 1973. The basic range for the ratio is between about 8 and 30. The long term average from what I've read on it is about 15.

Click on Chart to Enlarge

In the chart above I used stock charts to create the ratio for the last 3 years of prices. Notice that at the top of the commodity bull last year, with energy related commodities leading the way, the ratio fell very low, below 7. So gold was cheap relative to oil on a historical basis. The first chart shows a point where the ratio got down to about 6.2 in 2005, but the reading last year was the second lowest. The difference was that in 2005 gold shot up about 60% or so over the next year after the ratio got very low. Last year gold dropped about 30% in the months after the low and then got back to around even by this year.

From what I've looked at as far as ratio extremes, I don't see much predictability as far as gold moving up or down on an absolute basis after extremes in the ratio to oil. However, the ratio does seem to help determine points at which gold or oil is likely to out or under perform the other. Like much of the data and analysis I post on the blog, this is best looked at as a ratio that will undergo mean reversion on a long term basis. This means that the average of the ratio is pretty stable not trending over a long period of time. So when the ratio gets far away from the average, it is best to look for it to return back toward the long term average than to get further away. This sets up the opportunity to play the expected performance or relative strength of one versus the other via a pairs trade when the ratio reaches extremes.

A pairs trade is going long one stock and short another in the same sector. So you are market neutral but will benefit if your long position goes down less or up more on a percentage basis than the short position. So you benefit by accurately determining the relative strength of two related issues. As an example, when the market has come way down and starts to turn up you may buy Apple stock and short and equal dollar amount of Dell because you believe that Apple will display superior relative strength to Dell in a rising market.

So back to gold and oil, you could create a pairs trade by buying gold futures or ETFs and shorting oil futures ETFs if you believe that gold will outperform on a relative basis. So in the example of July 2008, the gold/oil ratio reached a historically low extreme indicating that gold was cheap relative to oil. Even though gold dropped about 30% over the next 4 months, oil dropped 60%. So if you had a long gold-short oil pairs trade you would be up 30% between the two and 15% return on total dollars invested at that point.

On the chart above I made some brief notes showing a simple possible strategy of using a close above/below the 50 day moving average to initiate and close a pairs trade after the ratio reached an extreme point. So when the ratio is in a very low historical position you would look to buy gold and short oil. If the ratio gets very high, you would buy oil and short gold. The last year shows a couple nice trades, one in each direction, using that simple method.

Now in a statistical sense the long term mean of the ratio is about 15. The +1 +2 +3 standard deviations are around 20, 25 and 30 respectively. The point is that you probably should not look to pairs trade something when the ratio is right around the average. You want to wait for it to get extreme to give a higher success rate. Currently the ratio is about 15 which is right around the long term average so is probably not a time to try to create a pairs trade.

Now unfortunately from anything I've looked at so far, I have not really found anything that gives me much insight into whether gold will go up or down from here on this basis. But the more you know how markets relate, the better investment decisions you should be able to make with more confidence, and the more opportunities you may recognize and know how to take advantage of.

Saturday, November 28, 2009

Some Charts to Help Gauge Sentiment

Click on Charts to Enlarge

This chart I often show which is the equity put/call ratio with 21 and 34 day averages. It is used as a contrarian indicator. When the ratio reaches extreme highs or lows, that can be helpful in timing market turns. But looking at the intermediate averages helps to see the longer ebb and flow of fear in the options market. Despite the senior indexes being only marginally off highs, the averages have started to trend up for the last month indicating a shift in sentiment that often accompanies a market downtrend.

This chart is from Sentimentrader.com and is a very interesting look at some of the Rydex fund data that they track. This particular study looks for times when the level of buying or selling in Rydex funds is disproportional to the price movement in the market. When there is lots of buying/inflow while the market does not really makes substantial gains (or even declines) that shows that the Rydex traders are buying the dips or are overly enthusiastic about further gains. During the rally since March when several readings like that show up in a cluster or narrow price range, it has often been at short term tops. We are seeing this again over the last 2 weeks.

This chart is also from Sentimentrader.com. It is what they call the Options Speculation Index and is a broad measure of bullish and bearish bets in the option market. It is used as a contrary indicator and excessive call activity often happens near market highs (and vice versa). This ratio looks at the ratio of calls bought to open and puts sold to open divided by puts bought to open and calls sold to open. The ratio jumped to multi year highs last week, which indicates that the options market is leveraged excessively toward the call side.

This chart is the OEX put/call ratio for 2009 so far. Unlike most put/call ratios I mention this one is a smart money indicator typically as smart traders buy puts as hedges when the market has gotten ahead of itself. In the past there have tended to be several spikes up in this ratio as a significant top approaches. The ratio spiked up on Friday again to 2.04. The intermediate averages of this ratio are also showing this group to be maintaining consistently high put exposure (on a relative basis) consistent with expectations of significant downside risk in the markets.

Another thing of note on the sentiment front is that one of the lowest bearish % readings in the Investors Intelligence survey occurred this week. This is a contrary indicator typically but is best used to time the market with the larger trend. So the question is whether we are still in a longer term bear market in which case I would find this very significant. The 200 day moving average (which is a simple way to gauge long term trend) is pointed up now though. But with several other signs of longer term excess bullish equity speculation, I think it is notable. Also the survey showed a relatively high percentage of advisers expecting a correction. Despite the contrary use of this survey, this particular aspect of the survey has in the past functioned more as a confirming indicator and there often is some pullback when there is a high percentage expecting a correction.

Most of the above measures are more significant over the time frame of a few months rather than a few days. On a short-term time frame there is some mixed data. The VIX spiked up Friday and may be slightly bullish short-term. Also there was a very low cumulative TICK reading on the Nasdaq Friday, which should be bullish as well. But most other short-term sentiment gauges are neutral.

From a charting perspective, the close below 1100 on the S&P made a third failed breakout attempt above the Oct highs. This tends to be a good reversal price pattern. But any move above the recent highs is likely to succeed in a breakout. I maintain the view that the market is in a topping process which may be complete with this most recent failed breakout on the S&P. Tops tend to be slow in the forming and take persistence to establish a successful low risk-high reward position anticipating a new downtrend.

Friday, November 27, 2009

A Look at Market Psychology of the Recent Past and Present

Click on Chart to Enlarge

I have been thinking a good bit about the action in gold the last couple months and trying to look at it from different angles. The chart above shows the CRB commodity index at bottom with wheat, oil, and gold prices above as well as some notes of what I believe the general crowd psychology was at some points in the past.

I can clearly recall news stories about third world starvation and global warming in relation to the soaring grain prices last year near the commodity peak. There was some backlash against use of food based fuels like ethanol from corn and sugar, etc. While all these things may be sensible or even true, it only helped to explain price behavior in the past. What most people do is to assume that the same trends will continue into the future. As a contrarian trader or investor, it is important to learn to recognize consensus opinion and behaviors and willingly act against them. For anybody who pays attention to this type of thing at all, I'm sure you can think back on what the buzz was near the high points of certain commodities over the last year.

Well despite the commodity index now being well off the peak, there is a resurgence of inflation fears with primary concern over monetary inflation and the death of the dollar. This has focused the commodity world's attention on gold. My take is that this could very well be just another successive inflationary peak in a longer process of fundamental deflation.

It is not clear cut to me though because when commodities break out to all time highs, they enter a very strong technical position with no overhead resistance to speak of. So maybe this is the early stages of a long and large move up in gold. But from a crowd psychology standpoint and look at measures of real money sentiment, I tend to think that it is more likely just another domino in the line.

Stocks and commodities tend to advance together over the long term in general. However, there is a key difference in psychology at extreme points between the two. When stocks advance to bubble levels the crowd is euphoric and happy about the high valuations. However, as commodity price reach bubble levels, fear takes hold. Fear of famine, shortage, etc manifest at commodity peaks while it is utter complacency at stock peaks. So the difference in psychology may be why we see stocks top out before commodities often. They are both advancing, but then as commodity prices get so high, the general climate shifts towards fear. Then stocks come down on the fear while commodities blow off to higher highs on the fear.

For those familiar with Elliott wave theory, you know it is a result of crowd psychology. So while prices may exhibit identifiable patterns, larger degree patterns will have identifiable psychological/social trends that happen with them. A correction of a larger trend in its simplest form is said to be a 3 phase move (i.e. down up down, ABC). In looking at the crowd psychology of the recent bear market and the advance since, I would say there have been 2 distinct phases thus far: a progressive fear of and recognition of deflation, and now a directed social effort to combat that and re-emerging fears of inflation. I personally expect there to be at least another reversal of the psychology back toward the deflationary side before any great buying opportunity comes in stocks. Maybe that will take the stock market to new lows, maybe not, but I expect it to take stocks down quite a bit lower than they are now.

Thursday, November 26, 2009

Heads Up Post For Friday - New SPXU Trade

Place a day only buy stop order at 39.75 on SPXU tomorrow. Use 37.00 as a GTC sell stop after entry if filled. Use money management guidelines here if guidance is needed.

For those who haven't used a buy stop here's what to do......choose "buy" and then choose "stop" from the order type (limit, market, stop, etc) choices. Then you will put 39.75 for the stop price. The trade won't be filled unless the S&P 500 drops about 2.2% tomorrow.

This post is just a heads up for tomorrow. The stock futures are down about 2% right now, and the US dollar index futures had a huge gap up to open near Wednesday's open. This is looking like a false breakdown in the dollar and corresponding failed breakout in stocks as I've talked about for the last 2 weeks or so.

So the main reason for this post is that there may be a large gap down in the stock indexes tomorrow, but with the market in the current position, it is not going to deter me from recommending a new inverse ETF trade. Granted the position size will have to be smaller because the stop loss will be wide due to the gap.

For those that didn't keep up with the news on Dubai, this is the type of thing that I think will be coming to the front more and more in coming months with Dubai just the Poster Child of excess and linked to what was one of the very biggest commodity bubbles/bull markets in history. The implosion of oil prices has obviously now months later lowered income and profits so that all the debt they took on can no longer be covered. Debt service (interest payments) is drowning them. Ditto with housing. Ditto with government spending in my opinion.

I have never fear mongered on this blog (I have no reason to) and certainly am conscious not to do that after major declines because that is when people will "fall for it" and make bad investment decisions. But after a nearly 70% rally in stocks, I don't consider it fear mongering. It is a reality check on a world awash in debt from "money" that came out of the ether and, if left to substantial free market forces, will surely largely return to the ether. And yes I know the Fed is "printing" money. But if you think that the amount of printing/monetization (say a few trillion $) counter or overbalances the amount of credit (say a couple hundred trillion $) that would disappear under free market conditions via housing/real estate, financial derivatives, etc, then I think you owe it to yourself to better understand the system of our money.

So, while it may be a sucker play to sell on a large gap down, after living through the market the last several months, I have become increasingly convinced that it would/will take a major news event to really shift the psychology out of the weakening uptrend to a legit downtrend. I don't know if this is it, but I expect it to be something with regards to credit/solvency issues.

With the technical set-up such that a close below 1100 on the S&P triggers a sell due to a thrice failed breakout, and the potential for a gap down below that level tomorrow, I am not assuming this gap will be bought and the market will move quickly to new highs like has happened so often the last few months.

Wednesday, November 25, 2009

EUO Trade Stopped Out and New Trade Set-Up

Click on Chart to Enlarge

The chart above is the daily chart of the S&P 500. I have made notes showing a trade set-up that will be triggered if price closes back below 1100 without significant further upside. It is a similar set-up to the one during the June high. Check the chart for the notes. In sum though, I do feel it is worth it to get back in on the short/inverse side of this market if there is another close below 1100 in the next few days. Then the stop will be the most recent high in the market.

The EUO trade was stopped out at 16.95 (down from 17.43 at entry) on the open today as the dollar index gapped down. Thus far all my attempts to catch a significant reversal on this index have failed. However, there is an identical (but upside down) set up on this index as in the S&P, so this puke gap down in the dollar index today may be the last one before a legit advance. I don't know if a lot of detail is necessary on this, but the dollar and stock indexes have had a strong inverse correlation recently. It has not always been so historically, and major turns over the last year or so have tended to see some breakdown of the correlation between the two. So that is something I have been anticipating may happen, and is my justification for making trades both long the dollar and inverse stocks. However, there really has been no point in retrospect - the correlation has been extremely high and not broken yet. So, until I see more definite signs of a reversal, I will probably only be playing one or the other.

Click on Chart to Enlarge

This is an hourly chart of SPY showing a continuing bearish divergence on the MACD on the recent new high. The ADX system is showing no trend, but bulls in control right now. These are still the indicators I am watching, but basically another close back below 1100 on the S&P will be the sign to get back in an inverse ETF.

Tuesday, November 24, 2009

2x Inverse ETF Volume Update

Click on Chart to Enlarge

The chart above is an indicator I made based off of the sum of the Dow, S&P, and Nasdaq 2x inverse ETF funds. I have posted this before, but for those that haven't seen it the idea is that volume will spike at bottoms of corrections as traders buy these as short term hedges or speculative plays. The reverse logic of that is that volume may fall to low levels at market tops when collectively there is not much fear of downside.

Now one thing that is evident from the chart is that the volume of these funds has dropped in seasonal fashion around the Christmas holiday. That makes sense because total market volume does as well. In fact, a better way to look at this may be to divide the volume above by total exchange volume to filter out the general market influence.

Anyway, the volume has dropped as of yesterday to levels lower than any except the past 2 Christmas periods. Also, Thanksgiving last year showed a low reading which again would be expected on an absolute level. The Nov-Dec January time period tends to show greater than random gains throughout history with the days surrounding the Thanksgiving and Christmas holidays being some of the most consistently positive.

So that may account for some or all of the low reading currently, but volume also dropped to quite low levels in late Oct before a sharp pullback, so it is something to keep an eye on from a sentiment perspective.

I'll try to recreate this chart as a percentage of NYSE volume and post that chart sometime relatively soon as well.

Monday, November 23, 2009

SPXU Stopped Out

The SPXU trade was stopped out today at 37.36 down from 39.25.

I don't have any charts to post right now, but there are some very important ones to look at. I would like to get a video up but really don't know if I will. If not, then I'll post or recap some notables.

It would have been justifiable to re-enter a bearish trade prior to close today, but I held off. There was a classic reversal candlestick (shooting star/doji) in SPY today. It also filled the open gap down off the recent high. However there was a large gap up at the open today, and so there was not really a major breadth reversal in the market as all indexes closed with basically solid gains despite being well off the highs.

With the holiday week which tends to be lighter volume and more bullish than normal, I will just wait to see if there is any downside follow through to today's reversal. Basically if the market moves below last week's low, then I will suggest returning to an inverse ETF trade. That will make the stop wider and thus a smaller position size, but will decrease the likelihood of being stopped out and increase the likelihood that there will be further retracement of the recent advance.

Friday, November 20, 2009

Solid Trade Set-Up in Natural Gas




Click on Charts to Enlarge

The charts above give some details on Natural Gas. It looks to me that this market should be in a good position to move higher. It has not really moved in lock step with commodities at large over the last year. From a charting standpoint, I think this looks really good.

The top chart shows the type of advance that is likely to be the first leg up in a new bull market now followed by a modest correction against that new up trend. The second chart shows a a graph of Commitment of Traders data showing extremely high net long positions by the commercials (smart money). Also the dumb money small speculators are coming off of a very low net long position. Looking back at the data, you see that following the commercials and against the small specs is the way to go.

The third chart shows the Dec futures contract which shows a nice buy pattern. There has been a large % decline that undercut the prior contract low, and then it formed a hammer type reversal and has moved back above that prior low. Also note the large red candlestick a couple days ago. Remember that for future charting purposes. After a long downtrend, when you see the biggest red bar/candle of the entire move down, that will often be very close to a capitulation low where all rest of the selling is exhausted. A similar thing happened in early Sept and is visible on the chart.

The bottom chart shows a similar set-up in the UNG ETF. It shows a similar undercut of the prior low and rebound above. There is a nice doji and then a bullish engulfing pattern today. I bought this ETF before the close and have a stop around the 8.50 area. This is not something I will track on the blog, but I thought these charts had several good examples of key components to a good entry. The exit will be the more difficult part but in this case, I would always wait for a move up then a swing low to form at a higher level before moving the stop up. Then at that point it is a game of moving the stop up below support as price moves higher and then use an objective indicator to sell when price gets overbought.

Anyway, I thought this was worth posting and buying. If it doesn't get stopped out, I will probably make a follow up post at some point on this just to show where to move the stop and what indicators I'm following for potential exit signals.

Forex Margin Changes- Will it Force Some Unwinding of the US Dollar Carry Trade?

http://www.forexmicrolot.com/forex-margin-llc.html

http://blogs.fxstreet.com/francesc/category/nfa-new-requirements/


There were recent changes by the CFTC regarding margin requirements on certain Forex pairs. The links above are just a few briefs about when some of the changes are taking place. A few Forex brokers are instituting the changes starting next week, though from the info I've read, it is only required by the following week (Nov 30).

I haven't gathered whether this is just for retail forex brokers or how it affects institutional trading. However, raising margin requirements will require more capital to initiate trades.

I wonder if/how this will affect the carry trade dynamic on the US dollar. It will certainly limit the leverage abilities of a certain portion of that market. Also, from what I read, it will affect already open trades. So that may mean that trades that are already open, may have to be exited or halved to decrease the risk of margin induced liquidation if they haven't done so already.

Now, the more interesting question which I can't answer is why this change is taking place. 200:1 leverage ability in the Forex market has been commonplace for quite some time on the major currency pairs. So why change it now to 100:1? I wonder if in all the data the CFTC has regarding the positions in the market, if they have some reason to believe that a certain part of the market is over-leveraged and/or potentially dangerous in some way. I think it foolish to assume that all action taken by such organizations is for the greater good, however the fact that they are reducing leverage and speculative capacity, makes me wonder why and who is being "protected" and who benefits from the move.

I am not a forex expert. But the movement in the forex market over the last years seems to have behaved how even a novice expects. The Fed instituted Quantitative Easing and the US dollar has fallen steadily and dramatically since. Now the QE was supposed to be basically complete by October. So now that, at least temporarily, some of that dynamic is gone, and here we are seeing a new rule that will almost certainly force some liquidation of speculative positions against the US dollar. Looking at this as a novice I would expect that there may be an impetus for a substantial move up in the dollar just off these changing dynamics.

Thursday, November 19, 2009

A Little More About Gold

Click on Chart to Enlarge

The chart above is a screenshot from Sentimentrader.com showing the last few years of Commitment of Traders data for gold. The top pane is gold prices. The next one down is commercials which tend to be smart money. The 2 panes below that are large and small speculators respectively. We see that the smart money is the most net short on the chart. Also, the speculators have both recently gotten the most net long on the chart. So the dumber traders are buying gold and the smarter traders are selling gold to the most extreme degree.

While gold can continue higher, from an investment standpoint, I think people need to stay away from purchasing now. Getting in the habit of either buying into selling panics (during bear markets) or on substantial pullbacks in bull markets is a much better idea. Also, I have seen reported on the blogosphere that the DSI (daily sentiment index) survey got up to 97% bulls yesterday. Again, when everyone is a bull, who's left to be another bull? It just screams caution on buying gold right now regardless of anyone's view of the long-term picture.

Now with that said.....whenever a commodity or stock breaks out to new all time highs, it has the potential to make major advances. To understand the psychology of it, realize that when an asset is at its highest point ever, there are no buyers who bought at higher levels and now want to sell. So there is no real impetus to sell other than belief that it is overvalued. Also, when short interest starts to rise as price advances, every new high will create pressure on the newly instituted shorts to buy back which adds further buying pressure. I checked the short interest on the GLD ETF and it has been increasing over the last month or so on this break to new highs. Because of that I think gold may have some more room to move up. And also there is really no technical divergence now. When trying to sell into an asset at all time highs, I think it is much better to wait for a major divergence to appear.

So technically gold looks strong but is overbought. From a sentiment perspective, it looks excessively bullish. For anything other than very short term trades, I would just watch and wait before making any trading moves on gold.

Click on Chart to Enlarge

This chart show the ratio of the Gold Bugs Index to gold prices. It has been common at tops to see the gold stocks start to weaken on a relative basis and create a type of divergence as gold prices continue higher. That has been occurring over the last 2 months. So this would also warn that gold prices may be hitting significant highs before a substantial correction.

New SPXU Trade

The channel I highlighted recently on SPY was broken with solid follow through to the downside and the indicator set-up has triggered.

New Trade:

Buy SPXU today with a market order. Place a GTC sell stop at 37.36 immediately after entry. Current price is 39.25 and is the blog entry price. Use standard money management considerations for position sizing.

A Quick Look at The Average "Wave" Up Since March

Click on Chart to Enlarge

The chart above gives a simple view of the average move up in this bull phase since March. Using the simple approach listed on the chart, it would average out to be about 15 days per wave up. Assuming the market makes a new high over the next few days, the current wave up will be 13 days or more which is approaching that average.

An oddity of this move up is that it is the only one since March that has had steadily declining volume throughout. From a textbook perspective this is bearish, but when it comes to real world back-testing that may not actually be that significant. In any case, when a market has an established trend and rhythm, it is worth noting when that rhythm is broken. Whenever this move up does end, the decline afterwards should answer some key questions I have about the larger context of the market.

The chart also notes that stocks have had a tendency to rise into the 3rd week of the month near expiration and then shown the declines in the 2 weeks around the turn of the month. So far that is playing out this month as well.

Click on Chart to Enlarge

On a short term note, the last couple days have created a pennant or triangle formation easily visible on a 15 min chart. These types of formations are typically seen as a next to last wave (4 or b in Elliott wave). While I don't typically read much into real short-term patterns, I do think it is likely that the pennant will resolve to the upside at least briefly. There are some news items tomorrow morning that could create a gap up or early run up, which could be sold to result in a bearish reversal candlestick pattern like an engulfing pattern or shooting star.

I think there is a good chance of a trade entry tomorrow, so for those interested, I would check for a post around mid day and during the last hour if nothing is posted earlier.

Tuesday, November 17, 2009

Still Waiting For Some Weakness

Click on Chart to Enlarge

I would like to see price move below the red uptrend line before getting back in a new bearish trade. At this point I expect another push above the recent high as there has been no classic reversal candlestick and all the sensible ones at this point would involve a gap up or run up to new highs and then reverse.

Click on Chart to Enlarge

This chart is a 60 min chart and shows the indicators I am watching for a new trade. The Parabolic SAR is the dots on the price chart and will show when the parabolic move up is broken. The MACD is showing a bearish divergence and started to cross down today. The MACD combines features of moving averages which are good signals for trading trends with a typical oscillator which is good for trading ranges. With the market still in an uptrend, you need to see a divergence at a minimum to consider a trade, but often waiting for the signal line go below 0 will keep you from getting in too early against a continuing divergence. The bottom pane is the +/- DI from the DMI indicator. This is a trend indicator. Right now it shows weakening trend but still in bullish control because the +DI line is on top.

So a combination of the above indicators - Parabolic SAR sell, MACD signal below zero, -DI cross above +DI, and a broken trendline - should provide a good indicator based sell signal. I will also look for any bearish reversal candlesticks on the daily chart.

Click on Chart to Enlarge

Now I made this chart this weekend, so the last 2 days of data are not there but there has been no change of significance. It shows the XLF:SPY ratio. What has been typical at market tops is for financials to be underperforming. Financials tend to be early to top and turn down and then exhibit outperformance off lows of new uptrends. This chart shows how financials are underperforming on a relative basis to the S&P 500. Because of this, I may shift to looking at financial sector inverse ETF's for trading purposes at points. I have considered this before, but have kept it pretty simple with primarily S&P related funds. But in any coming correction, I think the financials are likely to underperform and give a greater return given similarly weighted ETFs.

Click on Chart to Enlarge

The chart shows the S&P at top, the equity put/call ratio in the middle with 21 and 34 day averages and the NYSE new highs in the lower pane. We are seeing a divergence of sorts in the averages of the put/call ratio as price has been moving higher but the averages have been flat and slightly up for 2 months. I have seen this type of divergence happen at other important inflection points, so it is something to note. Also, on a short-term time frame the OEX put/call ratio was 2.00 today which typically signifies that smart traders see the need to hedge over the short term.

The lower pane shows that the # of new highs has diminished a bit on this leg up where other legs up led to increasing # of stocks making new 52 week highs. This could catch up with further strength, but for now, particularly with the Dow well above the Oct highs, this is also something to note. What this means is that the market is being pushed higher by fewer stocks. Also, the more heavily weighted stocks may be performing better, than stocks as a whole, which is evidenced by equal weighted indexes rather than the standard indexes.

Lastly for this post, there are a handful of time cycles from last week to this week, that would indicate this week being a topping week most likely. This is also in the context of a leg up in the markets that is mature (by both time and price measures) in comparison to historically similarly positioned markets major lows. I plan on going into a bit more on that in an upcoming post.

Monday, November 16, 2009

SPXU Stopped Out


The SPXU trade was stopped out at 38.06 this morning.

The technical indicator set-up is actually improving as this move to new highs has created a bearish divergence on the 60 min charts. On the 60 min chart above the middle frame is the MACD and is clearly not making new highs with price. I will still look to enter a bearish trade if this move rolls over with a good indicator set-up.

I don't think there's a good chance of that today, but maybe in the next couple days.

Saturday, November 14, 2009

Some More Ideas About Long-Term Valuation

I have spent some time this weekend following up on some valuation ideas from a long-term perspective because I know that this is likely to be (or at least should be) an important issue for some when looking at long term investments in IRA's, 401K's, etc.

The links I put in a recent post all approached the question from a perspective of P/E ratios relative to historical levels maybe taking into account another condition as well. Without going into critiques, I think that looking at P/E ratios alone is not adequate, and looking at only a few decades is also not adequate if trying to understand long-term de-leveraging cycles and periods of truly historic market over and undervaluation.

So I spent some time thinking, referencing books, and looking at charts and websites to try to give an easily understandable perspective on some other measures of valuation. A good place to start in getting background on this info is in Conquer the Crash by Robert Prechter which I have mentioned before. It presents a case for deflation and what to do with investments if you agree with the thesis and think that planning for that would be more prudent than (not) planning for the status quo. So whatever your leanings on the issue, the numbers can be evaluated in their own right for decision making purposes.

To start one measure that captures both a valuation and an inferred sentiment in one is looking at historical dividend yields vs market history. The long term average dividend yield on the Dow 30 has been about 3% over the last 100 years which encompasses both a Great Depression, multiple bear markets, and obviously all the bull in between. Just for a quick background on dividend yield.....Stocks have both a value per share and a yield to the extent that they pay dividends. Many stocks don't pay dividends at all and have no yield. But if they don't, then the investor must have rising share prices to make it worthwhile to own stock. If you get dividends, at least you share some profit along the way even if shares don't rise. A high dividend yield shows that the company is paying a large dividend compared to its share value.

Now looking at history dividend yields rise at market bottoms with most bear market bottoms hitting levels of 6-8% (and 15% at the 1930's/depression bottom). Several factors go into this. Stocks decline obviously. But earnings do also. So companies often cut dividends due to decreased earnings. So it's not really that dividends are rising, but that stocks are falling faster than dividends are. Also, the sentiment side of this is that as stocks perform badly for extended periods of time, investors will need a reason to buy stocks and demand higher yields. So basically high dividend yields will be in part a result of pessimism towards stocks. Because of this, the data can be used as a timing indicator of sorts.

So where are we today? This site has nice charts going back quite a while and to recent data to show stock prices relative to dividend yields on the Dow 30. At the lows in March the yield peaked at about 4.5%. Currently, the rise in the market has valuations at about 2.8% which is lower than the long term based off of the info here. So, even at the worst in March yields did not rise to historically bear market bottom levels. Given that the economic conditions are basically worse than all those other bear markets (maybe not the Great Depression but that remains to be seen), I wouldn't be too quick to assume that the March low was "the" low. Certainly making new purchases now doesn't seem to make a lot of sense by this metric.

While some good historical perspective on P/E's can be gleaned from the links I recently posted I will add a bit to that here, building on some data in Conquer the Crash. The long term average P/E ratio is in the mid teens. Historic bear market lows have seen P/E's reach 7 or 8. Prior to the 2000's and beyond, the bull market peaks saw P/E's in the mid 20's. The 2000's saw P/E's rise to the 30's at the peak prices and then the 40's on the way down. One thing Prechter notes are divergences where P/E's fall below prior lows even as prices make higher highs. That suggests sustained pessimism and undervaluation towards stocks despite price moving higher. That has portended the great bull markets. The other end of the spectrum is when the P/E rises to new highs after markets are well below peak values. This shows sustained optimism that stocks are undervalued and investor willingness to overpay for the real earnings. That had never really happened until the 2000 top. But that is what has happened since and in dramatic fashion.

The P/E continued to rise as the market rebounded to lower highs in the early 2000's. Currently despite stocks being 30% off the recent bull market highs, the actual P/E is near 140! So take what you want from that, maybe the earnings will rebound strongly and quickly put that back in line, but again it may be a sign of lingering optimism and sustained overvaluation towards stocks. So by this measure again, we have not seen historically low P/E's reached in this bear market, and the inference may be that we are certainly not witnessing a longer term disdain for stocks and corresponding undervaluation.

There is even more to that discussion in that P/E reporting standards were changed (I believe in 2001) to exclude interest payments on debt from the earnings number. That is called "operating earnings" and gives a lower P/E (due to a higher earnings amount), making it seem more reasonable. So, that may make the valuations of the last decade even more excessive compared to historical standards.

Another way to approach the valuation issue is to look at the relative valuation of the two main investment classes - mortgage backed securities and credit default swaps....I mean Stocks and Bonds. I suppose there are several ways to do this. One may be to compare the dividend yield on stocks versus high quality bonds or government note like the yield of the 10 year note. I haven't been able to find data on that. Another way is to simply divide the S&P 500 by the yield on the 10 year note. That will help to give a relative indication of whether stocks are overvalued compared to bonds. Looking at the current situation the S&P/10 yr yield ratio is nearly 2 standard deviations away from the average for the last year or so. This is not a real long term measure, but argues for intermediate term overvaluation of stocks possibly.

Now one ratio that did get pretty low was the S&P 500 value/book value. It hit around 1.3 in March. I had trouble finding data any longer than back to the early 70's on this. From that data, 1.3 was very low and should expect a major bottom. Currently it is back to around average book value during that period. So this would argue for a longer term bottom possibly. However, I think it is very important to keep a long term time perspective. I don't know that comparing the current environment only back to the 70's is good enough given what I think are greater comparisons to the 1930's environment. I would like to see more on the truly long term numbers particularly those after deflationary periods.

So hopefully this post will give either actionable information or at least start asking the right questions. In sum, these measures are hinting at overvaluation for the current period after a significant but not historically rock bottom valuation level in March 2009.

Thursday, November 12, 2009

Bullish Divergence Still Building on US Dollar Index

Click on Chart to Enlarge

I made this chart earlier today, so it doesn't include today's price on there, but I have indicated it with the thin blue line at 75.68. It has the largest white real body since August. Also it closed right near the highs showing that dollar bulls owned the close. Coming off a low like this, I think it would be very rare to not have some more strength to follow if only for a few day. However, a clear close above $77 especially if it happens in the next few days would be a higher high and potentially reverse the down trend to some degree.

I post a fair amount on the dollar because basically all major investment classes seem to be keying off the dollar and the dollar value is a fundamental issue at play in our struggling economy. Also, anyone who has done a reasonable amount of reading on the issue is likely to be familiar with the term "carry trade" as pertains to currencies and that the US dollar is the carry trade du jour. For those that are not familiar with this term, it means that currency investors are converting/selling the US dollar which has a very low interest rate and buying other currencies that have higher interest rates. That way they are able to profit from the yield difference of the stronger currency minus the weaker. The carry trade is certainly most beneficial to initiate against the weak currency early in a phase of interest rate deductions. However, when interest rates near zero, the potential risk of interest rate hikes start to obviously become a greater risk.

In some ways an immense carry trade against the dollar is akin to a huge amount of short interest in a stock. For those who understand what a short squeeze is in a stock, you may know how explosive price rebounds are in those cases. When a carry trade unwinds in a currency it is similar in that the move in the currency tends to be very explosive. Also, the leverage factor available in currency trading is much larger compared to stocks, and so the effect of say a 5% move in the currency market probably will have several times that % impact on equities.

The point I'm making here is that there is indeed a carry trade against the dollar. At some point, it is likely to be unloaded, and that could lead to declines in the market value of other dollar denominated assets like stocks, oil and commodities, etc as the dollar gains value.

Now the great thing about technical analysis is that you don't really need to know any of that type of thing or have to guess when it will happen. Often the indicators will show glaring signs of a trend that is weakening or slowing. The chart above shows a major divergence in most oscillators. The oscillators are making higher lows on each of the last 2 new price lows. The trend indicators have weakened quite a bit in recent months/weeks, so that they could turn bullish relatively quickly on the USD.

On stocks you can find data like short interest relative to total float, short interest change over a certain time frame, short interest divided by average volume which gives you an approximate # of days to cover the entire short interest, etc. That can help you determine which stocks are heavily shorted and have explosive potential at market turns. Also, with detailed data you can approximate the average price of the entire short interest which can be used as a squeeze trigger point, because if price rises to that point then the total short interest will collectively be at a loss and force a large amount of shares to be bought to cover as price rises further. That can lead to very heavy excess buying demand at times and lead to explosive price moves.

I inquired with Sentimentrader.com about if there was any data accessible as far as quantifying the carry trade on the dollar in hopes of being able to get some more detail about the USD dynamics akin to that described above on stocks. But he didn't really have anything to offer on that, and I don't know what kind of data is available. So right now I would just say, that I think there is the potential to what amounts to a huge short covering rally on the USD.

So that is just a little more background on the rationale for continuing to take bullish trading opportunities on the USD despite that several have been stopped out in recent months. I know it can seem stupid when you've been stopped out several times, but I think persistence will pay off in this case.

TLT Stopped Out and New EUO Trade

The TLT trade was stopped out this afternoon at 92.45 down from 93.26 at entry.

I had considered posting the exit on this one this morning and then immediately get into a new trade on EUO, but decided not to. Hindsight is 20/20.

In any case, the dollar index is putting a nice advance today after a potential failed breakdown yesterday which could be a longer term reversal. So I will take this chance to post a new trade on EUO which is the 2x dollar bull ETF.


New Trade:

Buy EUO today with a market order. Place a GTC sell stop at 17.03 immediately after entry. Current price is 17.43 which will be the blog entry. Follow typical guidelines for position sizing.


As a side note, the UUP fund is not leveraged, so that would be another option to trade this if anyone prefers.

Thoughts on Valuations, Stocks, and the Dollar

http://slopeofhope.com/2009/10/fair-value-of-sp-500.html

http://www.tradersnarrative.com/is-the-stock-market-cheap-after-a-50-rise-3168.html

http://www.tradersnarrative.com/technical-arguments-for-continued-weakness-3151.html


I have never talked a lot about valuation type measures of the markets on the blog. They are not really of value to the shorter term aspect of the trading on the blog. And I am in no way an expert in the area, but I do look at lots of charts and have tried to take in some different perspectives. The links above are a few that I thought I would pass along that regard longer term valuations of stocks relative to earnings.

From my perspective, the main economic issue at hand in our country and around the globe is the issue of debt/credit that has expanded with no accompanying productive output. As simple examples.....there is a difference between debt loaned to me to start a business where I build stuff and employ people and sell the stuff vs. debt loaned to me to buy a house that's already built that then I can't pay back and do nothing remotely productive with the debt. Also another thing to consider is just like any business or household in that there comes a point if you have too much debt that your interest you have to pay on those loans are so high that you can't meet your necessary obligations and then either go bankrupt or have to scale back in major ways.

Our country (government and populace) is awash in that second type of debt from the real estate hangover and financial derivative implosions, coupled with unemployment and corresponding declines in government revenues via taxes. And unfortunately there has not really been any type of accountability in the recognition and removal of that debt as perceived value from the creditors. Banks are now often not evicting and foreclosing against borrowers who haven't paid mortgages in months so that they don't have to account for the diminished value that the property is now worth compared to the original loan value, which obviously is not going to be repaid. So really when you see such extreme behaviors among lenders, there is something still vastly wrong and they all know it.

Because of these types of things going on across the board, my perspective aligns more with the first link above which factors in valuations relative to money supply growth being positive or negative. Because these basically fraudulent practices are still occurring without any enforcement, I think it is unwise to assume the the decline in money supply is done. So based on that article I think that it is reasonable to conclude that stocks are very overvalued in relation to a fundamental backdrop of debt deflation that has not run its course.

The other articles will give some differing perspectives and certainly everyone should try to make sense of it for themselves if considering what to do for a longer term investment horizon.

Now one thing that I doubt most people think a lot about is the value of stocks in relation to the value of the currency in which it is denominated. So it may be great to have a Dow of 100,000 or something, but that would not really mean you are wealthy if the value of our currency dropped to a tenth of what it is now. So what matters for wealth is purchasing power, not number value.

So building on that idea there are a couple ways that I have found helpful to look at valuation rather than just P/E ratios or that type of thing. One way is to look at the ratio of the value of stocks relative to commodities. So dividing the S&P 500 value by the CRB commodity index and looking at that over a long time frame will help to define periods where stocks are overvalued or undervalued relative to consumable "things".

Another way is to look at the value of stocks relative to the value of the dollar. So dividing the S&P by the US Dollar Index will help to recognize periods where stocks are trading at historically high or low levels compared to the dollar's value against other currencies. Currently, stocks are trading relative to the dollar at levels equal with the value in 2000. Stocks got even more expensive relative to the dollar in 2007 and early 2008, but then came way down last year. We aren't back to those highs now, but we're still at levels or beyond which the last 2 bear markets began.

So take what you will from all that, but I think that we are looking at a market that is at worst quite overvalued relative to historical P/E values and money supply change, and at best around fair value. Also, it seems that stocks are overvalued in US dollar terms which would take either a dollar advance, a stock market decline, or both to resolve in some measure.

SPXU Stop Adjustment

Modify the GTC sell stop on the open SPXU trade to 38.06.

That will cut the risk down to about a third of what is was originally. For anyone who really likes to get stops to breakeven early for whatever reason, you could do that now, but I will just use the stop above for blog purposes, to allow it the maximum room to move above yesterday's low.

Wednesday, November 11, 2009

Dojis Today in the Indexes

There are great examples of dojis on the DIA and $COMPQ charts today for those interested. The charts of SPY and IWM are not bad either. For those who want to get more background on what else to look for in a chart to increase the odds that a doji is a reversal, you could use the search feature on the blog page and search for "doji". The Japanese said that the doji represented a market that was tired, in balance, or indecisive. It by no means always leads to a reversal, but it is a classic reversal candlestick, and should give warning.

As a quick recap, here are things to look for......

1) the doji happens at or close to horizontal support/resistance that. This happened today in SPY as the upper shadow moved above the Oct high, but the close was a bit below it. $COMPQ is just below the corresponding highs from Oct.

2) the doji happens after a substantial trending move allowing the market to get tired of that direction. Use past up and downs to gauge this but I would say less than 5 bars is not real significant. Today is 8 up days in a row for SPY.

3) standard oscillators like stochastics or RSI are overbought/oversold. RSI(3) is very overbought right now (around 90) and stochastics is just hitting overbought territory.

4) it is more reliable if the next day closes in the opposite direction of the prior trend

5) reversal candlesticks at the upper or lower bollinger band are at an extreme price and may be more prone to reversal


There are probably some more things we could throw in there, but those are some highlights.

The SPXU trade closed right about the entry level this morning. We got a potential reversal candlestick with the doji, so we may be able to move the stop down if there is downside follow-through tomorrow. But right now, I'm going to keep the stop where it is. I will be quick to move it if there is a sizeable gap down tomorrow or a large down day.

Leave the other trades as is for now.

New SPXU Trade

The futures are up just above the October highs this morning and indicate a gap up in the indexes that will probably put the S&P opening right around those highs at 1100. From my take on the relationships of the sizes of legs up and down over the past year in conjunction with last night's post, I would say a reasonably good chance exists that the S&P will make a top of sorts in the 1100-1107 range which would be about 1% gain from yesterday's close.

As I've mentioned several times before in somewhat similar situations, it doesn't feel right to enter a bearish trade here, but I think that's all the more reason to do it. So I am going to post a trade with a stop here and probably update it later today.

I expect SPXU to open near 38.50 today, and will use that as a rough guide for the position sizing of this trade.


New SPXU trade:

Buy SPXU with a market order today at the open or ASAP. Place a GTC sell stop at 36.50 immediately after entry and use roughly $2/share as your risk amount for position sizing and follow the normal guidelines for position sizing if you need guidance.

If the market does not hold this gap up, and there is a substantial sell off, then I will likely suggest moving the stop closer and increasing the position size before the close today so that the total risk is still the same as it was on the first entry this morning.

Tuesday, November 10, 2009

Pattern Reaching Its Maximum Complexity I Think

Click on Chart to Enlarge

The chart above is the cash S&P 500, SPX. By the way I track "waves" I would say it currently is in the 7th wave of a pattern up since July. I also view the first move up from March to June as a 7 wave pattern. That is typically the maximum amount of waves you will see in any corrective type pattern, particularly if it is trending in one direction. In addition, if the trendlines of the early part of the pattern expand, they will usually contract on the later part. The opposite is true as well.

A primary rule of logic I have learned to apply to these situations is derived simply from price itself, because all possible information, supply, demand, etc that can be known boils down to one thing- the going market price. The direction of the largest and highest velocity price moves, is the direction of the trend. Only when a counter trend move is larger and faster than the most recent move/wave, can you have a high probability that the trend has changed. There are other things that can be taken into account, but simplifying it to this will be helpful to most people.

On that note, the trend remains up in my mind until we see such a price move. However, the risk to reward is skewed toward the downside from my perspective, and has been for the last couple months on both a sentiment and a qualitative pattern recognition level.

For trading purposes right now, my primary time frame for trading has been progressively shifting toward the intermediate (or longer) term time frame rather than only short-term. I will be relying primarily on candlestick patterns in conjunction with short-term technical divergences to try to locate a good spot to take a new bearish trade on the stock indexes. I would expect this opportunity to come by next week, or even in the next couple days.

There are some notes on the chart above, but I am very suspect of any break to new highs on the S&P and expect it to fail pretty quickly if it happens. It would be ideal to see a nice big engulfing pattern or shooting star or something like that to get into a new trade.

Long Term Short Sale Opportunities

Click on Chart to Enlarge

The chart above is EBAY showing its 2001-2005 bull market and then the following decline into 2006. I am putting it here first to use as a classic template so to speak to get the idea of what to look for in a great short sale candidate on a longer term basis.

First notice a multi year bull market. Then after the peak, a sharp decline that clearly breaks the simple trendlines of the bull market lows. After this there is an overlapping advance that is much less explosive than the decline. Often connecting the upper and lower boundaries of this advance will form a wedge pattern called a rising wedge. The total advance often retraces about 50-70% of the decline, or ideally around 62%, and usually does not go back above the broken trendline.

Studying technicals for divergences on new highs in the wedge can often clue you in to a topping area for the advance, as could staying on top of general market sentiment. Looking for false breakouts and technical divergences can offer an early entry point into a short position. However, another great time to go short is after price breaks below the uptrendline of the wedge.

So on a simplistic level you see price go from explosive upward moves with less explosive consolidations/declines to a larger and more explosive decline than any of the bull market. That is followed by a less explosive advance. So you can easily see the shift in price behavior.

Once the lower trendline is broken you can short with a buy stop above the high of the wedge, and hopefully move it down quickly if the stock declines further. Any time price breaks to new lows in the new downtrend, you should move your stop level down above the most recent consolidation. That will simplify the sell process in case you miss selling near the bottom of the decline and price start moving up substantially. However, following weekly charts with oscillators like stochastics and MACD will give you guidance in recognizing oversold conditions as they develop in the stock. Using a trend identifier like Wilder's DMI/ADX system will also help you stay with the trend and recognize when it starts to weaken. Progressive stop movement as price breaks to new lows is a key in protecting gains.

So keep those basic ideas in mind when looking at the current example in the next few charts.

This chart is Sears Holdings, SHLD. It has not broken its uptrend line yet, but may be close.

This is Ventas, VTR which is a real estate stock. It hasn't broken the uptrend yet but is close and is just underneath what I judge to be a major resistance area on the chart.

I love the look of this chart. It is FMC Corp., FMC, which is a chemical company with specialty in agricultural chemicals. It has a very nice looking wedge after a major decline off the highs of a long bull market in this energy related sector. It has not broken the wedge yet either but may be close.

As general guidelines on when to consider selling and what to expect, here are a few...

1) expect price to go below to lowest point of the bottom of the wedge (low of the major decline off the highs

2) use the percent decline from the high to the first major low, to project down from the top of the wedge once complete to get an approximate area for bottoming. So if the stock tops at 100 and decline to 50, that is 50% loss. Then it rallies back to 80 while forming the wedge. Once the wedge is broken, you then take a 50% off of 80 and arrive at 40 for a bottoming area.

3) If the stock has been declining for months and then it accelerates to the downside in near vertical fashion (like a crash) you often are looking at a capitulation into a bottom, so it helps if you can learn to recognize that and sell into it or at the first sign of a reversal. This time may be accompanied by a very large gap down after already falling a large amount. That would be a potential exhaustion gap.

4) The more adept you become at understanding general market sentiment, it will help you in identifying times of extreme general pessimism when you will expect a market bottom. When you recognize these time, move your stop down further, and be alert for the signs of capitulation.

5) Once you get out, particularly for a big gain, don't try to get back in any time soon. What in the past is past, and you should be looking for opportunities on the other side of the market or just waiting and watching.

I haven't ever posted trades on individual stocks on the blog, but in the event that anyone wants to look further at these or other stocks, just leave a comment. Also, I would consider tracking some of these if people have interest, but it's just more work and time for me if there is not much interest, so let me know.

TLT Stop Modification

Follow Up Trade Action:

Modify the GTC sell stop on TLT to 92.45.


That will be just a tick below the low of the hammer reversal candlestick. TLT gapped up today and made a higher high, so my experience with these says it is unlikely to break that low and still be the kind of trade we want to hang around in.

Monday, November 9, 2009

New TLT Trade

Click on Chart to Enlarge

Quick post in favor of time.....

This is a long term bond ETF. Generally moves inverse to stocks. Showed a bullish hammer reversal at support Friday and is holding up today. Buying now offers a good reward to risk and is pretty clearly worth the chance from a charting perspective.

New Trade:

Buy TLT today with a market order. Place a GTC sell stop at 92.00 immediately after entry and use that value for position sizing. Follow money management for trades with stops. 93.26 is the current price and will be the blog entry price.

Non-Confirmations Galore

The Dow Industrials have broken to new highs this morning. However, out of every major index (S&P 500, Russell 2000, Dow Transports, Nasdaq) it is the only one making new highs. While these types of non-confirmations are not magic and the other indexes could catch up, it usually pays to watch whether various indexes are confirming breakouts or breakdowns both on daily and intraday time frames.

The short-term model for the S&P 500 is now solidly in overbought territory. On that note an inverse trade could be taken right now with stops corresponding to the Oct highs in the indexes. However, so far today, the market has been an ideal trend day, and these tend to close near their highs. So unless there is some breakdown of the strength today, I will probably not post a new trade, at least until right near the close.

From a qualitative perspective, I think this move up is likely to complete a complex upward pattern in the S&P and Dow since March (I view this as the 7th wave/leg). But it will take a downward move to retrace this move up in less time than it took to form to confirm that. Short-term technicals are overbought but without divergences, so right now, a little bit of patience should be in order. And then it will be a decision on whether to anticipate a reversal and just get in on this strength or to wait for some type of price confirmation to the downside.

So, anyone planning on participating in the next trade, you may want to check for a post before market close at some point, but I'm not positive there will be a trade today.

Saturday, November 7, 2009

A New Proprietary Indicator


Click on Chart to Enlarge

This post will be the first part of probably 2 or 3 concerning a new indicator that I have come up with. I have closely followed put/call ratios for quite a while and have come up with a few insights here and there which I feel add to or expand the existing ways in which the data is used as a timing indicator. Also, in the past I have worked on developing a multifaceted indicator based off of several observations of the VIX, however, I have never got anything that I felt was quite what I wanted.

Most indicators based off of the VIX or put/call ratios compare VIX to VIX and P/C's to P/C's. So it's apples to apples. My idea with this indicator was to compare the VIX to P/C's. So more like a fruit to fruit comparison. The VIX is used as a contrary indicator, and the equity and total put/call ratios are also used as contrary indicators.

There were several observations regarding the VIX, equity put/call ratio, and total put/call ratio that led to a hypothesis regarding a relation between them that might prove useful. Some of the observations....

-The VIX tends to rise in tandem with market declines and spike at market bottoms

-The equity put/call ratio tends to rise in tandem with market declines and spike at market bottoms

-The total put/call ratio tends to rise in tandem with the market declines but often tends to diverge at market bottoms

-The total put/call ratio factors in a significant portion of "smart money" volume trading on index options, and this group may be diverging from the general trend (and dumb money) as the market gets stretched too far in any direction and hence near inflection points.

-There are ample ways to track whether the VIX is "too high" or "too low" and whether the total put/call ratio is "too high" or "too low", but I have never seen the question asked "Is the VIX too high or too low compared to the put/call ratio?"


Taking some of these ideas into account, I set out to try to answer that question. I decided to use the total put/call ratio in the study rather than the equity put/call ratio, because it seemed to me that conceptually I wanted to see if the fear premium on options was excessive or inadequate relative to the sentiment of the market at large (smart and dumb). My hunch was that while the fear premium (VIX) was hitting an extreme in one direction the smart market participants would actually consistently be taking a contrary position and thus causing the VIX to be too high at market lows (and vice versa) in relation to the total market sentiment as evidenced on the total put/call ratio.

After toying with some different ideas on how to draw this out, I decided to build on a commonly used method for evaluating the VIX which is to compare the closing value of the VIX to its 10 day average. So I calculated that out and also did the same thing for the total put/call ratio. so now I had numbers showing how stretched the VIX and total put/call ratios were from their 10 day averages. Then I subtracted the value calculated for the put/call ratio from the value calculated for the VIX. By doing this, times when the VIX was more stretched from its average than the total put/call ratio was, would lead to positive numbers and vice versa. My hypothesis was that relatively large positive numbers would be correlated with lows in stocks of some degree in that fear premiums had gotten ahead of things. The opposite would be the case for relatively large negative numbers. In other words, I was hoping to be able to identify an efficiency of sorts between two data sets that should be strongly related. Then you could take a position betting on a quick re-balancing of the data.

The chart above shows a 3 day average of the (VIX deviation - TPC deviation) spread in blue. Then there are +/- 1 standard deviation (from the 21 day average of the spread) bands around the data which help to filter out relatively high and low values. I have put a chart of the S&P for the corresponding time frame there as well.

After going through the data, it seems that only taking signals in the direction of a moving average like the 20 day average of price, will help to stay with the larger trend. I have placed arrows indicating approximate buy sell signals from the indicator, but have only put pink lines connecting successive signals in the direction of the 20 day average.

Of note is that price has consistently responded quickly to these signals. Because of this, my next post may look at the data without a moving average, and simply use the raw daily data with some standard deviation bands and then see what happens to price just 1 or 2 days out rather than waiting for an extreme in the opposite direction to exit the trade.

Friday, November 6, 2009

Thinking of Wading Back In

Click on Chart to Enlarge

Some notes are on the chart above. Basically price has retraced this move down to a point where I would expect the advance to stall if new lows are in store below the last week's. Now it would not be surprising at all to see price move back toward the recent lows only to rebound and move back up into this area or a little higher again to form an ABC type move. Anyone who has followed the blog for quite a while may remember some posts regarding the general expectation after an important high....

1) an initial move down to undercut the first support level (from the prior rally)
2) a rebound back to the middle of the the initial move down, often 50% retracement or so
3) often the rebound takes an ABC (up down up) type form

On the chart above the first support (on the S&P) was never undercut. However, several indexes did: Russell, Nasdaq, Dow Transports. So, as long as price doesn't move up much at all from here, the general fit is still good.

The technical indicator set-up for a bearish trade is improving but not glaringly obvious to take the trade yet. One thing of note is that volume has basically fallen every day for the last 5 days on the NYSE as during this advance. I am not a volume guru on these types of things, but I can't see this as supporting the case that there will not be further lows below last week's. Now a major advance type of day early next week could change that in my mind, but right now, I view it as a suspect bounce, and see no reason not to sell into it soon.

I plan on posting some charts of some good longer term short sale candidates, but for now any avid chartists may want to check out GMCR, CTB, FMC, SHLD, VTR for starts.

Thursday, November 5, 2009

High OEX Reading Today

Click on Chart to Enlarge

I had considered recommending a new SPXU trade today, but for a few reasons I didn't. For one thing, I don't see an obvious stop point that is close to current prices. So I would rather see weakness re-emerge and then use the peak of the recent advance as the stop. Also, the candlestick today didn't show any stalling or weakness, closing right at the highs.

On the other hand volume was low which may be a sign that the big money was not convinced that this will last and did not participate. On that note, the OEX put/call ratio looks to be quite high today, which shows the smart traders are taking the precaution of hedging/betting on downside risk from this level. I don't have the exact figure for today, but it looks to be one of the higher readings we've seen recently.

Technically the move up the last few days appears as a rising wedge on the 15 min chart. That is typically a bearish continuation pattern. So until price actually breaks out one way or the other, it is just something of note, but not really actionable. Besides the top of the wedge, there are also the base trendline from the highs as well as horizontal resistance from the 10/29 highs that are potential resistance at this level.

Basically I will be looking to enter a new bearish trade at any time from here, but need to see some better signs of reversal or at least stalling/divergence first.

General Update and Gold Rage

The EUO trade was stopped out (basically breakeven) today during the erratic post FOMC action. I anticipate re-entering this soon, maybe tomorrow.

I also plan on re-entering SPXU soon, most likely tomorrow. The cash S&P showed a shooting star type candle that reversed off the now declining 21 day exp. MA. When these types of candles happen in a trading range, I don't put as much emphasis on them as opposed to at the end of a trending move, but it does offer a nice clear stop point for a new trade entry, so I will probably see what things look like in the morning and then decide whether to enter right away, or see how the early part of the session goes.

I occasionally give updates on gold on this blog, typically noting times of extreme price highs. I take this approach because the sentiment was so uber bullish last year, that it smacked of a major long term top and just wanted to help any would be gold buyers out there steer clear of buy the top ticks of an inflation fearing gold mania. That remains my main emphasis with mentioning gold now, and even more so.

The latest Commitment of Traders data shows that large speculators are by far and away more bullish than any time in years. It is similar but not as extreme with small specs. Both groups tend to be wrong at the extremes. Additionally, the "smart money" commercial hedgers are way more net short, and thus bearish on gold, than any time in years. I know that at times like this, some percentage of people will be convinced of the next best thing, which is gold this time. But like with housing a few years back, when everybody thinks its the next best thing, it probably won't be for very long. In any case, I'd really warn anybody who's thinking about investing in gold or who may have a major investment in it to realize that the real money data like the COT and Rydex fund data, are consistent with very significant highs in gold. It looks like a little mania is ending - not the time you want to invest in it.

Also today showed a gap up on GLD and a doji at the close which could be indicative of some degree of topping. If tomorrow gaps down and falls, it may end up being an Abandoned Baby candlestick pattern which is one of the more rare and more reliable patterns, in this case a topping pattern.

Wednesday, November 4, 2009

SSO Trade Exit

Short-term model for the Nasdaq is quite overbought. S&P not quite there yet, but I may be out later today and unable to post, so I'm going to post the exit now so that everyone could get out around the lunch time prior to the FOMC news at 2:15 pm ET.

Exit the open SSO trade today with a market order ASAP. Current price is 34.40 for almost 4% gain from the blog entry price.

Tuesday, November 3, 2009

Bullish Engulfing on Russell 2000 ETF

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The indexes look to be in a solid short-term bullish set-up here. The Russell 2000 and Nasdaq have both undercut first support on this decline. The S&P and Dow have not. For those that have followed the blog for quite a while may recall prior posts highlighting the break of the first support as a target after an intermediate high. Often that support is undercut and then there is a rally back to the middle of the leg down from the top. On the IWM etf above that would translate to a move back to the 59 area.

The index etf's basically formed doji/harami's yesterday indicating indecision and possible consolidation or reversal ahead. Today, they mainly formed bullish engulfing patterns of yesterday's small real bodies. So short-term I think the odds favor a bounce, which is why I suggested the trade on SSO.

There is as FOMC announcement tomorrow afternoon, so there could be a large market move. Also, recent history would suggest likelihood of a gap up in the morning. I expect to exit the SSO trade tomorrow at some point, and possibly reverse the trade back into SPXU if conditions look good. From an indicator standpoint I think a choppy range would be likely for several days at least. Also, for anyone new, there has been a very consistent tendency for FOMC day strength to be reversed over the following 2-3 sessions, so in the event of a large gain tomorrow, that would be an added historical tendency to support consideration of a new bearish trade. In the event that the market moves down substantially, it will be important to see if any new lows get reversed back into the recent 3 day range quickly before reconsidering a bullish trade.

On an intermediate term basis the basic trend indicators are signaling a new down trend in stocks. Both the DMI and Aaroon indicators show bearish trends in the Russell 2000. Also the Bollinger bands are in the most bearish configuration. They are expanding with multiple recent closes below the bottom band after a horizontal channel and double top price formation. The text book target for the double top would put the IWM etf above down into the 53 to 54 region which is just under next support. So that may be a level to keep an eye on for any shorter term traders.

For what it's worth, I think the price action and pattern on this chart suggest that price is likely to move back to or below the July lows some time this month or early next month. Obviously we'll take it one step at a time, but whenever you see price completely retrace a leg of the prior
trend in less time than it took to form, you are usually looking at a larger trend change.

Also, historical studies I referenced in July and August suggested that after periods of such incredible trend persistency the norm was for them to experience very sharp declines that nearly or completely wiped out all those gains in a short period of time. In the Chinese market we saw it happen a few months back, and on the Russell 2000 chart above we've already seen the last 2 months of gains erased in 2 weeks. There is still some work to be done in that regard on the S&P and Dow, so I still expect further sharp declines, though at least a brief rebound looks likely.