Poker vs Trading

The best article about trading I've come across in a while is actually not about trading. It's about Poker. I am not a Poker player but some of the things mentioned in the latest Economist's article could very well be said about trading. To wit:
"The object is to control the swings of luck with skill, figuring out how to win the maximum with your luckiest hands and lose the minimum with your unluckiest one".
"Over the long run, a player with a head for calculating odds and a feel for the psychology of the game, such as bluffing, will always overcome an untalented opponent."
"The skill is in the betting. And it is apparent in the fact that you can win without the best hand. More than half of all hands end without the cards being shown, not because one player got lucky but because he managed to persuade the others, given their analysis of the available information and the size of the pot, that it was sensible to fold."

It seems Poker also has its share of skill vs luck controversies:

"Online poker sites have reams of game-by-game data. These could, in theory, be used to show what makes some players better than others, and what defines their skill (bluffing? Shrewd betting based on the rapid calculation of odds? Or both?). Through research in this area has been thin on the ground to date, number-crunchers are starting to rise to the challenge......These efforts may produce fascinating results. Or they might reveal nothing much. Even if the data highlight strong trends, it may still not be clear which are caused by skill and which by luck..."

One thought I've had while reading this is that, if we're ready to accept that good Poker players are more than just lucky and that, whatever the nature of their set of skills, they are more skillful than the other players, why is it so controversial (among a certain set of people) to say that good traders (or investors) are skillful and not lucky only.

Abelson bashing continued

It appears I have some competition in the game of Abelson bashing. A letter to the editor from an inspired Barron's reader starts like this:
"In Alan Abelson's soul, it is always 6 a.m. in a one-room apartment with a view of nothing. I can taste the ashes and bitter coffee." and ends like this:
"Abelson isn't a value investor. He is a perma-bear, who will rarely help investors. Unlike stopped clocks, he is never right, but as his calls for recession and apocalypse whine more vociferously, we must remember what he never understands: The market gets less risky as it corrects, and our equity markets and capitalist system though flawed, tend to make us real money over time - especially when Abelson's fear and loathing are in abundance."
I wouldn't be surprised if Abelson himself selected this particular letter out of his weekly stash of hate mail for its poetic qualities.

The following comment might be viewed as simplistic but sometimes simplistic is what is needed to drill down the actual meaning behind an overly complex reality:
"We really need to be plain about this: Companies such as Washington Mutual, which announced a $1.6 billion write-down of home-lending-unit losses Monday, essentially took money placed in passbook savings accounts by hard-working, conservative customers -- many of them retirees -- and shoveled it to low-income, Fantasy Island condo flippers. Bankers paid 2% or less to customers they obviously considered suckers and lent it out at 6%-plus to customers they courted. " More not so simplistic but very illuminating comments are to be found in this article by the always bold Jon Markman.

Interesting article on Jim Simons and his Renaissance Technologies LLC group of hedge funds.
Mr. Simons is otherwise known as "God" among the quant crowd.
The laws of the financial markets present a special challenge, Simons says. Unlike the laws governing physics or chemistry, they tend to change over time. ``One can predict the course of a comet more easily than one can predict the course of Citigroup's stock,'' he says. ``The attractiveness, of course, is that you can make more money successfully predicting a stock than you can a comet.''

Return of the technical

I have noticed in myself a tendency to write about peripheral matters or avoid writing (or thinking) about the market altogether when one of the following three things happen:

1) The market is extremely volatile

2) The market is extremely unpredictable and I feel I have no special insight into what it's going to do next

3) The market is doing the opposite of what I thought it was going to do.

As it happens, all three did occur at one point or another over the last few weeks. I must admit the latest bout of weakness and its vigor took me by surprise and that the eventual rebound (the one that's taking place now) came much later (and at a much lower level) than I expected.

Add to that the fact that I seem to have run out of exciting charts (and my natural laziness) and you have a ready made explanation for my avoidance of technical market analysis. But all things must come to an end and that thankfully includes lack of inspiration so here we go.

The chart above (it is strongly suggested the reader click on the chart to enlarge so as to have the faintest idea what I am talking about) is the most recent daily chart for Microsoft. After its breakout move on 10/26/07, the day after shockingly above-expectations earnings were announced, the stock looked like it was off to the races but it actually came down pretty hard with the rest of the market. However, starting 3 days ago, it did stage a rally that could be the real thing for two reasons:

1) it took place right at the 50-day Simple Moving Average around 32.6

2) and as the 10/26 gap was almost filled (or the window closed in candle-speak).

I could also add the fact that the RSI has formed what looks like a double bottom at around 45, a level that frequently marks the end of a corrective move within a larger bull move.

Granted, volume has been unexceptional at best and that's a cause for concern. Therefore, we would need a decisive close on decent volume above the previous intermediate high (reached on 11/20) above 35 to call with some authority for a resumption of the uptrend.

The end of the world as we know it

You know the market is due for a serious bull move when perma-bears like Barron's Alan Abelson, high from the fumes off the recent selloff, think Armageddon is upon us.
He announces in his most recent weekly oeuvre nothing less than the end of the financial world as we know it. Judge for yourself (emphasis mine):
"Pure and simple, we've had three decades of mostly bull markets fed by cheap and abundantly available credit and an insatiable lust for leverage. That's fast coming to what we suspect will be a crashing end."
"Part and parcel of this epochal change will be a purge of the hedge funds, the private-equity operators, the investment banks driven by a casino mentality, who have served as the hallmarks of this gilded age now teetering toward its close. Their numbers and, more importantly, their profits will be drastically reduced."
Quite a terrifying depiction of a financial end-of-days day of reckoning or Abelson's special wet dream.

Was Michael Jordan only lucky?

Fascinating article by Michael Lewis of Liar's poker fame pointed out by fellow blogger
Contrary Canary. As far as the efficient market/random walk theory, it's important to remember that randomness is in the eye of the beholder, a point Taleb makes repeatedly in his books. If I recall correctly, Taleb gives the example of a pregnant woman. From a stranger's point of view, her baby being a boy or a girl is a random event with probabilities 1/2 and 1/2 for the 2 possible outcomes. From her point of view, thanks to doppler technology, the sex of her child is not random anymore, she knows for certain that her baby will be a boy or a girl.

Apply this to investing/trading: to a hypothetical master trader, the fact that he or she is in the top 1% of traders is not a random event, because he/she (presumably) knows what he/she's doing. From the hapless scholar's (let's call him Mr. Fama) point of view, that particular trader is just lucky, he or she just happens to be part of the surviving 1% of the initial sample of traders. So as far as Mr. Fama is concerned, whether a particular trader beats the market or not is a random event and has nothing to do with that trader's abilities. Should Mr. Fama sit down with the trader, understand the trader's methodology and test that methodology (provided Mr. Fama has the intellectual curiosity, flexibility and capability to do so and provided the trading methodology is conducive to modelling) against a throw-the-darts methodology, he would discover that the trader's performance is indeed superior and that has nothing to do (or at least not much to do) with luck or survivorship.

I mean, just think about it for a second, has anyone anywhere ever accused Michael Jordan of being "just lucky" or theorized that the only reason he was such a great basketball player is that out of a starting sample of say 10 million basketball players, he was the only one lucky enough to survive all the tests, obstacles and competitions he faced? Obviously, luck had a hand in his success but how important was it compared to his talent, his work ethic and his competitiveness?

The unknown knowns

I have a couple of thoughts on the "black swan theory" and Taleb's thesis in general.
Doesn't it simply boil down to a belief in miracles? And isn't it a step backward? Once upon a time, most people did believe in miracles, i.e. very low probability events. A scientific revolution and more than a hundred years later, most people have stopped believing in miracles and are much more rational and sceptical. But on balance, I would say that people still believe in miracles more than they should and more education, more knowledge are needed to make us more realistic, less prone to irrational hopes and magical thinking. Here comes Taleb who would like humanity to go back to the Dark Ages and start believing in miracles again. Isn't a black swan just a fancy new name for what people used to call miracles?

My second (disorganized) thought is less a criticism of Taleb's thesis and more an avenue for further musings. Taleb likes to talk about the known unknowns and the unknown unknowns, the latter being basically the so-called black swans. How about the unknown knowns, in other words, the thinks we don't even know we know? I would think that those unknown knowns are the same thing as intuition or instinct. I guess a book such as Blink by Malcom Gladwell did cover just that.

The two-headed monster

As I was telling a technician friend lately, the market is a two-headed beast these days.

On the one hand you have financials, represented in the first chart by XLF, the financial ETF (it's actually the chart of the ratio XLF/SPY), which are in the middle of what could be an epic bear market. On the other hand, you have the technology sector, represented in the second chart by QQQQ, the Nasdaq 100 ETF (again it's the ratio QQQQ/SPY) undergoing a no less impressive bull explosion.

It appears that a good trade would be long QQQQ, short XLF, a gift that could keep on giving for quite a long time as these secular trend changes tend to last.

As far as the market in general (as represented by SPY), given the tug of war going on, it is much harder to trade.

First Principles

Technical Analysis of Stock Trends by Edwards and Magee is as close to the sacred book of technical analysis as it gets. In it, one can find such gems as:

1. The market value of a security is determined solely by the interaction of supply and demand.
2. Supply and demand are governed at any given moment by many hundreds of factors, some rational and some irrational. Information, opinions, moods, guesses (shrewd or otherwise) as to the future combine with blind necessities in this equation. No ordinary man can hope to grasp and weigh them all, but the market does this automatically.
3. Disregarding minor fluctuations, prices move in trends that persist for an appreciable length of time.
4. Changes in trend, which represent an important shift in the balance between supply and demand, however caused, are detectable sooner or later in the action of the market itself.

Rapid Cycling

Trading has not exactly been an easy ride lately as the market is trying to find some sort of a bottom to its latest bout of weakness. The market is going through one of those bipolar phases when it can't decide if bad news (and there are plenty of them) is good news (the Fed will keep cutting rates) or if it is so bad it can't possibly be good no matter what (a recession will be impossible to avoid). In psychobabble, what we have these days is not only bipolar disorder (formerly known as manic depression) but rapid cycling bipolar disorder.

Yesterday was a case in point. The morning news was uniformly disastrous, even by current standards. Merrill Lynch announced results that were even worse than the worst case scenarios and this despite the fact that the investment bank had done its best to prepare everyone for the worst. Housing data also came in worst than expected, a tour de force considering that it is now generally accepted that the housing situation will get a lot worse before it gets better. And finally, to add insult to injury, one of the rare sectors that had been reporting good earnings, the Internet sector, saw one of its illustrious members (Amazon) disappoint. All this added up to a relentless swoon that took the Dow down 200 points.

And then, after an obligatory test of the key 13,500 level, the Dow retraced the entire 200 points, egged on by rumors that the Fed would pull yet another trick from its hat and cut its discount rate a few days before it cuts its Fed Funds rate. And so the future is shaping up as a fierce battle between the Fed and the recession monster. The market will be counting points and reacting accordingly. No end in sight to the rapid cycling.

Kurtosis

The Black Swan is making me want to know as much as possible about statistics so I've been reading the statistics volume in the CFA1 reading material (not that I ever intend to take the CFA exam....actually I'm signed up for the December exam but will not take it for I am not and will not be ready....it's the accounting part that made me give up).
From what I understand, kurtosis is the statistical measure that tells us if a distribution is more or less peaked than a normal distribution. A leptokurtic distribution is more peaked than normal which I take to mean that it is fat-tailed. The normal distribution is a better approximation for U.S. equity returns for annual holding periods than for monthly returns which have very large excess kurtosis and are thus leptokurtic. My questions are: 1) Isn't the reason annual returns appear mesokurtic (normal-like) is that there isn't enough data to analyse? If we had 1,000 years of market data, wouldn't the distribution of annual returns turn out to be leptokurtic after all with many years of extreme returns? 2) Has anyone computed the kurtosis of daily, hourly, minutely, etc... returns? Does the distribution get more leptokurtic as we reduce the interval? If that's the case, it would explain why it is easier to make money trading off a 30-minute chart than off a daily chart, wouldn't it? More extreme/unexpected moves mean more trading opportunities. It would also mean that all the financial theories (which are based on the assumption that returns follow some sort of normal distribution) do not apply when we look at small intervals.

Free market OR free investors?

Isn't it interesting that the main champions of free-market thinking are also the ones who promote theories that have as their main underlying assumption the rational investor?
A rational investor is a predictable investor (very useful for modelling). A predictable investor, by definition, is not a free investor since freedom means freedom to invest in an irrational, self-destructive way. As behavioral finance has shown time and again, most investors do behave in a non-optimal way most of the time.
One must wonder how accurate a model assuming lack of freedom in investors can be at predicting future investor behavior in a free market.
You can't have it both ways: a free market with captive, predictable investors. Either the market AND the investors are free or they're not.

Truly fascinating article on Niederhoffer on the New Yorker's website. It seems like he blew up yet again. Fatal flaw? Greek tragedy? It seems Nassim Taleb was right when he specifically predicted this would happen as Niederhoffer is constitutionally incapable of comprehending the concept of Black Swan. He's basically picking up nickels in front of a steam roller.

Bonkers

Reading Alan Abelson's rantings and ravings about how the market is bonkers etc..., it occurred to me that he (among many others) is falling prey to a very common fallacy: he is confusing the stock market with the economy, the same way others are confusing a stock with the underlying company. He is in his role saying there is a disconnect between the level or the direction of the stock market and his appraisal of the current state of the economy if it's his opinion. But he is totally missing the point when he derives from that opinion that the stock market is wrong.
The stock market is never right or wrong, it just is. Sometimes it discounts things, sometimes it's late factoring things in and sometimes it's adjusting right along the perceived economic realities. Add to that the fact that those perceived economic realities turn out to be wrong most of the time and you have a situation where judging the market's sanity by comparing it to where we think the economy is heading is pure madness. And doing it every week on the first page of Barron's, week in week out is bonkers.
Having said that, I very much appreciate Abelson's wit, style, cynicism and refreshingly outside the box thinking.

Ebullient bullion continued

As a quick update to a previous entry concerning GLD, the gold ETF, once the 68 resistance was taken out it was only a matter of time before the all-time high at 72.26 was history too. Point and Figure charting is saying: stay all in, even better things are on the way.
On a totally different note, wasn't neat how the employment numbers came in weak a month ago perfectly on cue for the Fed to justify its electrifying 50 bp rate cut but then, wait, we learn today that it was all a big mistake, the numbers were actually just fine and the ones this month are great. Does that mean the Fed is going to take back its easing action? A 50 bp rate hike at the next meeting? More seriously, the Fed can now build a good case for leaving rates unchanged and not get too much grief from the market shrills.
On yet another subject, I'm reading The Black Swan, Taleb's second oeuvre and as expected it is teaming with ideas. As in:
we tend to underestimate the likelihood of black swans before they happen and overestimate that likelihood after they happen. More on this later.

Peter Boockvar, equity market strategist at Miller Tabak says:
"The market won't go down until it disabuses itself of the notion that the Fed can do anything."
But he also cautions against the possibility that "we're rallying ourselves out of a rate cut".
Well, what if the economy were OK all along and the 50 bp cut were all gravy, a pure gift to the market. Another cut or not would not matter much in that case except to the market's slope of ascent.

A boating analogy

Andrew Lo, a professor at MIT, is that rare individual who is, at the same time, a big time trader, a technical analyst and a top academic researcher. Pretty much anything he says about the financial markets is of value but I have singled out this little gem from a NYT article:
“Now that we have so many boats in the harbor, you can’t whiz by at 50 knots without rocking a few boats. In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption.”
You can guess what he is talking about, namely what happens when too many hedge funds using the same strategy panic and/or need to get out of their positions all at once.

If we must stay with the boating analogy and I am by no means a boating expert, I would say the solution to this problem would be to either leave the crowded harbor and find a new, isolated part of the wide ocean (i.e. find a new strategy out of the infinite universe of profitable trading strategies, no limit there but the human imagination) or lower your speed big time and be very very mindful of what the other boats are doing (de-leverage and improve your risk management). Both solutions can be implemented in parallel. However, finding a new winning strategy requires creative thinking, even contrarian thinking, something big institutionalized funds will have trouble with, leaving opportunities to new (or not so new but reinvigorated by the new found volatility), smaller and more nimble operators.

GOOG update (2)

Decisive.

GOOG update: up and running?

In a previous entry titled GOOG trouble written the day after Google's somewhat stunning earnings miss on July 20th, I had noted that the ratio GOOG divided by SPY (in other words Google relative to the S&P 500) always seemed to stall at a certain value (incidentally around 3.5).

Well, it appears that resistance was overcome today as you can see in the first chart.

Obviously, this level must hold in the next few days for it to be meaningful but should it hold, I believe GOOG will make new highs between now and the next earnings report. It would also be positive for the market as a whole, Google being a market leader and all. Now, if this scenario plays out as scripted, I would suggest getting rid of all longs or hedging a big portion of them....before earnings. Just in case. Once bitten, twice shy.

On a different note, I've been reading Greenspan's book and I must say I'm pleasantly surprised. I expected bland, close to the vest Fed speak. What I got so far (I'm half-way through) is introspective, penetrating analysis in eminently readable English. A few annoying self-congratulations here and there but hey, he's Alan Greenspan.

Since we're at it, here's another point and figure chart. This one is the chart for USO, the oil ETF. It too just gave a buy signal topping 60. As you can see there is much room to run before we even get close to the all-time high at 74.6. I'd say 65 would make as good an initial target/resistance as any.

Some traders dislike USO because it underperforms the price of oil and is therefore a poor proxy. It very likely has a design flaw as shown by the fact that oil is indeed making new all-time highs while USO isn't. Having said that, if we forget for a moment that USO is related to the price of oil and analyze it as we would any other stock, the fact remains that it is a good long.

Ebullient bullion

It's not often that I post a point and figure chart but passing this one up would be akin to criminal negligence.
Depicted here is the chart for GLD, the gold ETF.
As you can see, it has, after failing many times, overtaken its resistance at 68. Now don't forget that in point and figure charting, closing prices don't matter, only highs and lows do. So all that matters is that GLD traded above 69 today even if it closes below 69 (which looks like it will, as of this writing).
That is a very bullish development and gives very good odds that GLD will soon make new highs above 72.26.
Gold is said to go up when inflation threatens. With all the market turmoil, central banks around the world have to either stop raising rates or lower them, and this despite the fact that inflation measures are still in overheating mode. No wonder GLD is feeling the heat. It could be melting up soon. Keep an eye on it.

A journey into Bernanke's thinking

First, a disclaimer: I confess to total ignorance when it comes to Mr. Bernanke's thinking; what follows is pure speculation. Now that's out of the way, let me give it a try. Here goes:

The way I understand it, the most important thing for Bernanke is not inflation but the health of the economy. Put another way, fighting inflation is the Fed's number one priority, as long as the economy is healthy. The key to a healthy economy is, has been for many years and will continue to be the consumer and more precisely the consumer's sense of his or her personal wealth. That particular sense has been somewhat damaged by the fact that house prices stopped going up then started coming down in what appears to be a slow motion train wreck type of action. Now, if the stock market also crashes durably, then the consumer will very likely cut down on consumption and tank the economy. That could happen even if the stock market does not go down and stay down. But it is sure to happen if we enter a prolonged bear market. Most people have a large percentage of their wealth locked in their home and a large percentage of their savings and pension plans in stocks. It figures that if both house values and the stock market go down in unison, consumption will have to take a backseat.

Therefore, one thing Bernanke cannot let happen at this point would be a severe and durable stock market dislocation. He will use "all the tools at his disposal" to prevent just such an event.
Any notion that the Fed is not watching the stock market these days would seem to be very naive. I believe they are watching very closely and are ready to intervene, as they have on August 17th. (By the way, I also happen to believe they leaked their coming rate cut at around noon and major support the day before August 16th, which brought the market back from the brink of disaster, but then again I also tend to believe most conspiracy theories.)

However, preventing a market crash is not the same thing as engineering a rally. The market could stay within a large range where we don't make new lows because of the Fed's actions (or perceived actions) but we don't make new highs because every time we're about to, people come to their senses and send the market back down.

Just my take on things.

The big question

Isn't the first chart a thing of beauty (click to enlarge)? We'll get to that in a moment.

First, the big question:
Is the current rally corrective and once it is over, we're headed back down OR

the "meltdown" was corrective, it is now over and we're slowly but surely going up again with new highs down the road?

Obviously, nobody knows at this point. Anybody who forcefully declares one way or the other is nothing but a blowhard. But it always helps to establish some sort of "zone of no return" beyond which the question becomes moot. It goes without saying that a point of no return would be if the Dow makes new all-time highs above 14,000 (or conversely new intermediate lows below 12,500). But even before that, Fibonacci aficionados would tell you that if a move is retraced more than 76.4%, than it is very likely not corrective. As you can see on the second chart above (click to enlarge), that would give us a Dow level of 13,670 which is very close to the level (13,695) reached on 8/8 right before the nasty last part of the "meltdown" episode and above which we break the pattern of lower lows and lower highs characteristic of a downtrend.

So to sum it and round it up, if the Dow Jones Industrial Average breaks above 13,700 decisively (on a daily close basis and on above average volume, say), then we could safely (as much as anything can be safe in this field) assume that the previous downtrend was just a correction, the long-term uptrend has resumed and that we will be above 14,000 before long.

One ETF/market for which the big question has been resoundingly answered, as you can see in the first chart, is FXI ,the ETF for the Chinese stock market. A new all-time high was established on Friday .....and it's off to the races, giving the lie to any silly talk of bear market.

I couldn't resist mentioning this informational gem, courtesy of Robert L. Rodriguez, CFA.
It appears that, while investors, regulators and analysts have been (sheepishly) relying on credit ratings, the very credit agencies issuing these ratings have not had the utmost confidence in them. Case in point: every S&P credit rating report had the following disclaimer:
"Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision."

Will this (lame) disclaimer get them off the hook as the main sacrificial lamb in the current disaster? I think not.

The same source points out that Warren Buffet, in Berkshire Hathaway's latest annual report, wrote, in what could become a classic Wall Street saying:

"Be fearful when others are greedy, and be greedy when others are fearful."
Amen to that.

And now, for a change, a non-technical (read fundamental) entry

According to a Societe Generale research note, "financial shocks that occurred alongside strong corporate profitability [which is presumably the case now] were ultimately worked out without any major spillover effects into the real economy".
"The recent market turbulence is a confidence problem, not a fundamental problem. The distinction is important for the Fed and the markets. The economy is not yet in a position where companies need to restructure. Profit margins are strong and will encourage companies to invest and hire. Tighter credit is a modest negative for growth and will impair some businesses, but most generate sufficient cash flow to finance their investment plans.
The ultimate impact on the economy depends on how quickly the financial crisis is resolved. The key for the Fed is restoring confidence."
"If the Fed is ultimately pushed to cut rates, they would take on the risk that inflation runs away from them, a-la-1998. This could require a quick reversal once the situation is normalized."

I think the key here is "how quickly the financial crisis is resolved".
As bleak as the situation looked mid-day Thursday, look how fast things turned around. And for all the pronouncements that the Big Bear Market is upon us, who's to say that, come September, business as usual slowly starts taking over and this crazy summer becomes just a bad memory.
I am not saying that's what's in store for the market and I don't see it in the charts yet, but should it come to pass, the situation would fit right in with the analysis above.

Intuition still relevant in trading after all

As if any sane person (quants and stats arbitrageurs not included) ever doubted it, intuition does after all have its place among the tools traders can use to make money and more importantly to avoid catastrophic losses. This just in from Dow Jones News:

"Perhaps this is time to adopt a more qualitative approach," Citigroup says in a note titled "Quants Turn Toxic." Firm says "Maybe good old-fashioned human intuition does have something to add in the portfolio construction process." In putting together a simple hedge fund model to assess the current quant predicament, Citi sees things as more a hedge-fund problem than quant issue. Its analysis "emphasizes the vulnerability of hedge funds to the vicious circle of redemptions and margin calls. This can create significant dislocations in markets, as they are forced to precipitously reduce positions."

On a more general note, maybe the blogosphere was a bit unfair to Jim Cramer. For all the total craziness of his "meltdown" two weeks ago ("It's Armageddon out there", "They have no idea", "Call someone", "Bill Poole is shameful, he is shameful", etc....), he wasn't so far off the mark. Two weeks later, the Fed does get the idea that it's just maybe time to do something to avert Armageddon.
Now, will they succeed or are they too late, that's another question, to be answered on your quote monitors over the next few weeks.

It looks like, contrary to what I alluded to in my previous post, the VIX will not break its previous high of 45 reached in 1998 (taking into account the fact that the VIX as we know it did not exist during the 1987 crash when it would have fetched something north of 150). But we did get mighty close. And it's not over....yet. The weekly RSI is not anywhere near giving an all-clear signal. It's still in extreme overbought territory.

This Bloomberg article in the form of a letter from the Hedge Fund guy is an absolute must-read for anyone who wants to have an in-depth understanding of everything that's been going on in the financial markets of late. Peerless.
Excerpt 1: "Currently, all of the portfolios we manage are undergoing a rigorous screening known as ``crossing our fingers and praying that we don't have to try and find a bid in the market.'' This is supplemented by a cross-market statistical analysis originally developed by the U.S. military called ``don't ask, don't tell.'' This ``unmarking-to-unmarket'' procedure has been the benchmark for the hedge-fund industry for the past, ooh, 72 hours."
Excerpt 2: "We are pleased to report that, contrary to what current market prices might suggest, all of our top-rated securities remain absolutely AAA. Provided, that is, the future performance of the underlying collateral is identical to its history. Otherwise, the rating companies say our investments are likely to be reclassified as ``toast.'' "

How high can the VIX go?

(Click to enlarge)

This is the weekly chart of the VIX (the CBOE Volatility Index) dating back to its inception in 1990. It's interesting to note that the 14-day RSI is as high as it's ever been in the past 17 years. It's currently at 75.24, higher than during the 2 previous credit crunch-type situations in 1997 and 1998, higher than in September 2001, higher than during the summer 0f 2002 when it became clear the war in Iraq was inevitable.
How high did the VIX go on those occasions? 38 in 1997, 45 in 1998, 43 in 2001 and 44 in 2002.
Where are we now? Above 26, as high as we've been since these current "troubles" started.
I think there's a very real chance we revisit those dizzying heights of old. And once there, what's to stop the VIX from making history? Its RSI is already in uncharted territory after all.
No matter what happens, though, and if history is any guide (and if it weren't, there would be no technical analysis), a major buying opportunity will present itself when the RSI turns back down and crosses back below 70.

S C A R I E R ?

Last week I had an entry titled S C A R Y, thus this entry's title. None too original.

But instead of adding to the generalized bearishness out there following an all-around horrendous Friday meltdown (and I'm not talking about Cramer's), I will just point out the fact, lost amidst all the fear and loathing, that two things did NOT happen yesterday:

1) The VIX did NOT make a new high, and

2) the Dow did NOT make a new low

as can be seen in the two daily charts above (click to enlarge).

I could have shown myriads of nightmarish-looking charts but those are easy to find anywhere in the financial blogosphere. Tim Knight's blog, for example, is full of them. Instead, I chose to show you the two rare ones that do NOT depict an all but certain death of a bull.

I thought this very interesting, courtesy of Thomas Ingoglia, paraphrasing noted technician Gary Anderson:

"A market bottom usually has the weakest bouncing the hardest." "However AFTER THE BOTTOM, relatively strong stocks need to be strong. when we get stronger stocks getting weaker while weaker stocks are getting stronger, traders are being defensive and unsure of themselves. It is a much better sign when traders are putting all their money in leaders that have already made runs. It says that they feel the market is strong and safe"

Barron's Alan Abelson sums it all up:
"this was one dead cat that couldn't bounce"

Having said that, a gloating Alan Abelson is probably a bullish sign, an indicator that, at the very least, a bottom might not be too far, timing-wise. The only problem of course is that, level-wise, it could be hundreds of Dow points lower!

S C A R Y !

This has probably been the scariest week I've had in the market in a very long time. Buying was scary, selling was terrifying and just looking was frightening. SPY, the S&P 500 ETF, (weekly chart shown above) must have had its ugliest week ever. I mean, look at that monster 10-point wide body that basically opened at the high and closed at the low. And the volume! Off off the chart.

Is it overdone? Probably. Is it over? Probably not. We are however right on a rising support line starting from the July 2006 low. We're also bumping against the 40-week simple moving average. The 14-day RSI is at around the level that stopped previous corrections.

It's interesting to note that each correction since last summer has gotten shorter. Last summer's correction took about 2 months. Last February's correction took about 2-3 weeks. Could this "correction" (I have trouble calling this monster a correction, especially since this could turn out to be the first salvo of a much more protracted bear move) last 1 week? It better start reversing fast, then or else.

Technical Analysis useful after all

Here's an academically correct paper, The Predictive Power of "Head and Shoulders" Price Patterns in the US Stock Market by three researchers at the University of Iowa's department of finance that shows beyond the shadow of a statistical doubt that the Head and Shoulder pattern has an "economically significant predictive value for stock market returns".

A lot of advanced statistical mathematics in there but if there is one sentence I take away from this paper, it is this one:
"The evidence is consistent with the use of technical price patterns as a guide to trading decisions".

GOOG trouble

The first chart, as you might have guessed is the disaster du jour, Google, down 5% on an earnings miss. Since Google does not provide any guidance, the lucky analysts who follow the phenom company have to actually do some research and come up with an estimate. Collectively, they have not done a brilliant job this quarter, but hey, that's the way it should be. It certainly is an improvement over the "beat the number" game that some companies still play wherein meaningless, manufactured earnings beat the guidance (fed whole to the analysts) by one penny....every quarter.

But I digress. There's not much to say about the first chart, technically, except that the fall was seemingly held in check (no way to know for how long) by the 50-day moving average which is around 510 these days. Much more intriguing is the second chart, the relative chart of Google to the S&P 500 (it's GOOG divided by SPY to be precise) and it's interesting to note that, for the third time, resistance at 3.6 (the number does not really matter, I'm mentioning it for reference) came into play. Could it be that resistance levels do mean something in relative strength charts or is it pure coincidence? You decide.

Abelson's had enough?

Am I the only one to detect a slight tinge of frustration and sourness in Alan Abelson's weekly Barron's entry? A 300-point Dow explosion over a week will do that to any self-respecting permabear and god knows Mr. Abelson is one very prominent and permanent member of the ursine species.
I quote: "We can't say {Note from blog's author: he's a sucker for that imperial "we"} when the irrepressible urge of investors to buy will dissipate, whether it'll happen overnight or over time or what precisely will cause it to do so. All we can say confidently is that it'll happen, and we're not talking about the hereafter."
I even sense some discouragement there but I might be reading too much into it.

Rocket to the moon spotted

This is one major way hedge fund have changed the market landscape. Because they do get massively short from time to time, when a key resistance level is broken, especially one that has held for a long time, panic short-covering and then panic buying outright result in the upward explosion shown above in the daily chart of the Dow Jones Industrial.

We've been stuck in the 13,200-13,700 range for the past 2 months, a very long time in the market, ample time to add frustration to indecision to fear, ample time to get short huge, by way of index put options, inverse ETFs, VIX calls, and other fancy new shorting vehicles that hedge funds can't get enough of. The combined amount of short positions in the market as of this morning had reached all-time records. And when 13,700 was decisively broken out of, and even though the market was already up more than 100 points, a decent up day morphed into a panic buying day that propelled the Dow up almost 300 points.

This kind of market action used to happen on the downside when key supports were broken. The fact is that up and down action are becoming more and more indistinguishable because of all the new inverse products. It used to be that stocks went down much faster than they went up. A day like today forces us to revise that piece of outdated market wisdom.

Survival of the fittest trader?

I've been reading a classic of popular science, Richard Dawkins' The Selfish Gene and since I can't read anything without my trading-tinted glasses, this two sentences leapt at me:

"...group extinction is a slow process compared with the rapid cut and thrust of individual competition. Even while the group is going slowly and inexorably downhill, selfish individuals prosper in the short term at the expense of altruists."

This strikes me as particularly applicable to bubbles in general. "The group" (to which we could substitute "the market") knows the bubble will burst eventually but many "selfish individuals" (read "smart traders") benefit from it in the short term at the expense of "altruists" (read "suckers" or "public investors"), so nothing is done and the bubble does burst.

A stealth watershed?

One can't help being suspicious of seemingly momentous decisions announced in the doldrums of summer. For example, the SEC has decided that, as of today, July 6th 2007, the uptick rule does not apply anymore. Now, for anyone who has daytraded stocks and/or wanted to get short a stock while it was going down as opposed to before (for the prescient genius) or after (for the clueless), that is a major announcement. Whether this decision results in a generalized meltdown of small stocks the next time down and whether the date July 6th, 2007 will go down in history, only time will tell.

On a totally unrelated note, this is the site for the circuit-breaker levels for Q3 2007. 1350 DJIA points seem to be the key number.

A TLT update

Time for an update on TLT, the bond ETF. For reference, my two most recent previous entries on TLT are here and here. Shown above is the daily chart (click to enlarge).
I believe the upward corrective move (which turned out to be a fairly deep zigzag that filled the gap created on 6/7) to be over. We did get pretty close to the 50-day moving average before TLT got turned back. The 14-day RSI got up to 55 and is now turning down, a behavior consistent with my theory that TLT has entered a bear market (generally, in a bear market, the RSI range get lowered from 30-70 to 10...20-50...60).
The correction having run from 82.20 to 85.37, I would expect TLT to make a new low and reach 79 at the minimum.
This scenario would be nullified should TLT make a new intermediate high above 86.

Light review

Very good analogy between the weather and the stock market as regards the VIX on Adam's daily option report blog.

Beautiful chart with great titles (the push....the range) on Tim Knight's the slope of hope blog showing very clearly the box the S&P 500 has been trapped in for the past couple of months.

A fine piece of investigative journalism on the subject of the condo craze in the US coastal areas and how the game is up on the Running of the Bulls blog.

A fascinating detailed look at a trader's emotional response to good and bad trades (not necessarily the logical ones one might expect) and an unveiling of a few of the many biases that alter our processing of emotions on the Traderfeed blog.

The silence of the lambs?

Two reasons for my week-long silence: lack of inspiration and confusion about this market. Or is that one reason only?

I had pinned down 149 as key support for SPY and 149 was broken on 6/26. But in a typical twist, it was broken after the close during the 4-4:15 SPY trading window. The following day, SPY proceeded to open at 148.29 and rally from there above 149 therefore negating the sell signal. So basically, we're back to square one, trapped in that 2-month long 149-154 range.

The weekly chart above is showing SMH, the semi-conductors ETF. Many bloggers have pointed out the strength (relative and absolute) of that particular sector. I wanted to show how close SMH was to breaking out of a 5-year old downtrend represented by a pale blue line on the chart. I would say that breaking the 40 level and staying above it for more than a few days would qualify.

Where are we, market-wise?

This is the 30-minute bar chart of SPY (the S&P 500 ETF) since 5/2 (click to enlarge).

So basically, for all the gyrations of the past few weeks, we're pretty much where we were almost 2 months ago. The market has been trapped in a 149-154 range.

The orange line is the 20-day simple moving average, a very useful measure of the intermediate-term trend. It has started, for the past 2 days, to turn down which is a fairly bearish sign (again on an intermediate-term basis, not a long-term basis).

The 149 support level is therefore all the more important. If it breaks, the fall will be nasty and quick and I don't see it stopping before the 200-day moving average at around 143.

Great read on the Toro's Running of the Bulls blog on "sub(merging) prime". Get ready for some real fireworks this time. Apparently, the ratings agencies are the ones who will emerge as the real villains in this whole mess. They have been using Monte Carlo simulations to rate those toxic CDOs and as any reader of Nassim Taleb will tell you, Monte Carlo lulls you into forgetting the possibility of a Black Swan-type of event.

And I thought lower rates meant a higher stock market!



Every day the market has been down the past 2 weeks, we were told it was because rates were going up. There goes that theory. Today, 10 year rates went down 25 basis points while the Dow went down 185 points. As most so-called expert explanations in the media, this one is not worth much. Same with the dubious relationship between oil price and stocks or dollar and stocks. You can make the case (as I do sometimes) that, over the long term, such relationships/correlations do exist but not day to day.
On the other hand, one very significant relationship today was the fact that Google went up 2% with a market down 1.3%. Google closed at a new all-time high and I would expect it, after this mighty show of force, to keep going up. I will be posting an update on GOOG in absolute as well as relative terms shortly.

The trading person's contrarian

Tim Knight, founder of Prophet.net, a very serious trader and the author of one of the best trading blogs out there, is of a bearish bent most of the time. He has therefore been used (with some success I must say) as a contrarian indicator by a few wily traders. Two weeks ago, for example, after the market rolled over following the lead of treasury bonds, he was jumping up and down bearish and utilizing his sentiment as a contrarian indicator paid off. Now the situation is very different. Yesterday's action was, to say the least, very preoccupying for the bulls. They're all afraid to even think about it let alone utter it, but the expression "double-top" is on their mind. Yet Tim, as his entry yesterday indicates, is only "cautiously bearish" and his sentiment is imbued with new found humility and all sorts of caveats.
That, my friends, is problematic for the Tim contrarians out there. Is it time to be the contrarian's contrarian?
Market action today and tomorrow should go a long way in answering this question.

J.C. Penney in trouble?


This is the daily chart for J.C. Penney (click to enlarge).
This could be a head and shoulder pattern in the making in which case an initial target would be something around 65. This chart does have many bearish things going for it (or against it if you're bullish-minded). A solid support at 75 was broken, the 200-day moving average (which often acts as support, as it did in mid-May) was broken decisively and both the 20-day and the 50-day moving averages are trending down.
I would advise caution though (as in: don't go and short 10,000 shares right this second). The 200-day has not started to turn down yet, the RSI is at potential snap back level and the 75 support is still within reach. So there could be some sort of rebound. Ideally, and to get deeper and deeper into the details, JCP would rally back to a turning 200-day Moving Average and then head back down again. I'd give the odds at 50/50 of JCP breaking here for good vs having a last gasp. So I'm short a little with a stop at 76.20.

The Stock Market on borrowed time?

I mentioned John Murphy and intermarket analysis before. This seems a good time to dwell on the subject a little bit.
Intermarket analysis involves the simultaneous analysis of the four financial markets: currencies, commodities, bonds and stock. J.M. uses chart analysis extensively to that end.
It's noteworthy that, according to intermarket analysis, near the end of an economic expansion, for example, stock prices and commodity prices are usually strong, while bond prices are weak, a situation not unlike the one we have at the present time. Bonds peak before stocks do while commodities peak last.
Bond prices have an impressive record as a leading indicator of the economy, although the lead time at peaks can be quite long. Stocks and commodities also qualify as leading indicators of the business cycle, although their warnings are much shorter than those of bonds.
Bonds turn first (17 months in advance on average since the 1920's), stocks second (seven months in advance on average) and commodities third (six months in advance).
Now, what this is telling me is that, should this bond dowtrend continue, the stock market would be on borrowed time. How much time would obviously depend on many factors such as the willingness of the Fed to cut rates, the state of the Chinese economy, etc... But in light of all this, it wouldn't be altogether unreasonable to consider late 2008 a possible danger zone for the stock market.

Very enjoyable read on the dk report. Besides being exhaustive and to the point (and bullish), it has that California laid-back quality to it.

Another piece on quants, this time in Barron's. Time to short quants? The usual spiel about how quantitative analysis is now mainstream and gets inspiration from evolutionary biology, signal-processing techniques, etc... An interesting bit about how the best protection against a market crash would be a contract based on the maximum drawdown of the S&P 500 index as opposed to a put option on the index. It would basically be equivalent to a trailing stop and would theoretically be better than both a put option on the S&P and a call option on the VIX (very unpredictable). This maximum drawdown contract would need to be traded actively though.

Interesting Barron's this week, I must admit. How about this gem of a comment by none other than Mister Bond King himself, Pimco's own Bill Gross:
"If [the Chinese] are not going to be buying Treasuries, maybe we should be unloading some of ours before they unload some of theirs".
Which means that Pimco has been actively participating in (causing?) the bond destruction of the past two weeks.
He decreased the duration of his bond portfolio because:
"it is safer to analyze what the Fed might do than whether and what the Chinese might buy."
Maybe he should emulate commodity investor Jim Rogers who not only hired a Chinese nanny so that his daughter (and presumably himself) can become a fluent Mandarin speaker, but is planning to move to China.

For those technical analysis bashers and denigrators out there, this week's economist published a chart under the heading: Trend-breaking - US ten-year Treasury bond yields, identical to the one above (which I took the liberty of re-creating on Tradestation).

You'll notice the bearish falling channel being broken this week, which might indicate the end of the downtrend in ten-year bond yields and maybe the start of an uptrend (although it's too early to tell). The reference to trend-breaking in the title could not be more explicit. This, ladies and gentlemen, in the main article of the Finance and economics section of this most eminent of mainstream magazines is technical analysis at its most basic (and most effective), namely trendline analysis.

The myth of the rational investor has been thoroughly debunked over the last decade by, among other people, behavioral financiers and neuropsychologists. In this week's Economist, another myth comes under attack, the myth of the rational voter. Many political scientists believe that the wisdom of crowds phenomenon helps the best candidate get elected. Basically, if ignorant voters vote randomly, the candidate who wins a majority of well-informed voters will win, with the "ignorant votes" cancelling each other out. The Economist begs to differ, why? Because ignorant voters do not vote randomly. They, surprise surprise, fall prey to biases that make them systematically demand policies that make them worse off, therefore proving they are not rational.

Four biases have been identified:
1) People do not understand that the pursuit of private profits often brings about public benefits and as a consequence have an anti-market bias.
2) They underestimate the benefits of interactions with foreigners: they have an anti-foreign bias.
3) They equate prosperity with employment rather than production: a make-work bias.
4) They tend to think economic conditions are worse than they are: a pessimistic bias.

Doesn't that sound like the platform of about every politician you know?

I don't have anything original to say about yesterday's 187-point explosion in the Dow but will refer anyone who's interested to a great summary on "The dk Report" blog.

What I do want to post however is an update on the TLT chart. In a previous post , I mentioned the 82 area as a possible target for this down move. TLT did reach 82.20 2 days ago before strongly rebounding yesterday all the way up to 83.76. But now I'm not so sure that was the end of it. TLT got so thoroughly and rapidly destroyed the last few days (and Treasury bond rates in reverse, of course) that one cannot be faulted for thinking this just the initial (impulsive, to use Elliott Wave terminology) move of a much greater (higher degree in Elliott Wave speak) down move. I realize this somewhat contradicts another previous blog entry about how a broken downtrend line in the 10-year rates does not necessarily translate into an imminent uptrend, but I just want to stay open to the possibilities.

Oh yeah, and don't forget to CLICK ON THE CHARTS to enlarge them and have any kind of idea of what I'm babbling about. A black background for charts is not that great when they're in reduced size but I believe them to be the best in original size. Anyhow, that's the template I use for trading.

Maybe I should change the name of this blog to Death of a Trader. According to this Reuters article, most traders will be gone by 2015, replaced by powerful algorithms and other black box trading systems. The so-called algo-wars are raging between hedge-funds hungry for an edge.....blah blah blah. I mean, read the article, it's interesting as a sentiment indicator.
In the final analysis, you still need a trader (at least one) to program those machines. Also, in a panic situation, you can bet that those "algos" will be overridden. Human emotion will never be completely eliminated from trading, nor would it be advisable that it be so.

Jack Nicklaus, the greatest golfer who ever lived (at the present time) said yesterday on the subject of loosing (emphasis mine):

"Why would you talk about it or even think about it? It only perpetuates the problem. I always knew golf was a sport in which if you were really good, you might win 10 percent of the time. If you were the best in the world and were really hot, you might win 20 percent of the time. So you are going to have a lot of disappointments. It goes with the game, so you just can't worry about it."

Much in there applies word for word to trading.

The more I learn about China's version of capitalism, the scarier it becomes.
In this week's Economist, Arvind Subramanian, an economist at the Peterson Institute for International Economics in Washington, DC, points out that China's ability to sustain its exchange rate stems in part from "financial repression and autocracy" (emphasis mine). Basically, China forces its domestic state-owned banks to buy its central-bank issued bonds paying only about 2% interest while it earns about 5% buying American Treasury bonds.
The Communist Party geniuses in charge of this probably figure they have subverted the underlying concepts of any market economy, namely the self-interest of parties involved and, at the stock market level, our old friends fear and greed. I wouldn't be surprised if some of them were convinced that no bubble exists at present in their stock market and therefore no crash will ensue: they will always be able to control investors' fear and greed. Needless to say, and many people all over the blogosphere have been saying it better than I, this will not end well.
The only thing is that I don't believe it will happen anytime soon. It might take a few years to play out.

According to this surprising new study, it appears that anger improves decision-making.
I can't say that it agrees with my trading experience. Anger breeds a desire for revenge and seeking revenge in the markets after a bad trade is usually one of the surest roads to ruin.
But I can see how low-level anger (how should we call it...irritation, aggravation) could focus the mind and help the trade-selection process. A moderately angry (quite the oxymoron) trader would presumably make fewer mistakes than a bored trader, one would think.

Very nice recap of the late 90's Nasdaq bubble by someone who obviously observed it up close and personal on The dk Report blog.
This is the comment I made regarding that post:
It's funny how, even though I lived (and traded) through it all, I don't remember it quite like it really was, particularly the last few months of the bubble. I think it's partly because, while the indices were going up, many stocks were cratering. Every day had its disaster du jour and the new all-time highs on the indices were but a footnote.

You've probably been hearing this a lot the past few days: the 10-year rate has broken a major multi-year downtrend. Some people say 15 years, others say 30. My chart (this is the monthly) shows a clean falling trendline dating back to November 1994 that has definitely been broken this week. I fully realize that we have to wait until the end of the month to pronounce the monthly trendline broken but still...
Now a mistake most people make (including me, all the time) is to automatically conclude that, since a downtrend has been broken, an uptrend is about to start. Which is to forget that a market can do something else besides going up or down, it can go sideways. After the dust settles (and obviously emotions are running high these days), we could be stuck in a 5%-5.50% range for many months to come.

Everybody knows that John Murphy's all-time favourite tool is the relative strength chart. Intermarket analysis being his main area of expertise, it's understandable. And even if one can easily fall prey to overusing and overanalysing them, relative strength charts (or ratio charts) can be very useful. Shown above is simply the daily chart of (GOOG divided by SPY) and what it shows is that even though GOOG is making new all-time highs in absolute terms, it is still trading below its all-time high on a relative basis. Therefore (and you know where this is going), it still has room to go.
Granted I do own a few shares of Google and I am thus a prime candidate for the very common "cheerleader bias" where one only looks for facts supporting one's theories. I would be worried about it if GOOG were in a free fall, which is not the case (fingers crossed).