Head and Shoulder Bottom?

A lot of people have been mentioning a potential Head and Shoulder bottom forming on most of the stock indices so I thought I'd throw in my two cents on the subject.

Shown above (click to enlarge) is the daily chart of SPY, the S&P 500 Index ETF. I have marked the potential locations of the Head and the two shoulders. It should be understood that, as long as no break of the neckline has occurred, which is to say as long as we don't have a decisive break above 90, the formation is not yet a Head and Shoulder. What makes this an interesting potential H & S is the fact that we're about to enter a new year and any move that takes place in the next few weeks will be scrutinized, analysed to death and thus could be very significant. Also, the 14-day RSI has been trapped in a bearish [20,60] range for the last 6 months during which SPY went down some 40%. The RSI is now hovering near 50 and any breakout in the SPY accompanied by a breakout in the RSI could launch a serious rally.

As far as a potential target, the vertical distance from the head to the neckline is about 23 which, projected from a breakout point of 90 gives us 113. A more conservative target would be 109, the top of the window (or gap) formed on 10/06.

We're Not Day Traders

You know day traders have finally achieved legitimacy when a Treasury official answers a question with: "We're not day traders".

The question was about the warrants Treasury has extracted from the banks it bailed out, which have already lost a third of their value, something of the order of 9 billion dollars. The complete answer of Neel Kashkari, the director of Treasury's Office of Financial Stability (otherwise known as the TARP Czar) was:
"We're not day traders, and we're not looking for a return tomorrow. Over time, we believe the taxpayers will be protected and have a return on their investment."

OK, first of all, day traders aren't usually looking for a return tomorrow, they're looking for a return today. Second, trying to turn a losing day trade into a winning swing trade is such typical day trader behavior. The next step is either trying to turn it into a long-term tax-deductible loss or, alternatively, ruin.

A Diamond Truly Is Forever

What follows is a good illustration of current events-relevant and news-conscious advertising:

"Our lives are full of things. Disposable distractions, stuff you buy but do not cherish, own yet never love. Thrown away in weeks rather then passed down for generations.

Perhaps things will be different now. Wiser choices made with greater care. After all, if the fewer things you own always excite you, would you really miss the many that never could?" (Emphasis mine, suspicious grammar and not-so-subtle allusions to the financial crisis in the original text)

This ode to a new world of "less is more", a world where conspicuous consumption and vulgar materialism are strongly rejected in favor of more, shall we say, durable values is, in fact, the new "A Diamond Is Forever" De Beers advertisement.

These guys are good.

Moving on, a fascinating article in this week's Barron's is making the unorthodox (for Barron's but not so much for anyone else) point that Ben Bernanke has been prevented by a "boneheaded" (not my words but those of former Fed vice-chairman Alan Blinder - as a cheap aside, with such a last name, you know Alan's got inner vision), free-market fundamentalist Hank Paulson from living up to his nickname, Helicopter Ben.

Therefore, the article goes on, once the much more interventionist and activist Tim Geithner and Larry Summers (the Master and his Pupil, not in that order, apparently) take over in earnest, we should expect a massive intervention by the Fed in the credit markets. In other words, we ain't seen nothing yet from Bernanke's Fed. To which I say "bring it on", it can only be good for stocks short-term and gold long-term. And good for diamonds, obviously.

Say No More (Barron's Bashing, Part 989)

"It's tough to say when the markets will bottom, but unless the world is entering an economic depression, history suggests that stocks don't have much further to fall."

Do statements such as this one, noted in this week's Barron's, make you feel better about the market? I didn't think so.

The problem with this statement is, well, everything. If it's tough to say when the market will bottom, don't say that stocks don't have much further to fall. Oh, and by the way, the world IS entering an economic depression. As far as history, what good is a history so short and so unrepresentative that it contains only one event (the 1930's depression) that's remotely relevant to what's going on now? Need I say more?

Sick and tired of the bearishness and the annoying and persistent non-bullishness of the bearishness? Here's some truly (?) bullish news from unexpected quarters, the Barry Ritholtz blog.

Triple and Inverse Triple ETFs: Mini-Weapons of Mass Financial Destruction

I find it very interesting that trading in the Direxion 3x and -3x ETFs (which has been fast, furious and on huge volume) started on November 5th, at about the same time as this latest bout of extreme volatility. I'm talking about FAZ, TZA, ERY, BGZ, ERX, BGU, TNA, FAS.

BGU for example, the Russell 1000 big cap x3 (three times the daily return of the Russell 1000 index), traded 11 million shares yesterday after trading 19,000 shares on its first day of trading, November 5th!!!!! Daily volume increased by a factor of 600 in just 2 weeks. By the way its range yesterday was 22-30. Talk about adding nuclear fire to the fire. It is no coincidence that the long triple ETF was where all the action was yesterday, a treacherous day if there ever was one. It was all those people trying to catch THE bottom all day long who got flushed out in the end and might have turned a run of the mill bad day into another crashing disaster.

I would love to see a study on how much marginal volatility these little "weapons of mass destruction" have added to the market's volatility this week.

Quantitative Easing

For anybody who's wondering what quantitative easing is, this Bernanke's 2004 paper Conducting Monetary Policy at Very Low Short-Term Interest Rates should begin to give you an idea (courtesy of the Calculated Risk blog).

As we are not so slowly but surely drifting into recession, deflation and indeed a "very low short-term interest rate" environment, I have a feeling we'll be hearing about quantitative easing more and more.

It would appear that the Fed can do a lot of things once it reaches a zero percent fed funds rate and it can't cut rates anymore (we're almost there). It can for example shape interest-rate expectations and signal that, not only are short-term rates very low, but the Fed will keep them very low for the foreseeable future. But for that to work, the paper goes on, the Fed needs to have credibility and actually do what it says it will do.

Interestingly, this just might explain one of the true conundrums of the Fed's rate policy during and after the 2001-2002 recession, namely why Greenspan kept rates so low (1%) for so long, basically well after the economy had strongly rebounded. Well, maybe he did that, under Bernanke's advice, because the Fed had promised to keep rates low for a while and, for the sake of its future credibility, it had to keep its promise.

Granted, the Fed's credibility has taken quite a knock lately as basically none of the sometimes creative measures it has taken over the past year has stopped or even slowed the hellish economic plunge.

Let's see if quantitative easing circa 2008-? works as well as the 2002-2004 version.

Markets as Complex Adaptive Ecosystems

One book I would wholeheartedly recommend to anyone having serious problems with mainstream financial theory and more generally with what is known as neo-classical economics but needing a new conceptual framework to work with is The Origin of Wealth (Evolution, Complexity, and the Radical Remaking of Economics) by Eric Beinhocker.

Excerpt:

"First, a substantial body of empirical and experimental evidence shows that real-world investors look nothing like their theoretical, perfectly rational counterparts. Investors do not discount in the way traditional theory assumes; they have various biases regarding risk, are subject to framing errors in processing information, and use heuristics to make decisions. (....)

Second, Bachelier was wrong. Markets do not follow a random walk. (...)"

Regarding this last point, I've already mentioned the work of Andrew Lo from MIT. Beinhocker goes deeper in presenting Lo's incessant work since his seminal 1986 paper (Lo, MacKinlay) to convince the remaining die-hard random walkers of what even Burton Malkiel has admitted in the seventh edition of his classic A Random Walk Down Wall Street: that markets do not, in fact, follow a random walk.

Beinhocker goes on to introduce a new paradigm much more adept at modelling the financial markets: the markets as adaptive evolving ecosystems.

The tools and science of evolution and biology (and more generally of complex adaptive systems) are found to be a much better conceptual and theoretical fit when it comes to markets than those of equilibrium physics.

More on that in a later post.