From Bear to Bull
Close but no cigar. I am a stickler for data and trend, especially the antiquated confirmation indicator from Dow Theory. Therefore, I am waiting for DJIA to move above 10537, confirming TRAN’s strength. We are extremely close to that break through point –- less than 58 pts to go! Until then, I am a spectator, not a speculator. Frankly, I am not anxious to get back to the trading table, because I just don’t see any value at all. Maybe I am not looking hard enough. Surely there is got to be one sector out there with some kind of value. Or maybe I should just join the game of inflation.
Also note that last hour rallies are always triggered by program trading, meaning hedge fund and large institutional money managers are playing the market, not investing. The likelihood of a sell-off of these last minute purchases is pretty high tomorrow or the day after.
It’s a go fishing for the big boys. They spend millions buying up the market in the last minutes of the trading day, then dump them plus old holdings to anyone, most likely retail investors, biting the bait the next day. This is a common practice when institutional investors want to dump large holdings at a premium with little price disturbance.
To Kill a Mosquito
I am off in Taiwan composing a piece of the Asian economy. While swimming in a sea of number last night, I noticed two black mosquitoes parked on my naked leg, enjoying the summer special red-warm cocktail courtesy of yours truly. As I get ready to smack both elfish Dracula, the alarmist one flew off and disappeared into the dark corner, leaving the lumpen one behind. “More for me,” laughed the lumpen mosquito while nourishing like infant. With a thundering wave of my right arm, following a loud clink, the lumpen mosquito ended flat on my palm, legs bended in all directions, guts exposed, spilling my blood all over my palm -- a gruesome picture. While I was cleaning my hands at the sink, I thought to myself what had played out is like the current stock market. A number of greedy investors, like the lumpen mosquito, are still feasting off the markets, not knowing the risk of that extra nourishment is now more than life itself.
As much as I, an alarmist mosquito of the market, wanted to fill my ego, I chose not to be the soon-to-be R.I.P. mosquito. I’d sucked enough blood from this bear-rallying market from mid 2003 to early 2004. I have departed from this cholesterol-rich land (debt laden economy), gliding effortlessly in high altitude with little energy (no debt and little expense), overlooking at what looks to be the Fed’s finger on the trigger of the spray (rising interest rates) and the invisible hand holding a flyswat, knowing that every place it smacks, it will spill mucho guts out of drunken and lumpen mosquitoes.
The funny thing is that this land is so high in cholesterol even the vicious vultures flying above are afraid of landing.
Last week, the market's rudderless trend persisted, as the Dow rose 6 points to 10,416 (ahead .6% YTD), and the Nasdaq lost 13 points to hit 1986 (down .6% YTD). This market has gone nowhere year to date, and it is still too rich for my blood. And I consider myslef a very risky investor.
Bill Gross: We are not Worthy
Instead of reading my rants on this imbalanced economy, let me direct you to two recent interviews of Bill Gross, the Bond King.
--
FT Interview
(if you don't have FT subscription, this article is published in June 16 on dead tree version)
--
BusinessWeek Interview
A few highlights from Bond King Bill:
We have a 7% nominal gross domestic product growth rate. Normally, the short-term rate is close to the nominal growth rate...the Fed has to raise rates, you'll see a decline in housing prices and all asset categories, including bonds and stocks.
I thought it was remarkable that Greenspan would recommend adjustable-rate mortgages. I have been recommending them as well for the past few years. Over 5, 10, 15 years, those that borrow at short-term rates manage to pay less.
comment: ARMs is an excellent way to obtain cheaper money as long as you don't abuse it by using it as a leverage tool for a more expensive house that is over the budget.More than any point in the past 20 or 30 years, there's potential for a reversal.
The US dollar is being supported by the kindness of strangers - Japan and China...It should be 20 per cent lower than it is...The dollar isn't overvalued against the euro but it is against Asian currencies.
Defense is Your Best Offense
In any sports, whenever a finals is play by two extremes teams (the best offensive team playing the best defensive team in the league), defense will always be triumphant in the end; hence, defense is your best offense. We have two obvious examples in NFL: the ‘01 Ravens and the ‘03 Buccaneers. Today, we witnessed the victorious defensive Piston claiming the NBA trophy by defeating the best offensive team Lakers in game 5.
Similarly in the stock market, playing the best defense will provide the best returns. With stocks, bonds, real estates and commodities all inflated in 2003, a rare occurrence, and some, such as real estates and core materials, continue to inflate in 2004, the investment climate is becoming hard to generate solid risk-free income. Playing first-class defense maybe the only available instrument left guaranteeing positive returns in the future. Defense means going back to the basic interest compounding strategy with Treasuries. Since we all know the Fed is about to gas its short rates, the only safe Treasuries in the raising rate environment is short-term T-notes, 3 or less years maturity. While raising short rates will lower the face value of T-notes, the goal is to hold the notes till the matured date and earn the interests. In order to success on compounding strategy, you need to keep re-investing the interests and purchase more T-notes in succession.
I, probably the only person in the world, still believe in the possibility of the Fed lowering the short rate below 1% in 2006, after a couple of rises from now to 2005. In this case, lowering the rate below 1% will increase the value of T-notes in addition to the interests earned. The rule of the game is to purchase T-notes at least twice a year and keep doing it for at least 3 years. After 3 years of interest accumulations, you are likely to have more money than investing in other asset classes -- stock markets will be much lower 3 years from now; real estates will stagnate this year and begin to depreciate in 2004 and on; most commodities will be lower than today’s price.
This is the only safe investment advice I can dispense short of holding cash.
Random Walk down Bubblicious Avenue
Today, the markets are closed in observance of the national day of mourning for former President Ronald Reagan. Since there are no markets to chinwag with, I will take this perfect opportunity to review the lovely real estates.
Aside from the stock markets, the real estate sector is on one of its biggest bubble in the US history. The consumer version of ‘carry trade’ (the act of using low interest rates via ARMs to purchase houses priced over buyers’ income level) is inflating the housing markets well over the affordability range. Even at this point, everyone walking down the streets still doesn’t believe housing prices will ever come back down, because of their strong believe that demand will always be there -- we all need a house to live in, and owning one is the American dream. The problem is buyers going nuts or extreme bullishness to beyond sense and logic. [
READ]
I, on the other hand, have been dispensing the notion below to friends and family. Use this ‘bubblicious’ opportunity to sell your house for a ‘bubblicious’ premium, comfortably situate your family in this ‘once in a life time’ cheap rents locked in for 6-10 years, and purchase a much bigger house 6-10 years down the road at a ‘once in a life time’ bargain. I think 50% off current market price isn't far fetched.
Let me spell ‘bubblicious’ with a contrarian hat on. When you see or hear people crowding into a sector, especially those with experiences in other areas charting into this unknown hot territory with simple fact that it's hot, and when you ask your co-worker what is their dream job, and their immediate respond was a loan officer or a real estate agent, the bouncing bubble is alive and quiet possibly reaching its peak. At this time, it requires more force and energy to make it bigger, but it may stay this way for some times. No one knows exactly when the bubble will pop, but when it does, it will be loud and traumatizing. Remember in 1999 and 2000 how everyone everywhere wanted to walk across street and work for an Internet company? We are eating the same food but on a different plate. Within my circle of friends and family, I’ve heard more of them changing jobs to be a loan officer than being lay-off. This is a scorching hot sector, and, as usual, the so-call switchers and sell-outs always appear in abundance at the bubble top.
I wasn’t always this cautious on real estates. For once, I was a member of the home shoppers club, but that was more than two years ago. My only regret of the time was not taking up on the offer to purchase a beautiful 4-bedroom, in wall entertainment living room, outdoor water fountain with speakers hooked to the indoor entertainment system, a sandbox playground next to 2 car garage house just a few blocks off University Avenue in Palo Alto for a basement price of $850,000. That house will probably sell for 1.8+ million in this market. But that was in 2002, when the stock market was at its lowest, and the owner of the time, who was a VP at Netscape (pictures in the study are worth a thousand words), told the agent to sell the house lower than the asking price (she whispered a much lowered price to me as we walked out the door).
Ah, the good old days and we shall see that again. This bubble isn't unexpected. We are merely following the foot steps of the Japanese 1989 crash (2000 for us) and the continuation of the real estate inflation after that. [
READ]
Summation of Indicators
Dow Theory – DJIA and TRAN moved opposite direction today -- DJIA up, TRAN down. We are still waiting for DJIA to confirm TRAN by breaking its previous high of 10537. I will scoot my little butt to the BULL camp when this happens.
21dma of Put/Call Ratio – At 0.99 today, it is below 1.0 when I first reported it but we still have an eon to wait for this indicator to carve out a meaningful trend.
VIX – 6/10 made a new low (extreme bullishness), erased the low set on May 27. For the short duration, the market remains very complacent. So I am still on the sideline with my money tucked away safely. No need to play superman here.
Dow Theory on Primary Bear Markets
The great Dow theorist, E. George Schaefer, defined primary bear markets in three phases.
“The First Phase represents abandonment of exaggerated hopes upon which stock prices were based when they reached their bull market peaks. The Second Phase reflects poor business and earnings reports as they steadily become worse. The Third Phase plunges the market to its final depths as economic deprivation forces many investors to sell against their wishes, regardless of price, in order to raise cash.”
In addition to this, Robert Rhea, a Dow Theory Laureate, added “each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.”
If Schaefer and Rhea were alive today, the two savants would place our markets right about the end of the first secondary reaction.
We’d experienced the First Phase in 2000 to early 2003. Since then, the birth of secondary reaction (the cyclical BULL) carries us all the way to today where both DJIA and TRAN are topping out, and in a non-confirming state. Second Phase of the bear market will not crack a light until the confirmation prophecy is fulfilled, which calls for DJIA to drop below 9850 and TRAN less than 2743. But until that happens, we will keep seeing the market tread sideway as Richard Russell foresighted.
On the fundamental end, the second phase will probably be fueled by the ever shrinking power of the fiat money. The USD devaluation will drive multi-national corporations to report disappointing earnings, dragging the rest of the domestic business down with it.
On a side note, Greenspan exposed that he would raise interest rates faster if inflation is more than expected today. This makes me think that the ‘carry trade’ is NOT unwinding as fast as it should be.
Monitoring the Pulse through the Stethoscope of Dow Theory
Since its conception in the late 19th century by Charles H. Dow, the founder of
The Wall Street Journal, Dow Theory has been a reliable instrument for stock speculators in understanding the movements of the stock markets. Although pundits nowadays renounced the theory as antiquated and incapable of studying modern markets, I am a strong believer that Dow Theory still reads current markets as correctly as it read markets of its time, based on a sample fact that traders today have the same greed and lust as those in the 19th century.
One of the prevailing key points for reading the markets with Dow Theory is confirmation between the two widely tracked indices: the Industrials (
DJIA) and the Transports (
TRAN). When both indices move side-by-side and break above previous high or below previous low within close time proximity, a sign of confirmation, the market is thought to be on the right track of the major trend. Conversely, a non-confirmation is when one indices reaches a new high while the other is still far below its previous high; at some point, the markets, as a whole, will submit to the imbalance (non-confirmation), and be pulled the opposite way.
This is precisely what is happening to the stock market now.
Back in May, the low of both indices were non-conforming -- DJIA dropped past its previous low of 10007 to 9852 on May 12, but TRAN dropped only to 2785 on May 17; it didn’t overrun its previous low of 2743. Because of this non-conformation, the market changed its downward trend, and started to move up.
Fast forward to today. DJIA and TRAN have been trending up lately. TRAN raced above its previous high of 3020 to 3072, yet this time DJIA is lagging behind, closing today 105 points away from its previous high of 10537. This is labeled as an upside Dow Theory non-confirmation. If DJIA doesn’t confirm the strength of TRAN by breaking above 10537 in the next few trading sessions, we will see the overall market commencing a downward trend. Remember my post that DOW is topping out, where it's making lower highs and lower lows; therefore, my money is on the DJIA turning downward before hitting 10537. The chance of seeing the markets hitting new lows is much higher than continue its upside.
There aint many Dow Theorists around these days. The most celebrated one is Richard Russell, the creator of
Dow Theory Letters. He writes pretty much daily, commenting the market actions and everything under the sun. He was the first to point out the non-confirmation, and believes the market will tread sideway until both confirms.
The Highest Ever CBOE Put/Call Ratio 21dma
The 21dma (21 day moving average) of CBOE Put/Call Ratio is an excellent indicator for judging the reversal of the long-term trend for the stock market. Adam Hamilton laid out the nuts and bolts of the line in his latest article. [
READ]
On June 4, 2004, the 21dma line cross above the unseen level of 1.0 (Put volume equals Call volume) in addition to breaking its current downward trend. Many stock technicians quickly made various predictions and calls (they are mostly reactionary) for the bulls and bears regarding the event. As you can see from the chart on the article, there were five other anomalies (96, 98, 00, 01 and 02) in the past. Of the five, three quickly fall back to its trend at the time, and two represented a trend reversal. Although all the previous spikes always coincided with the like of market corrections, the recent one didn’t. I am not sure what I should make of that -- anomaly of an anomaly?
To the bulls, this is just another anomaly that will fall back to its overall downward trend. To the bears, this is a sign of 21dma shifting momentum, and starting a new bear-confirming upward trend.
Since I am on the sideline with the wait and see attitude (21dma of Put/Call ratio is also a long-term trend indicator, not a short-term one), I am waiting to see how the next 90 days will turn out in order to draw my final conclusion of 21dma's latest rebellious move.
The markets were up big today with diminishing volume, as if lesser
greater fools are trading amongst each other now.
I read Morgan Stanley’s Global Economic Forum like a Bible. With senior staffs all over the developed countries contributing daily to the forum, it delivers the best fundamental overview of the global economy. While timely economic data never proves to be an excellent market timing tool, it does provide a good general direction of where the markets will end in the long run.
In the short run, the markets are controlled by the herd. Currently, the herd is led by the hedge funds – the unregulated hedge funds are busy inflating all asset classes with their almost-free leveraged money.
In the long run, the markets always fall back to where the fundamental treads -- they will adjust themselves back to where they belong, and, most times, fall further, a classic case of extreme on both ends.
The problem is when and how the markets normalize themselves. Just exactly when will the markets show fear for the debt bubble mentioned by
Mr. Roach and
Dr. Faber, and how much adjustment will be required to normalize the markets?
At this very moment, the markets are still living in euphoria, as
Jim Jubak admonished the longs and shorts that “a bubble expands far longer than anyone expects.” But, maybe we are near the end, or it had already busted in a vacuum (silent pop) and we are just not “admitting the cycle is over.”
If Mr. Roach is right on “history tells us that carry trades end when central bank tightening cycles begin,” then
the BEAR case wins. The markets will drop 10 to 14% in a short period of time after June 24th hitting
the Fibonacci levels.
Although markets seldom play out like the professionally drawn story boards, they do rhyme well. The best way to manage your risk now is to stay out of the market. There is no reason trying to squeeze every penny out of them.
In summary, while the majority of S&P500 companies did well last quarter, reporting earnings well exceeding expectations, the majority of consumers are overextended in debts. The bond market may have escaped the “carry trade” thanks to the extra month head start awarded by the Fed Chairman Alan Greenspan, “carry trades” from the consumer sector, the biggest indebted sector, may pop when the Fed starts the ‘rates’ train.
VIX is still low showing no fear, with the closing sell signal issued on 5/27. Short-term trader should stay on the side line, waiting for the extreme bearishness signal from VIX to open new long positions.
A Case for the Bear
A contrarian is most successful at making money when the market is at the top (extreme bullishness) or at the bottom (extreme bearishness).
When I was reading
this article last week, what really caught my eyes was that tiny chart on the right-hand side labeled “Reason to Worry: Adjustable-rate Mortgages as a percentage of all mortgages.”
Putting on my contrarian cap, I say to myself, this can be a decent sentiment measuring tool. For example, when more borrowers are fearless of the future (there is nothing to fear; the world is all good and is going to be better), more choose the adjustable-rate mortgages. Conversely, when more borrowers are not certain of what the future holds ahead (fear and uncertainty), more go for the 30yr fix mortgages.
The chart showed three spikes of 30+ % of mortgages are adjustable-rate since 1990: one in mid 94, one in early 00, and the current one is now. We all know what happened in 2000. But in 1994, DJIA dropped 12% from March to May; Nasdaq dropped 14% within 3 weeks around the same time, and 10% drop for S&P100.
What happened in 1994? It was the year of the bloody bond crash. At the time, there was little sign of inflation, the economy was growing, and the U.S. had a record deficit. Sounds familiar? In February, the Fed unexpectedly raised interest by 25 basis points to 3.25%, the first of four hikes in four months, which caused the bond market to pinic due to the overly leveraged "carry trades." Deja-vu?
The only difference this time is Greenie issued an early warning in May allowing the bond market to cover their “carry trades.” We will know how much this advance notice helped, as the story unfolds later in June when the Fed starts raising interest rates.
A Case for the Bull
I am a big fan of the advance decline line, as it is a very power tool in measuring the breath of the market movements, up and down. In addition, Marty Zweig is one of the prominent options traders to-date. When Zweig's advance decline indicator is signaling a BUY, I stop everything and read very carefully.
While I pay homage to this signal, it doesn't convert me to a long-term BULL, nor do I foray into the short-term BULL camp.
But, I am a cautious BEAR because of this. [
READ]
VIX: The Oracle of Short Term Trend
In general, the price of a stock is determined by supply and demand, which is measured by the sentiment of the collective investors, the herd. While it is hard to measure the sentiment of one particular stock, it is easy for an index.
VIX (Volatility Index) measures the volatility of Standard & Poors 100 Index by weighting bid/ask quotes of 8 put and call options. It has been used widely by traders as a general indicator of market volatility and sentiment. The VIX is an inverse indicator. High number means excess bearishness, and low number indicates excess bullishness.
VIX is a good short term trend indicator if you’re a contrarian. You buy during excessive bearishness or high VIX; you sell during excessive bullishness or low VIX. But how high is too high, and how low is too low? You can’t tell from just looking at
VIX. That is when the Bollinger Bands is here to help like
so. Now, you can see when
VIX is too high (touching the upper Bollinger line) and when it is too low (touching the lower line).
Below are the buy/sell signals issued by reading
VIX.
1/1 (High: Buy signal)
1/7 (Low: Sell signal)
1/12 (High: Buy signal)
1/22 (Low: Sell signal)
2/4 (High: Buy signal)
2/27 (Low: Sell signal)
3/22 (High: Buy signal)
4/2 (Low: Sell signal)
4/23 (Low: Sell signal)
5/17 (High: Buy signal)
5/27 (Low: Sell signal)
There were 2 sell signals issued in April without a buy signal in between. Since the closing price for DOW, S&P100 and Nasdaq were close on both 4/2 and 4/23 dates, I will use the 4/2 sell signal for this demonstration, which is what a trader would do if he followed VIX in real time.
If you were to directly buy and sell DOW, S&P100 and Nasdaq based on the above signals, you would end up more than the buy and hold strategy.
Below are the comparisons using the VIX buy/sell signal vs. the buy and hold strategy since the beginning of 2004 to the end of May.
DOW
+1,074.5 pt (10%) - VIX Buy/Sell Signal
-221.4 pt (-2%) - Buy and Hold
S&P100
+349.0 pt (17%) - VIX Buy/Sell Signal
+19.9 pt (1%) - Buy and Hold
Nasdaq
+59.7 pt (11%) - VIX Buy/Sell Signal
+4.9 pt (1%) - Buy and Hold
Timing with VIX is one of many tools and signals I will put on this blog in the future. It is an excellent indicator for measuring the pulse of the market.
The latest VIX signal is a sell signal, issued on 5/27.
If you believe what the VIX crystal ball is saying, by the end of this week, DOW, S&P100 and Nasdaq will be lower than today’s close of 10202.65, 545.11, 1990.77 respectively.
