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Below is the text of a post that I originally published on May 13, 2010. I am reposting it now because I believe it is particularly relevant to the state of the current market, as well as for the the viability of the concepts and theories mentioned herein.

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Ever since March 2009, virtually every time that we have had a market correction it seems as though we have been on the verge of ending the bull run and starting a new phase of the bear market.  Often times, however, just as it seemed as if the bears were about to push the broad indices down through their respective 200 day moving averages, the market would stop on a dime and proceed to sharply turn up on low volume and make new highs.

This phenomenon has been especially frustrating to many traders who were not already fully invested, because they never really got a good chance to reenter.  Many technical traders, in particular, missed out on a lot of those moves higher because they either sat out or decided to go short.  Needless to say, they either missed out on some big profits, or lost a lot of capital trying to go short (or both).  Indeed, the correct play was to simply go along for the ride and chalk the whole thing up to us climbing the “wall of worry” that the early to middle stages of bull markets are so famous for.   It was also correct to dismiss the low volume rallies as being due to the fact that we had a huge gap/vacuum/void to fill from the crash of 2008, which had alleviated a significant amount of selling pressure.

At the beginning of this month, however, several key indices and sectors had recovered many or all of the losses from pre 2008 crash levels.  Because of that fact,  the notion of ignoring the low volume on rallies has become less and less valid. Beyond that, many key leading stocks since 2009 have either become too extended, or have broken down on heavy selling volume.

One trend I am noticing amongst traders is that they have grown so frustrated with trying to short technically weak charts, that they are now using what would normally be their own sound analysis as a contrary indicator.  Instead of going short, they think “I really got squeezed hard the last few times I tried shorting this stock that was up against heavy resistance after a weak volume rally.  So, this time I will go long, even though I know this is a short.”

That kind of thinking can be very dangerous for several reasons.  First off, as I noted before, the market has now effectively filled most or all of the huge gap created by the 2008 crash, so the drift up unsupported by volume argument is weaker than before. Next, to use your own sound technical analysis as a contrary indicator is a mistake because you are allowing the market to throw you off your game–or effectively put you “on tilt.”  The phrase, “on tilt” is a common term used in the poker world, whereby a player loses his cool and changes his playing style for the worse due to a multitude of reasons.

One example of going on tilt would be if you are dealt pocket kings before the flop in a Texas Hold ’em poker game.  You raise, and an opponent goes all-in.  You ponder if your opponent has pocket aces (the only hand that has you beat), but eventually you correctly call, as your opponent turns up pocket queens, meaning you are a huge favorite to win.  When the dealer flips a queen on the board with no king in sight, you lose all of the money you had in front of you.  Despite the painful short term result, you made the correct long term decision. In other words, if you keep making that same decision over the long run, it will be profitable. The odds of another (regular playing) opponent having pocket aces in that situation are not great enough to compel you to fold.

However, you become extremely frustrated from the short term result and think, “Well, if I cannot win playing good cards and making good decisions, then the hell with it.  I am going to gamble it up and play whatever crappy cards I want.”  It is exactly this kind of emotional, knee jerk response that causes otherwise good poker players to go on tilt, and to go broke.

In the stock market, not making those same knee jerk trading decisions based on painful short term results is equally as important, so long as you are making the technically sound decision that is profitable over the long run.

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“There Will Be Head Fakes”

-chessNwine 12/31/10

Accordingly, please use caution headed into the next several weeks. There is nothing wrong with taking a wait-and-see approach to start the year.

HAPPY NEW YEAR

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With one day left to go in both the month and year, here are a slew of monthly charts that should help put the price action we have seen over the past few quarters in perspective. Please see my thoughts and analysis on the charts.

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A full week ago, on Wednesday, November 17, I made this video, seen below, for members of the 12631 Trading Group. Essentially, I used The PPT algorithm in order to gauge which area of the market was going to offer the best returns over the next few weeks. Without question, the algo pointed me towards a bevy of retail/consumer discretionary names with massive short positions, but also with healthy charts despite the over 4% correction the market had seen from November 9-17. Even with the broad market weakness that we saw on Monday and Tuesday of this week, 12631 members have been absolutely crushing the retail trade, playing everything from BONT, to OPEN, to LULU.

This video is a pretty good example of the type of work that RaginCajun and I perform as part of our stated goal to extrapolate on The PPT algorithm for our 12631 members, in addition to doing our own independent work.

Have an enjoyable Thanksgiving everyone, and I hope to see you inside the “Pelican Chat Room” shortly, as Ragin and I continue to build a winning atmosphere full of traders executing with precision and discipline.

NOTE: The video only cuts me off one or two seconds at the end, so no material information is left out.

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[youtube:http://www.youtube.com/watch?v=I-vIJZoBpqg 450 300]r

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I apologize for my lack of regular posting over the past thirty-six hours, as I was attending to some personal business. As an aside, note that even when I take unannounced leaves of absences, I still post more then 99% of the bloggers on third-tier sites. Indeud.

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One of the reasons why I have supreme confidence in my trading style is because I know my limitations. I am fully aware of two things that are extremely difficult for many traders to admit:

1. Trading is, in fact, gambling. If you are a regular reader of mine, then you have read this before. Simply put, we traders are wagering money on outcomes that have yet to be determined. Rather than stubbornly arguing that we absolutely MUST make money on a trade because our given thesis is so strong, a better approach is to recognize that luck is most certainly a factor in our success. Nonetheless, luck is the enemy of the professional trader. We are constantly doing things to minimize luck (cutting losses, taking profits, selectively picking trading ideas, refraining from outrageous earnings gambles, etc…), whereas novices are actually relying on luck to bail them out of mistakes, such as going all-in on a stock before earnings.
2. Technical analysis can only go so far. Anyone who argues that expert chartists are omniscient regarding the market is a fool. Price action and volume can only go so far as to illustrate the market’s best hunch about everything that is currently known and knowable. Nothing more, nothing less.

Because I can admit to the two points above, I find it increasingly laughable to hear audacious calls by bears who have been consistently wrong since we hit 1040 on the S&P 500 last August. They insist we will revisit the lows of March of 2009, yet they admit to no wrongdoing. Their macro thesis goes something like this: “Things are bad, and they have not gotten much better in the broad economy. Therefore, if you go long stocks, even for a trade, you will be the sucker who winds up holding the bag when the market rolls over.”

Should we actually fall apart and head down to 666 on the S&P, there will be plenty of warning signs, such as heavy selling volume, charts topping out followed by confirmed breakdowns, as well as an overall unhealthy market. If and when that time comes, I will be more than happy to do an about-face and join the bears.

However, until then, you sir, are an ignoramus. You have been wrong, and you will likely continue to be wrong in your choice to make trades based on a macro thesis of which the market is already fully aware. When $LVS went from $147/share to $1.38/share during 2007-2009, that was not the market pricing in a few less bachelor parties taking place in Las Vegas. No, that was the market pricing in a deep depression on the Las Vegas Strip not just for one year, but a few years out.  Don’t believe me? How hypocritical are you?! You are the same bearshitter who argued that the Nasdaq bubble in 2000 was pricing in years, if not decades, of amazing technology growth. Have some pride and be consistent in your arguments.

The bottom line is this: Your macro investing style, bullish or bearish, has likely already been discounted by the market. Even if it has not, you could easily be wiped out before your thesis comes to fruition (think about how many smart guys got squeezed in the housing run up until 2005-2006). The market can remain irrational longer than you can cherry-pick facts that support your bias.

In poker, it is often said that if something is not happening at the poker table, then it’s not happening at all. In other words, who really cares about something that takes your focus off of being the best poker player that you can be, dealt hand after dealt hand? The same applies to the stock market. If your bearish thesis is not happening now, then it’s simply not happening. Disregard that fact at your own portfolio balance’s peril.

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I. Introduction: Inflation v. Deflation

I have received a few emails and direct messages on twitter regarding my take on the now hot button issue of whether inflation or deflation is presently the most pressing threat to the American economy. If you are wondering why I say that this issue has become so contentious, just check out this clip featuring Rick Santelli and Ron Insana duking it out on CNBC last Friday. Before I delve into my arguments, let me make a few points upfront. Make no mistake, this piece has nothing to do with what the Federal Reserve and the federal government should or should not have done. Rather, I am focusing on what has actually been done, and the ramifications thereof. Also, the performance of the precious metals should be taken with a grain of salt, as they have historically performed reasonably well not only in times of inflation, but also during deflationary periods as well.

II. The Other Side of the Mountain

First and foremost, those who simply point to zero interest rates and all of the money printing and federal deficit spending by the Federal Reserve and the Legislative and Execute Branches of the federal government, respectively, as inflation per se are missing a critical issue. That is, the zero interest rates and all of the quantitative easing and stimulus spending have been done in an attempt to try and combat an enormous amount of money that has been destroyed.

Over the past several decades, the availability of easy credit has allowed individuals, households, corporations, as well as governments around the world to borrow against the supposed growth of the future, in order to spend freely in the present. This all works well when, for example, house prices appreciate in a seemingly perpetual manner. When future growth becomes so complacently assumed, consumers can buy three or four houses with no money down, and then turn around and get a home equity loan to spend like a rockstar. Eventually, when the party ends, house prices cease to rapidly appreciate, more realistic expectations about future growth start to set in, and credit begins to contract. When this happens, an enormous amount of supposed wealth will naturally be destroyed. House prices will crash, and consumers and small businesses will have a much tougher time getting credit.

III. Inflation is Desperately Trying to Play Catch Up

The issue of whether the money printing and federal deficit spending will lead to imminent inflation is a lot like asking whether world-class swimmer Michael Phelps will soon become an obese, unhealthy man. Two summers ago, in the midst of his incredible string of medals at the Olympics in China, the media focused a good deal of attention on the young swimmer’s diet. He would regularly eat three fried-egg sandwiches, along with three chocolate chip pancakes, one five-egg omelette, a bowl of grits and three slices of french toast, all loaded up with goodies. And that was just for breakfast!

If one had simply looked at his diet in a vacuum, without knowing anything else about who he was, the easy answer would be to readily assume that Phelps was an obese person, even if he did not have health problems. He regularly consumed tons of calories from fatty foods. Similarly, if one looked at the zero interest rates and all of the federal spending in a vacuum, it would also be very easy to simply scream,”Inflation, inflation, inflation!”

However, there is more to the story. Michael Phelps regularly consumes an exorbitant amount of calories because he is a young, muscular male with a high metabolism, who vigorously trains many hours per day. In essence, his diet is trying to “play catch up” to the amount of calories that he is burning through training, as well as (presumably) the amount of calories he is burning naturally with his metabolism. Likewise, the Fed and the federal government have been trying to “play catch up” to the amount of perceived wealth that has been destroyed through the bust of the credit bubble. Sure, spending a few trillion dollars sounds atrocious to a law-abiding, tax paying citizen of America. However, keep in mind that the amount of perceived wealth that has been destroyed, worldwide, is estimated to be somewhere around twenty trillion U.S. dollars.

Thus, as eye-popping as Michael Phelps’ diet is, he is still “in the hole,” playing catch up to the amount of calories that he burns every day. Need proof? Just look at his lean and wiry body. Similarly, the Fed and the federal government–as egregious as their printing and spending measures may seem–are still deep in the hole, trying to play catch up to the amount of perceived wealth that has been destroyed. Thus, deflation is by far the stronger force, just as with Phelps the amount of calories he is burning overpowers whatever mind-boggling amount of food he eats every day. Need proof? Just look at the bond market, notably the 10-Year.

IV. Nothing Lasts Forever

Thus far, I have presented the view that deflation is the clear theme in society today. Notice that I am not calling it a “threat” like many others are. It simply it what it is. Risk is being repriced in a much more rational way, despite how painful it may feel to some. Perceived wealth has been destroyed, home prices have cratered, unemployment is high, and consumers continue to retrench. While some corporations have done a good job of keeping their balance sheets clean, many big banks are still, essentially, insolvent zombies. Moreover, those healthy corporations with stockpiles of cash are more or less sitting on that cash, like a dog hiding a stash of delicious food to be put to good use at a later date. In my view, all of the above factors point to deflation.

However, nothing lasts forever. Eventually, at some point in the future, Michael Phelps’ metabolism will slow down as he grows older, and his workouts will become infrequent and less intense. If he continues to eat the diet that he currently does, there is a high probability that he will become obese and possibly have health problems. Simply put, the amount of calories that he takes in will begin to exceed–and possibly greatly exceed–the amount of calories that he is burning. If he is not quick in adjusting his diet, he will see a sharp weight gain in a very short amount of time.

Likewise, with America’s newfound high savings rate, more and more consumers will eventually become creditworthy again. Individuals and households will eventually emerge from a painful deleveraging process with far better balance sheets. Further, the rate of credit and wealth destruction will slow and eventually turn up again. When this happens, the velocity of money in our society will begin to pick up. The bond market will start to reflect the idea that merely a marginal return on capital will be insufficient to keep pace with higher expectations of inflation. When this happens, if the Fed and the federal government do not quickly adjust their policies, we could easily see a very sharp spike in inflation in a short amount of time. If history serves as our guide, the Fed and the federal government are not likely to adjust their policies in a well-timed manner.

V. Conclusion: It’s All About Timing

All of the machinations by the Fed and the federal government are desperate attempts to combat a vicious deleveraging process. Inflation is not the issue today, and in fact it is not likely to be the issue of tomorrow. Instead, a more constructive way to view inflation would be consider it as the last chapter in a long and dramatic novel, to paraphrase Hugh Hendry. For now, deflation remains at front and center. The argument that “the Fed has the printing press, and therefore we cannot have deflation” is misguided because it fails to consider: 1) How big of a deflationary hole we are in, and 2) The lack of velocity of money in society today, given very tight credit and a shift towards savings rather than free-wheeling spending without regard to one’s balance sheet.

Eventually, that will change. However, that change could just as easily take a few decades to materialize, as it could a few years. In the short term, any spike in inflationary expectations should probably be viewed as a head fake that will set us up for the next deflationary leg down, just as we saw in 2008.

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