Market Outlook

531 views

Let’s start with the transports which are the greatest sign for concern for the general markets.
transports warning

You can see a failure to make new highs, a breach of prior lows, and a breach of the long term trend channel. However, in order for markets to be confirmed bear market, you need ALL major markets to show the same thing.
So let’s look at the S&P

spx

If you were to draw a single trendline from the lowest low to the most recent low, you certainly have a trendline breach. However, the trend channel appears to be intact, and because the most recent low didn’t close the week below prior low, it remains unconfirmed by some definitions. However, the weekly close of week ending 1/16/16 was a lower weekly close than the prior weekly low (on closing basis), we have a lower weekly close than the 1/16 close, so it’s definitely leaning towards confirmed breach of recent lows. Nevertheless, the oversold conditions near a long term trend channel support is certainly a historically a good location to be a buyer, not a seller.

Let’s look at the dow.

dow

The long term broadening pattern formed resistance that temporarily was broken to the upside but failed to stay above. As we zoom in we can see that the long term trend channel has been breached. The rest is a little confusing once again because the daily/intraday shows a higher lows, but on a weekly closing basis we have the current recent low lower than the last 2 and a pattern of lower lows and lower highs on a weekly closing basis.

Finally, I saved the most fun chart for last, the nasdaq.
nasdaqWe can see that the all time high of 5132.52 acted as resistance, even though we surpassed these highs briefly. Also interesting is that the next high following the 2000 top is acting as support. The recent low is above the October 2014 closing lows, but below the August-September 2015 closing low despite being above the open of August 24.

In conclusion, there isn’t a clear, decisive bear market underway just yet. There is some evidence for a range bound market, some evidence for a short term bounce, and some evidence that an intermediate term, or even long term correction may be in development (unconfirmed).

However, the signs suggest considering caution into strength moving forward. There certainly is evidence pointing towards a short term correction if you are judging off of the weekly closes of the lows. The fact that ALL markets are showing a lower low on a weekly closing basis than the low made in the August-September 2015 time range is significant enough to create cause for concern and a minimum of lighter position sizes and/or number of positions moving forwards. This concern is increased by the fact that the July 2015 high has not been breached, but in the current position (short term) are somewhat mitigated by the location of stocks still in an oversold condition near long term trend channel support.

If you were to draw a single trendline from the 2009 low to the most recent significant low, all markets show a breach. You would thus consider selling the next bounce or the retest of this breached trendline in a 1-2-3 trend change. The retest would probably correspond to up to a 3-5% rise in the dow.

Chart blasts 12-2-15

132 views

2 1

Ticker symbols:AAPL, ACHN, AMBA, AMRN, BTU, CAT, CL, COF, DATA, DVN, EXXI, FLR, GILD, HAL, KNDI, LVS, MBLY, MRK, NOV, TWTR, UTX, WFM, WLL, YPF, ZNGA

Finviz Link

Chart Blast 11-24

67 views

12

Ideally looking for a stock consolidating (contracting volatility) following a break of the prior down trend, a 1-2-3 bottom, with an equal high being made and another low or consolidation range being met. Simply quality patterns or notable long term consolidation is enough to trigger interest as well. Looking for “risk aversion”.
sentiment chart

Scan method: Manually looking over charts (stocks only) that trade weekly options and looking for anything that catches my eye.

I came up with these names on 11/24 but I’ll post them now for reference.

Ticker symbols:achn,amba,amrn,btu,data,dvn,exxi,flr,gild,gpro,joy,kndi,lvs,mrk,ms,rax,s,wll,wfm,ypf,znga
finviz link here.

Pros And Cons of Cheap Commodities

81 views

prosncons

After this post about commodities, I thought I should look at the pros and cons of declining commodity prices.

Pros:
-Cheaper commodity prices helps consumer and allows for cheaper production.
Low prices may provide for discouragement to develop in the sector and provide good opportunities.
-The valuations are being neglected and the volatility in P/B ratios are consolidating. The technical setup of the price/book suggests a big move most likely higher in the price to book developing. (Unfortunately, high price/book could just mean declining book value rather than increasing price.)

-The economy is perhaps less dependent upon commodity prices than it used to be. We’re not in the agrarian or industrial ages when the economy ran on food output and oil prices. We’re somewhere between the services and technology era (or information age if you prefer).

side note: I suspect the “cybernetic age” is ahead where the old rules correlating employment rate and economic growth begin to diverge as robots/machines can do more and more to take over a lot of the old tasks. Meanwhile the economy becomes less about how the major institutions are doing and more about the individual company using crowd sourcing to fund projects and compete with the big companies as the creme rises to the crop.

-Any future increase may help commodity stocks and may lift the market.
-1998 had notoriously low oil and gold prices which matches the analog of having a roaring market ahead.
Cons:
-The speed of decline may signal deflation is hitting the overall economy even if it hasn’t effected stocks yet. Even if it is similar to 1998, the other side could be devastating.
-If I potential rise in commodity IS coming then all the pros about low prices helping consumer and businesses may in the future actually hurt everything that it should help. As a forward pricing mechanism, then markets may price in a rise in commodity prices soon.[[[However, since more attention is being paid to the negatives of declining oil/commodities, then rising would be seen as good. Either way, you should look at the uncommon or contrarian view in this manner.]]

-A complicated implication that I won’t get into too much detail about is that the impact of low oil on countries like Russia may have influenced events that create the conditions to lead to WWIII.

I tend to actually place greater weight on the bearish side, but the good news is, none of the reasons you should be bearish are necessarily immediate. In other words, we could continue to match the 1998 analog of having a roaring market ahead before the impact is felt.  

We could easily have 6 months to 3 years of upside in stocks before the deflation hitting the oil market effects the stock market. The 2005-2007 period saw deflation of housing market, inflation of energy markets. It wasn’t until long after the losses from the banks and subprime, that it really began to spill over into the global economy…. Even if there’s a similar effect, that doesn’t necessarily mean the speed of the 2015 decline has any immediate impact in stock prices even if commodity prices don’t bottom soon. And if they do, we still could very easily see the markets continue higher until they reach their extreme while commodities and companies in that space quietly begin to pick up steam as an investment.

It’s also worth looking at 1998-2000 as energy prices and commodity prices swung to their extreme lows as the market rose, before rising in sync with the stock market, and continuing upwards without ever taking out that low even during the 2000-2002/2003 decline in the economy.

source: http://www.financialsense.com/

Nevertheless, 1998-2000 was a great time period to invest in commodities. That doesn’t mean that trading stocks short term was a bad idea, or even holding if you could get out before the top. However, for asset allocators and long term buy and hold investors, it may be a decent time to look at commodities and continue to watch that space for opportunities.

wtic

The initial speed of the 2014-2015 decline from $100 to $50 is what concerns me a little moving forward
DBC

Commodities Are Screaming? Are You Listening?

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I’m not a fundamentals guy, but does the fact that commodity based companies seem to be pricing in Armageddon concern anyone? US Steel price to book value has not been this low in the 25 years of data that I just looked over as an example. XOM price to book this year hit levels not seen since early 90s. PBR hit levels this year not seen in 15 years of data.

source:Ycharts.com

x xom PBR

 

update: Just noticed the interesting technical setup in the price to book value. Technical analysis isn’t usually done on a fundamental chart like this, but I thought it was interesting.

valuation squeeze

 

Value Vs Growth

239 views

OA had a post comparing value vs growth since 1993. I was curious what it looked like before that. I came across the following doing an image search
source: http://i563.photobucket.com/albums/ss73/dorseydwa/LCGrowthvsValue.jpg


and source: http://i563.photobucket.com/albums/ss73/dorseydwa/SCRSvsValue.jpg

 

Using the data from this post @ fidelity, I reconstructed a chart in excel to show stats from 1980 onward to include small cap, big cap, and mid cap for both growth and value. I started with 100k invested in 1980 in each. Unfortunately, the data I pulled only went through 2010.

value-vs-growth

We can also just isolate 1980-2001 to see what that looked like, which is what I’m after as it will be interesting to watch as a comparison going forward.

1980-2001

 

Asset Allocation Strategy

197 views

PP

Capital has to move. I believe the market can almost never be in a state of equilibrium because new debt is being created which creates additional capital that changes the balance of allocation, and old debt is being replaced when it’s being paid or assets are being foreclosed for the inability to pay and moey leaves the system or rotates away from one particular system such as a domestic, localized economy to a foreign one.

As such, the efficient market hypothesis can almost never be exactly correct, and if it could be, it only is for a moment since new debt being created and old debt coming due and interest payments are never coordinated to sustain parody in the market place. People have to make moey to pay bills and transactions HAVE to occur. If they don’t, such as in communism, the economy collapses as has occurred historically anytime any nation even attempts to move towards a communistic state.

With this in mind, we still should care about how one might position in an effecient market, because a true “game theoretic optimal solution” or “equilibrium solution” is indifferent to how the actual market is positioned. The key behind this philosophy is to position such that you profit from a movement of capital regardless of in which way it occurs.

A simplified example is shown at the top of this post, but an even more simple one would be a world where you could choose between 2 types of currency assuming neither could be eliminated from legal usage. The optimal “equilibrium” solution would be 50% of each at all times. If 99.9% of the world used dollars, you still would gain from 50% mixture of each because you’d maintain the ability to reduce higher and add lower. If it was 99% the other way that would also be the case. Although a more “exploitative” solution would be to position the inverse of the crowd such as being 99.9% of the currency that is owned by .1% of the population, that doesn’t detract from the profitability of the “equilibrium” solution of 50/50%

Understand this difference because I do not advocate an “equilibrium strategy” entirely, but by being aware of it you can deviate from it to the degree by which you have an edge and to the degree by which you can stand volatility.

If you have an edge, you can try to assess that edge probabilistically and use simulations to match your goals such that you have an expectation that satisfies you at a level of volatility that you can stand.

If you were to integrate your ability to make short and long term trades, you might create a baseline that adds in an edge playing the market, but curbs it with an allocation based equilibrium strategy as a core staple of that strategy in the following regard.

equal

As you can see, by including individual short term and long term trades as an allocation, there is a bias towards stocks and stock picking.

With the introduction of this, the problem is that over time your allocations will change and the reality of transaction fees require less frequent rebalancing. Also, individual trades usually have upside expectations and you want to let your winners run. As such it is possible that your individual positions may cause portfolio to grow out of balance. So you probably want to build in a more flexible mechanism to maintain overall parody with regards to your intended allocation of risk and stocks overall. This can be demonstrated below
1

2

3

Rather than sell short of targets to maintain balance in asset allocation, you can use this reflexive, adaptive model to maintain the balance. As long term allocation grows you can reduce or entirely sell your broadbased stock ETFs. As short term allocation grows you can add hedges that last at least until your exit strategy triggers a sell and the increase in cash can allow you to make the adjustment to bring your strategy back into the intended risk allocations. You can develop more complex models to work subasset class allocations as well, and even try to handicap those or handicap the actual market movements by weighting your positioning according to risk and reward and expectations overall to more aggressively try to game the market as well as use leverage.

4

If you believe that you have a large enough edge and want to use additional information, you may use volatility as a tool and include options.

When volatility is high, you add to option selling strategies or XIV or SVXY ownership, and you might add to broadbased ETFs since correlation tends to be higher and the edge for picking stocks is less. You might increase longer term exposure following a crash weighting heavier in value and fundamentals. When volatility is low, you add to overall option exposure and may opt to reduce your allocation of XIV or SVXY. When correlations are less you may want to increase option ownership and decrease broadbased ETF ownership and look to apply your “edge seeking” as a larger percentage of your allocation.

This dynamic approach can still have with it a set of rules from which to govern the overall intent, and some kind of checklist to help you operate it efficiently as intended. The overall idea is to not get emotional and allocate emotionally, but instead strategically according to a plan made when your mind is operating at a high level, rather than when you are in fight or flight mode and you’re in “panic mode” and your amygdala is active.

So if I were trying to game the market right now, on the long term I may be interested in commodities, but in the short term I don’t see any setups. Any allocation towards ETFs or calls would have to be with plans of long term ownership. I think it’s a good entry for a longer term horizon on the stock market, but the individual names aren’t suppolying great entries aside from maybe some long term stock investments.

So with a volatility spike I’m rotating out of my individual stock trades as they stop out, and then if I have any hedges, I’m seriously reducing or taking them off as the decline reaches extreme. I’m looking on adding or increasing an inverse volatility ETF as long as the primary bull market thesis remains intact, and I’m looking to position for long term stocks but I’m not really looking to add long option strategies. I may be willing to sell puts on stocks I’m willing to buy or sell put spreads on stocks with high IV that look to be likely to hold or go higher.

You don’t necessarily need to force trades, but if you have thought all of this out and have thought out position size, maximum and minimum allocation for each assetclass or a way to objectively determine the allocation based upon certain measures, you will avoid fear taking over.

You will also be able to remain consistent. One of the biggest problems traders run into is that at the bottom, an allocation of 50% stocks seems high, where as at the top it seems low… At the bottom finding individual stocks to buy is tough, where as at the top they are easy. This is why you need a system in place while you’re thinking rationally that you can apply as the market changes, or at least increase the size of your hedges and bearish bets at the “top” while selling you broadbased ETFs to counterbalance your ability to have confidence with individual positions without unnecessarily over exposing yourself.

You also need to have thresholds at which you rebalance. Perhaps if a stock is within 5% of targeted allocation you don’t bother rebalancing, but outside of that number you do.

from an exploitative philosophy it’s okay to increase your allocation as the market goes lower if you are buying individual stocks, and you have some sort of risk management mechanism which acts as a kill switch if buying lower fails. While in equilibrium strategy you don’t want to expose yourself to further declines with a “martingale” type of strategy, there are many times when both the odds of a bounce and the expectation when it does happen actually increases as stocks get more oversold. But you need to have limits. So if your average allocation of an asset class is 25% you might take that up to a maximum of 40% when buying the ideal oversold conditions and down to 10% or 5% when selling oversold.

I can’t define these to you because that depends upon what your pain tolerance is and what your goals are and timeframe for those goals, and whether or not that is realistic for you.

With an equilibrium strategy, you are basically looking at a strategy that works over an infinite time horizon, where as realistically you should approach it with variance in mind. As such, position sizing becomes important and your cash position should increase. This is why the logic to weighting assets by volatility may actually make some sense on the surface, but I don’t believe it’s pure equilibrium strategy.

Unfortunately, that which is not volatile may not remain that way forever. I believe real estate had not undergone much downside volatility at all for decades until it finally crashed in 2007-2009. The global demand for bonds on the basis that it has been “safe” or less volatile isn’t an accurate reflection of the last 200 years of history where governments defaulted, nations have risen and fallen and political power and influence has shifted. It may provide some normalization of risk through the INCOME, but that doesn’t make it immune from default risk or loss of confidence and asset class wide loss of risk appetite. Since that risk still exists, you have to ask yourself if the prospect of complete default is worth such a low yield. For example, a 2% yield requires 36 years of interest accumulation until it makes a 100% return. If the chances of a default in that time period is greater than 50% than there is no advantage at all from holding bonds instead of just cash. In fact, it’s worse to hold bonds probably even if those odds were 40% because of volatility risk, opportunity costs of not being invested elsewhere, taxes on income and “black swan” risk even though there are some advantages in curbing volatility as a result of income. For many people even if that amount were 20% due to risk tolerance and transaction costs it may be better to hold cash than bonds, and even if it were much lower it’s not a huge loss. In some cases bonds can be used as collateral to borrow from to create leverage.

The real risk to cash is not the failure to return value, but the failure to protect purchasing power. As such, assets that gain from inflationary pressures, particular that effect the individual the most (such as food and fuel and stocks) is the best way to mitigate that risk. Currently, I don’t view a shift of capital from stocks to bonds as a major risk to stocks, so overall the exploitative strategy should probably be to have a mixture of cash stocks, some commodities and perhaps even betting against bonds and finding other income strategies such as preferred shares, corporate debt and occasional option selling strategies when conditions warrant it.

 

update:

Another approach to maximizing a particular expectation of return is looking at synergy between asset classes. Since the rotation of one into the rotation of another produces gains to the degree at which you are able to effectively buy low and sell high and since allocation of income provides additional capital to more efficiently rebalance and normalize returns, you can look at the downside deviation or the overall deviation of results to compare the overall portfolio strategy as a measurement of risk.

While this only tells you a backwards looking result of how volatility can be smoothed, it is more appropriate than backtesting of actual results since it’s looking at historical correlation.

I came up with the following strategy as an effective means historically to balance risk efficiently as can be seen at this link.

Sortino ratio: 3.23

Sharpe ratio: .87

CAGR: 10.23%

Std Deviation: 8.08%

worst year -2.71%

Backtested since 1985

 

Allocation:

Intermediate term treasuries 29% (IEF)
Long term treasuries 41% (TLT)
Small Cap Value 11% (IWN)
Mid Cap Value 14%
Large Cap Growth 5%

Midcap values weren’t around before 1985 so the following is the best I could do backtested since 1972.

Sortino Ratio 2.21

Sharpe ratio .76

CAGR 9.81%

std deviation 6.18

worst year -1.67%

10% Small Cap Value
12% Int Small Cap
70% Intermediate term treasuries
8% gold

Another strategy which involves cash to reduce the volatility is
8% small cap value
11% int small cap
3% LT treasuries
47% intermediate term treasuries
24% cash/money market
7% gold

If you progress towards using leverage and rebalancing more frequently, you are going to have to increase cash position and income positions to replenish that cash position so you can normalize the volatility without having to pay a lot of extra transaction costs to rebalance.

Since the goal is not return overall but instead return vs downside volatility, you potentially could leverage this up significantly and still have less volatility than a non leveraged strategy that was more aggressively allocated. The result can be a better return on better risk.

I believe this philosophy is somewhat flawed since it looks at past performance and past risk as defined by volatility and past correlation to determine overall portfolio volatility. I think to some degree, the less volatility a market has experienced over the past the more vulnerable it is to more dramatic volatility if people are following models expecting the future to resemble the past. Once it starts producing more volatility than expected, that forces people to re-calibrate their models and reduce allocation which creates more selling pressure and more re-calibration among mutual fund managers and others.

But I think you can still look at bonds and convert that to other forms of income that are currently better positioned, and try to identify the areas better positioned for growth in the future as well and keep in mind how down years of stock and bonds may see positive results in gold and commodities and how certain assets compliment each other. Or you can use some mixture of a more balanced strategy that allocates among a few asset classes evenly and this mixed with some tweaking based upon your outlook and adding cash as necessary or leveraging as necessary to better meet your goals and risk tolerance.

This is designed to get you thinking about how capital flowing from one asset class to another plus past history vs future potntial and your own volatility tolerance to come up with a flexible strategy that works for you and isn’t overly complicated to follow.

Primary Bull Market Remains Intact

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In the book Trader Vic there was a chapter on Dow Theory. The author went over some lesser known aspects of early dow theorists.I plan to look this up if I can get around to finding the book when I get a chance to look for it.

From memory, the aspects of importance here are that when declaring a change in the primary trend ALL major indices must agree. It is not enough for the dow to break below the most recent primary low, but all major indices must break these levels.

While the all world index, the dow and the nasdaq and others broke below the October 2014 primary low, the S&P and Russel 2000 did not.

As such, this confusion and “breakdown” could very well be a fakeout. According to this aspect of the early dow theorists, it should NOT be treatet as anything but “primary bull still intact”.

The disagreement by the markets or “divergence” of course can certainly mean EITHER that the other major indicies overreacted to the recent selloff, or that the dow and russel under reacted. One approach is, “when in doubt, stick with the prior trend”.

Another which Vic also advocated was treating the market sort of like an insurance premium. The insurance company should expect that the older a person gets, the more vulnerable they are to a medical problem. Similarly, the older the bull market the more susceptible it should be to declines and economic problems.

However, he also stated that the closer it got to the extreme, the more likely it was to be an “outlier”. It wasn’t really clear how he would treat “outliers”. Would he give up on his thesis of positioning more cautiously after the market entered “outlier” territory”? Would he position more neutral? Would he just remain more vigilant in watching for signs of tops technically? Would he just trade different timeframes and avoid trying to position one way or another for the longer term until it ended?

Nevertheless, he would handicap the duration and magnitude of the move as well as the probability that the moves reached certain thresholds in the primary markets. He also would look at moves in different durations. The moves as an active swing trader would not be classified as the same as a longer term investor who held for years. So a breach of a minor low made in July of 2015 for example would have a different duration, move expectancy and timing approach to the October 2014 low.

If you believe in this theory of examining moves median and mean length and magnitude, you’d probably also enjoy Bulkowski’s Encyclopedia of Chart Patterns, and/or Encyclopedia of Candlestick Charts where he loads it with statistics like this relative to individual patterns on individual stocks rather than studying broad market moves in general like Trader Vic and Trader Vic II.

The main reason I want to pull up a copy of the book out when I get a chance to reexamine these differences between how he defined “swing trader”, “position trader” and “Investor” and the statistics on each move.

Nevertheless, considering the implied volatility of the VIX, the liquidity concerns following brokerage outages and the nature of a fast selloff I’m putting my money on the low holding. I believe that using the criteria of the VIX spike surpassing 2011 highs that the “panic” was filled with over exaggeration rather than under exaggeration. Over exaggeration means we can rebound in all markets and continue the primary bull market with these levels representing the next primary low.

Due to the volume profile of stocks below, if we somehow don’t manage to hold volume profile support at around S&P 1825-1880, I think you can be pretty confident that the last recent primary low will not hold and look to find an entry to the downside; ideally on a rip higher and retest of those support ranges

For those keeping track, I said in the last post that if I had to make a trade when we were in “no man’s land” I’d side on selling premium and selling a call spread. That was because I looked at the volume profiles to define a range that provided the potential for loose and fast action from the range of just north of 205 and just under 190 when at the time SPY was around 200. With changes in price action and support, your position should change as well. I think you can manage a long entry, or sell a put spread as the upside outweighs the downside in terms of price and overall management of the position would provide a positive return on risk. Meanwhile, the VIX is still high so you can profit from a decline in volatility if prices don’t move much.

 

Market Outlook

531 views

Let’s start with the transports which are the greatest sign for concern for the general markets.
transports warning

You can see a failure to make new highs, a breach of prior lows, and a breach of the long term trend channel. However, in order for markets to be confirmed bear market, you need ALL major markets to show the same thing.
So let’s look at the S&P

spx

If you were to draw a single trendline from the lowest low to the most recent low, you certainly have a trendline breach. However, the trend channel appears to be intact, and because the most recent low didn’t close the week below prior low, it remains unconfirmed by some definitions. However, the weekly close of week ending 1/16/16 was a lower weekly close than the prior weekly low (on closing basis), we have a lower weekly close than the 1/16 close, so it’s definitely leaning towards confirmed breach of recent lows. Nevertheless, the oversold conditions near a long term trend channel support is certainly a historically a good location to be a buyer, not a seller.

Let’s look at the dow.

dow

The long term broadening pattern formed resistance that temporarily was broken to the upside but failed to stay above. As we zoom in we can see that the long term trend channel has been breached. The rest is a little confusing once again because the daily/intraday shows a higher lows, but on a weekly closing basis we have the current recent low lower than the last 2 and a pattern of lower lows and lower highs on a weekly closing basis.

Finally, I saved the most fun chart for last, the nasdaq.
nasdaqWe can see that the all time high of 5132.52 acted as resistance, even though we surpassed these highs briefly. Also interesting is that the next high following the 2000 top is acting as support. The recent low is above the October 2014 closing lows, but below the August-September 2015 closing low despite being above the open of August 24.

In conclusion, there isn’t a clear, decisive bear market underway just yet. There is some evidence for a range bound market, some evidence for a short term bounce, and some evidence that an intermediate term, or even long term correction may be in development (unconfirmed).

However, the signs suggest considering caution into strength moving forward. There certainly is evidence pointing towards a short term correction if you are judging off of the weekly closes of the lows. The fact that ALL markets are showing a lower low on a weekly closing basis than the low made in the August-September 2015 time range is significant enough to create cause for concern and a minimum of lighter position sizes and/or number of positions moving forwards. This concern is increased by the fact that the July 2015 high has not been breached, but in the current position (short term) are somewhat mitigated by the location of stocks still in an oversold condition near long term trend channel support.

If you were to draw a single trendline from the 2009 low to the most recent significant low, all markets show a breach. You would thus consider selling the next bounce or the retest of this breached trendline in a 1-2-3 trend change. The retest would probably correspond to up to a 3-5% rise in the dow.

Chart blasts 12-2-15

132 views

2 1

Ticker symbols:AAPL, ACHN, AMBA, AMRN, BTU, CAT, CL, COF, DATA, DVN, EXXI, FLR, GILD, HAL, KNDI, LVS, MBLY, MRK, NOV, TWTR, UTX, WFM, WLL, YPF, ZNGA

Finviz Link

Chart Blast 11-24

67 views

12

Ideally looking for a stock consolidating (contracting volatility) following a break of the prior down trend, a 1-2-3 bottom, with an equal high being made and another low or consolidation range being met. Simply quality patterns or notable long term consolidation is enough to trigger interest as well. Looking for “risk aversion”.
sentiment chart

Scan method: Manually looking over charts (stocks only) that trade weekly options and looking for anything that catches my eye.

I came up with these names on 11/24 but I’ll post them now for reference.

Ticker symbols:achn,amba,amrn,btu,data,dvn,exxi,flr,gild,gpro,joy,kndi,lvs,mrk,ms,rax,s,wll,wfm,ypf,znga
finviz link here.

Pros And Cons of Cheap Commodities

81 views

prosncons

After this post about commodities, I thought I should look at the pros and cons of declining commodity prices.

Pros:
-Cheaper commodity prices helps consumer and allows for cheaper production.
Low prices may provide for discouragement to develop in the sector and provide good opportunities.
-The valuations are being neglected and the volatility in P/B ratios are consolidating. The technical setup of the price/book suggests a big move most likely higher in the price to book developing. (Unfortunately, high price/book could just mean declining book value rather than increasing price.)

-The economy is perhaps less dependent upon commodity prices than it used to be. We’re not in the agrarian or industrial ages when the economy ran on food output and oil prices. We’re somewhere between the services and technology era (or information age if you prefer).

side note: I suspect the “cybernetic age” is ahead where the old rules correlating employment rate and economic growth begin to diverge as robots/machines can do more and more to take over a lot of the old tasks. Meanwhile the economy becomes less about how the major institutions are doing and more about the individual company using crowd sourcing to fund projects and compete with the big companies as the creme rises to the crop.

-Any future increase may help commodity stocks and may lift the market.
-1998 had notoriously low oil and gold prices which matches the analog of having a roaring market ahead.
Cons:
-The speed of decline may signal deflation is hitting the overall economy even if it hasn’t effected stocks yet. Even if it is similar to 1998, the other side could be devastating.
-If I potential rise in commodity IS coming then all the pros about low prices helping consumer and businesses may in the future actually hurt everything that it should help. As a forward pricing mechanism, then markets may price in a rise in commodity prices soon.[[[However, since more attention is being paid to the negatives of declining oil/commodities, then rising would be seen as good. Either way, you should look at the uncommon or contrarian view in this manner.]]

-A complicated implication that I won’t get into too much detail about is that the impact of low oil on countries like Russia may have influenced events that create the conditions to lead to WWIII.

I tend to actually place greater weight on the bearish side, but the good news is, none of the reasons you should be bearish are necessarily immediate. In other words, we could continue to match the 1998 analog of having a roaring market ahead before the impact is felt.  

We could easily have 6 months to 3 years of upside in stocks before the deflation hitting the oil market effects the stock market. The 2005-2007 period saw deflation of housing market, inflation of energy markets. It wasn’t until long after the losses from the banks and subprime, that it really began to spill over into the global economy…. Even if there’s a similar effect, that doesn’t necessarily mean the speed of the 2015 decline has any immediate impact in stock prices even if commodity prices don’t bottom soon. And if they do, we still could very easily see the markets continue higher until they reach their extreme while commodities and companies in that space quietly begin to pick up steam as an investment.

It’s also worth looking at 1998-2000 as energy prices and commodity prices swung to their extreme lows as the market rose, before rising in sync with the stock market, and continuing upwards without ever taking out that low even during the 2000-2002/2003 decline in the economy.

source: http://www.financialsense.com/

Nevertheless, 1998-2000 was a great time period to invest in commodities. That doesn’t mean that trading stocks short term was a bad idea, or even holding if you could get out before the top. However, for asset allocators and long term buy and hold investors, it may be a decent time to look at commodities and continue to watch that space for opportunities.

wtic

The initial speed of the 2014-2015 decline from $100 to $50 is what concerns me a little moving forward
DBC

Commodities Are Screaming? Are You Listening?

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I’m not a fundamentals guy, but does the fact that commodity based companies seem to be pricing in Armageddon concern anyone? US Steel price to book value has not been this low in the 25 years of data that I just looked over as an example. XOM price to book this year hit levels not seen since early 90s. PBR hit levels this year not seen in 15 years of data.

source:Ycharts.com

x xom PBR

 

update: Just noticed the interesting technical setup in the price to book value. Technical analysis isn’t usually done on a fundamental chart like this, but I thought it was interesting.

valuation squeeze

 

Value Vs Growth

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OA had a post comparing value vs growth since 1993. I was curious what it looked like before that. I came across the following doing an image search
source: http://i563.photobucket.com/albums/ss73/dorseydwa/LCGrowthvsValue.jpg


and source: http://i563.photobucket.com/albums/ss73/dorseydwa/SCRSvsValue.jpg

 

Using the data from this post @ fidelity, I reconstructed a chart in excel to show stats from 1980 onward to include small cap, big cap, and mid cap for both growth and value. I started with 100k invested in 1980 in each. Unfortunately, the data I pulled only went through 2010.

value-vs-growth

We can also just isolate 1980-2001 to see what that looked like, which is what I’m after as it will be interesting to watch as a comparison going forward.

1980-2001

 

Asset Allocation Strategy

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PP

Capital has to move. I believe the market can almost never be in a state of equilibrium because new debt is being created which creates additional capital that changes the balance of allocation, and old debt is being replaced when it’s being paid or assets are being foreclosed for the inability to pay and moey leaves the system or rotates away from one particular system such as a domestic, localized economy to a foreign one.

As such, the efficient market hypothesis can almost never be exactly correct, and if it could be, it only is for a moment since new debt being created and old debt coming due and interest payments are never coordinated to sustain parody in the market place. People have to make moey to pay bills and transactions HAVE to occur. If they don’t, such as in communism, the economy collapses as has occurred historically anytime any nation even attempts to move towards a communistic state.

With this in mind, we still should care about how one might position in an effecient market, because a true “game theoretic optimal solution” or “equilibrium solution” is indifferent to how the actual market is positioned. The key behind this philosophy is to position such that you profit from a movement of capital regardless of in which way it occurs.

A simplified example is shown at the top of this post, but an even more simple one would be a world where you could choose between 2 types of currency assuming neither could be eliminated from legal usage. The optimal “equilibrium” solution would be 50% of each at all times. If 99.9% of the world used dollars, you still would gain from 50% mixture of each because you’d maintain the ability to reduce higher and add lower. If it was 99% the other way that would also be the case. Although a more “exploitative” solution would be to position the inverse of the crowd such as being 99.9% of the currency that is owned by .1% of the population, that doesn’t detract from the profitability of the “equilibrium” solution of 50/50%

Understand this difference because I do not advocate an “equilibrium strategy” entirely, but by being aware of it you can deviate from it to the degree by which you have an edge and to the degree by which you can stand volatility.

If you have an edge, you can try to assess that edge probabilistically and use simulations to match your goals such that you have an expectation that satisfies you at a level of volatility that you can stand.

If you were to integrate your ability to make short and long term trades, you might create a baseline that adds in an edge playing the market, but curbs it with an allocation based equilibrium strategy as a core staple of that strategy in the following regard.

equal

As you can see, by including individual short term and long term trades as an allocation, there is a bias towards stocks and stock picking.

With the introduction of this, the problem is that over time your allocations will change and the reality of transaction fees require less frequent rebalancing. Also, individual trades usually have upside expectations and you want to let your winners run. As such it is possible that your individual positions may cause portfolio to grow out of balance. So you probably want to build in a more flexible mechanism to maintain overall parody with regards to your intended allocation of risk and stocks overall. This can be demonstrated below
1

2

3

Rather than sell short of targets to maintain balance in asset allocation, you can use this reflexive, adaptive model to maintain the balance. As long term allocation grows you can reduce or entirely sell your broadbased stock ETFs. As short term allocation grows you can add hedges that last at least until your exit strategy triggers a sell and the increase in cash can allow you to make the adjustment to bring your strategy back into the intended risk allocations. You can develop more complex models to work subasset class allocations as well, and even try to handicap those or handicap the actual market movements by weighting your positioning according to risk and reward and expectations overall to more aggressively try to game the market as well as use leverage.

4

If you believe that you have a large enough edge and want to use additional information, you may use volatility as a tool and include options.

When volatility is high, you add to option selling strategies or XIV or SVXY ownership, and you might add to broadbased ETFs since correlation tends to be higher and the edge for picking stocks is less. You might increase longer term exposure following a crash weighting heavier in value and fundamentals. When volatility is low, you add to overall option exposure and may opt to reduce your allocation of XIV or SVXY. When correlations are less you may want to increase option ownership and decrease broadbased ETF ownership and look to apply your “edge seeking” as a larger percentage of your allocation.

This dynamic approach can still have with it a set of rules from which to govern the overall intent, and some kind of checklist to help you operate it efficiently as intended. The overall idea is to not get emotional and allocate emotionally, but instead strategically according to a plan made when your mind is operating at a high level, rather than when you are in fight or flight mode and you’re in “panic mode” and your amygdala is active.

So if I were trying to game the market right now, on the long term I may be interested in commodities, but in the short term I don’t see any setups. Any allocation towards ETFs or calls would have to be with plans of long term ownership. I think it’s a good entry for a longer term horizon on the stock market, but the individual names aren’t suppolying great entries aside from maybe some long term stock investments.

So with a volatility spike I’m rotating out of my individual stock trades as they stop out, and then if I have any hedges, I’m seriously reducing or taking them off as the decline reaches extreme. I’m looking on adding or increasing an inverse volatility ETF as long as the primary bull market thesis remains intact, and I’m looking to position for long term stocks but I’m not really looking to add long option strategies. I may be willing to sell puts on stocks I’m willing to buy or sell put spreads on stocks with high IV that look to be likely to hold or go higher.

You don’t necessarily need to force trades, but if you have thought all of this out and have thought out position size, maximum and minimum allocation for each assetclass or a way to objectively determine the allocation based upon certain measures, you will avoid fear taking over.

You will also be able to remain consistent. One of the biggest problems traders run into is that at the bottom, an allocation of 50% stocks seems high, where as at the top it seems low… At the bottom finding individual stocks to buy is tough, where as at the top they are easy. This is why you need a system in place while you’re thinking rationally that you can apply as the market changes, or at least increase the size of your hedges and bearish bets at the “top” while selling you broadbased ETFs to counterbalance your ability to have confidence with individual positions without unnecessarily over exposing yourself.

You also need to have thresholds at which you rebalance. Perhaps if a stock is within 5% of targeted allocation you don’t bother rebalancing, but outside of that number you do.

from an exploitative philosophy it’s okay to increase your allocation as the market goes lower if you are buying individual stocks, and you have some sort of risk management mechanism which acts as a kill switch if buying lower fails. While in equilibrium strategy you don’t want to expose yourself to further declines with a “martingale” type of strategy, there are many times when both the odds of a bounce and the expectation when it does happen actually increases as stocks get more oversold. But you need to have limits. So if your average allocation of an asset class is 25% you might take that up to a maximum of 40% when buying the ideal oversold conditions and down to 10% or 5% when selling oversold.

I can’t define these to you because that depends upon what your pain tolerance is and what your goals are and timeframe for those goals, and whether or not that is realistic for you.

With an equilibrium strategy, you are basically looking at a strategy that works over an infinite time horizon, where as realistically you should approach it with variance in mind. As such, position sizing becomes important and your cash position should increase. This is why the logic to weighting assets by volatility may actually make some sense on the surface, but I don’t believe it’s pure equilibrium strategy.

Unfortunately, that which is not volatile may not remain that way forever. I believe real estate had not undergone much downside volatility at all for decades until it finally crashed in 2007-2009. The global demand for bonds on the basis that it has been “safe” or less volatile isn’t an accurate reflection of the last 200 years of history where governments defaulted, nations have risen and fallen and political power and influence has shifted. It may provide some normalization of risk through the INCOME, but that doesn’t make it immune from default risk or loss of confidence and asset class wide loss of risk appetite. Since that risk still exists, you have to ask yourself if the prospect of complete default is worth such a low yield. For example, a 2% yield requires 36 years of interest accumulation until it makes a 100% return. If the chances of a default in that time period is greater than 50% than there is no advantage at all from holding bonds instead of just cash. In fact, it’s worse to hold bonds probably even if those odds were 40% because of volatility risk, opportunity costs of not being invested elsewhere, taxes on income and “black swan” risk even though there are some advantages in curbing volatility as a result of income. For many people even if that amount were 20% due to risk tolerance and transaction costs it may be better to hold cash than bonds, and even if it were much lower it’s not a huge loss. In some cases bonds can be used as collateral to borrow from to create leverage.

The real risk to cash is not the failure to return value, but the failure to protect purchasing power. As such, assets that gain from inflationary pressures, particular that effect the individual the most (such as food and fuel and stocks) is the best way to mitigate that risk. Currently, I don’t view a shift of capital from stocks to bonds as a major risk to stocks, so overall the exploitative strategy should probably be to have a mixture of cash stocks, some commodities and perhaps even betting against bonds and finding other income strategies such as preferred shares, corporate debt and occasional option selling strategies when conditions warrant it.

 

update:

Another approach to maximizing a particular expectation of return is looking at synergy between asset classes. Since the rotation of one into the rotation of another produces gains to the degree at which you are able to effectively buy low and sell high and since allocation of income provides additional capital to more efficiently rebalance and normalize returns, you can look at the downside deviation or the overall deviation of results to compare the overall portfolio strategy as a measurement of risk.

While this only tells you a backwards looking result of how volatility can be smoothed, it is more appropriate than backtesting of actual results since it’s looking at historical correlation.

I came up with the following strategy as an effective means historically to balance risk efficiently as can be seen at this link.

Sortino ratio: 3.23

Sharpe ratio: .87

CAGR: 10.23%

Std Deviation: 8.08%

worst year -2.71%

Backtested since 1985

 

Allocation:

Intermediate term treasuries 29% (IEF)
Long term treasuries 41% (TLT)
Small Cap Value 11% (IWN)
Mid Cap Value 14%
Large Cap Growth 5%

Midcap values weren’t around before 1985 so the following is the best I could do backtested since 1972.

Sortino Ratio 2.21

Sharpe ratio .76

CAGR 9.81%

std deviation 6.18

worst year -1.67%

10% Small Cap Value
12% Int Small Cap
70% Intermediate term treasuries
8% gold

Another strategy which involves cash to reduce the volatility is
8% small cap value
11% int small cap
3% LT treasuries
47% intermediate term treasuries
24% cash/money market
7% gold

If you progress towards using leverage and rebalancing more frequently, you are going to have to increase cash position and income positions to replenish that cash position so you can normalize the volatility without having to pay a lot of extra transaction costs to rebalance.

Since the goal is not return overall but instead return vs downside volatility, you potentially could leverage this up significantly and still have less volatility than a non leveraged strategy that was more aggressively allocated. The result can be a better return on better risk.

I believe this philosophy is somewhat flawed since it looks at past performance and past risk as defined by volatility and past correlation to determine overall portfolio volatility. I think to some degree, the less volatility a market has experienced over the past the more vulnerable it is to more dramatic volatility if people are following models expecting the future to resemble the past. Once it starts producing more volatility than expected, that forces people to re-calibrate their models and reduce allocation which creates more selling pressure and more re-calibration among mutual fund managers and others.

But I think you can still look at bonds and convert that to other forms of income that are currently better positioned, and try to identify the areas better positioned for growth in the future as well and keep in mind how down years of stock and bonds may see positive results in gold and commodities and how certain assets compliment each other. Or you can use some mixture of a more balanced strategy that allocates among a few asset classes evenly and this mixed with some tweaking based upon your outlook and adding cash as necessary or leveraging as necessary to better meet your goals and risk tolerance.

This is designed to get you thinking about how capital flowing from one asset class to another plus past history vs future potntial and your own volatility tolerance to come up with a flexible strategy that works for you and isn’t overly complicated to follow.

Primary Bull Market Remains Intact

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In the book Trader Vic there was a chapter on Dow Theory. The author went over some lesser known aspects of early dow theorists.I plan to look this up if I can get around to finding the book when I get a chance to look for it.

From memory, the aspects of importance here are that when declaring a change in the primary trend ALL major indices must agree. It is not enough for the dow to break below the most recent primary low, but all major indices must break these levels.

While the all world index, the dow and the nasdaq and others broke below the October 2014 primary low, the S&P and Russel 2000 did not.

As such, this confusion and “breakdown” could very well be a fakeout. According to this aspect of the early dow theorists, it should NOT be treatet as anything but “primary bull still intact”.

The disagreement by the markets or “divergence” of course can certainly mean EITHER that the other major indicies overreacted to the recent selloff, or that the dow and russel under reacted. One approach is, “when in doubt, stick with the prior trend”.

Another which Vic also advocated was treating the market sort of like an insurance premium. The insurance company should expect that the older a person gets, the more vulnerable they are to a medical problem. Similarly, the older the bull market the more susceptible it should be to declines and economic problems.

However, he also stated that the closer it got to the extreme, the more likely it was to be an “outlier”. It wasn’t really clear how he would treat “outliers”. Would he give up on his thesis of positioning more cautiously after the market entered “outlier” territory”? Would he position more neutral? Would he just remain more vigilant in watching for signs of tops technically? Would he just trade different timeframes and avoid trying to position one way or another for the longer term until it ended?

Nevertheless, he would handicap the duration and magnitude of the move as well as the probability that the moves reached certain thresholds in the primary markets. He also would look at moves in different durations. The moves as an active swing trader would not be classified as the same as a longer term investor who held for years. So a breach of a minor low made in July of 2015 for example would have a different duration, move expectancy and timing approach to the October 2014 low.

If you believe in this theory of examining moves median and mean length and magnitude, you’d probably also enjoy Bulkowski’s Encyclopedia of Chart Patterns, and/or Encyclopedia of Candlestick Charts where he loads it with statistics like this relative to individual patterns on individual stocks rather than studying broad market moves in general like Trader Vic and Trader Vic II.

The main reason I want to pull up a copy of the book out when I get a chance to reexamine these differences between how he defined “swing trader”, “position trader” and “Investor” and the statistics on each move.

Nevertheless, considering the implied volatility of the VIX, the liquidity concerns following brokerage outages and the nature of a fast selloff I’m putting my money on the low holding. I believe that using the criteria of the VIX spike surpassing 2011 highs that the “panic” was filled with over exaggeration rather than under exaggeration. Over exaggeration means we can rebound in all markets and continue the primary bull market with these levels representing the next primary low.

Due to the volume profile of stocks below, if we somehow don’t manage to hold volume profile support at around S&P 1825-1880, I think you can be pretty confident that the last recent primary low will not hold and look to find an entry to the downside; ideally on a rip higher and retest of those support ranges

For those keeping track, I said in the last post that if I had to make a trade when we were in “no man’s land” I’d side on selling premium and selling a call spread. That was because I looked at the volume profiles to define a range that provided the potential for loose and fast action from the range of just north of 205 and just under 190 when at the time SPY was around 200. With changes in price action and support, your position should change as well. I think you can manage a long entry, or sell a put spread as the upside outweighs the downside in terms of price and overall management of the position would provide a positive return on risk. Meanwhile, the VIX is still high so you can profit from a decline in volatility if prices don’t move much.