Analyzing Efficientish Markets

A Quick Update

2011-10-17T19:45:00.001-07:00

Just a few words since it has been a while since my last update.

The strength of the recent rally caught me by surprise. Generally speaking, the market knows a lot more than I do – so if the market is moving in the opposite of what I expect it usually means that I am wrong and that I need to reevaluate my thinking.

However, every time I considered buying into this most recent run-up I found myself thinking about the following:

Greece will likely default before the end of the year
Once Greece defaults, Portugal is next
Despite the recent upbeat news, we’re probably headed for a recession

Although it pains me to miss out on gains, I don’t believe that this is “priced in” and I can’t be a buyer here.

Gold and the Bear Market

2011-10-02T17:06:00.001-07:00

Regular readers know that I am a fan of gold as an investment but not a true-believer in the hyper-inflation trade.

To me, the gold trade here is very simple:

We are in a bear market driven by concerns about sovereign default.
If (when) Greece defaults, counter-parties (banks, investors, etc) will need to raise dollars for a variety of reasons.
Assets such as stocks and gold, regardless of their “intrinsic value,” will be liquidated in exchange for dollars.
At this time, governments and central banks appear to be too preoccupied with their own debt and inflation to provide enough supply to meet the coming dollar demand.
Eventually, our debt problem will only be solved by default or inflation.
In the event of default or inflation, hard assets (like gold) will rise in value.

After the recent run-up, gold is now approaching its 200 day moving average. Over the past few years – this has been a solid entry point into gold.

However, over the past few years we have been in a bull market and not a bear market. This is no longer the case.

As inflation policy shifts from its current stance (highly undesirable) to its future stance (the least horrible option) – gold will shift from an asset that must be liquidated to an asset that must be bought.

So, in other words, I am skeptical that gold will remain above its 200 day moving average right now – but it remains a long-term asset that must be owned.

Q3 2011 Results

2011-09-30T14:19:00.001-07:00

While I am pleased to pull ahead of the S&P in relative terms, it’s never fun to lose money in real terms.

The biggest issue that I had this quarter was simply that I was not able to trade when the market made its big swoosh lower – and therefore I missed out on a huge chance to outperform.

2011 Q3

S&P 500: –14.3%
My Portfolio: –10.9%
Relative Performance to S&P 500: +3.4%

2011 YTD

S&P 500: -10%
My Portfolio: –6.9%
Relative Performance to S&P 500: +3.1%

Trouble Ahead, Trouble Behind

2011-09-11T18:39:00.001-07:00

The dollar broke through the 200 day moving average last week as the Euro fell through the floor.

Unless there is some unexpected news out of Europe, I believe that the next leg down in the bear market is in progress.

I will be largely in cash for the foreseeable future. In terms of investments the only “safe” harbors are dollars, treasury bonds, or bear market index funds. Gold may continue to ride high for a while, but when the liquidation phase of the bear market happens it will get whacked as well.

The Path of the Hurricane

2011-08-29T19:46:00.001-07:00

Bearing in mind my earlier post about what a bear market “looks like” - I remain of the opinion that we are in a bear market rally.

My expectation is that we will rally for a bit more on declining volume and roll-over into further declines.

The Economics of the iPad

2011-08-21T20:35:00.001-07:00

And now for something a little different…

In the not-too-distant past, the preferred handheld gaming platform was the Nintendo 3DS. My two nephews have their own devices and they are pretty much glued to them at all times. Except, of course, when I let them use my iPad – which offers a far superior gaming experience with its large screen and touch interface. There is no doubt that, given the choice, they would much rather play on the iPad.

However, conventional wisdom is that purchasing an iPad as a gaming device for a youngster is an extravagance. Starting at $499 its price towers over the $169 price of the latest Nintendo 3DS.

But the lifetime cost of an iPad versus a Nintendo 3DS tells a different story. Those that have been to the App Store for iPad know that games can be had for between $2 to $10 at any time – and during special sale periods those same games sell for just $1. I’ve purchased over 20 games for my iPad and I paid $1 for almost all of them. Nintendo 3DS games, on the other hand, run from $19 to $39 with no such special discounts.

If a gamer were to purchase an iPad and 20 games (at an average price of $2) versus a Nintendo 3DS and 20 games (at an average price of $29) – the total cost of the iPad plus games is $539 versus a total cost of $749 for the Nintendo 3DS plus games.

Bear Market Update

2011-08-21T11:57:00.001-07:00

I have been early to the game in the bear market watch for this cycle.

Back in May I noted that the market was putting in a rolling top, which is a bear market hallmark.

In June I noted that the rolling top had continued to form and was looking very ominous.

It appears as though those concerns have come to fruition and we are now in the grips of a bear market. Before I talk about the current market activity, let’s do a quick refresher on the general patters in a bull and bear market.

Bull markets look like this:

Bear markets look like this:

Rolling tops (aka “head and shoulders”) look like this:

Now, here is the current chart of the S&P 500 for the past year:

Many market commentators have tried to draw a parallel between the 1987 crash and the current steep decline. However, the 1987 crash was more like an extremely steep correction – the market had been rallying and then sharply dropped. This current decline has come on the heels of a rolling top – which is indicative of a classic bear market.

Going forward, here is what I expect to see:

Long Term:

I don’t expect to see the market drop more than 10%
I expect the market to regain its highs within the next 12-18 months
We are approaching a reasonably good long-term entry point
All of this is null and void if Europe really falls off a cliff (which I don’t expect to happen)

Short Term:

The rules of a correction apply, where are in phase 3 approaching a bottom
I expect to see a lower-low, but not much lower
I expect to see a sharp rally by the end of next week

Remember the anatomy of a correction

Gold Parabola

2011-08-21T11:26:00.001-07:00

Not long ago I called a top on silver based on a parabolic rise. Now gold is extremely overbought and has risen to parabolic levels - I believe that a in gold top is now imminent.

The fundamentals for such a huge rise in gold are not sound. Typically gold trades with an inverse correlation to the dollar, but the dollar has been trading sideways for months now:

Silver has also risen, but it is far below its recent parabolic top:

And copper, fellow metal and economic barometer, has turned markedly lower:

General Housekeeping

2011-08-07T12:19:00.001-07:00

Just a general update: I’ve found myself with significantly less time to market-watch, tweet, and maintain the blog due to some recent upheaval in my day job - and I don’t see that improving for a while.

I realize that the timing of this is particularly bad, since a large part of my strategy and posting is about maneuvering around the kind of action that we are seeing right now. However, it is what is is – for now.

To Infinity and Beyond

2011-08-07T12:10:00.001-07:00

My expectation is that the market will rally tomorrow in the face of the S&P downgrade. The market may open in the red and may not close in the black, but regardless I expect it to move higher and not lower during the trading day.

Why? It’s all about timing. The market is extremely oversold right now with the RSI reading an astonishing 23! The last time we saw a reading this low was during the bottom of the last bear market in 2008. The market HAS to rally here because the sellers have already exhausted themselves. The S&P downgrade is already baked into the cake.

Looking at the chart below, the market has put in a clear “head and shoulders” pattern.

I would place the odds at 50/50 right now as to whether this decline ultimately exceeds the 20% bear market threshold. My inclination is to be defensive and sell into strength here.

However, keep in mind that a bear market does not go straight down. A bear market is punctuated by steep sell-offs followed by breath-taking rallies. In one of my first posts, Anatomy of a Bear Market, I detailed the long, gut churning path that a bear market takes.

I think it is far more likely that the next 5% move from here will be higher and not lower.

Debt Ceiling Home Stretch

2011-07-24T22:22:00.001-07:00

It’s Sunday night and the government has failed to come to any kind of terms prior to the self-imposed Monday deadline. As of this writing, futures are down almost 1%.

My guess is that the weakness in the futures is owed more to thinly-traded panic moves than any genuine concern on the part of broader market participants. However, one has to wonder if it really will take a huge market plunge to finally jolt congress into action like we saw with the original TARP voting. As long as the markets remain calm, congress seems to think that they don’t need to actually do anything.

Assuming that I am right on both counts (that the market won’t drop much tomorrow and that Congress won’t act until the market drops) – I am looking to sell some shares this week to raise capital for future trading opportunities…

Linked-in Update

2011-07-24T21:52:00.001-07:00

Linked-in is up around 10% since it initially IPO’ed and I proclaimed it to be “undervalued”. I put “undervalued” in quotation marks, because clearly Linked-in is not really undervalued by any traditional metric. Linked-in is the beneficiary of the circumstance in which there is a huge investor demand for social networking stocks with very little supply available. The stock has risen because demand has outstripped supply – but this will not be the case forever as new social networking IPO’s come on the market.

The best metric for valuing Linked-in is the Price/Sales ratio. Although the Price/Earnings ratio is the most common valuation metric, I find it to be a poor metric for this new crop of social networking companies because they often make little-to-no actual profit – which, to be fair, is not necessarily a bad thing for a young company with huge growth. The Price/Sales ratio gives us a much better perception of what the company could earn in profit once it matures.

Currently the Price/Sales ratio for Linked-in based on 2011 estimates is at the nosebleed-inducing level of 20x. Based on forward estimates for 2012, which expect sales to increase by around 50% year-over-year, the Price/Sales ratio is 13x.

To put this into perspective, a value stock typically trades at a Price/Sales ratio of less than 1x. Mature tech companies like IBM trade at 2x. The ultra-hot Apple trades at 3.5x, and the ultra-profitable Google trades at 6x. So Linked-in is really in rarified air here.

At the current presumed sales growth rate of 50% per year, Linked-in would need three years to triple its sales in order to get down to the still-ridiculous Price/Sales levels of Google. In other words – three years of great sales growth and NO gain in stock price – and the company might be approaching a reasonable price.

My assumption is that, once a greater supply of social networking stocks comes onto the market, LNKD is much more likely to trade at $50 as opposed to the current price of $100 per share.

Thoughts on the Debt Ceiling

2011-07-16T21:25:00.001-07:00

It seems clear to me that there are two big bluffs happening in this debate.

Republicans say that the only way they will allow the debt ceiling to rise is if there are significant spending cuts. However, while the Tea Party might be calling the shots politically for the Republicans – Wall Street is still paying the bills. The Tea Party might think that default is acceptable but Wall Street knows better and so does the majority of the Republican party. There is no way that Republicans will fail to pass some kind of a deal.

Obama says that he will veto any compromise that simply kicks the can down the road a few more months. Right now public opinion is putting the failure to find a compromise in the hands of the Republicans. If there is simply no deal – Republicans will take a heaping portion of the blame and they know it. However, if a deal passes the House and the Senate and Obama vetoes it – then he has just taken sole responsibility for the ensuing mess. There is no way Obama vetoes any reasonable deal that comes across his desk.

The most likely outcome is something along the likes of the McConnell plan – a (more or less) clean vote in which Obama takes responsibility for raising the debt ceiling and the Republicans can claim that they voted against it. Whether that happens right before or right after August 2nd is anyone’s guess.

So how will the stock market react?

The United States is facing two undesirable choices: 1) Take on more debt and risk the long-term solvency of the country or 2) Accept harsh austerity in the short-term and risk plunging the country right back into a recession.

While the stock market is a discounter of probable future events, the time horizon is usually only a couple months. Politically most of Wall Street seems to believe the theory that the ongoing economic weakness is caused by a lack of confidence due to excessive government spending. Therefore, one might think that the stock market would rally on the news of a “Big Deal” that makes severe cuts to government spending. However, I suspect that the opposite would happen – austerity in America would cause the stock market to sell-off as investors price-in what would likely be a huge economic hit. Such a reaction would be a true test of political beliefs versus economic realities.

However, the McConnell plan simply kicks the can down the road – which would mean that the next few months would likely look a lot like the last few months: not a lot of jobs but a lot of corporate profits. I suspect that the market would rally on the McConnell plan – again proving that economics trumps politics when it comes to investing.

Some additional thoughts:

The time to debate spending cuts is when the budget is being set. Debating on spending cuts when the bill comes due is incredibly irresponsible. Imagine going to a restaurant and ordering a meal, then deciding that you can’t afford it once the check comes.
Voters are generally in favor of cutting government spending conceptually. However, voters tend to be opposed to specific cuts in government spending. So far the proposed cuts have been all general numbers with no specifics attached – and the anxiety of getting a deal done is taking precedence over the details. But wait, just wait, until the specific cuts are announced and people are protesting in the streets.

Wait, what just happened?

2011-07-04T13:36:00.001-07:00

I had a busy end to the quarter for my day job which meant that I had little time to follow the market, much less post to the blog.

Clearly, I missed the big rebound off the bottom – which in hindsight looks pretty solid.

My schedule, such as it is, should return to normal now – so regular posting will resume as I look for re-entry into the market.

Q2 2011 Results

2011-07-04T13:25:00.001-07:00

Just like last quarter, I was ahead of the S&P 500 by several percentage points heading into the final week. And, just like last quarter, I remained stubbornly bearish while the market raced ahead.

Had I simply been in “market perform” mode during those two final weeks, I would be beating the market by over 10% so far on the year. Cash is dangerous!

2011 Q2

S&P 500: +0%
My Portfolio: +2.1%
Relative Performance to S&P 500: +2.1%

2011 YTD

S&P 500: +5%
My Portfolio: +4.5%
Relative Performance to S&P 500: –0.5%

Psychology of a Correction

2011-06-22T20:51:00.001-07:00

One of the cornerstones of my approach to trading is the notion that corrections generally look pretty similar and that it is possible to sidestep the downside and thereby beat the market.

As I have mentioned numerous times, corrections typically have 4 stages:

Steep Drop #1
Recovery Rally
Steep Drop #2
High Volume Reversal

I believe that there is some pretty simple psychology behind this pattern that explains what it is seen so frequently.

Consider first what happens before the correction. The market is usually in rally mode and moving higher. Bears are slowly turned to bulls as the market marches inexorably higher. Towards the end there are some sharp one-day sell-offs, but the market shrugs them off and continues to make new highs. At this point, bullishness reaches a crescendo.

During the first steep drop and contrary to what you would read in the news – only the smart traders are selling. The media will say that this is a panic, that the fundamentals are sound, and that only fools would sell into this kind of carnage. The newly minted bulls that had recently convinced themselves that it was finally safe to make a long trade have now become “investors” – convinced that they will just ride this correction out. Investors are more shocked than scared.

The recovery rally is really more of an absence of selling – which is why this phase typically features small gains and low volume. The smart traders have already dumped their shares and the sell-off has become too extended, and so a mix of opportunistic trading and short-covering will drive the market temporarily higher. The media will speculate aloud that the correction is done.

While the smart money sold during the first steep drop, the dumb money is selling during the second steep drop. After the false bottom of the recovery rally, there is now genuine fear that this could be a bear market. All of the traders-turned-investors that held on during the first drop are now capitulating and selling their shares.

The final phase, the high volume reversal, is key because it represents real buying and not the small gain / low volume buying that was seen during the recovery rally. After the dumb money has capitulated and the last of the weak hands have been flushed out – the market will sharply rally back, trapping all of the newly minted bears in cash. Those that just sold will be too stubborn to admit their mistake and buy back in – and they will wait on the sidelines for another leg down that does not come. The foundation of a new rally has been formed.

Not Done Yet

2011-06-20T22:01:00.001-07:00

Corrections typically last around 30 days. Although the market topped almost two months ago, I am not convinced that we have seen the lows.

The decline in May was ultimately just under two percent and hardly a real gut-check. The “real” stomach churning correction has run through April and is only a few weeks old.

Looking at the chart from this prism, the correction seems to be shaping up in a more typical pattern:

Steep Drop #1 (Done)
Tepid Recovery Rally (In Progress)
Steep Drop #2 (Next?)
High-Volume Reversal (When the correction is really done!)

Update on AAPL

2011-06-20T21:40:00.001-07:00

Back in January I put forth the notion that Apple might have reached a major top.

I was about a month early on that call as it seems that Apple indeed did put in a major top in February – and it has now broken below its 200 day moving average.

Trading in a Volatile Market

2011-06-17T19:55:00.001-07:00

I stumbled upon this Jack Macke post the other day:

If you bought yesterday and sold today, you weren't "early." You were wrong. You gave into a perfectly natural and insanely expensive instinct. You paid full price the day before a sale. If you're selling into this mess, you're also wrong. You're dumping into the panic, which is horrible investing or trading.

Aside from the humorously NAR-esque, “It’s a bad time to be a buyer or a seller!” message here – this post actually provides us with a teachable moment.

If you bought the day before a big sell-off, yes you were wrong. But this is also called hindsight-bias – because there is an implication that you should have known yesterday that the market was going to sell-off today. That is impossible. If Mr. Macke knew that the market was going to sell-off tomorrow, he could make a fortune shorting it – but of course he didn’t and he won’t. Put simply, nobody knows nothing.
Making mistakes happens a lot and owning up to them is critical. But refusing to sell today because you bought yesterday is bad advice. Remember, outperformance is the key. If you can sell at any time (regardless of what you paid) and buy-back at a lower price, you are a winner.

Strong Dollar Buffoonery

2011-06-17T19:25:00.001-07:00

I read this recent article from Larry Kudlow where he re-states a common misperception:

If King Dollar recovers, the sputter could turn into real growth. And bullish stocks will pick this up quickly.

In a previous article I discussed how to use the correlation function in Excel to determine the relationship between the dollar and the S&P 500. Most of the time, when the dollar goes up the stock market goes down. But for those that don’t trust fancy math, a picture might be worth a thousand words (or dollars).

The dollar in 2008:

The S&P 500 in 2008:

Mark It, Dude

2011-06-16T19:49:00.001-07:00

Conventionally, investors think of selling a winning trade as a way of “booking profits”. I take a slightly different approach – I look at buying back after going to cash as a way of “booking outperformance”.

For example, I’ve recently been largely in cash (either 100% or 50%) for almost all of the recent decline. This has enabled me to significantly outperform the market, which has dropped precipitously.

This morning I returned to a 100% invested stance. Although the market may very well continue to fall, I have (for the time-being) booked my recent outperformance. So far for the month of July, my portfolio has dropped 2.7% and the S&P 500 has dropped 5.8% – which means that I am outperforming by over 3%. Over time, solid wins like this will add up to substantial gains.

That said, I view today as a successful test of the 200 day moving average – so moving back to 100% invested is warranted beyond just booking the win. I remain “bearish” in my Market Outlook, but I am looking for a bounce of some sort here.

A Rolling Top Gathers No Moss

2011-06-15T20:18:00.001-07:00

Recently I speculated that the recent market action has the look of a bear market “rolling top” as opposed to a typical correction. I want to reiterate that it is still too early to call a bear market, especially given that we have not even officially reached a 10% correction or breached the 200 day moving average. However, it is not too early to start thinking about a potential bear market which is now theoretically nearing Phase 2 territory (per my Anatomy of a Bear Market) and allocating capital accordingly.

Note that the market has been effectively moving sideways for the past six months and is now sitting at the 200 day moving average:

Note that the dollar is consolidating and the 200 day moving average is not far away.

I would be fairly surprised if we don’t see some kind of strength here off of the Japan earthquake lows and the 200 day moving average. After that, a substantial break below the 200 day moving average would have me very concerned.

Nearing the Midway

2011-06-11T19:38:00.001-07:00

At the end of last year I set forth some predictions for the coming year. Making these predictions serves three goals:

It forces me to focus on long-term trends that generally get forgotten amidst the short-term volatility.
It forces me to come up with a theory on why the market is behaving the way it is behaving. If the market does what I expect, it is a good indication that I am on the right path. If the market does not do what I expect, it means I need to re-calibrate.
It's fun!

Here are my predictions for 2011, originally posted on December 29th, 2010:

The S&P 500 will be flat. As the recovery grows more robust, profits in the stock market will shrink. Comment: The market is nearly flat on the year right now, so this appears to be spot-on. Remember I went way out on a limb on this, most of the major firms were predicting strong gains this year.
Corporate profits will grow over 25%, leading to P/E compression. Comment: So far this is on track.
Gold will outperform the S&P 500. The global economic recovery will strengthen the demand for commodities. Confounding bulls and bears alike, gold continues to be strong without going parabolic. Comment: Precisely right on this! Remember at the beginning of the year most pundits were predicting that gold would finally falter in 2011.
The Dollar Index will outperform the Euro. There's some sort of trouble on the other side of the pond, if you hadn't heard... Comment: Totally wrong so far, but I am not giving up yet. The ECB is doubling-down on its ridiculous austerity + bailout approach which has strengthened the Euro, but another panic about Greece leaving the Euro will reverse that strength in a hurry.
10 Year Treasury Yields will increase to 4%. Improving economic conditions drive investors into riskier asset classes. Comment: Way wrong. In fact it seems like I get this one wrong every darn year.

The Next Few Weeks

2011-06-08T08:45:00.001-07:00

My expectation is that the market will be putting in some kind of a short-term tradable bottom this week. At that time I will look to initiate some long positions (potentially including some calls) to provide cover in case we get a real rally.

However, I suspect that overall this correction has a few more weeks to run before a long-term bottom can be established. If this were to prove to be the case, it would represent a fairly serious two-month correction that has been long overdue.

In reviewing my posts over the past three months, I have been growing concerned about the failure of the market to sustain a sell-off.

Growing to the Sky

Bearish

We Aren’t Afraid Enough

The Bounce Stops Here

Waving the Rally Flag

Rolling Top

Each time I pointed out that the market needed to have some anguished selling to pave the way for future gains – the market rallied back on low volume. Hopefully this time we will finally get a much needed correction that will provide a solid entry point into the next leg of the bull market.

Silver Update

2011-06-06T18:54:00.001-07:00

A while back I speculated on how silver would recover from its blow-off top. My prediction was that silver would remain in a choppy bull market and generally behave like gold did after its blow-off top in 2006.

Here is the current silver chart:

Here is the gold chart from 2006:

So far so good!