The Van Tharp Institute

May 4, 2005 — Issue #218

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In this Issue:

Market Update

Market Update for April 30, 2005 1-2-3 Model Still in Red Light Mode By Van K. Tharp

Core Education

Helping Traders and Investors with Peak Performance  Results for Over 20 Years. 

Trading Tip

Volatility Returns to the Markets – For Now, By D.R. Barton, Jr.

Listening In...

Scared to Take the Next Step... 

View this newsletter on-line, or read back issues

 

 

Market Update

Market Update for April 30, 2005

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Part I:  Market Commentary.

On April 15th I issued a special bulletin because 1) all three major averages were down over 3% on the week.  In fact, it was the only the second or third weekly change over 2% for 2005.  In addition, 2) all three market averages were below their price five weeks ago.  As a result, it was the first clear signal for our bear market mutual fund strategy since Safe Strategies for Financial Freedom was published.

However, the market has now resumed its flat, do-nothing state.  Over the last two weeks, all three averages are up just about 1%.  And remember that is for a two-week period.  Basically, nothing seems to have changed.  However, this now remains a very dangerous market.  And today (May 3rd) the Federal Reserve raised interest rates for the 8th straight time since a red light signal was flashed.

The 1-2-3 Stock Market Model IS IN RED LIGHT MODE.  BE CAREFUL.

What the market is doing.  Currently, all three major averages are 1) down for the year and 2) down for the last five weeks.  I don’t like this market at all.  It’s just being a very subtle bear, making it hard for anyone to take much money out of the market.  It’s probably nibbling most of you to financial ruin – but just a few percent each month.  However, we could expect some real fireworks once the pension fund money stops moving into the market.  We’re now into May and that usually is the first month of the seasonal downturn.  Will we go into a major bear market down leg this month?  That’s anyone’s guess.  But after eight straight interest rate increases and now the seasonal factor being in favor of a down movement, it’s beginning to look that way.

The table below shows the five-week status of each of the major markets.

Date

DJIA

% Change

S&P500

% Change

Nasdaq 100 (QQQ)

% Change

4/1/05

10,404.30

-0.3%

1176.12

+0.4%

1476.72

+0.5%

4/8/05

10,461.34

+0.5%

1181.20

+0.4%

1485.60

+0.6%

4/15/04

10,087.51

-3.6%

1142.62

-3.3%

1408.59

-5.2%

4/22/05

10,151.13

+0.6%

1152.12

+0.8%

1421.21

+0.9%

4/29/05

10.191.51

+0.4%

1156.85

+0.4%

1420.79

-0.0%

Incidentally, this data is calculated by hand based upon last Friday’s close (i.e., April 29th).  There is always a possibility of human error in our numbers.

What’s a good strategy for the month?  Well, a bear market mutual fund signal was given two weeks ago.  And the market is only a little higher now, meaning you’d get a better price.   In addition, the market is clearly down for the year and over the last five weeks.  However, for many of you, it might be best to stay on the sideline until this market tips its hand a little more.  There are very few strategies that are working well right now in this sort of market – a low-volatility, down to sideways market.

Part III: Our Four Star Inflation-Deflation Model.

In Safe Strategies for Financial Freedom, we argued both sides of the inflation-deflation argument.  We established four indicators that would help us track inflation and I’ve been reporting those indicators in Tharp’s Thoughts in the first email of each month.

However, I’m not that happy with the four indicators because many of them can be manipulated by the Federal Reserve.  Let’s look at the four indicators and what we could use instead.

Our current four indicators for inflation are:

1)      The CRB index

2)      The price of Gold

3)      The CPI and

4)      The trend in interest rates.

My biggest problem with these indicators, which have suggested inflation since we’ve been using the model is that all of the figures (with the exception of the CRB index) can be easily manipulated by the government.. 

The second problem I have with these four indicators is that you can look at the data and find some sort of trend that might support your conclusion.  For example, the deflationary argument above was all based on what has been happening in the markets over the six-week period from March 1st through April 15th. 

So let’s look at some new indicators that we will be using in the future – indicators that are less likely to be manipulated by the government.

1)  The CRB Index.  I already said that I believe that the CRB index is the one we have currently that is the least manipulated by the government.  But what’s the best way to measure it?  For consistency, I plan to give two measurements. 

·        Is the CRB index higher than it was six months ago?  If it is, we are on track for inflation.

·        Is the CRB index higher than it was two months ago?

Now there are several ways to monitor these two indices.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation. 

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

2)  The Basic Materials Sector ETF (XLB).  In an inflationary environment, basic materials will definitely go up. This sector, to the best of my knowledge, is not manipulated by the government.  Thus, we will use this sector to monitor inflation and we’ll use the same measurements use for the CRB.  (1) Is the XLB higher than it was six months ago; and (2) Is the XLB higher than it was two months ago.  These two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation. 

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

3) The London PM Gold price at the end of each month.   Although Gold can be manipulated by the government, I still like to look at monthly gold prices.  However, to be consistent, we’ll use the same two measurements that we’ve used for the other indices that we are monitoring.  1) Is the price higher than it was six months ago and 2) is the price higher than it was two months ago.  Again, these two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for inflation. 

·        And if both the two and six-month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

4) The Fourth Measurement we’ll use is related to the Financial Sector of the S&P 500.

The financial sector (XLF) tends to do well when we have deflation and poorly when we have inflation.   Martin Pring, in fact, has used an index in which he divides the XLB by the XLF.  Since we already use the XLB, we’ll use the XLF by itself as well.  Again, we’ll use the change over six months and over two months.  However, the four possible outcomes with give us a different interpretation.

·        If both differences are higher, we’ll count one star for deflation. 

·        If the six-month change is higher, but the two-month change is not, then we will only count ½ star for deflation. 

·        And if both the two and six month changes are lower, then we’ll be plus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be plus ½ star for inflation.  Obviously, the two minus scores will point to strong inflation.

Okay, so now let’s look at the results for the year.  We’ll pretend that April 15th is the end of the month so that we have a current reading.

Date

CRB

XLB

Gold

XLF

August 31st

276.5

26.24

407.25

28.4

September 30

285.1

27.30

415.65

28.13

October 31st

283.70

27.04

425.55

28.38

November 30th

291.10

29.24

453.40

29.16

December 31st

283.90

29.63

435.60

30.37

January 31st

284.75

28.72

422.15

29.71

February 28th

305.00

30.98

435.45

29.51

March 31st

311.02

30.16

427.15

28.39

April 30th

303.75

28.01

435.70

28.44

We’ll now look at the two-month and six-month changes over during 2005, so see what our readings have been.

Date

CRB2

CRB6

XLB2

XLB6

Gold2

Gold6

XLF2

XLF6

Total Score

Jan 05

Lower

Higher

Lower

Higher

Lower

Higher

Higher

Higher

 

 

 

-+/2

 

+1/2

 

+1/2

 

-1

+1/2

Feb 05

Higher

Higher

Higher

Higher

Lower

Higher

Lower

Higher

 

 

 

+1

 

+1

 

+1/2

 

-1/2

+2

Mar 05

Higher

Higher

Higher

Higher

Higher

Higher

Lower

Lower

 

 

 

+1

 

+1

 

+1

 

+1

+4

Apr 05

Lower

Higher

Lower

Higher

Higher

Higher

Lower

Higher

 

 

 

+1/2

 

+1/2

 

+1

 

-1/2

+1.5

All four months this year have show some signs of inflation, with our indicator heating up to +4 by the end of March.  However, notice the dramatic drop to just +1.5 in April (i.e., it was even more dramatic in the first two weeks of April).  It looks like some major changes are taking place in the market – and they are now moving toward deflation.

Part IV: Tracking the Dollar.

The dollar is now much higher than it was at the start of the year and its gone up every month of the year.  The dollar has probably bottomed out against the Euro.  However, my guess is that it will continue to be weak compared with commodity currencies such as the Canadian Dollar, the New Zealand dollar, or the Australian dollar.  I’d still recommend putting some funds in the Max Yield Strategy for 2005 if you don’t do so last month.  Be careful here.  Follow the guidelines we set for you in Safe Strategies for Financial Freedom.

Fundamentals (i.e., with the main factor being the US debt) suggest that the dollar has a long ways to go on the downside.  However, we could have made that argument for much of the last ten years.  The dollar is once again looking very shaking and putting 20% of your portfolio in the max yield strategy makes good sense right now.

What this all means.

Our big picture continues to suggest that the stock market is a very weak place to be.  Be very careful.  We still expect a long term, inflationary BEAR market.  And that decline could start this month.  However, predictions mean nothing.  Let’s let the market tell us what will happen. 

Until the May update on the market…..

About Van K. Tharp: 

Dr. Tharp is the author of three acclaimed books published by McGraw Hill; the New York Times Bestseller, Safe Strategies for Fin-ancial Fre-edom, Trade Your Way to Fin-ancial Fre-edom, and Fin-ancial Fre-edom Through Electronic Day Trading. More...

 He is the founder and president of the Van Tharp Institute, dedicated to offering high quality education products and services for traders and investors around the globe.

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

 

Recommended Materials: 

Van Tharp's

Peak Performance Home Study Course

 Has been helping traders and investors with break through results for over 20 years. 

Learn more about this highly effective and unique course for traders and investors...

“Just wanted to drop you a line to thank you for all your help and to give you some feedback on my progress…after completing your course and developing a game plan and journal I started back to trading…To make a long story short, I have had 8 trades since the end of July when I started trading. I lost four and was profitable on four. The last two were also quite spectacular, netting a total of over $37,000 in two weeks…your course and  inventory Profile helped me to get a hand on my more self defeating tendencies.”
—E.W. 

 

Trading Tip: 

Volatility Returns to the Markets – For Now

Trading Tip

by  D. R. Barton, Jr.

In absolute terms, the volatility of the markets is at its highest point since July of 2003.  

In a mere 14 trading days, the market’s volatility (based on the S&P 500 futures), has increased by 44 percent, as measured by Average True Range (ATR).  

ATR is an indicator that measures the average range of a bar, taking into account the effect of gaps.  Daily ATR has jumped to 16.5 points a day on the S&P.  This is up from an ATR of just 11.45 points on 4/10 and a level that was below 9 points a day for most of February.

What does this spike in volatility mean for traders and investors?  

There are different implications for different groups of traders.  

Day traders are dancing in the streets.  Okay, maybe just doing little jig next to their computer.  Wider daily ranges mean more and better opportunities for intra-day traders.  (Editors note:  for those interested in day trading, you don’t want to miss the workshop being presented by D.R. Barton and Brad Martin.  There are still a few seats left, so for details, go to this link:

But while day traders are rejoicing, the current market is presenting some real challenges for swing and position traders.  Let’s see why.  Van likes to characterize markets as falling into one of six categories:

Up Trend with 

Low Volatility

Sideways with 

Low Volatility

Down Trend with

Low Volatility

Up Trend with 

High Volatility

Sideways with 

High Volatility

Down Trend with 

High Volatility

The markets of the past two weeks have been highly volatile (by recent standards) and moving sideways.  This is a rather unusual market condition, and anecdotally, I would hazard a guess that it is the least common of the six market types listed in the table.  

This is tough market environment for swing traders, because it’s almost impossible to keep a tight stop.  Position traders are less affected, but their stops are being hit more readily and one of the most popular trend following entries (the volatility breakout) is giving false triggers.  

It’s easy to see why: a volatile move is often followed by a continuation in the direction of the volatility (which is why folks use these types of breakouts in the first place).  In the recent markets, a volatile up move has been followed by a volatile down move.

If your swing and positions system stops are getting hit more often in the last couple of weeks, it may be prudent to either reduce your position size for new trades or strand aside all together.  

You can most likely resume normal trading when we either break out of this sideways trading range or when volatility drops back below 12  points for a few days as measured by a 14 period ATR on the daily S&P futures chart.

As market conditions, such as the current one usually resolve themselves fairly quickly. 

Look for a volatile break to the upside or downside in the near future that will give us a good indication of the direction that the market should take for the next couple of weeks.  

Until then, take prudent measures to reduce your exposure if your trading strategies are having difficulty navigating these tough market conditions.

D. R. Barton, Jr. will be teaching the upcoming Professional Tactics of Day Trading Course, May 14-16, 2005. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading. He also writes a stock screening newsletter called Ten Minute Trader.

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

Listening in....

Excerpts from Dr. Tharp's Mastermind Discussion Forum

 

Scared to Take the Next Step... 
Author: J. 

To all Traders who Trade for a living...

I have been trading full time for 1 year and have recently taken 3 months off to take the Peak Performance Home Study Course. I trade strictly intraday with no overnight holds. I attended DR Bartons Day Trading class, so I feel I have taken the correct measures for educating myself. I absolutely love to trade and would love for it to be my full time occupation, but......

I have a cash flow problem. I have yet to get my trading to a profitable level to where I can fully support myself. I have plenty of equity to continue trading but I recently had an unexpected outlay of cash and my savings that I had planned to live off of while I was learning to trade is now gone. (I have had many part time jobs to help cover expenses during my first year of trading but there was still a negative cash flow every month.) I feel like I am so close to being profitable with my trading but I am scared to take the next step and continue trading knowing that I still have a cash flow problem. The Peak Performance Home Study course suggests eliminating as much stress from your life, since stress inhibits ones decision making capabilities. But I know that every trade I make is going to be stressful because in the back of my mind I will be thinking of the cash flow problem and the need to make some money.

I have even gone to the lengths of starting another career in the mortgage business just so I can have a base income to trade off of. The mortgage business requires a lot of time and attention, time in which I am not able to study the markets, so now I feel as though I have given up on trading because I have no time to give to trading. I am totally discouraged at this point, and I need some advice from some of you established traders.

I just need to hear some real life stories of some successful traders who had a hard time getting going in the trading business.

I want to trade so bad, but I am scared to take the next step...

Thanks for your time

J.

Reply To This Message 


Re: scared to take the next step... 
Author: PMK

Justin,

Sorry this is a long post, but I just had a lot to say on this subject since it is similar to my own experiences.

I think you are encountering one of the most difficult problems faced by any new business venture: cashflow, and how to survive financially through the period of (usually years) before a new business becomes cash-flow-positive (never mind generating enough excess cash to cover personal expenses as well).

It sounds like you have overcome the other 2 major hurdles in creating a successful trading business, i.e. creating a positive expectancy trading method or system, and having the discipline to implement it accurately, and you have a clear trading plan.

The thing you have to consider is, even though you started out with a good plan to cover your personal expenses (your savings, and part-time income), your circumstances have changed, and your new plan has to take that into account.

For other types of more traditional businesses, the way this is usually tackled is by getting a small-business loan to cover startup and operational expenses in the first few years. This is usually not a good idea in a trading business (even if you can get anyone to loan money for a this type of business) due to the fact that trading with borrowed (or scared) money doesn't work because of the additional stresses involved (as you are experiencing).

My advice would be to firstly recognize that you can't simply carry on as if nothing has changed in your plan. You need to either replace your savings somehow (maybe the traditional way by earning more than you spend for a few months/years to make it back up). Generate other passive income (for example, from managed real-estate rentals) that does not take up too much of your time, although I understand that this takes startup capital too. Or do something that has a smaller impact on your trading that you can do at the same time - this sounds similar to your mortgage career idea but you need something that still leaves you enough time/attention to trade.

Don't get discouraged, it is not a disaster if you need to go and do a traditional job for a while to build up your savings (you generated excess cash somehow in the first place to save the money you used to open your trading account, right?).

I am in year 3 of my business plan and my business is cash-flow-positive for the first time. My plan included 4 potential income streams:

1 Primary income from trading my own money (this is working OK :-)
2 Primary income from asset management fees and profit fees from trading external funds (this has not happened yet, I have not had the time to seriously pursue it)
3 Secondary income from fee-based financial advice (my registration as a financial advisor is pending at the moment)
4 Secondary income from business consulting (I used to be a Wall Street business consultant for financial companies - the consulting environment sucks at the moment as financial companies ship in low-cost (usually foreign) consultants instead of paying huge hourly rates to 'experts' like me :-) so it is not worth the potential trading income lost to go and do full-time consulting.

If I can't generate enough cash this year to be cash-flow-positive with business and personal expenses, I will just have to go get a 'real' job for a while until my trading account is built up to a level that is adequate. It is definitely a juggling act to make this all work and keep afloat financially as well, but nothing really worth doing is ever easy.

Don't give up, if this was simple everyone would be doing it (and rich too!)

Hope this helps

Paul 

Click  here to read more  responses on Dr. Tharp's Forum. There were many great posts on this topic this week.

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