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Tharp�s Thoughts

Market Update for January 31, 2006

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Look for these monthly updates on the first issue of each month. This allows us to get the closing month data.  In these updates, we�ll be covering each of the major models mentioned in the Safe Strategies book:  1) the 1-2-3 stock market model; 2) the five week status on each of the major stock U.S. stock market indices; 3) our new four star inflation-deflation model; and we�ll be 4) tracking the dollar.

Part I:  Market Commentary.

Welcome to the new year!  It�s clear that, so far at least, volatility has returned to the United States stock market.  The monthly changes in the three major indices are starting to look more like normal changes than last year�s weak volatility.  Except for the week ending January 13^th, we�re seeing changes of 2% or more each week in the Dow and the S&P 500.  Last year such weekly changes were very rare.  And the NASDAQ 100 has two weekly changes over 4% -- which is starting to look more �normal.�  In addition, high flyer Google showed after hours trading on Tuesday that brought it down nearly 11% and it only recovered 1/3 of that loss during the day yesterday [February 1, 2006].  I suspect we�ll see a lot more of this sort of behavior in 2006.

However, if you think the U.S. stock market is again the place to be, think again! Ken Long�s conclusion from his weekly market commentary aptly summarizes what is going on: �It is abundantly clear that the �anywhere but the US strategy� is in full force. While most folks are happy with the 2% return in the S&P this week, it was, once again, the worst place to be (except cash).�

Part II: The 1-2-3 Stock Market Model IS IN RED LIGHT MODE.

The Federal Reserve, with Tuesday�s [January 31^st 2006] increase, has now increased interest rates 15 times since it began doing so in 2004.  We are also starting to see an inverted yield curve, which usually predicts a recession.  Is this going to be a good year to be in the stock market?  I very much doubt it.  However, on a week to week basis, I let the stock market tell me what to do.  So what is the stock market saying?

Let�s look at what the market has done over the last five weeks and compare that with where the averages were December 31^st 2005.  This is given in the next table. Incidentally, this data is calculated by hand based upon last Friday�s close (i.e., January 27th, 2006), so there is always a possibility of human error in our numbers.

Efficient stocks.  What�s the market telling me in terms of efficiency?  Here the data is very interesting.   I now have a proprietary indicator of the entire market � its efficiency.  What percentage of the stocks that I screen show positive efficiency?  What percentage of the stocks show negative efficiency?  I�ve only been doing this for about four months so I don�t have much historical data.  However, the market is stronger than it has been since I�ve been doing it.  As of Tuesday night [January 31, 2006], 78.3% of the stocks in my database (over 4000 stocks) show positive efficiency, while only 21.7% of the market is negative.  Is this a contrarian indicator?  I have no idea, but I certainly hope not. 

My own trading system requires that I keep the percentage of long and short stocks equal to the market percentages.   Thus, I am now about 20% short.

One stock that I�ve liked fundamentally on the short side is RIMM.  RIMM has lost court ruling after court ruling on its patent infringement suit.  Blackberries in the U.S. could be shut down on February 27^th.  However, the market doesn�t seem to care.  Yesterday RIMM shot up 9%.  That�s strikes me as very irrational.  Here�s a company that could lose most of its US business within 30 days (or at least agree to a huge cash settlement) and it is trading a PE ratio of 40 plus.  Even Wall Street analysts are commenting that the stock has already discounted its patent infringement case.  As a result, I�m beginning to think that the market may be as insane as it was in 1999.  If that is the case, watch out.

Does this mean that I�m out of the market?  Of course not, 78% of the stocks I screen show positive efficiency and that might continue for a few more weeks or all year.  However, given the inflation scenario outlined below and the inverted yield curve, I�m not too optimistic about the future for 2006.   Nevertheless (AND THIS IS IMPORTANT), I won�t be short in much of my portfolio until the market starts to clearly go down and that�s not what it is saying.

The top five efficient stocks in my database include PKS, ATI, ASA, TSU, and DBRN.  Several shorting candidates include DLX (which was one of the best positive efficiency stocks I�d ever seen in 2001), WON, and CHCI.  Incidentally, since I trade this strategy, I may or may not, have positions in the stocks that I mention.  However,qa these examples are given for educational purposes and you should do your own due diligence if you decide to trade them. [Editors note: These stocks are NOT recommendations. Dr. Van Tharp never gives buy or sell recommendations. Any stocks used as examples are simply educational examples.]

Part III: Our Four Star Inflation-Deflation Model.

I now strongly believe that we are in an inflationary bear market and that our inflation rate is simply masked by government statistics. 

So far our models have been telling us that inflation/deflation is pretty steady, with a slight inflationary bias and that�s where secular bear markets tend to start. 

So what�s our new indicator telling us about inflation?

1) The CRB Index

2) The Basic Materials Sector (XLB)

3) The London Price of Gold and

4) The Financial Sector (XLF)

Since the description of the model we�re now using is not in any of my books, I�ll continue to give it here. 

1)  The CRB Index.  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 � 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 � 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 and 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?  (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 � 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 � 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 the government can manipulate Gold, 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?  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 � 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 � 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 will give us a different interpretation.

�        If both differences are higher, we�ll count one star for deflation (i.e., minus one for inflation). 

�        If the six-month change is higher, but the two-month change is not, then we will only count � star for deflation (i.e., minus � for inflation). 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 � star for inflation.  Obviously, the two minus scores will point to strong inflation.

Okay, so now let�s look at the results for the last six months. 

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

The results of this model are much more sensitive (I believe) than the model I presented in Safe Strategies for Financial Freedom.  For the last two months the model has shown a score of +2.  However look at the first three factors.  THEY ARE IN HUGE UPTRENDS.  The only thing keeping us from a huge inflation signal is the fact that the XLF index is also moving higher.  However, the two month move is almost insignificant (i.e., 0.07).  Thus, my suspicion is that inflationary forces are much stronger the one would suspect.

As many of you know, I collect rare stamps and they are absolutely booming!  I find it impossible to buy rare stamps using my normal criteria that I�ve used for the past three years.  Instead, they are selling at 30% premiums to what I�m willing to pay.  Either I�ll have to re-adjust my base or stop.  Also notice that the increase in gold is beginning to get parabolic with ASA now being one of the top efficiency stocks. 

Part IV: Tracking the Dollar.

The U.S. dollar is beginning to look weak again.  Given the weak dollar and the fact that foreign stocks are BOOMING compared with the U.S. stock market, you could lose money even if the U.S. stock market does well this year.  Foreign based ETF such as ILF (Latin America with an efficiency rating of 14.54); EEM (Emerging Markets with an efficiency rating of 13.32); and EWZ ( Brazil with an efficiency rating of 12.62) have efficiency ratings that are better than the efficiency ratings of most U.S. stocks.  Again, these are not recommendations.  Do your own due diligence before investing.

Look at the next Table, showing the dollar index over the past year.

The dollar is higher than it was in August, but it is now showing a two month decline.  Be careful here.  If the stock market goes up 10% this year (and I�m not predicting that) while the dollar goes down 20%, you will have lost 10% of your wealth on a world wide basis.

What this all means.

Our big picture has not changed.   It still suggests a long-term BEAR market.  The secular bear began in 2000, but conditions are ripe for one to start even at current levels.  Plus debt continues to grow faster than the economy.  So something must happen to correct it all. 

During this secular bear market we could perhaps look forward to any of the following: 

q       We could have a decline in the housing market which could cause a crunch for the U.S. consumer who is now spending more than he makes for the first time since the Great Depression of the 1930s. 

q       The dollar could stop being considered the world�s reserve currency.  (What if we have to pay for oil in a gold based currency?)

q       The U.S. debt situation could easily unravel (i.e., the best way is to inflate it out of existence).  Furthermore, our new Federal Reserve Chairman is very concerned about deflation, saying he�ll never let it happen, so the printing presses could really open up. 

q       In addition, before this secular bear market is over, I�d expect most of the baby boomers to be withdrawing money heavily from the stock market.  Social security definitely will not fund their retirement, so they�ll have to rely on the equity in their houses and in their stock market portfolios.   

And it�s very reasonable that perhaps all four of these scenarios could play out in the next 10 years plus.  However, who knows how these things will unravel. 

This is not about prediction, it�s about looking at conditions influencing the economy and seeing what happens.  There will always be good ways to make money if you are willing to work on yourself to get past your fear, greed, and other emotions to just see what is going on in front of you.  So let�s continue to watch the market for more signs.  Until the end of February update on the market�this is Van Tharp. 

About Van Tharp: World�renowned trading coach, author and psychologist Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Special Reports on Money Management and Expectancy

Van's next book The Definitive Guide to Position Sizing is still a work in progress and we don't expect publication until later in 2006.

However his Special Report on Money Management and Special Report on Expectancy are still available and great resources for understanding the critical role these concepts play in your system development and trading profits. $79.95 each. Click below to learn more.

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Trading Tip 

Trading Tip

Foreign Exchange Markets Part IV (and final)

Some Conclusions on Currencies

by D. R. Barton, Jr.

We�ve spent three weeks looking at the positives and the negatives of the Foreign Exchange market or forex.  I�d like to thank everyone who was kind enough to send an e-mail about their thoughts and experiences.

Today we�ll look at some alternative ways to trade the currency markets.

Currency markets are very appealing for several reasons: 

�        They are huge (lots of volume changes hands daily). On a dollar volume per day basis, this is world�s biggest market.

�         Currency markets operate around the clock.  With distinct openings in  Tokyo, London and New York  there are also usually three �high activity� periods per day.

�        Currency markets trend better than most.  Macro-fundamentals and country-wide or regional economic and financial policy drive trends, which tend to be more persistent that most financial markets.

If you want to trade in currencies, there are three direct ways to do so: through forex, through currency futures or using mutual funds.  I have no doubt that we will see Exchange Traded Funds (ETFs) offering direct currency products in the future.  But for now, let�s summarize our finding on the forex market and look at the other two current ways to trade the currencies:

�        Forex:  the advantages of liquidity, leverage and small account size requirements seem to be outweighed at the current time by the negative side of the forex ledger.  Minimal regulation has led to some horror stories for accounts.  First of all, there are some forex brokers that have minimal financial stability of the underlying company. Also, brokerages can (and do) take the other side of your trade.  So they can withdraw bids and offers, re-quote and use other methods to fill your order at prices that are advantageous to the broker.  Transaction costs (slippage and the spread paid when entering and exiting) are extremely high, making this a tough market to overcome the cost of trading.  If you choose to trade forex, you should investigate the firms that do not have a conflict of interest with your order.  Three firms that I know of have set up virtual exchanges that match orders electronically: Interactive Brokers, COESfx and HotspotFX.

�        Futures:  In the U.S., the Chicago Mercantile Exchange (CME) offers a variety of currency futures and a dollar index that tracks the dollar versus a basket of currencies.  The main downsides to the futures market for currencies are contract expirations (traders have to deal with roll-overs from expiring contracts), a reduced field of currency crosses to trade (though it is still quite sufficient for most needs) and limited overnight liquidity.  These are offset by a well-regulated exchange, a plethora of financially stable brokers and low transaction costs.  Until the forex industry provides a more level playing field for retail investors, the CME will remain the vehicle of choice for trading forex.

�        Mutual Funds:  For longer term traders and investors who want to play movements in the U.S. dollar, there are four relatively new mutual funds available.  Two of the most progressive fund families are offering both rising and falling dollar funds.  ProFunds has a rising dollar fund (Nasdaq: RDPIX) and that goes up when the dollar index rises and an inverse fund that rises when the dollar index falls (Nasdaq: FDPIX).  Rydex  �juices� up the results by offering a fund that goes up twice as fast as the dollar index (Nasdaq: RYSBX), and an inverse fund that rises twice as fast as the dollar index falls (Nasdaq: RYWBX).  These funds have the same downside as most mutual funds � they can only be entered or exited at the end of the trading day.

Until next week � great trading!

D. R. Barton, Jr.

D. R. Barton, Jr. 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.

Listening In...  

From Van Tharp's Mastermind Forum

Is Accurate Prediction a Prerequisite of Successful Trading 
Author: PMK
Date: 01-27-06 12:02

If you've read my posts on the 'One Simple Question' thread you know my beliefs on this.

I just wondered what everyone else thought.

Paul


Reply To This Message 


Re: Is Accurate Prediction a Prerequisite of Successful Trading
Author: Level 7
Date: 01-27-06 13:31

I believe that accurate prediction is a contradiction in terms. 

Computers work logically and humans cannot. That is provable (IMO) by the fact that most people lose. If they were like computers they would have a track record closer to 50% over large numbers of trials. Instead they have to try very hard to lose so consistently.

Is prediction a prerequisite of successful trading? 
Absolutely since all systems rely on this. In fact the point of testing is to prove a system predicts more than 50% (a random entry system outcome) is it not? If not, why not use a random entry system? 

Discretionary traders do predict since that is where the big money is. If they predict correctly, they win more on that particular guess. The difference is that they don't have to be right. They don't expect. That they leave for the system traders. They realize that it is a statistical game. So they rely more heavily on the confirmation than the entry and money management to ensure they win more on wins and lose less on losses.

A discretionary example: 2 days ago I bought puts on PFE since it looked to be hitting solid resistance. A mental stop was triggered yesterday and I dumped it at a loss. Today it popped through support - today it would have been good to buy calls in the other direction. So would this be illogical of me? Or is this very logical?

Reply To This Message 

Re: Is Accurate Prediction a Prerequisite of Successful Trading
Author: PMK 
Date: 01-27-06 13:55

What if everyone is actually using a random entry method and they just haven't had enough trials to realize it?

Take a look at my latest blog entry for why I think it doesn't matter even if your entry is random.

For systematic traders, an interesting exercise is to test your system with a random entry, but leave everything else the same and see how much of your performance is actually dependent on your entry signal. This gives you an idea how dependent your success is on prediction.

Paul

Reply To This Message 

Re: Is Accurate Prediction a Prerequisite of Successful Trading 
Author: Chicken Little
Date: 01-27-06 14:05

The answer is no, but, respectfully, I think it twists things a bit. For me it really isn't about prediction but creating low-risk ideas. It is about creating a likelihood of events happening...a map of the future say. These might become part of a low-risk game plan. Then when orders are placed the outcome is uncertain for sure and I agree with much of what you say on that. I think low risk ideas are important for successful trading.

My point is that it seems from research that not everyone can do this. It is probable 3 in 4 that can't. Wouldn't it be an edge if someone could do this just from that point alone? 

You talk about >>If you could devise a trading method that simply adapted to what is happening right now<< To me the person I associate most with this thinking is Ed Seykota. The funny thing to me is that in Market Wizards he talks about 'if you catch on early, before others believe, you might have valuable "surprise-a-mentals." In another section he is asked if he uses other traders opinions. In his response he says, "...The old-timers, who talk about 'maybe there is a chance of so and so,' are often right and early." That to me is when prediction isn't prediction. 

Regards,
Chicken Little

Reply To This Message 

Re: Is Accurate Prediction a Prerequisite of Successful Trading
Author: PMK
Date: 01-27-06 14:21

A low-risk idea to me simply means that your potential reward is large in comparison to your estimated risk - which has nothing to do with being right, or making a prediction so I don't think it 'twists things a bit' - we agree.

Yes, most people seem to want to be right more than they want to make money so it is an edge if you can forget about your win% when you develop trading systems and concentrate on how it matches your objectives not how often it has winning trades.

'if you catch on early before others believe' can simply mean your rules for determining what is happening right now can be more sensitive than those used by others. Yes, you will get a lot of false signals that will make you 'wrong' a lot, but you will always be there at the start when a new real change has occurred and benefit from being 'at the front of the line'

Paul

Editors Note: As Always...read the complete and unedited thread  at the link below. Look for the title above Is Accurate Prediction a Prerequisite of Successful Trading, to read many more posts on this topic.

Special Reports By Van Tharp

Click below to read page one of each report, or to order. 

Self  Sabotage - Two Reports of Self Sabotage

Does Your System Still Work in Changing Markets?

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