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Tharp’s Thoughts

Market Update for the Week ending August 31, 2009

Market Condition: Normal Strong Bull

by

Van K. Tharp, Ph.D.

I always say that people do not trade the markets; they trade their beliefs about the markets. In that same way, I'd like to point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, you may not find them useful. I find the market update information useful for my trading, so I do the work each month and am happy to share that information with my readers.

However, if your beliefs are not similar to mine, then this information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp’s Thoughts each month. This allows us to get the closing month’s data. These updates cover 1) the market type (first mentioned in the April 30, 2008 edition of Tharp’s Thoughts), 2) the five week status on each of the major U.S. stock market indices, 3) our four star inflation-deflation model plus John Williams’ statistics, 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I:  Van’s Commentary

 “Where ever you are now will be your best situation for years to come. The trick ahead will be to hold on to what you have.” Richard Russell – Aug 28^th 

Market volatility has returned to normal, making bullish conditions much more likely.  The 25 day SQN™ is now bull and the 100 day SQN™ is listed as strong bull—the same readings we had at the end of the last month.  In my opinion, this rally has a lot to do with market manipulation by the government and is not based on sound fundamentals.  However, markets all over the world suddenly are doing well; this cannot be due just to the U.S. government stimulating the stock market. 

Although nothing good is happening from a fundamental perspective, even the financials are doing well. The primary financial sector ETF, XLF, is now up 140% from its March low.  Perhaps we are really seeing the start of massive inflation.  When the banks do well, everything tends to go up in value.  If that is the case, you will need inflation protection.

My Visit to Berlin

I just returned from Berlin. Prior to my trip, people in West Germany had been telling me for some time not to go to Berlin: It was cheap but not a good place to be. Well, I have news… it’s now one of my favorite cities in Europe, and we plan to return to Berlin for workshops next summer.

I guess it’s hard not to have some trepidation over visiting a city that was the capital of Nazi German, and then became a focal point of the cold war.  However, up until several decades ago, Berlin was known as the City of Tolerance. And, in my opinion, it’s like that now. There are 175 museums in Berlin. There are memorials to all sorts of holocaust victims, as well as to the German resistance during World War II. The movie, Inglourious Basterds, is not only playing in Berlin, but doing well. More people seem to speak English in Berlin than Munich, and I found everyone very friendly. Berlin (area-wise) is the largest city in Europe. Currently, 3.5 million people reside there compared to 4.5 million people 70 years ago.

There were fewer signs of problems in Berlin than here in Cary, North Carolina. For example, at the local shopping centers in Cary about 20% of the stores are vacant; this was not the case in Berlin—despite perpetual 20% unemployment. Stores in Cary always seem to have sales and this was not the case in Berlin either. And Cary, as far as I know, hasn’t had massive layoffs or a big drop in unemployment. That being said, why work if you live in Berlin? If you don’t work, the government pays you about the same as you’d make if you worked at a low paying job. But that means few homeless and a very safe city.

Berlin is 60 billion Euros in debt.  The East German’s tore down a huge palace during the cold war to build their own palace and government center.  That subsequently has been torn down in the last few years because of asbestos.  And now the city of Berlin is going to rebuild the original palace to the tune of 700 million Euro.  That sounds a little like U.S. thinking to me.  But it really adds to the charm of Berlin (which was 80% destroyed during World War II) and has mostly been reconstructed since the Berlin Wall fell about 20 years ago.

Van with a caricature artist in Berlin

Part II: The Current Stock Market Type Is Normal Strong Bull

The SQN for 100 days is still in a strong bull market.  And the ATR as a percentage of the close is only slightly above the mean at 1.5, so it’s normal.  The 25 day SQN is still in a bull market.  Both the 25 day and the 100 day have been bullish since July 21^st.

Let’s look at what’s happening in the three major U.S. indices.  The next table shows the Dow, the S&P 500, and the NASDAQ over the past five weeks.

All three indices are showing nice gains.  It’s hard to believe that all three indices were down huge amounts just a few months ago.  Remember that the DOW 30 is now an entirely new index after losing GM and Citibank. 

Part III:  The Strongest and Weakest Market Components

I have a new model in which we track the relative strength of the various ETFs representing the economy of the entire world.  I will be publishing this once a month.  Ken Long, who developed the algorithm we use, publishes a similar report every weekend at www.TortoiseCapital.com. If you’d like more information, then I’d suggest you attend one of Ken’s workshops, which are held several times each year. The next one will be held in New Zealand in February (we will announce details about those workshops soon).  Ken explains how these numbers are derived in this workshop and how to apply them for better trading.  He teaches numerous systems that have System Quality Numbers™ above 5.

The August 31^st data are given below.

View Larger Chart

The areas in green are strongest (the total rating is at least one standard deviation above the mean); those in yellow are the next strongest (above the mean).  Those below the mean are in brown and those more than one standard deviation below the mean are in red.  I’ve taken out all the double leveraged funds from my database; otherwise, the top and bottom funds would be devoted entirely to those types of ETFs.

Most of Europe is doing well, with only the UK and Germany not being green.  Thailand and Australia are doing well, also.  In terms of sectors, financials, REITs, homebuilders, and semiconductors are all doing well.  These were some of the weakest areas six months ago.

What’s doing poorly?  Hong Kong, India, China, Chile, many currencies, regional banks and telecom are among the weakest areas and colored red.  

The next chart shows the commodities and the 15 strongest sectors for August 31^st.

Here Australia, insurance, finance, biotech and some banking ETFs are doing well.  But the only area in commodities that is really strong is timber.

This last chart shows real estate, interest rate products and the bottom 15 ETFs for August 31^st.

Interestingly, real estate in both the US and the UK seems pretty good.  Interest rate products are generally weak across the board.  Natural gas and short funds are among the weakest ETFs.  I looked at the data for UNG, and I have no idea why it rated at zero.

Part IV: Our Four Star Inflation-Deflation Model

Once again, we are in credit contraction mode, so it is not the inflationary bear market I once thought we were going to get six or seven years ago.  But I suspect that we’ll be in one by the end of 2009.  Gold is certainly suggesting that.

We’ll now look at the two-month and six-month changes during the last six months to see what our readings have been.  The CRB is almost at it’s month end high set last May.

We appear to be moving toward deflation again based upon the movement of our index.  We were at 3.5 the last two months. 

Part V: Tracking the Dollar

The dollar is heading down again with its weakest showing since August last year. 

General Comments

Crisis always implies opportunity.  Those with good trading skills can make money in this market, but you need the training and self-work to do so.  Right now we are in a manipulated bull market.  Be careful!

Next week, Florian Grummes will update us on gold.  The following week, I’ll continue with my update of other market types, we’ll be discussing the oil market at that time. 

 Until the next update, this is Van Tharp.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

Trading Tip

Some Hints about the Bear Market Rally

by 

D.R. Barton, Jr.

“The moment that government appears at market, 
the principles of the market will be subverted.”
 —Edmund Burke (British Statesman and Philosopher, 1729-1797)

Last week, I watched a talented magician on TV. He performed the classic sleight-of-hand magic rather than the big production “make a jet disappear” variety.

His fluidity of motion was amazing. Every trick was entirely believable and he constantly added new twists to the action.

I never knew where the next surprise would appear - kind of like the way I feel about the financial markets today.

The magician used misdirection (elaborate gestures with one hand while the other is doing the work of concealment), strategic shielding and other techniques to pull off very realistic tricks.

The market today has so many things happening behind the scenes, that it seems like a “sleight of hand” artist itself. A misdirection here, a bit of shielding there, some cash and liquidity generated out of thin air, and viola! You see a big market rally despite much in the way of supportive underlying economic conditions.

An Interesting Way to Segment the Market

I saw a chart of the performance by market segmentation that was really interesting. The chart is reprinted below and uses a fairly old, and somewhat esoteric, analysis technique to segment the market called the “Z-Score Financial Analysis Tool.” Let’s have a look.

First the bottom line: the financially weakest stocks have far outperformed their healthier brethren in the rally since early March. Stocks closest to bankruptcy were up 90% during the rally and those that have stronger underlying fundamentals were up just 49%.

Now, some explanation: Edward Altman published the Z-score for predicting bankruptcy back in 1968. The formula was developed to predict the likelihood that a company would go into bankruptcy in the next two years using ratios of earnings, liabilities, working capital, sales and book value. 

To verify that all of this has some real-world meaning, I hypothesized that the Russell 2000 small cap index would have outperformed the S&P 500 and the Dow 30 over the same time frame. As you can see from the chart below, that is certainly the case.

So what does this all mean? Part of the market’s “sleight of hand” involves the media, Wall Street, and the Federal government who are hyping the recovery. We now have trillions of dollars of excess liquidity floating around, thanks to stimulus and bailout money that has been handed out. That extra money has to go somewhere – it needs to find a home. With interest rates near zero, some of that money heads to the stock market to buy shares. Share prices go up. The media, Wall Street and the government all scream, “Recovery!” so people and institutions buy more stock. Stock prices go up some more.

Stock prices have been going up even though economic fundamentals still signal no sustainable signs of recovery—unemployment rates increase, home prices drop, personal spending falls, et cetera. This dichotomy might be confusing but as I have said recently, until the economy digests all of the excess liquidity that the government has pumped into it, traditional analysis has no power to inform us of what’s really going on. This is what makes Burke’s quote at the top of the article so true and why I love it so much. 

The two charts above help show some concrete evidence that excess money is heading to the most speculative stocks. The more excessive the level of risk taking gets, the closer we probably are to the end of the rally. 

Just be sure that your trading and investing is informed rather than excessive!

Great Trading!
D. R. 

About D.R. Barton, Jr.:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  "drbarton" at "iitm.com". 

Reader Feedback

Consistency

Q: I started as a full time trader at a bank a few months ago. Basically, I feel like I have a Ferrari, but I can only drive it on a parking lot. I have all of the currencies available to me and tons of capital, yet I do not have consistent results. I am an engineer with a masters in financial risks, so I have good understanding about the market. 

I also consider myself highly disciplined. I get up every day at 4:30 am to exercise no matter the weather; it is just on me. Consequently, I don't have any problem executing my stops; however, I am still inconsistent. For me to ask for a course or some learning seminar, I need to be able to generate some profit so it can be paid for. It is like, "Which came first, the chicken or the egg?" So I need to show at least some potential. (I am sure I have it, and I know they saw it because they hired me.)

I like to think of trading as a probabilities game where I can have an edge to make it profitable. If I can let the good ones run, I can be consistent.  I like to think about R in terms of volatility and then define the position I am willing to risk. 

My main problem is that volatility (ATR) is too big for currencies. Since I need to show daily profits, it is impossible to wait that long for my trades. So I have been thinking about taking 10 pips as an arbitrary value, (linked to my risk, so I can afford 1000 USD loss) for example, and put in a trade waiting for at least 3-4R. But 10 pips is nothing really; it is pure noise. Are the probabilities going to work in this case? What is the best way to do intra-day spot trading? What approach can I learn about in order to design a good system?—Patricia

A: Your biggest problem is that you work for a bank and most banks don't understand trading or risk (they just think they do). But they do know how to make markets and make money from customers, so they think that the traders they hire should be able to make money.

Do you know how much money you have to trade? That's a key question. Out of the 3,000 bank traders that I've talked to almost no one knows the answer. So how can you do position sizing, which is key?

Do you know how much money you could lose without losing your job? You could do position sizing based upon that.

But then there are other questions: Are you supposed to trade every day, even when there are no good opportunities? 

Does the treasurer have a meeting every day? Are you supposed to trade along the bank's line of thinking (i.e., okay to lose if you do what the bank says, but not if you don't)?

If none of these are the case, then you are in an exceptional position. If the answer is yes to all or most of my questions, then the question you need to ask yourself is, "How can I make money under conditions in which it is very difficult to make money?" And I should point out that currencies are not even great places to put money right now.

As a starting point, I'd recommend my new book, Super Trader. That will at least open your eyes to what you might be missing. — Van

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