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Feature Article Market Update for Period ending May 31, 2010 Market Condition: Volatile Bear 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 US stock market indices, 3) our four star inflation-deflation model plus John Williams' statistics, 4) tracking the dollar, and 5) the strongest and weakest areas of the overall market. Part I: Van's Commentary—The Big Picture According to William Buckler, the Global Financial Crisis can be broken into three stages. In the first stage (from 2007 until the Lehman bankruptcy in September 2008), the government said we were having a glitch in the banking system. There was also some debate about new money, with ideas about ending the U.S. dollar’s role as the world’s reserve currency. In the fall of 2008, the U.S. government refused to bail out Lehman. It went under and so did Bear Stearns, another major investment bank. As a result, the U.S. banking system practically shutdown. This leads to the second stage of the crisis in which the U.S. government immediately came to the rescue with an open checkbook to bailout the banking industry. We are now in the third stage—a sovereign debt crisis. This is where governments go broke. What’s interesting is that U.S. rating agencies lowered the rating of the debt of the PIIGS nations (Portugal, Ireland, Italy, Greece, and Spain), which caused an immediate crisis. The situation in the U.S. is not much better, but the rating agencies are U.S. based and they wouldn’t dare lower the rating on U.S. debt, would they? By the way, the Euro was the number one challenger to the supremacy of the U.S. dollar, but now the European Union is in trouble and people aren’t talking about that anymore. In 2002, Argentina defaulted on its debt ($US100 billion) and now has a new debt of $US150 billion. Default for Argentina is again possible and probable; it’s only a matter of when. And, in my opinion, that’s also true for the U.S. government. Remember that most of the things you consider safe are safe because they are guaranteed by the government. All of this is inevitable, and may unfold sooner than we might think. This is the fundamental crisis behind the ups and downs of a normal business cycle. Bob Prechter of Elliott Wave fame said recently that we are now in a 200-year down cycle. Who knows if the situation is really that dire; regardless, it isn’t rosy. The current conditions we are seeing in the markets and are likely to see in the near future mean great potential profits for those who have trained themselves to be ready. For those who believe themselves to be an “average investor” and who have been unwilling to prepare themselves, investing in these conditions means potential disaster. Part II: The Current Stock Market Type Is Now Volatile Bear Each month I look at the SQN® of the daily percent changes over 200, 100, 50, and 25 days. Volatility is now approaching the category of “very volatile.” The 200-day SQN is neutral, the 100-day has turned to bear, and both the 25- and 50-day changes are strong bear. Clearly, we have now turned the corner into another down leg of the secular bear market.
I now have the ability to show you the 100-day market type (our primary focus) graphically. I believe this presentation of the data is much easier to interpret than the table format. Each month I’ll show you a one-year chart of market type and the volatility level. In February, I was concerned about a market turn to bearish territory, but we didn’t get below neutral and volatility didn’t get out of the normal range. Now, the move to bear territory is clear, and volatility is approaching very volatile. Chuck LeBeau recently said that more than 80% of the stocks in their SmartStops database were dangerously close to being stopped out. He takes this as a very ominous sign. In addition, I regularly look for positive efficiency stocks to buy, but now can find mostly candidates for shorting long term. Let's look at what's happening in the three major US indices. The next table shows the Dow, the S&P 500, and the NASDAQ over the past five weeks and over the last few years. All three indices are down now over the first five months of the year.
Part III: The Strongest and Weakest Market Components By this time, most of you understand how we track the relative strength of the various ETFs representing the economy of the entire world. I publish this model once a month. Ken Long, who developed the algorithm we use, publishes a similar report every weekend at www.TortoiseCapital.com. Ken uses his data as a framework for trading a number of his systems. And Ken will be teaching that material along with his best systems in our June 2010 workshops. The areas in green are strongest (those areas are more than one standard deviation above the mean); those in yellow are the next strongest (above the mean up to 1 standard deviation). 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 leveraged funds from my database, which means that the top and bottom funds are devoted to the strongest and weakest performers rather than entirely to those leveraged instruments.
Right now Chile and South Africa are the strongest countries; however, in this climate they could be the weakest by next month. Notice that the strongest country on the European side of the chart is Russia with a rating of 40. And on the Asian side, there is nothing above 46. The strongest currencies are the U.S. dollar, the Japanese Yen, and the Brazilian Real. The strongest sectors are pharmaceuticals, retail, food and beverage, telecom, and REITs. Energy and oil and gas are dismally weak. The next table shows the commodities, real estate, interest rates, and the strongest and weakest areas of the overall market.
Gold, silver, real estate, bonds, and B2B Internet are the strongest sectors. The weakest areas are the energy sectors and Europe. This is a market in which very little can be relied upon to hold its strength. That means the markets can be traded, but long term investors will really suffer. Part IV: Our Four Star Inflation-Deflation Model We are starting to see weakness in our inflation signals with a movement toward deflation. These are the same signs we were seeing in 2008. Gold and commodities are higher, but commodities are starting to weaken.
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 results have shifted to deflation and look quite ominous for the future.
I also wanted to show you another chart that I think helps explain what is going on in terms of the inflation picture. Typically when the Federal Reserve is stimulating the economy, money is pumped into the banking system and the banks lend out more than they receive; this has a multiplying effect. However, because many banks are in danger of failing and the government is requiring them to increase their reserves, the banks are not lending out the new money they are getting. The graph below, from the St. Louis Federal Reserve shows this happening with the M-1 money multiplier. When the banks stop lending money, the multiplier goes below 1. Right now, it is at 0.87.
To put the current levels in perspective, look below at the longer term chart of the money multiplier with the numbers sometimes being above 3. It would be interesting to see this chart going back to the time when interest rates were 15% or more in the early 1980s. Even though we’ve been in a recession since 2000 (according to real inflation numbers, not what the government says), the Federal Reserve claims that the most recent recession ended last summer.
Part V: Tracking the Dollar
I typically visit http://www.federalreserve.gov/releases/h10/Summary/indexn_m.txt to get information on the dollar. But the Fed seems to be changing the numbers. It’s pretty common to see changes for a month or two after the fact, but lately, the Fed has been very inconsistent with their numbers for a long period of time. Unfortunately, the only other good source is the U.S. dollar index, which is a futures contract. However, I’ve decided to include a chart of that contract each month. The chart below is a graph of the June contract, which shows the huge increase in the relative value of the dollar that is not showing up in the Fed statistics.
As you can see, the dollar is in a nice uptrend right now, mostly because of the weakness of the Euro. We’re also in a debt crisis and most debts are denominated in U.S. dollars, so people need to buy dollars to pay off the debt. General Comments Let me repeat some general principles, so you can understand what's important to consider when trading the current market conditions. First, it’s not that hard to design a system that has “Holy Grail” qualities for any given market type. However, it’s impossible for that system to work in all market types. The market type has changed to volatile bear, so you need systems that work in this type of market. When the Dow crashed 1000 points intraday in early May, many people were stopped out of all of their long term positions. This led many of those people to decide that stops don’t work and mechanical systems don’t work. In the second week of May, I reported that Ken Long made 100R swing trading that same week as the “flash crash.” When I mentioned that Ken would review his 100R result in his June workshop, we got a few additional registrations mostly for the long term workshop. Ken didn’t make 100R from his long term trading systems. He made it swing trading, yet the 100R has had no impact on attendance at that workshop. I find that fascinating. Speaking of our workshops, I also find it interesting that a high percentage of our workshop attendees are now from overseas. Our historical ratio of domestic to international workshop attendees has been around 3 to 1. Americans are probably more afraid than people in other countries, but now is not the time to be afraid. What you resist tends to persist and fearing these conditions will only generate inaction for you on the trading front. This is the time to learn how to profit from the interesting opportunities ahead. In my opinion, you should be using the information in these monthly updates to discern when to switch trading systems, not to forecast the market. This is why it’s imperative that you know how your system will perform under various market conditions. If you haven't heard this before or the other ideas mentioned above, read my book Super Trader, which covers all of this, so you can make money in any kind of market. Crisis always implies opportunity. Those with good trading skills can make money in this market—a lot of money. There were lots of good opportunities in 2009. Did you make money? If not, then do you understand why not? The refinement of good trading skills doesn't just happen by opening an account and adding money. You probably spent years learning how to perform your current job at a high skill level. Do you expect to perform at the same high level in your trading without similar preparation? Financial market trading is an arena filled with world class competition. Additionally and most importantly, trading requires massive self-work to produce consistent, large profits under multiple market conditions. Prepare yourself to succeed with a deep desire, strong commitment, and the right training. Until the June update, this is Van Tharp.
Peak Performance Home Study YOU are the most important factor in your trading success! You create the results you want. Going through this home study course, you’ll gain a perspective on the "how" and "why" of your past trading results and learn tips and techniques to make your profits increase. Your success as a trader depends upon the amount of work you put into applying the principles of the course to your investing and trading. Buy now and take charge of your trading success!
Should the Flash Crash Change the Way You Use Stops? Part 3
Unusual events capture our imagination. They also expose our biases in a very distinct way. With the “Flash Crash” still visible in our rearview mirror, let’s look at one bias in particular that reared its ugly head during that brief but significant turmoil. A number of traders are familiar with the groundbreaking work of Daniel Kahneman. He is best known for winning the 2002 Nobel Prize in economics for a paper he wrote with Amos Tversky on Prospect Theory. In that paper, they quantified the decision biases that arise when people approach risk decisions where probabilities are known but individual outcomes are uncertain. Kahneman is not an economist; however, he is a psychologist. He also wrote (or, more appropriately, edited) a lesser known work on the summary of research in the area of well-being. This particular work thematically reinforced the biases that arise in self-reported well being—with a unique twist. The research showed that self-report of pain is influenced by only two variables: the peak amount of pain and the last level of pain. Essentially, Kahneman and his colleagues found that the last result experienced (or more specifically the emotion involved with that result) unduly biases our memory and recall. Therefore, the last experience also disproportionately biases our decision making on future events. Kahneman called this psychological behavior the “peak-end rule.” We simply might call it “last event bias.” Either way, the concept has significant implications for traders. Last Result Bias in Trading Let’s discuss how we might find Kahneman’s theory at work in our trading. Say you’ve had a trading system that's been performing consistently well for a period of many months. Then, an outside event hands you an out-sized losing trade—perhaps overnight news created a big gap against your position and stopped you out for a loss two or three times bigger than you planned. Or maybe you experience a huge and unusual move like the “Flash Crash” that gave many traders significant problems. When the next trade set-up comes along, your mind clearly remembers that last painful experience. You hesitate. You contemplate changing your stop strategy to try to protect against big losses. You question whether holding any trade overnight is really worth the potential gaps. All these extraneous thoughts happen regardless of the success of your trading strategy leading up to your latest trade. One recent negative event overshadowed the nice aggregate performance that your trading strategy had provided over time. Last event bias is particularly troublesome for intraday traders, if for no other reason than it can affect their trading more because of the frequency of their trades. Useful mental states and thought processes can quickly be replaced by negative ones that then override time-tested strategies. What to Do Can we overcome this subtle and rather insidious bias? Yes. How? We must begin with a good sense of personal awareness, which can be developed by constantly looking at yourself from an outside party’s perspective. Once you are aware that a decision blocker (e.g., last event bias) is creeping in, you can overcome it by dismissing extra decision loops and sticking to the established game plan. If you haven’t looked at them in awhile, review Van’s daily Top Tasks of Trading, which can be quite helpful in minimizing this bias and others. Next week we’ll look at sources of peak emotional pain and solutions for overcoming them. I’d love to hear your thoughts and comments on any part of this series! Please send your correspondence to drbarton “at” iitm.com. Great Trading,
Gann Swing Trading Q: I am interested to know your opinion on Gann Swing Trading as a system. I am in the last few chapters of your Peak Performance Home Study Course and read your newsletters every week. Through both these media the message is constantly conveyed that market analysis is not very important, and a rigid system is most important. I am confused as to where swing trading would fit into this. As a system, it would seem illogical to take every swing generated on a 1-, 2- or 3-day swing chart. And the rules Gann sets out for trading swings can be quite subjective. You do reference him as one of the masters, so I assume his theories are accepted to some degree in the Tharp institute. Swing trading makes it very simple to calculate reward-to-risk ratios and position size, so it must have some merit also as these are the most important aspects to profitable trading in your lessons. I guess I am interested to know how you categorize swing trading, and if you have any examples of successful traders that use it as a stand-alone system, or as a rule-based discretionary system. A: I have no opinion on any specific type or style of trading system; however, if you give me the SQN scores for the system from various market types, I'll be happy to provide you some opinions. The only way I could really answer your questions about swing trading would be to assume my own criteria about trading and systems, which aren't the same as yours. Furthermore, I'd filter swing trading through all my beliefs, which also aren't the same as yours. You will have to do some introspection and research to generate some answers about swing trading for yourself. I recently mentioned that Ken Long made 100R during the recent crazy week in early May. That was swing trading. A lot of your inquiry has to do with finding a system to fit you. But you need to answer a lot of questions before finding such a trading system:
It's interesting that you interpreted my writings to say I think it's most important to use a rigid system. I don't believe I have ever used the word "rigid" in relation to systems. I also don't recall ever specifically saying Gann was a master; I've just mentioned his ideas as one set of many possible ideas for coming up with a trading system. For some additional input into your exploration, I suggest you read my recent article on mechanical trading and next week's article on rules-based discretionary trading. Good luck. Van Ask Van... Everything that we do here at the Van Tharp Institute is focused around helping you improve as a trader and investor. Therefore, we love to get your feedback, both positive and negative! Email UsEmail us [email protected] To end your subscription look at the very bottom, left corner of this email and click on that link. That section will also let you know which email address was used to send the newsletter. |
June 2, 2010 - Issue 477
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