Tharp's Thoughts Weekly Newsletter (View On-Line)

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• Article December Market Update: Quiet Bull by Van K. Tharp
• Workshops 2011 Workshop Dates
• Trading Tip System Quality Number Report for December 2010 by Van K. Tharp
• Mail Bag Opinions on Options

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Feature Article

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, 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, and 4) tracking the dollar. Beginning this month, I will now report on the strongest and weakest areas of the overall market as a separate SQN® Report. And that may come out twice a month if there are significant market charges.

Part I: Van's Commentary—The Big Picture

So what’s going on? We’re in a secular bear market, but we had a fairly good up year in 2010. Most of the market had double-digit returns for 2010. Gold and silver had huge gains in 2010. Bonds started to go down with pressure on interest rates.

Secular market cycles tend to last for 15 to 20 years, so this one could easily last another ten years. A secular bear market does not mean that indexes and prices go down. PE ratios drop in a secular bear market, and it won't end until the Dow PE ratio is in the single digits. At the end of the cycle, when those single digit PE ratios occur, however, the Dow might be 30,000, especially if we have hyperinflation.

Also, secular bear markets don't necessarily mean the economy is weak overall or weakening for the entire period. Sometimes the economy actually grows in a secular bear. I don’t think that’s the case with the current economy, however, as it has huge fundamental problems behind it.

The chart below shows the debt situation for the US. The chart, however, really only counts “official debt” rather than any unfunded future obligations. That “invisible” debt gets bigger each year. Total debt including unfunded future obligations was estimated to be $67 trillion in 2003 when a Federal Reserve paper said the US was essentially bankrupt. Official debt is now about $13 trillion and going up about one trillion dollars each year. The unofficial debt (and this is just a wild guess) could be anywhere from $75 to $100 trillion.

Notice that the Revolutionary War, the Civil War, and World War I didn’t manage to create anything close to the debt burden that we have now. We have never had a secular bear market like this before, even though the chart suggests a similar situation existed at the end of World War II. The US came out of that war with the strongest economy in the world, which helped it to quickly pay its debts. The US certainly doesn’t have the strongest economy in the world now. The US has basically exported both its manufacturing and its service base portions of its economy overseas. Where is growth going to come from?

Also my generation represents the first of the baby boomers. I’m officially at retirement age this year (don’t worry, as far as I’m concerned I’m already retired meaning I only do what’s fun for me). Most baby boomers, though, will need to withdraw money from the financial system and that typically means the stock market. Expect this to begin to happen before the secular bear market ends.

Finally, the education system in the US is no longer elite among the world. A highly educated population has always been the basis of a strong economy. While our higher education system is still quite strong, most of the best graduates are now foreign students. Rather than encourage them to stay, we instead make it difficult for them to stay. They come to the US for an education and leave to use their skills in some other economy.

All of this simply shows that there are huge changes ahead of us. Huge changes mean huge opportunities, if you keep up with what is going on and learn to trade.

Part II: The Current Stock Market Type Is Now Bull Quiet

Each month I look at the SQN® of the daily percent changes over 200, 100, 50 and 25 days. On December 31st, the market volatility was quiet, which suggests no immediate bearish action. Furthermore, volatility had declined significantly and the market-type graph showed a trend moving toward bullishness. On December 31st the SQN 200 was neutral; the SQN 100 (our primary indicator) was bullish, the SQN 50 was bullish, and the SQN 25 was strong bull. So based upon our 100-day data, the market is bull quiet. If you are 100% invested at this point, there is no strong reason to change that yet. The 100-day SQN has been going up strongly since September.

The next graph shows market volatility. You can see that the trend has been towards lower and lower volatility since late May. Remember, that can change quickly (e.g., April/May 2010). Currently, however, volatility suggests nothing ominous approaching.

The only negative data I can find on the market comes from Jason Goepert’s sentiment newsletter. Dumb money is 79% confident in a rally, whereas the smart money is 29% confident in a rally. This is usually a pretty good sign that a major correction will come soon.

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 up nicely for the year now with the NASDAQ 100 actually up 14%.

Over the last three weeks all three indices have shown slight down movements. The recent weekly changes, however, have not been very big.

Part III: Our Four Star Inflation-Deflation Model

Inflation looks a little stronger this month.

We'll now look at the two-month and six-month changes during the last six months to see what our readings have been.

We are in an inflationary environment unless we have another massive derivatives collapse. However, we will see little inflation until the banks start lending and then it could become interesting.

Part IV: Tracking the Dollar

I couldn’t find the government database for the dollar that I’ve been tracking. My hope is that something was wrong with their servers and I’ll find the site back up next month. In the meantime, I’ll show you a chart of the US Dollar futures index. Note this is a futures index, whereas the government data represents cash prices.

As you can see, the dollar has moved up for the last two months or so. By the way, if you plan to attend our Australia workshops, we’d recommend registering quickly. The dollar is still at a pretty good price versus the Aussie dollar, but the longer you wait, the worse it could get.

General Comments

We’re in a secular bear market. And a long term trend will mean dramatic reductions in valuations, taking the S&P 500 PE ratios into the single digits. Fundamentally, things certainly support that trend even though in some secular bear markets the economy can actually be doing quite well. And as I said last month, the next down phase looks like is has been put off; bear markets don’t generally spring out of normal market volatility. Still, this is not a buy and hold market. These are trading markets and that goes for every country in the world right now.

Once again, it’s my opinion that you should use the information in these monthly updates to discern when to switch trading systems and 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 these areas and more 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, 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 January update, this is Van Tharp.

About the Author: 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.  

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Trading Tip

by Van K. Tharp, Ph.D.

I now use the System Quality Number or SQN® to measure the market performance of countries, currencies, commodities, and various equity sectors in my world model.  I use the SQN 100, which calculates the SQN over the daily percent change of the various ETFs we follow over the last 100 days.  A score over +1.45 is strongly bullish; a score below -0.7 is very weak. 

• Green (strongest): Those that are more than one standard deviation above the mean (about 1/6 of the ETFs scanned).
• Yellow (the next strongest): Those above the mean up to one standard deviation (about 1/3 of the ETFs scanned).
• Brown (weak): Those within one standard deviation below the mean (about 1/3 of ETFs scanned).
• Red (very weak): Those more than one standard deviation below the mean (about 1/6 of the ETFs scanned).

(Click on image for larger version.)

The report covers most ETFs currently traded except for leveraged ETFs.

We still have a lot of green in the market this month. Only one country has a 100-day SQN above 2.0—Taiwan.  The other countries that had been in this category—Hong Kong, Chile, Thailand, Malaysia, and India—are now much lower.     

Generally, the strong countries (above 1.75) include Thailand, US growth stocks (small and mid cap), Mexico, Chile, and the Middle East/Africa.

Other strong areas include Energy, Oil and Gas Equipment, Oil and Gas Exploration, Retail, Food and Beverage, Software, Telecom, and Gaming.

There are only four negative ETFs on the entire chart: the US dollar bullish, the British Pound, the British Pound/US dollar, and Spain.  US microcaps, which used to be negative, is now strongly in the green. 

The next table shows commodities, real estate, interest rate instruments, and the strongest and weakest areas of the overall market.  

The strongest areas are silver, energy, food, precious metals, US retail, Taiwan, and the Internet.  The five weakest ETFs are all short major US indices as was the case last month.

Among the commodities, commodities in general, silver, gold, coal, agriculture and global agribusiness are all strong.

Can you remember recently when nearly every category of bonds was strong? Not anymore; the crash in bonds has started.  We basically have a bubble that is popping. Anything with a maturity over 3 years is crashing and showing negative numbers.  Only Junk Bonds retain any strength.  “Mom and Pop” and a lot of professionals tried to escape the ravages of the stock market in the bond market.  In 2011, expect a lot of sad stories in this area from people who don’t treat trading/investing as a business or give it the appropriate study that is due.

About the Author: 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.  

Mailbag

Opinions on Options

Q: I've been reading Super Trader, and I finished Trade Your Way to Financial Freedom a few weeks ago. These are just two of the trading books I've gone through this year in an effort to stop getting knocked around by the markets.

Dr. Tharp doesn't mention trading options. He does mention trading contracts in futures but nothing on options specifically. What are his opinions on trading options? As a rule of thumb, what would be the minimum account balance to try and trade successfully? Dr. Tharp is big on understanding R; however, he mentions a simple exit strategy of 3x the ATR. If you use this stop, does this not half-way define your R (meaning if you want 2R gain, you have to "shoot" for a profit exit that might not be realistic)? Moreover, if you trade options, and use a 3x ATR stop, that could be a significant amount of the option value, hence my question about options...

A: In regards to your question about trading successfully, how do you define success? What instruments would you like to trade? What kind of trading systems would you like to use? What kind of average holding period would you like? Because of these variables and many others, we don't provide "rule of thumb" minimum account suggestions. If you answer those questions and give your objectives a lot of thought, you can determine what a good minimum amount would be for you.

If you want a 2R gain and you use a 3x ATR stop, you would have to find situations that have some probability of yielding a 6x ATR or more move. A 3x ATR or 6x ATR move could be highly profitable for an option or wipe out its value—it depends. In short, some trading systems work well with options and other systems are better suited for stocks or other instruments.

In general, options are a fine instrument for anyone with the intellectual horsepower to understand their complex properties and unique risks. They can be incredibly profitable and are so for some of our clients.

The instrument you trade has less to do with trading success than working on your self, treating your trading as a business, understanding position sizing strategies and the other main factors that Dr. Tharp talks about in the book. Do the work in those areas and you can trade the market instrument that makes the most sense for you. —RJ Hixson

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