Saturday, August 29, 2015

Wow, what a week

Wow, what a week it was in the financial markets.

Let's see how my prognostications from last week held up in terms of the Fiblines.  Recall I expected we would find support at about 188 on SPY just south of the tree line.

On Monday we opened just below the 188 level and quickly plunged down to the next lowest level at the 182.5 level and bounced hard and ended up closing for the day at about 187.5.  From there, we rallied back up to the upper white line at about 195 and got deflected back down again and closed the day Tuesday at about 187.2, just below Monday's close.

Tuesday's close was the lowest close for the week from there we shot up and closed for the week just shy of the breakdown point at about 199 on the SPY. So while we violated my expectations in terms of the maximum moves, the extremes of the price moves were very well bracketed by the Fiblines lines we knew in advance.  If the chart on the left does not convince you, nothing will.

As to how I traded it, I didn't!   Instead I went into the week already with a high cash position as a result of analysis done earlier in August and detailed in my post Time to Raise Cash.  I did put on a small offsetting short position in SPY on Friday since I think we may have run our course to the upside for the short term.  In other words, I think the rally off the bottom was just a relief rally back up to the breakdown point and we have further work to do on the downside before all this is over.

As for the rest of out favorite stocks, the FANG stocks (Facebook, Amazon, Netflix and Google) had big rallies of the lows of the week.  But experience tells me not to chase these rallies regardless of what the market does.  Instead, I'm going to stay on the sidelines for the next few 6-8 weeks since we have a very strong seasonal tendency for increased volatility (to the downside) between now and the last week of October.

So keep a high cash position, keep your powder dry and have a great week ahead.

Saturday, August 22, 2015

SPY - How Bad is it?

Welcome back Active Traders and Wealth Builders.

Long bull markets with periods of low volatility tend to lull us into false sense of security.  This past week's carnage in the financial markets is a healthy reminder that stocks can and do go down.

The weekend gives us a chance to step back and put the declines into perspective.  So let's take a look at the biggest declines in the SPY in the past 15 years.  To this, I used a weekly chart of the SPY and the excellent trend line tool in Thinkorswim to build the following table showing the declines greater than 12% since the year 2000

StartEndWeeksPct DeclineAngle
4/200010/2002136-50%-71 Deg
10/20083/200976-57%-84 Deg
4/20107/201010-16%-83 Deg
5/201110/201123-21%-82 Deg

The angle of the decline is important since it shows the steepness of the move.  Just for sake of comparison, I took a look at the angle of the upward move off the lows of 2008 to the recent high and found in increased at about 66 degrees.  That is some solid evidence that stocks go down faster than they go up.

Now let's look at a table of the current decline assuming it ends now - which I don't think it will.

StartEndWeeksPct DeclineAngle
5/20158/201510-7.5%-66 Deg

To put it into perspective, we have not yet declined even 10% from the recent high in SPY!  So I expect we have further to go to the downside before we find some support.  How much further you may ask?  Let's take a look at voodoo to concoct a few likely scenarios, along with some advice as to how to play it.

The chart above shows a weekly chart of the SPY.  The lowest red line on the chart is the 161% move off the lows of 2008 at about 155 on the SPY which also corresponds to the highs set in March of 2000 and September of 2007.

Most of the meaningful declines since 2008 cross 3 voodoo boundaries before finding support.   If that plays out in this case,  I expect we will find support at about 188 on the SPY which is the green line just south of 190 on the chart.   That would be about a 12% pullback which is about another 4.5% to the downside from Friday's close.

As to how to play it, here is my advice:

1) Don't sell into a panic

For those of us who are careful with our money, the dollar losses is these moves can be staggering. Its easy to panic and sell at the worst possible time.  Don't let the dollar figures freak you out.  Instead, turn off the monitor, go for a walk and look at the big picture.

2) Don't buy the first dip

If you were looking a buying a great stock like Facebook, you might be tempted to jump in early in the decline and pick it up a bargain prices, right?  Don't fall for this, you will probably get a better entry later, see #3.

3) Stay on the sidelines and wait for it!

Don't base any buying decisions on a single day's action.  You won't pick the bottom since they typically occur on large one-day capitulation-type moves to the downside.  Instead wait for a few days confirmation that the market has found its footing before changing to a bullish mindset. Remember bottoms take time to form and don't try to be a hero and pick the bottom, particularly this early in a decline.

Seasonally speaking, the odds of a decline being over don't occur until the 3rd week of October. So I expect we are relatively early in this bear cycle.

A much better play from here is to wait for a rip-the-shorts-heads-off rally up the breakdown point at 200 in the SPY before entering some bearish positions.

4) Look at the bigger picture

Pull up a weekly or monthly chart to see how far we have come off the bottom.  This decline is not that bad and I expect it will get worse before it gets better.  So keep your powder dry, and cash on the sidelines, because I expect you will get a better entry point in the future.

Have a great week ahead.

Saturday, August 15, 2015

Time to Raise Cash

Welcome Back Active Traders and Wealth Builders.

One of the things I have learned from all of my years of investing and trading is that it doesn't pay to fight the market.  Put another way, if the stock market is in retreat generally, odds are against making money on the long side in stocks.  Sure you might find a few stocks or sectors making new all-time highs, but they will be few and far between.   During these times, you hard eared assets are better just sitting in cash.

In his classic book 'Reminiscences of a Stock Operator' author Edwin Lefevre made a strong impression about observing general conditions.  Taking a cue from the author, here are my top reasons why I have the highest levels of cash I have had all year.

5) Market Breadth is Declining

Recent all-time highs in the SPY have not been confirmed by the broader market.  The chart on the right shows a weekly chart of SPY for the past 2 years versus the T2107 which is a proprietary Worden indicator measuring the percent of stocks above their 200 day price moving average.  You can clearly see a divergence between the SP-500 price and the percent of stocks above their 200 day moving average.

Keep in mind this is not a particularly new phenomenon and looking at the same chart for the past 10 years, the T2107 peaked back in mid-2009 at nearly 94% and currently stands at about 39%.  In practice this means fewer stocks are taking the market higher and you know who they are, AAPL, AMZN and NFLX to name a few.

4) USD remains strong

The US dollar remains strong and is up about 7% for the year and up about 20% in the past 2 years as measured by the Dollar Index DXY.  This is a mixed blessing since it makes our exports more expensive, but it makes the dollar buy more when US citizens travel abroad.  Where is really hurts is the earnings of US-based multi-nationals who make a large portion of their sales outside the US.  When those overseas earnings have to be translated back to the USD, the currency conversion cuts into profits.   A strong dollar also makes Oil and Energy cheaper since its priced in USD which leads us to #3.

3) Oil and Commodities

Oil and Commodities in general have been in major bear markets, in part due a strong USD.  In fact this past week oil prices actually pierced (to the downside) the lows made during the Financial Crisis of 2008.  As an oil consumer, I love this trend because energy is one of the non-negotiable expenses of modern living and every drop in the price means more money I have to spend for other things. In fact, your humble blog author filled up his car (along with his portable gas can) this past week in Irvington, NJ for $2.18 a gallon cash! 

Keep in mind that gasoline prices are very much a regional item.  A quick look at the national Gas Price heat map here shows that the Chicago area and most of the state of California have the highest prices in the country due in part to issues in refineries in the region.

So what does all this have to do with stock prices?  The fact is about 30% of the SP-500 are energy companies and low energy prices do not help earnings of these companies.  Take a look at long term charts of the Select Energy ETF (XLE) and SPY and you will see how closely correlated that the price of energy stocks are to the overall market.

2) China

The Chinese market as measured by FXI has had a spectacular round trip in 2015 rallying as much as 28% from late 2014 levels, just to give it all back.

To say Chinese government has an awkward relationship with Capitalism is putting it mildly.  They
like the positives of market economies, growth and development and rising standard of living.  They also like a rising stock market, but don't like when it goes down.  So how does the Chinese government react to a falling market?  They order people and companies to buy and prevent then from selling.  This of course defeats one of the major benefits of investing in stocks to being with which is their liquidity.  In the course of this fiasco, they have destroyed the faith of the people in the market.  And it will take a long time to rebuild this faith given the fact that the Chinese public has little experience with stocks to begin with.

Now you could easily make the case that what goes on in China has a limited affect on the US.  After all, the US markets didn't follow the Chinese market up and therefore should not follow it down.  But the fact is that many large US companies (for example APPL and QCOM) get a large portion of their sales from China and a defensive consumer in China does not bode well for future earnings growth.  Plus the world is more interconnected than ever and stock prices around the globe are highly correlated.

1) Seasonality

Its well known that stock prices typically suffer their biggest losses in September and October.  I did a detailed study in seasonality back in 2013 in my post Evidence of Autumn.   The bottom line was that stocks to tend to decline in the fall, but guess what?  They almost always end up higher for the year in the rally that follows between Thanksgiving and Christmas.

Granted stocks sometime rally in September and you may see a marginal new high in the SPY between now and the end of September.  But don't buy into that rally, wait for things to get ugly in October and then buy when you see a close above the high of the low bar in your favorite stock or index.

0) The Fed

In all my years of playing the markets, I have never seen a Fed this easy for this long.  Interest rates as measured by the Fed Funds rate have effectively been zero for the past 8 years.  To see how extraordinary this is, look at this chart here  Of course, stocks love low rates which explains why they have done so well, effectively tripling since the lows of the Financial Crisis.

Now after years of speculation, it appears the Fed is ready to start raising rates in September.  In fact, many have argued that the Fed has been too easy for too long and that an interest rate increase will actually signal the Fed has more faith in the economy and trigger a rally in stocks!  But the rally will likely be short lived because higher rates are not a positive for stocks.

Overall, I don't want to give the impression of being bearish on stocks or the economy.  I'm only suggesting that if you have some gains, take some profits and raise some cash.  You will likely get  better entry point in the next few months.

That's all for now, enjoy the fruits of your labors and have a great week ahead.

Saturday, August 1, 2015

Active-Trader - Flash Boys

Welcome back, Active Traders and Wealth Builders.

I'm back from a week of sailing the high seas and had a chance to read Michael Lewis's book Flash Boys.  It was an excellent read and an eye-opener as to how you can be taken advantage of when trading on-line.

Here's a quick overview of what I learned and how you can protect yourself.  There are many types of algorithmic trading going on in the market place. What surprised me is how much of it occurs with little or no risk being assumed by those trading against you.  And it explains why many market-making firms pay the brokers for order flow.  Its because when a trading firm has your order to buy or sell in hand, they have the opportunity to transact elsewhere or at a different price and use your order to offset it.

There are 3 of the most basic type of high-frequency trading HFT trading scenarios:

- Front Running - You place an order to buy 1000 shares of a stock.  The first hundred goes off at close to the spread and the HFT firm goes out immediately (and I mean microseconds) goes out and buys up the available shares on the remaining exchanges driving up the price just to turn around and sell them back to the original buyer at a now higher price.   This gives the HFT firm a small but relatively guaranteed profit.

Front running successful requires physical proximity to the exchange computer since the advantage requires the minimal amount of delay between receipt of the order and execution.  HFT firms pay dearly for this proximity.

- Rebate Aribitrage  - As mentioned above many retail brokers (including the ones I use) receive payment for order flow.  Some exchanges will rebate the firms who send them orders versus charge them which is the standard arrangement.  Rebate Arbitrage occurs when the firm sends your order where they get paid the highest rebate.  BTW the only broker I am aware of which does not accept payment for order flow is Interactive Brokers.

- Slow Market Arbitrage - This method involves monitoring the difference between prices on various exchanges and transacting on one then making offsetting transactions on other exchanges who are slow to update their quotations.

You might think all of this was impossible due to regulation NMS which requires that all transactions be executed at the "NBBO" or National Best Bid or Offer among the available exchanges.   To implement regulation NMS, all of the prices from the various exchanges are aggregated at the SIP - Security Information Processor.   What was unforeseen was that other non-public versions of the SIP data exists on the computers of the high frequency trading firms inside the exchanges which get a first look the data and have a time advantage in terms of how to use the data to their advantage.

Now granted I don't trade that much, so I am not particularly outraged about this arrangement.  Things are still much better now than they were back in the bad old days when a commission of $14.95 for 100 shares was considered a 'Deep Discount Broker'.  Now I can trade the same 100 shares for $1 through TradeStation with a bid-ask spread measured in pennies.

So what's the take away, how to protect yourself and your hard earned money?

1) Use Limit Orders

This one is so obvious and Cramer also preaches this same mantra.  When you put in a market order, you are essentially telling the market maker and HFT firms - here, take my money!  Instead, put in a limit order under the market or in the middle of the spread.  You might still get HFT'd, but at least you got can transact on your terms and not someone else's.

2) Use Market on Close orders.

Large investors avoid these issues by using "Market on Close" orders which is a special match up of buyers and sellers which occurs on the close at the New York Stock exchange.  Why would anyone want to get just an "average" execution?   Just to avoid this entire mess and when you are a large institution with a lot of average investors, average executions work just fine.

3) Transaction with IEXG.

If you have a platform which allows you to route orders to a particular exchange,  send your orders to IEXG.  That is the Market Participant ID (MPID) for the IEX Group which is the exchange formed by Brad Katsuyama who is one of the heroes of the book.  The exchange was created, and at a great personal and professional cost to Mr Katsuyama, to create a fair exchange for buyers and sellers to transact.

4) Start following VIRT

If you can't beat them, join them as the saying goes.  One HFT firm which was identified in the book which is publicly traded is Virtu Financial ticker VIRT.   This company came public back in May of 2015 at about $23 a share and has trade as high as about $24.70 and currently stands about $23.50.  The company is a market maker and liquidity provider.  It's unclear how much of their income comes from market making versus HFT activity, so more research is required.

Thanks again to Michael Lewis for an excellent read.  And have a great week ahead.