Friday, May 22, 2009

Dennis Gartman's trading rules

I was a happy reader of the various Book of Lists that were around in my childhood (I was just reminiscing about one such list tonight - the top ten recorded accounts of spontaneous combustion...that is the smouldering shoes variety).  In my continuing homage to their memory, here is Dennis Gartman's 22 trading rules...

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent". Illogic often reigns and markets are enormously inefficient despite what the academics believe.

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable.

21. There is never just one cockroach!

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Wednesday, May 20, 2009

Chicago's new WNBA franchise - the Volatility VIXens?

Much ado about nothing perhaps?  A notable pickup in interest in all things VIX over the last twelve months (maybe distorted a little by VIX swimwear's summer collection) seen in Google trends searches for VIX...  

The needle in 2008 (E) corresponds to the peak in the VIX about the same surprise there perhaps...but there seems to be renewed interest from the media as it has dipped below 30 for the first time in a while - seen in CNBC's headline...

"As the VIX Continues to Drop, Is S&P at 1,000 Far Behind?"

The VIX is just like any market index, it is an average of what buyers and sellers are prepared to pay - in this case for implied (or expected) volatility in the S&P500.

(If you'd like a reasonably simplified discussion of what volatility and the VIX are - then Barron's has a quick overview and a link to CBOE's "VIX: Fact & Fiction")

Then what is the significance of a VIX below 30? 

Not much really suggests Condor Options -  Interpreting any given value in isolation is meaningless - it's value lies in comparing against realised volatility (that is actual, real-life, this-is-what-happened volatility in stocks). So while a level of say 30 in the VIX may look good when seen from the perspective of last week it was 40 (suggesting that buyers and sellers of volatility have a relatively more sanguine outlook than last week), if realised volatility over the previous 30 days was only 15, then whoa baby - the market is actually expecting a truckload more (realised) volatility over the next 30 days...  In this context, Condor Options points out that realised volatility over the last 30 days was 26 versus a spot at the time of 28...the VIX is slightly expensive versus recent history.

Adam Warner at The Daily Options Report - seems to concur, pointing out that until the VIX starts underpricing actual volatility - implied volatility as priced by the VIX is still expensive.  He also makes the inconvenient observation for snappy television headlines - "I think the larger point here is that 30 is not actually a low volatility reading. It just seems that way based on where we went. Historically in fact 30 VIX was quite high." 

So does the VIX give any insights into future stock movements?

Well perhaps - while the S&P and the VIX are not inversely correlated  (see CBOE report) as some suggest, the VIX, as an average of the market's expectations for volatility, can be expected to be bid up when participants become more uncertain about the future. If you want to protect yourself against uncertainty then buy insurance.  The point being that the VIX provides a gauge of how the market is positioned for an uncertain world.  The higher the VIX - the more that people are prepared to pay for protection.  If they are paying a lot more than recent history in stock movements would warrant, then this could well signal a shift sentiment and prospectively a decline in the S&P500 itself.

In that context, I'm not reading too much into a VIX below 30 when its in line with realised volatility.  What I am sensitive to is a rapid movement in the VIX ahead of actual movement in stocks.  For example if the VIX were to spike back up through 30, while the S&P500 continues to meander between 875 and 930, then that might be telling us something...

Finally, back to the Evil Speculator where step 2 of his VIX sell signal has been fulfilled...a close above 28.80...

Tuesday, May 19, 2009

Consensus has the US market peaking last week

A trip to the temple on the mount reveals a consensus view that the US market topped last week...

From David Rosenberg (ex-Merrill Lynch chief equity strategist) via The Pragmatic Capitalist

The bulls enjoyed and the bears endured a massive 37% rally in the S&P 500 from the March 9th lows to the May 8th highs. Both in terms of duration and magnitude, this proved to be the most intense rally during this 20-month long bear market. And, the bounce has been so impressive that it has taken what was widely considered to be a massively undervalued stock market in early March to one that is now at least moderately expensive. (The FTSE All-World market P/E ratio on forward earnings estimates is now around 15x, well above pre-Lehman collapse levels and nearly double the lows for the cycle.)

Since the rebound from the March 9th lows was again led by the four sectors that led the decline during the bear phase – financials, consumer discretionary, materials and industrials – it stands to reason that this was just another counter-trend rally. What we know about history is that the sectors that led the downturn are never the ones to emerge as leaders in the next sustainable bull market.

The thoughts of Jeffrey Saut from US based Raymond James (via Market Folly)
last week felt like a trend change to me with the S&P500 losing more than 8%, the Russell 2000 surrendering some 7% and the DJ Transports shedding nearly 9%
Gary Shilling interviewed on (Via TPC again) calling the S&P back down to 600 - using S&P EPS of $40 and a generous P/E multiple of 15x...

From Zentrader on Robert Prechter (Elliot Wave practitioner) calling for a resumption of the downtrend near term ...his target for the Dow is 2000 in a replay of the 1929-32 debacle where the Dow lost 80% of its value...

...and even Fox News trying its hand (the Evil Speculator)... 

From my currency trading days, nine times out of ten the consensus opinion turns out to be wrong. When it is right, it is because no one is actually backing their opinions with large positions.  Now given that we have blown most bears out of the water, maybe this time it will be the "end of the bear market rally".

For mine, I'm with Tim Knight at Slope of Hope
if the highs from May 7/8 aren't taken out this week, I think the bulls are in for a meaningful correction; if we do get new highs this week, I think the bulls could carry the S&P back into the quadruple-digits with virtually no pause.

And some more hope for bears  from the Evil Speculator - Molecool is on VIX watch (waiting for confirmation of a sell signal that has proven prescient at turning points) 

Mr Vix closed below its 2.0 Bollinger again and you know what that means. We are one step in a possible equity sell signal.

Saturday, May 16, 2009

Dow Theory

Basic principle is that the index is "an average that discounts everything" - builds all the market's moods, information and supply/demand dynamics into its price.  

The market then has two states - the bull and the bear - each of which has three phases

1) Bull market 
(a) reviving confidence - the index starts to move higher.  This occurs where
- there is fundamental undervaluation (low P/E ratio)
- all news is bad
- public is absent from the market
- market may ignore bad news
- looks like a normal bear market rally
- there is general disbelief and then increasing fear of missing out
- its a rally based on anticipation
(b) Increased earnings - the initial rally is confirmed.  This is the longest and safest to trade and occurs when:
- fundamental values return to normal
- earnings increases emerge
- good news announced
- each correction ends higher
- sector rotation to growth oriented stocks
- increasing employment
(c) Rampart speculation - the market takes off under the 'new' paradigm.  This occurs when:
- increased price volatility
- significant fundamental overvaluation
- there are a smorgasbord of new IPO's and capital raisings
- the public enters the market and day traders emerge
- media coverage increases
- market regulation relaxed
- market is driven by a few stocks

2) Then there are the three phases of the Bear market.
(a) Abandonment of hopes - the first and quick sell-off.
- fundamental valuations still high
- market may ignore good news
- interest rates increase
- maybe other shock news
- IPO's fail then abandoned
- volume falls away - indicates buying is done or is sustained only by deleveraging
- public may see the correction as a buying opportunity
- public may also panic
(b) Decreased earnings - the long slow realisation that its not going to get better quickly.
- fundamental valuations return to near normal
- market ignores good news
- earnings decreases announced
- No IPO's
- Sharp sucker rallies followed by new lows
- Public lose interest
- former market leaders fail
(c) Distressed selling - the tail end of the bear market sell-off - it doesn't have to be quick or in high volume 
- significant fundamental undervaluation
- unemployment peaks
- bad news discounted
- no public participation except for forced liquidations
- specialist media disappear
  - many bankruptcies and failures

Phoenix stocks - identifying stocks to buy

Looking for candidates to buy, how about these criteria?

1) A growing business - business with wide and growing opportunities
2) Earnings certainty - a sustainable competitive advantage - strong pricing power
3) Mispriced opportunity - misunderstood business situation
4) Quality management/board - with a track record and significant insider or founder ownership and buying
5) Strong returns on invested capital and ROE
6) Solid balance sheet - low debt and ideally not a capital intensive business
7) Strong, stable cashflows - cashflows as good or better than net income
8) Buying back shares - EPS accretive
9) Small market capitalisation - brokers only like companies that need to pay them fees, small is beautiful but unloved
10) Attractive valuation - sustainable P/E below 10x and preferably trading below NTA

Tuen Draaisma - Buy signals for an end of the bear

Tuen Daaisma (chief strategist at Morgan Stanley) signals to look for:

1) Valuations low - Shiller P/E ~10x and Price to NTA ~30%
2) Earnings at cyclical low - ROE below the long run average of 12.8%
2) Fixed income markets rallying while equity market is still heading lower
3) Copper price is bottoming out
4) Auto sales improving (or at least getting less bad)
5) Inventories very low - US housing inventories of unsold homes under 8 months
6) Banks balance sheets repaired and ready for business - as measured by senior loan officer survey being greater then negative 20% (ie. not still undergoing credit contraction)

Tuen Draaisma - Lessons from bear markets past

Tuen Draaisma is chief equity strategist at Morgan Stanley (with good form on reading the markets) - his lessons from bear markets past...

1) Valuations get very low indeed 
(a) Shiller PE to 10x
(b) Price to NTA of 30%
2) Equities become cheap slowly - average duration of a bear market is 14 years
3) Sentiment is not hugely negative at the bottom - no climactic final sell-off on high volumes, in fact the opposite final slump more likely on lower and lower volumes - then subsequently higher volumes at higher levels confirm bear market is over
4) Patience - equities do trough during recessions but they do not anticipate recovery by 6-9 mths - that is there is not much anticipation of the upturn in prices prior to the end of the bear market
5) Times have changed but the rules have not
6) Don't fight the Fed - when the Fed cuts rates and equities are cheap you should buy - but wait for the signal - there has been no signal yet...
7) Fixed interest markets have given some good warning signals - government and corporate bonds rally on average 10 and 4 months before equities reach their final trough...

Seven Sell Signals

Trade parameters
1) Protective stop - set to protect against sustaining a large loss at the time of entering a position
2) Price targets - set to lock in profits 

Change in trend signals
3) Gaps against the prevailing trend - something has broken - is it time to get out?
4) Trailing stops - breaking trend of higher highs 
5) Moving average crossovers - typically confirm changes in trends
6) Key reversal - an inside-out day where a new high (low) is made yet close below (above) the previous day's range

Time is money 
6) Time based stops

Thursday, May 7, 2009

Are we there yet?

This is a bear market rally - a reflexive bounce in the parlance of Bill Farrell.
- It all began with the classical 'world in going to end' phase, was followed by 
- "I'm shorting this baby - damn that hurt - maybe next level", through
- the media finds 100 different ways to say "green shoots" (well actually just the one way said over and over),
- until we have reached the "maybe this is the start of the next bull market - geez, I better invest some of this cash".

I'm not yet a convert to the brave new world hypothesis.  The major trends I'm seeing are:
1) USD - still hanging in there but due to breakdown sometime soon - this is good for commodities
2) US treasuries are struggling from oversupply - longer term bear markets are supportive of bonds, but the sheer weight of money that the US government (amongst others) is requiring from the market is going to impact longer dated rates over the near future - this is bad for equities
3) Gold - looks like it'll be a beneficiary of a stagflationary outlook - expect a test of $1000 and push through to around $1300 before its done.
4) Oil - looks overdone to my eyes over the near term - there's just too damn much of it floating around in boats playing the contango trade.  I'm a buyer on a pullback though - higher oil prices are one sure way to pass on aggregate demand in a world where asset deflation prevails
5) Financials - expect a pullback, banks still have a ways to go before they are through the woods - expect the individual, the consumer, the retail client to bear the brunt of this one - if Goldies and Macquarie are issuing equity, then its time to sell 
6) Property - the banks remain unwilling to the realise their bad loans - Schrodinger's cat is alive and well as long as we don't open the box - hiding behind your hands doesn't change the facts - asset based enterprises that are stuffed with debt are naked before the asset price downdraft going on.  It plays out in one of two ways - the banks do pull the pin (not likely at the moment with Ruddbank in tow) or just drags the recapitalisation process out for years (ala Japan).  Great!

More folkloric wisdom

From David Rosenberg,
1) In order for an economic forecast to be relevant, it must be combined with a market call.
2) Never be a slave to the data – they are no substitute for astute observation of the big picture.
3) The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.
4) Fall in love with your partner, not your forecast.
5) No two cycles are ever the same.
6) Never hide behind your model.
7) Always seek out corroborating evidence.
8) Have respect for what the markets are telling you.
9) Be constantly aware with your forecast horizon – many clients live in the short run.
10) Of all the market forecasters, Mr. Bond gets it right most often.
11) Highlight the risks to your forecasts.
12) Get the US consumer right and everything else will take care of itself.
13) Expansions are more fun than recessions (straight from Bob Farrell's quiver!).