Thursday, July 31, 2008

Proprietary Trading Firms Offering Training

As I mentioned in my recent post on training successful traders, a number of proprietary trading firms that train their traders are rolling out their training programs as stand-alone offerings for independent traders. This is a promising development and a potential win-win situation: it offers real-time education for traders from mentors who actually trade for a living, and it leverages the activities of the prop firm into a separate profit center. It also potentially creates a path by which independent traders could prove themselves and eventually trade prop capital.

In addition to SMB Capital, mentioned in the original post, here are two more firms actively participating in the training space:

T3 Live - I'm very impressed with the use of technology to create a virtual trading floor, in which traders can watch prop traders live. Among the features offered by T3 Live are a radio/squawk box to hear traders call out their ideas; live video broadcasts; training videos; and daily analyses of markets.

TCA Markets - This UK firm operates on a unique model. They offer training for traders on a remote basis, with the understanding that graduates of the training can qualify to trade the firm's prop capital. They also offer salaried positions to selected graduates.

I cannot stress enough the importance of due diligence. These programs are not inexpensive, and it is important that they offer the specific kinds of training that a trader most wants and needs. I strongly recommend that you talk with graduates, review details of the curriculum, and make sure that what the firm is offering truly meshes with your particular interests and strengths. While promising, this field is also ripe for abuse, much as so-called modeling schools promise grand agency contracts to graduates, only to leave them high and dry after taking their tuitions.

Disclosure and Caveat: I do not work for any of these firms, do not receive any compensation or consideration for mentioning them, and have not been solicited for mentions by them. My goal is to highlight possible opportunities out there in the trading community; it's up to you to engage in the due diligence and ensure that these truly represent opportunities for you.

Keys to Successful Trading and Investing: The Company You Keep

I've been reading Katherine Burton's book Hedge Hunters, which is an interesting collection of interviews with leading hedge fund money managers. One of the goals of the interviews is to dissect what makes these very successful traders and investors tick. The book's findings very much fit with my own experience in working with professional traders: there is no universal personality pattern or trading style associated with success, but there are common features exhibited by those who sustain profitability year after year after year.

One of those qualities is networking with other, successful traders. A hedge fund manager interviewed by Burton put it far better than I could, "Find out who the three or four most important people are in someone's life, and you'll know what kind of person he is...The great managers have great mentors and great friends and great sources."

Every close relationship is a confession: we gravitate toward those that confirm our most deeply held views of ourselves. Integrity is attracted to integrity; achievement is drawn to achievement. Those with damaged self-esteem find themselves in abusive relationships; mediocrities are threatened by ambition and accomplishment and wind up in mediocre company. We are known by the company we keep, the saying goes, and it's true psychologically. Each relationship is a mirror that reflects our experience of ourselves. If you want to know someone, look no further than his or her spouse, closest friend, or closest colleagues.

When successful traders seek out other successful traders, the result is synergy: a sharing of ideas and an explosion of creativity. There are too many markets out there, too many stocks to follow, too much news, too many global trends and relationships. Without quality sources and many eyes and ears, you're going to miss a big part of the picture. The great traders of financial markets are also great traders of knowledge and information, but they are not promiscuous in their sharing. Like any good trader, they trade: they share value when they receive value in turn.

I'm putting the finishing touches on my own new book, and this is one of the themes: success is a team effort. Your success depends upon the team you assemble. Who are you talking with? What value do you bring to conversations with seasoned pros, and what value do you seek from them? Who and what are your key sources of information, and what is the quality of insight that they bring?

You will never achieve great things surrounded by mediocrity. If you want to see what to change in yourself, look at what's missing around you.


Four Qualities of Successful Traders

Ten Lessons I've Learned From Traders

Wednesday, July 30, 2008

A Glance At A Mixed Market

Recall that my Technical Strength measure is a way of quantifying the trending behavior of a stock or index. I follow a basket of 40 stocks, which consists of five highly-weighted issues within each of eight S&P 500 sectors. I sum up the Technical Strength readings for each grouping of five stocks to arrive at a general strength/weakness score for each sector.

Interestingly, after Monday's drop and Tuesday's rise, we have 13 of the stocks in the basket trading in uptrends, 14 neutral, and 13 in downtrends. This suggests an environment of sector rotation, rather than one of general trending.

Here are the most recent Technical Strength readings by sector:

ENERGY (XLE): -360

Weakness in the commodity-related sectors, Materials and Energy, is evident. The two strongest sectors are among the most recession-resistant: Consumer Staples and Health Care. Everything else is not in a trending mode, as the very recessionary themes that are weighing on commodities are also making it difficult to sustain a broad stock market rally. I will be watching the sector ETFs for evidence of breakout moves; those will likely point the direction for the general market.

Tuesday, July 29, 2008

Banks You Can Bank On

Since looking at how many troubled banks are out there and their geographic distribution, I've been focusing my attention on financial issues that offer more bank for the buck. These are banks that, largely because of conservative lending practices and capital management, have not followed their sector lower and, indeed, are up on the year.

I identified the following nine banks by screening for year-to-date performance and weighted relative performance with the help of the excellent Barchart site. These issues are trading relatively close to their 52-week highs in a market that has been nothing short of brutal for banking stocks. After all, the Banking Index ($BKX) is down over 30% this year, and that's after the recent solid bounce from the market lows.

These stocks are the result of an initial screen; they're not buy recommendations in themselves. Please exercise due diligence before adding to your portfolio. Following each bank name and symbol is the percentage price change on the year and the approximate dividend yield. Only shares paying a dividend in excess of 2% were included in the screen; it's always nice to have a positive carry when you're waiting for a market turnaround:

Univest Corp. of PA (UVSP): 24.29%; 2.9%
Citizens Northern (CZNC): 43.38%; 3.8%
Community Bancsystem (CBU): 16.81%; 3.5%
First Bancorp (FNLC): 27.01%; 4.0%
First Financial Bankshares (FFIN): 19.98%; 3.0%
First Financial Corp. (THFF): 35.66%; 2.3%
Mainsource Financial (MSFG): 14.37%; 3.3%
City Holding (CHCO): 29.41%; 3.2%
Hancock Holdings (HBHC): 16.36%; 2.2%

There are many more banking shares that are up on the year. A large proportion are located in the northeast, where overbuilding and housing price collapses have not been as prevalent as in the west and southeast. If these shares can keep their heads above water during the most difficult of times and can maintain healthy balance sheets, they should be poised to make loans and prosper in a general economic recovery.

Monday, July 28, 2008

Identifying False Breakouts and Market Reversals

I was watching a false breakout pattern set up this morning and decided to take a few "snapshots" that I could share from my desktop. We're looking at the unfolding pattern with the Market Delta application. The distribution of volume at price is reflected in the histogram at left; the distribution of volume at offer vs. bid for each price is written within the bars on the chart. When buyers are more aggressive at a particular price (more volume transacting at the offer than the bid), those areas are color coded green; when sellers are more aggressive at a particular price (more volume transacting at bid than offer), the areas within the bars are coded red.

The top chart shows the S&P emini futures market (ES; half-hour bars) prior to the New York stock market open. We are range-bound, within Friday's trading range. Note the relatively normal distribution of volume in the histogram at left that we also noticed in Friday's market.

The second chart shows the upside break above the morning range, with buyers aggressive (green color). At that point, I was already entertaining the idea of a reversal. Total advancing stocks versus declining ones were not robust, and we were seeing weakness in rates, strength in oil prices, and unsteady performance from the financial group.

The third chart zooms in on a five-minute basis to show the high-volume selling that accompanied this initial breakout move. Indeed, this turned the net volume traded at offer vs. bid negative on the session, though we were still trading toward the upper portion of the session's range.

The fourth chart, now looking at a 10-minute view, shows that we made a marginal price high in the ES contract after this bout of selling. That price high was not confirmed by either the NASDAQ 100 futures (NQ) or the Russell 2000 futures (ER2). It was also not confirmed by the key housing and financial sector stocks. We proceeded to sell off even more aggressively, and that selling pressure continued through the majority of the session, as we now experienced a downside breakout of Friday's trading range.

By tracking the unfolding distribution of volume and the extent of participation and divergences among sectors, we can make informed judgments as to whether breakout moves are likely to be to reversed or sustained. Traders who followed the S&P 500 Index market only, relying on price data alone, were most likely faked out by the morning move and left unprepared for the very profitable reversal trade.

Indicator Review for July 28th

Last week's review noted a sharp rebound in the indicators, as buyers flocked to the most beaten-up market sectors. As we can see from the Cumulative Demand/Supply measure (top chart), this rally has continued in the past week, taking us toward overbought status before a pullback late in the week. Such sharp rises out of a market bottom are typical for this indicator and generally precede price tops, sometimes by a considerable time period. It's when we see indexes making price highs with weakening Demand vs. Supply that we generally look for sustained reversal. After an initial upthrust such as we've had, it's generally worked out well to be a buyer on dips in Demand vs. Supply. Note that you can track daily Demand and Supply figures each morning via my Twitter posts.

A similar rebound is evident in the number of stocks making new 65-day highs vs. lows (bottom chart), as the vast majority of issues have come off their lows. As long as we continue to expand the number of stocks registering fresh new highs and don't see an expansion of stocks making fresh new lows, it is premature to fade market strength. (That same principle was instrumental in not fading the significant market weakness during June and the early part of July). The 20 and 65-day new highs/lows are also updated each morning via Twitter.

As you can see from the charts, however, we seem to be hitting overbought status at successively lower price levels in the S&P 500 Index, which is characteristic of longer-term bear markets. My recent analysis suggested that much of the bounce we've seen in stocks can be attributed to short covering and sector rotation, not an influx of new money coming into equities. Smaller cap stocks have tended to outperform larger caps of late; I would become particularly defensive should weakness from the larger issues infiltrate those smaller ones.

Longer term, of course, the market is anything but overbought, as we have only 26% of S&P 500 stocks; 39% of small caps; 36% of mid caps; 33% of NASDAQ 100 stocks; and 13% of Dow Jones Industrials stocks trading above their 200-day moving averages. Note again how the larger the index cap, the weaker the performance. Intermediate-term rallies of late--even during the recent market weakness--have tended to peter out after over 70% of stocks are trading above their 50-day moving averages. We're not near that point yet. That measure is also updated each AM via Twitter.

In summary, we have made a strong upthrust from mid-month market lows and have moved higher, as short-covering in weak sectors and a drop in oil and other commodity prices has been supportive for stocks. If precedent holds, this bounce has further to go, but so far the evidence points to the distinct possibility that it will only be a bounce in a larger bear market. Should the indicators show signs of weakening even as stock prices are in their bounce mode, I would become more aggressive in pursuing the downside. Should we test the mid-month lows with significant divergences among indicators and sectors, I would turn very strongly bullish.

Sunday, July 27, 2008

Money Flow: Fewer Sellers, But Still No Influx of Buyers

In my last post, we saw evidence of resilience in the price behavior of smaller cap stocks. I suggested that such resilience can be part of a longer-term bottoming process. Another part of bottoming is seeing an increase in the funds being put to work in the stock market. That is the function of the money flow indicator, which tracks the dollar volume entering or exiting stocks on a daily basis. It does this by tracking every single market transaction in every stock, adding the dollar volume (price times volume) to a cumulative total if the transaction occurs on an uptick and subtracting it from the total if the transaction occurs on a downtick.

Above we see a four-day moving average of money flows into the Dow Jones Industrial stocks. Note how selling dried up from January through March prior to the market's bounce higher and how selling also dried up from the latter part of May through early July prior to recent market bounce. I've found this to be a common pattern: a decrease in buying or selling prior to an intermediate-term market reversal.

Still, a waning of selling is different from an influx of buying. When the market bounced after the March low--and now during the market's recent bounce--we have not sustained days in which dollar inflows have exceeded outflows. The moving average's excursions above the blue zero line (the point at which inflows equal outflows) have been brief. This suggests to me that much of the bounce consists of short covering and asset reallocation, not necessarily fresh funds being put to work in equities. As much as I've been impressed with the resilience of many stock market sectors and styles, I will need to see more evidence of positive flows before concluding that we are out of bearish woods.

Mid Cap and Small Cap Stocks: Looking Resilient

Three charts from one of my favorite data sources, Decision Point, show the market performance for S&P 500 large caps (top chart); S&P 400 mid caps (middle chart); and S&P 600 small caps (bottom chart). The index performance is in the top pane of each chart, and the advance-decline lines specific to the stocks in those groups appears in the bottom panes.

What we can readily appreciate is that this recent bout of market weakness has been dominated by the large caps thanks, most likely, to the influence of large financial and housing-related shares. We made significant bear market lows in the large caps, but note that the mid caps never moved below their March lows. Small caps made a stab a new lows and quickly pulled back into their range.

Since the lows of earlier this month, moreover, small caps have led the bounce. They have recovered nearly half of their recent decline before pulling back late in the week. The bounces in the mid caps and in the large caps have been far less robust--something that is evident by examining the advance-decline lines.

The above view suggests that there are many segments of the equity market that have not been in panic mode. Indeed, if you had asked me a year or two ago where these indexes would be if we had $4.00/gallon oil, a historically weak dollar, prominent bank failures, a need to bail out the GSEs, and housing values falling 20% per year in many markets, I would have expected far lower levels than we're seeing now. That doesn't mean we can't go lower, and it doesn't mean that systemic problems in the financial sector couldn't drag everything down, from small cap to large.

Still, however, with all that has gone wrong, we are holding well above the 2002 and 2003 lows, with smaller stocks particularly resilient. Back in the early 1980s, we had one scary headline after another: steep inflation, high interest rates, savings and loan institutions going under, and a market that had been significantly lower over the prior 10 years in real terms. That market stubbornly held above the 1974 lows in what we now see in retrospect as a long-term bottoming. The inability to make new lows when all the news is bad is one characteristic of such bottoming. That process can take a while, as in the late 1970s and early 80s, but it eventually poses unique opportunities for those with long time horizons, patience, and cash.

Saturday, July 26, 2008

Thinking and Linking on a Saturday Morning

* Why dividends matter; what hedge funds really provide; and other important market themes from Abnormal Returns;

* My open letter to Edenbridge;

* Which banks are in trouble; questioning the market bottom; and more good link updates from Trader Mike;

* Kirk tracks stocks in play each morning;

* Chris Perruna reviews Brian Shannon's text on technical analysis across multiple timeframes;

* Thanks to an alert reader, who passed along this article on the brain as a muscle;

* What happens after a drop following a bounce from Quantifiable Edges;

* Jeff Miller links the Best of A Dash;

* Declan posts an interesting trading strategy;

* Nice to be one of the top three. I think. Even nicer for a Duke grad to be compared to Coach K, even if it's a bit over the top. Here's an interesting trading post from SMB.

Friday, July 25, 2008

Distinguishing Trend Days From Range Bound Days

If you click on the Market Delta chart above, you'll get a unique view of today's action in the S&P 500 emini futures market.

The histogram at left shows the total volume transacted at each price traded during the day, with the volume divided by the amount transacted at the market offer price (green) and the amount transacted at the market bid price (red). The numbers to the immediate right of price on the left vertical axis represent the difference between volume transacted at offer and bid at each price point.

What you can see is that it is a very mixed picture, with only 9803 more contracts transacted at the market offer than bid over the course of the entire session. Some prices show more volume at offer than bid; other prices display more volume at bid than offer. This relatively even distribution of volume across bid and offer is typical of range bound trading sessions. The quicker a trader can recognize this evenness, the more able he or she is to fade moves at range extremes rather than get caught chasing breakout moves that never materialize.

A second clue of the range bound day is the shape of the volume histogram at right: a shape we recognize from Market Profile theory. Note how the shape forms a relatively normal distribution, with the majority of volume transacted at the center and far less at the price extremes. That tells us that higher and lower prices were not attracting participation. This drying up of volume away from the central, value area is what keeps markets in trading ranges.

Also observe the half-hourly distributions of volume. These show how volume traded at the market offer vs. bid for each half-hour during the trading day, with the "point of control"--the price at which greatest volume was transacted--outlined. We can see that there is no trend to these half-hourly points of control. Indeed, the inability of the market to move value above the 1260 area early in the day provided a nice fade trade toward the other end of the range.

Finally, note the volume histogram bars at the lower horizontal axis. These also are color coded based upon whether more volume during the period was transacted at the market offer (green) or bid (red). We can see how volume dwindled through much of the day, particularly during the periods in which the market tested range extremes. This failure to attract participation during the day is also characteristic of range markets.

Thursday gave us a great trending market; Friday gave us a trading range. In a trending market, you'll play ranges for breakouts in the direction of the trend. In a range market, you'll tend to fade breakout attempts. One mode assumes continuation; the other reversal. Making the read of trending market or range market early in the day can make all the difference in trading success. Observing unfolding price and volume distributions can provide useful clues in making that call.

Training Successful Traders: The New Breed of Proprietary Trading Firm

Increasingly, I'm coming across prop firms that are succeeding by investing in training their traders. These firms tend to be owned and operated by successful traders with a passion for teaching their skills to others. It's a great win-win: the firm wins by earning a percentage of each trader's profit; the trader wins by receiving an education you couldn't pay for.

Interestingly, because veteran traders are running these training programs, they recognize the importance of both teaching skills and instilling proper trading psychology. In my opinion, this makes the training programs far more "real world" than many of the "trading education" offerings from self-anointed gurus.

As an example of this new breed of prop firm and the kind of skills and information they teach, check out the blog for SMB Capital. I had the recent privilege of visiting with SMB and witnessing their program first hand. Steve and Mike, featured in this video summarizing their ideas, strike me as experienced traders who run their firm with integrity. (Here is Part II to their video).

Perhaps the most interesting part of what they're doing is that they've opened up their training programs to traders who can't join their New York firm. This enables independent traders to receive the same education/training/support that would be available in a professional firm, thanks to the online medium.

Keep your eyes open; a number of proprietary trading firms--several of which have been in touch with me--will be entering this space: going public with the training they offer their traders. As they compete, they will be driven to offer more and better training. Eventually, the most savvy ones will integrate coaching with the education/training through videoconferencing and intermittent personal visits. If they're even more savvy, they'll use their public training efforts to identify future successful prop traders.

Few people realize it at the moment, but it's a great time--a very promising time--to be a trader.

Thursday, July 24, 2008

Rogue Traders and How Trading Coaches Help Prevent Blowups

France 24 recently filmed a documentary dealing with rogue traders, featuring the case of Joe Jett from Kidder Peabody. As part of the feature, they wanted to get an inside look at how a trading firm avoids blowups. Only one firm in Chicago, Kingstree Trading, opened their doors to the reporters who flew in from Paris; that can be found in the second segment of the documentary. You'll be able to see a few of the prop traders and, of course, yours truly who works with them.

We commonly think of trading coaches as people who can help traders with their performance. An important, secondary function that is rarely discussed, however, is the coach's work with risk managers to prevent losses and even blowups. It's the teamwork between coach and risk manager that helps traders create and follow plans for managing capital (and managing risk), and it's the eyes and ears of both coach and risk manager that identify problems early on to make sure that plans are followed or appropriately modified.

Trading firms have a fiduciary responsibility to investors/partners (and, in some cases, shareholders). Ensuring that traders are able to fulfill that responsibility is a major task of management--and one of the highest priorities in my work with banks, prop firms, and hedge funds.

Tracking Sentiment in the Movements of Sectors and Asset Classes

I recently noted the stock sector rotation that had dramatically shifted patterns of performance in the market. Tracking these themes has been key to trading the market so far this week.

Above we see percent changes in the S&P 500 Index (SPY); the financial sector within the S&P 500 universe (XLF); the homebuilders index ($HGX); the consumer discretionary stocks within the S&P 500 (XLY); oil (USO); gold (GLD); yields on the ten-year Treasury note ($TNX); and energy stocks within the S&P 500 Index (XLE).

Note the continued weakness in energy stocks as a function of commodity weakness (oil, gold), and the continued strength in the financial stocks, housing, and consumer discretionary issues. As financial shares and stocks overall (SPY) have strengthened, we've seen a bounce in the U.S. dollar and a rise in Treasury rates--a clear reversal from the flight to quality that had driven yields below 3.8% early last week.

By tracking the thematic movements of sectors and asset classes, we can gain a perspective on whether markets are avoiding risk or displaying risk tolerance. Those sentiment shifts have defined both down moves and up moves so far in 2008.

Wednesday, July 23, 2008

Dilemmas of Integrity

Consider the following scenarios:

1) You're a scientist renowned for your research based on an elegant theory that has been named for you. Your research has attracted steady grant funding and a host of prestigious publications. Suddenly the results from your most recent experiments disconfirm your theory and suggest that a rival theory--one advanced by a competing researcher--accounts for the data much better. What do you do?

2) You're a squadron leader in the field and, under the pressure of battle, two of your men fire on civilians and kill them. If reported, this will likely destroy their career and yours. It would also greatly set back relationships with the host government. One soldier suggests planting weapons on the dead civilians to make the squad's actions look like self defense. The others quickly agree. What do you do?

3) You're a trader who has been cultivating skills at reading and trading short-term market patterns. You love trading and envision making your living from it. Suddenly your research uncovers a much larger edge to a set of market patterns that set up over months or even years. The returns are much better than for short-term trading--and they are achieved with far less risk, making only a couple of decisions per year. You only have enough capital to allocate to one set of strategies, and the correlation of returns between the two approaches make it unlikely you'd benefit from pursuing both anyway. What do you do?

It's not always easy to "do the right thing". We live, Ayn Rand, by the evidence of our senses, but sometimes that evidence leads to an unpleasant verdict.

Still, I suspect there's a special place in Valhalla for those who shut the door on one set of dreams to open the door to many others.

Tuesday, July 22, 2008

Second-Guessing: The Should-Have Syndrome

As someone who works with traders across a variety of settings, I've learned to be sensitive to their self-talk: how they process markets and especially their own performance. We do not experience the world directly; rather, we actively interpret events and react to those interpretations. Our self-talk--how we reflect on the events of our lives--is the product of this interpretive process.

Our self-talk, like our behavior, tends to be patterned. Patterns of negative self-talk have been associated with depression; worry is common among anxiety problems. Traders, as a group, are a highly achievement-oriented group. They do not take losses easily. Very often, their self-talk reflects their intolerance of shortcomings.

This intolerance takes the form of second-guessing trading decisions; the theme of traders' thinking is "should have": I should have taken profits earlier; I should have entered the trade earlier; I should have traded larger; I should have traded smaller. Each "should have" is an implicit self-criticism. Over time, this second guessing takes its toll on self-confidence.

There are times when we break rules of prudent trading, and then it makes sense to reflect on our mistakes and learn from them. The "should-have syndrome", however, is often not a sober reflection on genuine error. Rather, it is a second-guessing from a perspective of omniscience: only an omniscient trader would have known to buy the low, sell the high, size the winners large, and size the losers small. The second-guessing is not part of a constructive, problem-solving process. Rather, it is an expression of frustration.

As I review the journal entries of many traders, I read one "should have" after another. Ironically, those traders would never want to be second-guessed by someone else: they would view the "should haves" as backseat driving at its worst. Driven by perfectionism, however, we can undercut our own judgment and lose sight of our successes.

How do you interpret your trading results? What is the tone of your self-talk? Is it a tone that builds motivation and confidence, or one that destroys those? Much of success in trading lies in the interpretation of market patterns. All of that is imperiled, however, if we cannot accurately interpret the results of our own decisions.


A Technique for Preventing Frustration

Monday, July 21, 2008

Indicator Review for 7/21

Last week's indicator review noted that the major indicators continued to be weak, but had stopped weakening, particularly among the small caps. The weakness continued into the early part of this past week, expanding the number of stocks registering fresh 65-day lows (middle chart), but not taking the Cumulative Demand/Supply Index (top chart) or the Cumulative TICK to corresponding lows. This suggested a loss of downside momentum and sentiment, even as the financial sector was selling off furiously. As I noted in my Twitter comment at the time, it was an unusual market, in that some sectors were in absolute panic selling mode, while the broad market was holding up surprisingly well (though weak).

The result was that we had a ferocious short-covering rally during the latter half of the week, which took us out of oversold mode (middle chart) and sent the Cumulative TICK sharply higher. As long as the TICK is in rally mode and we're getting improvement in the new high/new low data (top chart), it is premature to fade this rally.

As my recent post indicated, we've seen considerable sector rotation these past few days, with the weakest sectors (financial stocks; consumer discretionary issues) benefiting most from the short covering. At the same time, energy stocks, which had been performance leaders, have moved to the bottom of the pack thanks to a commodity-related selloff.

As you can see from the top chart, these oversold conditions in the Demand/Supply Index have tended to yield rallies of intermediate-term duration. So far, we're seeing lower highs during these rallies and lower price lows on the declines, which is the definition of a bear market. I am not at all convinced that we've seen the ultimate lows for this bear, but I've also learned not to fight the indicators when they're in sharp rally mode off a severely oversold condition.

Sunday, July 20, 2008

Localized Housing Bubbles: The Distribution of Inventory

My last post took a hometown look at the variation in the distribution of troubled housing. In this post, we'll zoom outward for a national view.

Based upon population data of top 100 U.S. cities, I selected three pairs of very similar-sized cities:

* Atlanta (population 519,145) and Albuquerque (population 518,271)
* Miami (population 409,719) and Omaha (population 424,482)
* Las Vegas (population 558,880) and Louisville (population 557,789)

I then went to the site and looked up the total number of units for sale in each city, in each of three categories:

* Single family homes
* Condominiums
* Multi-family homes

The data are charted above. Note that the total number of units for sale in Atlanta, Miami, and Las Vegas are large multiples of the number for sale in Albuquerque, Omaha, and Louisville. As we saw in the prior post, the formerly hottest real estate markets are the ones with the greatest inventories. Those, to be sure, are also the markets that have seen the largest price drops. Observe, however, that--even after these drops--they continue to sport monster inventories. It is difficult to imagine that the housing crisis is near an end in these areas.

Also note the differences of the distributions among the various units. Condominiums comprise well over half the total inventory in Miami and about a third of the inventory in Atlanta. In Albuquerque, Omaha, and Louisville, condos are a significantly smaller share of the inventory. It appears that condominium speculation is a good part of the housing bubble, but not the whole thing. Las Vegas, for instance, simply has a glut of single family homes--more than 3x the number for sale as in Louisville.

Once again, it's the lumpiness of the data--the extreme variation--that characterizes this housing crisis. It's not that the general housing market is in decline. Rather, some areas are soft and others are wildly overbuilt, to the point where it is difficult to see how they will be sold. Are more than 37,000 households likely to move into Miami--a city of a little over 400,000 people--in the foreseeable future, particularly when they'd be buying into a falling market and finding it difficult to get financing? There are many, from builders to banks, that are hoping the answer is yes. For my part, I'll cast my lot with Omaha.

Beneath the Housing Crisis: Variation in Housing Inventory

We've all heard of the overconfident swimmer who was convinced he couldn't drown in a lake that averaged four feet in depth. Averages don't tell us anything about variability and, when it comes to keeping one's head above water in swimming or in real estate, variability matters quite a bit.

This lesson hit home during a weekend car ride. Son Macrae, shown above in rocker incarnation, has his learner's permit, so he took Dad for a drive around hometown Naperville. We headed southwest and soon reached formerly rural areas that are now the sites of multiple housing tracts. As we drove, the signs for open houses in housing developments first became more numerous, then they became larger. Still further to the southwest, every major intersection was overrun with the signs.

As we forged ahead, the signs began offering massive discounts on the new properties--many of which were obviously not selling. Indeed, many of the developments were half-completed, seemingly frozen in place. By the time we ended our trek, we came across a large sign for a development that offered a free Toyota Prius, $75,000 in options/upgrades, and five years of free utilities to anyone who would buy one of the homes.

It was clear from our drive that there is no single housing crisis. Much of Naperville real estate is in slow-down mode: prices are holding reasonably well, but taking longer, on average, to sell. In the formerly hot areas of development, however, the overexpansion is mind-boggling. Not even free cars and large rebates can move the inventory--particularly with the tightening of mortgage loan criteria for would-be buyers.

This is not an intensification of the slowdown in the general market; it is many standard deviations from the mean. I have significant doubts that many of these subdivisions are viable at any price. From the pricing of the regional bank stocks that have loaned to these developers, I don't seem to be alone in this opinion. C'mon: are you going to jump in and buy a home in a half-filled, half-built development, when it's not clear that the builder will ever be able to finish the work? Are you going to buy a condo in a partially filled building and hope that the remainder of the units will sell, so that you won't have to cover the shortfall in maintenance assessments?

A number of discussions treat the housing problem as if it's a general slowdown that just requires a boost of confidence among homeowners, a cut in mortgage rates, and perhaps some government aid to those at risk of foreclosure. My drive with Macrae suggests the opposite: this is like tech stocks in early 2000. While many sectors back then were overpriced and experienced a significant but normal bear market, a host of internet-related companies were brought to market with no underlying demand or value whatsoever. The bust wasn't over until many of these roundtripped to zero.

The difference, of course, with housing is that, when developments fail, contractors don't get paid; their suppliers aren't paid; bank loans go into default; mortgage-backed securities are threatened; homeowners lose value in their homes; municipalities lose property tax income; and on and on. Just as surviving the 2000-2003 period meant staying out of the formerly hot areas, I suspect that those who get through the current crisis will insulate their funds from the many areas touched by the collapse of developments that are forced to resort to increasingly desperate discounts and come-ons.

To be sure, not all the outliers in the housing market are marked with large signs. When I last looked at the number of Naperville properties for sale as a function of price--and then compared those numbers with the average number of properties that sell each year at each price level--I found similar large variation. Many houses were for sale in the $500,000 and under categories, but not hugely more than the number that sell in an average year. When I looked at the homes that were selling for $1 million and over, however, there was six years or more of inventory on the market. Is anyone likely to pony up that kind of money for what looks to be a depreciating asset? With tightening loan conditions, where are these buyers going to come from?

The irony is that, in the national scheme of things, Naperville is a relatively healthy real estate market. But its housing problems, like the hapless swimmer's lake, average four feet in depth. How many more markets are like this--or worse? My next post will take a look.


Regional Bank Woes

Saturday, July 19, 2008

Plenty of Stock Sector Rotation

With the stock market's vigorous bounce during the latter portion of the week, the technical strength of the S&P 500 sectors that I follow has improved significantly. The data below are taken from eight different sectors, summarizing the short-term technical strength (a quantified measure of trending behavior) of five highly weighted stocks within each sector.

ENERGY: -400

What is clear is the massive sector rotation that has occurred in recent days. Energy stocks are now solidly in downtrends, while the former leaders to the downside--financial and consumer discretionary issues--have turned around significantly.

Here are the percentage of stocks within each sector currently trading above their 50-day moving averages, providing us with a longer-term perspective on relative strength. Once again we can see the surprising weakness of the energy stocks:


Oil Volatility and Market Psychology Perspectives for a Weekend

* Illusion of Volatility? - Just at the time the CBOE rolls out a VIX for the oil market, we seem to be getting quite a bit of volatility in the price of a barrel of crude. Interestingly, however, my look at the 20-day moving average of daily price volatility in West Texas Intermediate crude suggests that current volatility is only modestly above average for the period 1984 - present. The reason for this? You can see the breathtaking rise in crude prices since 2002. A 2% move in crude prior to that time was a move of 40 cents or so. Now, a 2% move is over $2.50. In percentage terms, the latest series of moves in the oil market have not been unusually volatile. But we are anchored to the prices of a bygone era, and that makes the changes at the pump--and in the pits--seem quite extreme.

* Evolving Market - Great historical study of how price patterns evolve over time in the stock market.

* Extreme Negative Sentiment This Past Week - Interesting observations from Richard Peterson's blog, which covers both trader and market psychology.

* Hope Comes at a Cost - Excellent review of research from CXO Advisory on how active trading strategies lower average market returns.

* When Markets Rise on High Volume - Quantifiable Edges finds a worthwhile edge.

* Thanks - For the continued positive comments on the Twitter posts, which have expanded to include links to key market themes, summary of market indicators, upcoming economic reports, and occasional market observations.

Friday, July 18, 2008

Forex Trading Expo

Just a quick note for any readers that might be attending the Forex Trading Expo in Las Vegas, September 12-13, 2008. I'll be a keynote speaker on Saturday the 13th and will be around much of the 12th for anyone who would like to get acquainted. The program includes exhibits and educational sessions, along with the keynote addresses. It will be held at the Mandalay Bay Resort, so there should be plenty to do when you're not attending sessions!

My keynote address will address some of the topics from the new book, focusing on how traders can effectively coach themselves. Do drop me a line if you plan on attending; my email address is on the blog page in the section "About Me".


Preferred Stocks: Anything But Dull

I had to smile when I came across this 2002 article from Forbes titled "Dull is Good: Preferred Stocks". As the charts for two preferred stock ETFs above depict, preferred stocks have been anything but dull in recent weeks.

The reason for this, as Index Universe points out, is that the majority of preferred shares are issued by companies in the financial sector. As the banks and other financial issues have cratered and then bounced sharply higher, their preferred shares have followed suit. The charts for PFF (PowerShares Financial Preferred Portfolio ETF; top chart) and PGF (iShares S&P U.S. Preferred Stock Index Fund ETF; bottom chart) show a considerable volume spike in recent sessions, as investors have questioned the viability of banks and worried about associated risks of default.

Among the top holdings for PFF are preferred shares in Ford Motor, Citigroup, Countrywide, and J.P. Morgan Chase. Among top holdings for PGF are preferred shares in Barclays, Citigroup, Credit Suisse, Merrill Lynch, and Wachovia. If investors thought those preferred dividends were secure, we'd see a lot less volatility in those shares than in the common stock. When preferred shares fall 25% in a matter of days, we're either seeing the buying opportunity of a lifetime or an efficient market pricing in worse things to come for these companies.

Thursday, July 17, 2008

Trading Breakouts and Other Market Themes

* Tracking A Breakout - Note the move this AM of the Russell 2000 (ER2) futures to a multiday high, breaking above longstanding resistance. Rennie Yang of the excellent Market Tells service notes favorable market expectations following very strong NYSE TICK days. As I noted this AM in my Twitter comment, we had an explosive up move in the Demand/Supply indicator that I track for market momentum. When an upside breakout move is accompanied by indicator strength and participation of multiple market themes, it gains credence. Check out this excellent post from Corey on trading the trend day.

* Tracking Market Themes - Trader Mike's updates include a look at the credit rating of U.S. debt and especially interesting interviews with hedge fund managers. Abnormal Returns takes a look at S&P 500 dividends, an explosion of stocks making new lows, and borrowing costs in the U.S. The Big Picture offers a word cloud for the Fed chair.

* Tracking Blogs - I still think NewsFlashr is *the* tool for tracking updates on financial blogs. I notice they'll be adding live tracking of keywords, quite a nice feature for active traders.

* The Foundation of Failure - Great quote from Brian at AlphaTrends.

* Last Frontier? - Thanks to an alert reader in South Africa for this link to an article on Africa as the last investment frontier.

* Trading for a Living - An interesting formula on how much capital traders need from The Proprietary Trader.

Wednesday, July 16, 2008

Tracking a Strong Stock Market

I recently showed what the distribution of the NYSE TICK looks like on a very weak day. Wednesday gave us an opportunity to see how the TICK behaves on an especially strong day. The blue line represents a five-period moving average, and we're looking at how the line behaves relative to the horizontal pink, zero line (scale for the moving average of TICK is at left). We can see the rising slope of the moving average line and the way in which the line stayed above zero throughout late morning and all afternoon. Add to that the strength in the leading themes we've been tracking, as noted in the morning Twitter post, and it made for an excellent trading day.

Trading Psychology, Tax-Free Bonds and Geography, and More

* Trading and Investing Podcasts
- Andrew Horowitz has assembled a nice collection of podcasts from a variety of market perspectives. Here's my recent interview with him on the psychology of recent markets, from real estate/housing to stocks.

* Continuing Market Weakness - Tuesday saw 351 new 20-day highs and 3649 lows across the NYSE, NASDAQ, and ASE. Of those 3649 lows, 2177 were also 52-week lows. Among NYSE common stocks, new annual lows expanded to 456, with 11 new highs. Meanwhile, we continue to see weakness in those sectors that have been leading the retreat, most notably bank/financial shares and housing-related issues. I will continue to update indicators via the Twitter posts.

* Sentiment Spike? - An alert reader reminded me of this post and pointed out that we are seeing the same pattern repeated at present. Indeed, equity put volume has now exceeded equity call volume for seven consecutive trading sessions, a situation that in the recent past has been associated with market bounces.

* Tax-Free Bond Pricing by Geography - I took a look at four Vanguard state-specific long-term, tax-free bond funds. Two are from formerly hot real estate regions, California (VCITX) and Florida (VFLTX), and two are from the northeast, Massachusetts (VMATX) and New York (VNYTX), which has experienced less boom/bust. Recall that I found bank performance weakest in the West and Southeast. Since July of 2007 (chart at top), we've seen the weakest price performance among the tax-free funds in California. Florida and California tax-free bonds in the funds are yielding about 20 basis points more than bonds from N.Y. and Massachusetts for bonds of similar duration. Should housing and economic slowdown progress to the point of threatening the budgets of municipalities, I would expect these divergences to widen.

* Changing Expectations - Note the rally of short-term Treasury note prices (SHY) to multi-week highs. We've seen two-year notes lose something on the order of 30 basis points in just the last two trading sessions, a huge move for that market. This suggests quite a shift in rates sentiment from inflationary concerns (and anticipation of Fed tightening) to recessionary concerns (and anticipation of growing economic weakness).

Tuesday, July 15, 2008

Is Gold an Effective Hedge Against the U.S. Dollar?

With the recent crisis among financial institutions promising further economic weakness and an expansion of fiscal deficits, the decline in the U.S. dollar (blue line above) has gotten the attention of traders and investors. I've been hearing particular talk of hedging this dollar weakness through the purchase of gold as an alternative currency. But is gold an effective dollar hedge?

There's no denying its recent appeal. Over the last three trading sessions, volume in the gold ETF (GLD) has risen to over 20 million shares each day. That's easily twice the average volume over the last few months and the highest three-day total since the Bear Stearns crisis in March.

As the chart above indicates, since 2005 gold (pink line) and the U.S. Dollar Index (blue line) have been traversing opposite paths. The correlation of daily changes in gold and USDX was -.31 from January, 2005 through June, 2007. Since that time, it has soared to -.54. Over a quarter of the daily variance in the U.S. dollar and gold has been shared, suggesting that it has, indeed, been a kind of hedge.

When I went back to November, 1985--the first dates for which I have both U.S. Dollar Index and cash gold data--I found that the correlation of daily price changes between the two has been -.26. That led me to surmise that the current correlation might be historically high.

What I found was that the correlation of daily price changes in gold and the dollar from January, 1986 through December, 2002 was -.20. Since the start of 2003, that correlation has more than doubled to -.43. Interestingly, the period of the correlation's expansion has also been a period in which the U.S. dollar has fallen by more than 28% to modern lows.

The data suggest that, since the marked weakness in the U.S. dollar, gold has increased its role as an effective dollar hedge. Given the surge of interest in gold during March and now in the last few days, it wouldn't surprise me if participation in the gold market also emerges as a kind of sentiment indicator for the dollar.

Keeping Open Minds in Roiling Markets: Overcoming Endowment Effects in Trading

Please mark this down: We make our greatest trading mistakes when we start managing our emotional responses to markets and stop managing our trades and portfolios. Fear is the enemy of flexibility. When we react out of fear of loss, we are deer in headlights. When we react to a fear of missing a market move, we lurch into trades impulsively, often at the worst times. In each case, we're acting in a way to assuage the fear of the moment, not to address opportunity or its absence.

Yesterday was a perfect case in point for me. Noting that smaller cap stocks held up reasonably well late last week and seeing that we had a nice overnight bounce in stocks thanks to the announcement of the government's plan to support FNM and FRE, I was leaning to the long side at the start of the day. I didn't have an overnight position and decided to let the market talk for itself once trading commenced.

As you can see from the distribution of the NYSE TICK above, sellers dominated from the outset. Many more stocks were transacting at their bid price than at their offers. The blue, five-period moving average of the TICK (which is scaled at left) spent essentially the entire day below the zero (pink) line. That is quite unusual. Just seeing that extreme distribution of real-time sentiment was enough to keep me out of trouble. My hypothesis about the day's action was wrong; seeing that quickly--and having the mental flexibility to acknowledge it--was key to the day's success.

Once we're in a large position, it is more difficult to maintain that mental flexibility. The endowment effect noted in behavioral finance research appears to have a basis in brain physiology, affecting decision making by overweighting perceptions of possible loss or risk. When we have positions in the market, they become OUR positions, and we place special value upon them. When we have large positions in the market, we've doubled down not only in our financial commitments, but most likely in our emotional ones as well.

The mindset I have found most helpful for combating the endowment effect is to frame each of my trade ideas as a hypothesis--not as a conclusion--and to clearly articulate the conditions under which my hypothesis is not validated. To be sufficiently committed to a hypothesis that you will test it with trades, but to not be so wedded to it that you ignore the data coming at you: such a scientific stance lies at the heart of trading success, enabling us to focus on managing our money, not our fears.


Trade Like a Scientist - Part One, Part Two, Part Three

Attribution and Bias Among Traders

Monday, July 14, 2008

A Regional Bank Collapse: No Moral Hazard Here

The charts above show price changes for the S&P 500 Index (SPY) and seven major regional banks: Bank of America (BAC); Comerica (CMA); Fifth Third Bank (FITB); SunTrust Bank (STI); KeyCorp (KEY); Wachovia Bank (WB); and National City Bank (NCC). The top chart displays the percentage changes from Friday's close to the end of trading today, Monday. The bottom chart shows year-to-date percentage changes for the issues as of Monday's close.

To say that the regional banks are underperforming the broad, large cap market would be a massive understatement. As a group, as tracked by the regional bank ETF (KRE), they were down over 8% today alone. Bank of America was down 7% today; National City was down over 27%.

Year to date, the group sports 50+% losses, with National City now down over 80% on the year.

As I noted in today's Twitter comments, it's become clearer that Federal bailouts will be designed to protect the functioning of the financial system, not to bail out shareholders. We've heard a fair amount of anguished commentary regarding the "moral hazards" introduced by possible bailouts of investment banks and Government Sponsored Enterprises (GSEs, such as FNM, FRE). Well, take a good look at the charts above. That's what a crisis of confidence free of moral hazard looks like.

Will depositors respond calmly to the collapse in share values among their banks? After Sen. Schumer's disclosure of problems at IndyMac Bank, depositors chose to vote with their feet, leaving the bank and precipitating its seizure by regulators. An eye-opening statistic reported in today's Wall St. Journal indicates that, at the nation's banks, "the percentage of uninsured deposits has doubled since 1992, climbing to about 37% of the nation's $7.07 trillion in deposits at the end of the first quarter...". In the wake of continued bank weakness and the realization that funds thought secure may not fall within FDIC insurance limits after all, we may see depositors as well as shareholders flee from the financial hazards that accrue in the absence of moral ones.

Indicator Review for July 14th

Last week's indicator review noted that it was unwise to engage in bottom picking, given the expanding weakness across the majority of indicators. That proved to be a sound policy, as we hit fresh bear market price lows during the week. Three of the most important themes leading the market continued to point to weakness, and a heads up from the Chair alerted us to government intervention--first with IndyMac, then with Fannie and Freddie. The last large intervention--with Bear Stearns--stemmed a market decline in March and led to a respectable rally. Might that be the case this time around as well?

Interestingly, as the Fed made its intentions known, the indicators remained weak, but stopped getting weaker. As we continued to make price lows into Friday in the S&P 500 large cap stocks ($SPX), the Russell 2000 small cap issues held above their lows from early in the week. This was reflected across a range of indicators: on Friday, the number of stocks making 65-day highs minus lows held above the levels from Monday (top chart); the advance-decline line specific to NYSE common stocks (middle chart; credit to Decision Point) failed to move to new lows late in the week; and the proportion of NYSE stocks trading above their 50-day moving averages also rose as the week progressed (bottom chart).

When I examined the advance-decline line more carefully, a pattern emerged: the line specific to the S&P 500 large cap stocks made fresh lows on Friday, but the lines specific to the S&P 600 small cap stocks and the S&P 400 midcaps held above their lows. This lack of participation among the smaller issues was the first time in a while that the market weakness was not begetting more weakness.

As I noted on Friday, if this divergence is meaningful, we should see good buying off the lows early this week. So far, we are seeing a bounce in stock index futures as I write this, in response to the Treasury's support of the GSEs. I will watch the financial/banking and housing stocks particularly closely to see if the government actions stem the selling in these most vulnerable sectors. Also keep an eye on the consumer discretionary sector (XLY), which has borne the brunt of the market's recessionary expectations. Given the resilience of the indicators late in the week, it would not surprise me to see some sharp short-covering ahead, especially among these beaten down sectors. If that is going to happen, we should see some sustained positive action in the NYSE TICK; I'll be updating that indicator shortly. And, as always, I'll be updating some of my favorite indicators daily via the Twitter app, along with links to timely posts on key market themes.

Sunday, July 13, 2008

The Geographic Distribution of Troubled Banks

After reviewing strong and weak bank performers, I decided to look at banks specific to regions of the U.S. and identify the proportion that have shown weak year-to-date performance. My criterion for weakness was that the stocks had to be down at least 50% year-to-date, much weaker than the broad stock market and weaker than the commercial banking stocks as an entire group. Once again, my hat tip of credit to Barchart for the data:

MIDWEST: 14/57
WEST: 22/55

TOTAL: 57/310

Overall, about 18% of the bank stocks are displaying pronounced price weakness. The highest concentrations are in the midwest, southeast, and particularly the west. It would not be surprising if lending is most curtailed in these areas, as banks build their capital, making economic recovery more difficult.

It is also not surprising that two-thirds of the troubled banks are in the southeast and west, which had been the hottest real estate markets.

These data don't include the major regional banks, savings and loan banks, and banks that are privately held. I don't have data on the latter, but the first two groups display just as much weakness as the banks summarized above, posing a challenge for regulators and for particular regional economies and municipalities.

Banking on Bailouts: How Many IndyMacs are Out There?

In what has been billed the third-largest bank failure on record, IndyMac Bank has been taken over by federal regulators. According to a weekend Wall St. Journal story, the bank's collapse will cost the Federal Deposit Insurance Corp. between $4 billion and $8 billion. That would exhaust over 10% of the entire deposit insurance fund of the FDIC.

That eye-opening statistic led me to wonder how many more IndyMac banks might be lurking in the wings. We had some alert to the gravity of IndyMac's situation simply by following its stock price, as shares moved from over $10 early in the year to under $2 by May. Perhaps year-to-date stock performance might alert us to other candidates for seizure--and further challenges for the FDIC.

With the help of data from the excellent Barchart site, I tracked the year-to-date performance of every publicly traded bank and savings and loan institution. I particularly focused on two groups of companies: those that have enjoyed a rising stock market performance year-to-date and those that have severely underperformed the market. I measured this latter group in two ways: those that fall into the lowest 20% of year-to-date performers across all NYSE, NASDAQ, and ASE issues and those that fall into the lowest 10%. Mr. Market is alerting us to the possibility of an IndyMac-like demise for this latter group, the majority of which are down more than 60% on the year.

Interestingly, I found 33 banks and savings and loan institutions that are up year-to-date in their stock market performance. They are outperforming the broad stock market, and they are trouncing their sector peers. Many are yielding 3% or more and have enjoyed solid earnings growth. I took it upon myself to look up a few annual reports for these financial institutions. All appear to have conservative lending practices, with no subprime residential loans and no major problem loans to overextended real estate developers.

Many of these high performing banks are located in decidedly unsexy areas where there was no real estate boom. Two of the banks, for example, are located in my former hometowns of Syracuse and Ithaca, NY. More than ten of the banks were located in the Northeast; only one was in the West.

The bank and savings and loan stocks falling into the bottom 20% of all market performers were far more numerous: there were 113 in all. Of these, 45 are severe laggards, falling into the bottom 10% of market performers. Interestingly, about half of these are located in the West and Southeast regions of the country: two of the hotter real estate markets during the boom. And the large regional banks? Seven fall into the underperforming category; two in the lowest group. None are up on the year.

The housing crisis does not appear to be over and yet the market is already warning us of at least 45 banks in straits potentially similar to IndyMac. Many more of the group of 113 may join that list as the housing situation unfolds, particularly among smaller banks. Meanwhile, I notice on the Bankrate site that many of the banks offering the juiciest CD rates are those on my list of stock market basket cases. It's understandable that they want/need to raise capital, but if the banks cannot fund those juicy returns, it will only be a larger call on FDIC funds. That is a demand that the FDIC is ill-prepared to meet, given its historically low reserve ratio, raising the unpleasant prospect of bailing out the regulators.

Saturday, July 12, 2008

Not Too Big to Fail: Tracking a Decade of Negative Stock Market Returns

I recently pointed out how the Dow Jones Industrial Average ($DJI) is down about 23% over the last decade on a real (inflation-adjusted) basis.

Here we see the Dow adjusted for changes in the value of the dollar via the U.S. Dollar Index. While the nominal Dow is only down a few percent over the last decade, on a constant dollar basis, the Dow is down about 13%. While the pundits quibble over whether or not we're in a bear market based upon the criterion of a 20% decline, it's clear that--on a dollar-adjusted basis--we are down closer to 30% just in the last year. Indeed, we're not so far from testing the dollar-adjusted lows of 1998 and 2003.

We hear about bailouts of financial institutions and how taxpayers will have to "bear the burden". One burden borne by taxpayers is created when an economy laden with debt papers it over with a weak currency. That creates an implicit tax on everything from food to gasoline. It also weighs on the real returns of financial assets.

Over the past decade, the U.S. dollar index has moved from a bit over 100 to about 72. The flip side of being too big to fail is being too small to bail. So far, there's no bailout in sight for the individual investor/consumer.

Adapting to Shifts in Market Regimes

We all know that the way to make money in a bull market is to buy dips. And, indeed, that made traders and investors quite a bit of money from 2003 to mid-2007. As this three-year chart from the excellent Decision Point site makes clear, however, we have been lurching from one period of extended numbers of stocks making new 52-week lows to another since that time.

The chart shows the Wilshire 5000 Index (a very broad market proxy) versus the number of NYSE, NASDAQ, and AMEX stocks making new annual lows. In the right hand panel, we can see what that distribution has looked like over the past 21 trading days. We have had day after day of high/expanding new lows with nary a bounce in the market index.

What that tells us is that, as prices move lower, longer time-frame participants are not finding value. What makes for a market bottom is the perception by these participants that the selling has been overdone; that bargains are to be had. When markets move lower and cannot attract buyer interest, they can only do one thing: probe yet lower value regions until equilibrium is attained. That's exactly what we've been seeing over the last month. Traders who have succeeded have been able to separate themselves from the conditioning of the 2003-2007 period and adjust to a different regime of persistent weakness.

This is why I spend a good amount of blog space tracking market indicators, including weekend reviews of data I consider most pertinent to the issue of whether the stock market is strengthening or weakening. I update some of the data most important to my own trading each weekday morning via the Twitter app. These indicators kept me out of trouble during the 2000-2002 bear market, and so far they have filled the same function in this period. The goal is to be neither a bear nor a bull, but to capture the actual buying and selling behaviors of market participants, utilizing data that range in frequency from every 6 seconds (NYSE TICK) to every day; that cover the broad market as well as individual sectors and styles.

It's the only way I know how to stay flexible and adapt to wrenching shifts in market regimes.


Weakness Leading to Weakness

Friday, July 11, 2008

Tracking Participation in Market Moves

With the GSEs falling like a stone and further selling among such financial shares as LEH, it made sense that today's market would be in the toilet. While the S&P 500 Index (top chart) was making fresh lows for the week, however, the small cap Russell 2000 Index (bottom chart) remained well above the horizontal blue support line from the 7/8 lows.

The market today was weak, to be sure. My preliminary numbers show 268 NYSE, NASDAQ, and ASE issues making new 20-day highs today, against 2366 lows. The number of new lows, however, on Monday was 3276 and on Tuesday was 2390. In other words, while the financial, housing, and consumer discretionary sectors were leading the large cap index lower late in the week, other market segments were not participating in the weakness.

When we get moves to new lows in which many stocks are not participating in the breakout, the odds of reversal are enhanced. This is what we saw late in the day today. If this is part of a larger bottoming process, we'll need to see buying interest come into the market early in the week. For intraday traders, however, the moral of the story is to look, look, look at the level of participation in any market move: the rising (and falling) tides that fail to move all boats are the most suspect.


Why Participation Matters

A Few Stock Market Perspectives

* No Panic - A look at the average high-low trading ranges for the S&P 500 Index (SPY) over a moving five-day period (top chart) shows increased volatility on market declines. We've seen a jump in volatility of late, but nowhere near the levels seen in August, 2007; January, 2008; or March, 2008. This mirrors the VIX, which, at about 25, is well below the levels from those prior bottoms. It also mirrors sentiment data, as noted recently.

* Not a Good Decade for Stocks So Far: I took a look at the returns of the CPI-adjusted Dow Jones Industrial Average from 2000 to the present. The nominal Dow is down around 200 points--about 2%. On an inflation-adjusted basis, however, the Dow is down 23%. As a hedge against inflation, stocks have not been cutting it. With housing now retracing the gains of the past several years, two important pillars of wealth accumulation appear to have toppled.

* Not Much Discretionary Income: With stocks and housing in retreat and more income going to basics such as food and gasoline, it's not surprising that consumer discretionary stocks (bottom chart) have been making new lows. As you can see from the advance-decline line specific to the S&P 500 issues in the consumer discretionary sector (XLY), it's been a steady downtrend.

* Relative Sector Strength: Here are several S&P 500 sectors and the percentages of their stocks that are above their 200-day moving averages:

ENERGY - 87%

The credit situation and recessionary environment are clearly weighing on financial and consumer discretionary shares, respectively.

Thursday, July 10, 2008

Small Edges, Consistent Returns

Today we're going back to Henry Carstens' P&L Forecaster to take a look at how small edges in trading result in meaningful differences in long-term outcomes.

I ran the Forecaster 10 times under different scenarios to generate a variety of forecasts. Let's imagine a small trader with a $20,000 portfolio whose average win size per day is $100, or 50 basis points. Imagine that this trader's average win size and loss size are equal, but that he has different win percentages: 48%, 50%, and 52% over a period of 100 days.

Here are the outcomes I generated for the 48% scenario: -442.9, -534.0, -250.1, -351.2, -332.0, -137.2, -373.9, -324.0, -432.5, and -211.8. As you can see, the trader with a ratio of 48% winners and 52% losers ends up losing over 1% of his portfolio on average during the 100-day period. There is no scenario in which he makes money.

Here are the outcomes for the 50% scenario: -73.8, 23.6, -96.8, 10.0, 244.3, -50.0, 87.6, -3.2, -95.5, and 114.5. Now, with 50% winners and 50% losers, the trader neither consistently makes or loses money, as we'd expect.

Finally, let's look at the outcomes for the 52% scenario: 240.3, 26.9, 370.2, 322.2, 394.5, 385.7, 393.5, 441.3, 333.4, and 552.9. Here, with 52% winners, the trader makes over 1% during the 100-day period and makes money across all scenarios.

My findings were very similar if we assume that the trader has 50% winners and 50% losers, but vary the ratio of win size to loss size from .90 to 1.0 to 1.1. Under the .90 scenario, all outcomes were losers, with the trader losing well over 1% over the 100-day period. Under the 1.1 scenario, all outcomes were winners and the trader made well over 1%.

Here are the outcomes for the trader who has 48% winners, with the ratio of win size to loss size at .90: -904.2, -727.4, -718.5, -763.5, -786.1, -551.0, -518.9, -610.5, -760.5, and -812.6. The trader loses over 3% of his portfolio before expenses over a 100-day period.

When the trader has 52% winners and win size to loss size is 1.1, the outcomes are: 769.9, 667.5, 614.7, 783.8, 528.7, 830.4, 933.0, 500.7, 791.5, and 884.2. Here the trader makes over 3% during the 100-day period.

What this tells us is that even small edges in the market generate consistent returns if they are consistently acted upon. This is the message of Henry's Axiom of the Small Edge: you don't need a huge edge to make good money; you need to act consistently on the edge that you have.

Our little exercise also shows you how fragile these things are. Just a dip in win percentage from 52% to 48% matters quite a bit over time. Changes in market conditions, changes in our psyche: it doesn't take much of a nudge to make us profitable or unprofitable.

Finally, note the scenario in the chart above with 52% winners and win size to loss size of 1.1. Even in these situations, drawdowns are common. Traders with an established edge can still undergo extended periods of flat performance or drawdown merely by chance. If they are not resilient and change what they're doing out of a lack of confidence, there goes their edge. It's a vivid demonstration of why, psychologically, it is so difficult to maintain profitability even when you are a trader with profitable methods. That conclusion will be important for my next post, when we look at risk and return in these scenarios.


The Psychology of Risk and Return