Tough Swing Trading Market and Some Wednesday Resources

* No Trend, No Friend - Since 2006, the correlation between the current day's price change in the S&P 500 Index (SPY) and the next day's change has been -.095. Since June of this year, however, it has been -.214. Buying after an up day or selling after a down day has been a losing strategy. The trend has not been a friend for swing traders of late.

* Impressive Rally, Less Impressive Indicator - The market rose sharply on Tuesday, but we only had 1027 stocks making fresh 20-day highs against 868 new 20-day lows across the NYSE, NASDAQ, and ASE. That is fewer new highs than we saw during the prior market bounces in July. I will be watching closely to see if the rally is gaining or losing traction, particularly among the small cap stocks, which have shown less relative strength of late.

* Signs of the Times - The only two sector groups within the S&P 500 universe that are currently showing a majority of their highly weighted stocks in downtrends (my Technical Strength measure) are Materials and Energy, the two commodity-related groups. Consumer Staples and Health Care, two sectors usually thought to be more recession-resistant, are the strongest sectors. Note how Utilities have been following the commodity/energy stocks lower. We've seen a 2008 low for gold and silver mining stocks ($XAU), which have been hammered of late.

* What's Hot? Instant Bull displays the stocks that have gotten the most searches over the last four days, as well as calendar links to get economic and earnings news. See also the news search engine at NewsFlashr, with regularly updated headlines, including a page of financial headlines with search.

* Staying Current - FinViz stays on top of financial news and blog updates. Check out their screener as well, as well as their sector-based heat maps.
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Cross-Talk: Trading Coaches as Whores

* You are 5'10" tall and have a vertical leap of less than a foot. You probably shouldn't try to make your living playing basketball.

* Your verbal IQ is quite high; your performance IQ is below average. You probably shouldn't try to make your living as a mechanic.

* You are not particularly visual in your way of processing information and your fine motor coordination is at best average. You probably shouldn't try to make your living as a graphic artist.

All three statements happen to be true of me, and I suspect the conclusions are not especially controversial. Truth be told, I'd make a rotten pro basketball player, mechanic, or artist. I accept those things and focus my energies in areas of strength.

Suppose, however, we take a new set of statements:

* You don't like taking risks and you're not especially disciplined in your work and lifestyle. You probably shouldn't be a trader in the financial markets.

Well, you've just touched the third rail of coaching. To even intimate the above is to incur the wrath of every losing trader who seeks advice that would justify a continuation of his ruinous path. It reminds me of couples I used to see in counseling who hated each other, made life miserable for each other, put their children through the agony of a loveless home, but who wanted help to "work on our marriage" because they didn't want to separate. Lord help you if you ever intimated that perhaps--just perhaps--they weren't cut out for each other. They could feel justified staying in the marriage as long as they were "working on it". Take away that prop and they hated you for making them face unpleasant realities.

Those situations turn counselors into enablers. Just like coaches are enablers for those who shouldn't be trading, fail to support themselves and their families, and pour their last, desperate hopes into the assurance: "I'm working on it." Maybe there's a way to make a living as a coach for the trading public without being a whore. I doubt it. It's why I steer clear of that part of the business; why I never went into the private practice of counseling and therapy. Too often, you're taking money to prop people's illusions, not to make a real difference.

Hats off to Dr. Bruce Hong for being willing to touch that third rail and open a discussion of who shouldn't be trading. Bottom line from my end: give trading a year or two, track results diligently, work daily on your skills, absorb as many resources as you can, and then see at the end of that time if you can at least cover your costs and break even. If not, consider that your greatest skills might lie elsewhere. I respect Michael Jordan for trying his hand at baseball and giving it all he could. I respect him even more for deciding to stick with his greatest strength and return to basketball.

The only real failure is to spend your life doing things you're not meant to be doing.
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Drama Creates Trauma: Position Sizing and Risk Management in Trading

I recently received an email from a trader who was going through difficult emotional swings as a result of swings in his portfolio. He assured me that he was a knowledgeable, experienced trader and that he limited his risk to 5% per trade.

I didn't need to read any further to know the problem.

So let's return to Henry Carstens' P&L Forecaster to see what's gone wrong.

In the top chart above, we're looking at forecasted returns for a $100,000 portfolio in which the standard deviation of returns per trade is 1% or $1000 and the trader has entered a period of flat performance (average zero return per trade). That might represent the scenario in which a trader risks 1% of portfolio per trade with moderate discipline. Over the course of 100 trades, that trader shows an equity peak of about $9000 (up 9%) and trough about -$3000 (down 3%), for a peak-to-trough drawdown of 12%.

In the world of professional money management, such a swing would merit the attention of risk managers. I don't know too many portfolio managers who would feel good about going from up 9% on the year to down 3% within the span of 100 trades. It wouldn't be a catastrophe, but it would be a concern.

Now, in the bottom chart, let's take a look at the performance of the trader who ramps up risk to a 5% standard deviation per trade, like our correspondent. That again might represent a scenario of risking 5% of the portfolio per trade with moderate discipline. Over the course of 100 trades, that trader displays an equity peak of about $15,000 (up 15%) and trough of almost -$30,000 (down 30%) for a gut-wrenching peak-to-trough drawdown of 45%.

In the world of professional money management, that would be wholly unacceptable.

We all hit periods of flat performance; during those times, note how risk levels affect *psychological stress*. In one scenario, we swing from 9% up to 3% down. Raising the risk per trade by a factor of five swings up from 15% up to 30% down. Note that the order of the gains and losses could just as easily have been reversed: in the first scenario, we could have first gone from 9% down to 3% up; in the second scenario, we could have gone from 30% up to 15% down.

It's the swings that are important--and the effect of those swings on the psyche.

When we trade size that is too large for our account size, we subject ourselves to drastic swings in P/L, and that subjects us to drastic swings in mood. In turn, we then make trading mistakes that bring a negative expectancy to each trade, and the size eventually blows us up.

My advice to the gentleman? Think of the charts above as measuring risk per day instead of risk per trade, so that the equity curves represent 100 days of trading. You can see that a 1% standard deviation of returns still generates peak-to-trough drawdowns of over 10%. I would cut risk below that level--risking less than 1% per day, and thus significantly less than 1% per trade--for at least a month of consistent, disciplined trading before considering a *modest* rise in size (which, in turn, would need to be accompanied by a full month of consistent, disciplined trading).

Only such a sustained period of trading without large swings will counteract the emotional fallout created by the large equity swings. In trading, if you create drama in your returns, you'll create trauma--and that's how trading careers end. The links below explain this in detail.

RELATED POSTS:

The Psychology of Risk and Return

Risk Management and Human Biology

Inside the Trader's Brain
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More Site Seeing For A Monday

* Thanks - I want to thank the 18 trading professionals who have generously given of their time and effort to contribute to the new book;

* More Themes - Do stop loss orders work and other market themes from Abnormal Returns;

* Neuroeconomics - Thanks to an alert reader for pointing out this post on cognitive neuroscience and economics.

* Tracking Performance - Nice example of using a blog as a trading journal from Don Miller;

* Difficult Job Market - Robert Salomon passes along his outlook;

* Deteriorating Fundamentals - Sajal passes along a grim perspective from Jeremy Grantham.

* Oil Bear - Correct Call looks for $100/barrel.

* Screening Tool - HingeFire offers stock screening by technical criteria and more; here's an example of screening for strong bank stocks;
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Indicator Review for August 4th

Last week's indicator review noted the rebound in stocks and the sharp bounce among most of the indicators. The view expressed was that the upthrust from an oversold level generally leads to higher prices over the intermediate term.

Since then, stocks have been largely range bound. We continue to see moderately overbought levels in the cumulative Demand/Supply Index (top chart); pullbacks in that indicator during an upturn generally represent good entry points for buying. Note that I update the Demand/Supply measure each AM in my Twitter posts. While we did rebound from the pullback early in the week, the number of stocks registering fresh 20-day and 65-day (middle chart) highs has not expanded. We also do not see positive inflows of capital into the Dow Industrial stocks, as shown by the money flow measure (bottom chart).

My Technical Strength measure shows that, in my basket of 40 stocks taken from eight sectors within the S&P 500 universe, 12 are trading in uptrends, 15 neutral, and 13 in downtrends. This suggests a range bound environment. With a Fed announcement coming up on Tuesday and BOE and ECB announcements on Thursday, it would not be surprising if we continued that range mode until there is further clarity on central bank policy.

We remain far from overbought levels longer-term. Among NYSE stocks, only 39% are trading above their 50-day moving average, and only 51% are above their 20-day averages. For S&P 500 large caps, those percentages are 36% and 47% respectively; for S&P 600 small caps, they are 55% and 63%.

I continue to view the recent market bounce more in terms of sector rotation and short-covering than in terms of fresh longer-term capital being put to work to take advantage of attractive valuations. We need to see increased money flows and an expansion in the number of stocks registering fresh new highs for this rebound to have legs.
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Checking Out Financial Blogs: More Weekend Site-Seeing

My recent site-seeing post featured links from Newsflashr and Abnormal Returns. Let's take a look at other sites from those two sources, as well as from the excellent links provided by Charles Kirk and Trader Mike.

* Accountability - Credit to Tim Sykes for not only posting his trades, but also his trading results; ditto to Charles Kirk. Thanks to Bill Rempel as well for pointing out the tracking of trades on his site, as well as on the Stock Logic site. These are great learning tools.

* Digging - 10-Q Detective digs through news at several energy firms;

* Weekend Reads - Paul Kedrosky offers several themes from the mainstream media;

* Alerts - Declan Fallond notes that Zignals is offering an advanced alert service;

* Contrary Indicator - Footnoted finds a very unusual one in midnight filings;

* Pronounced Slowdown - Excellent economic review from Investment Postcards;

* VIX Views - Daily Options Report notes continued complacency and divergence between implied and historical volatilities;

* Odds of Recession - VIX and More notes the new trading in recession probabilities;

* Too Clever? - The Aleph Blog notes a flat monetary base, even as the Fed provides enhanced liquidity to banks;

* Confirmatory Bias - The Stock Market Prognosticator takes a look at what sustains bubbles;

My third set of site-seeing links will be posted Monday afternoon. Note that I also post links daily via the Twitter app, with posts focusing on important market themes.
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Shifting International Stock Market Regimes

Since July 15th, we've had a rally in U.S. equities, with the S&P 500 Index (SPY) up over 4%. Above we can see the performance of markets in other countries, including Germany (EWG); Hong Kong (EWH); Japan (EWJ); China (FXI); India (EPI); Russia (RSX); Brazil (EWZ); Canada (EWC); and Australia (EWA).

What we can see is that the rally has been most robust in the energy and resource consuming countries. We've actually seen declines since mid July in the energy and resource producing nations, as commodity markets have tumbled.

It's a great illustration of the linkages among global markets, with equity returns dominated by commodity-based inflation themes.
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Risk Management in Trading: Where to Place Your Stops

I recently received a couple of emails from traders asking me about placing stops. Should they use stops? Should the stops be 1% away from their entry point? 2%?

I'll provide my perspective on the issue, but also welcome comments from readers and other perspectives.

My quick response is that stop loss exits are necessary; without them, trades lose any favorable risk/reward edge. You can only make money in one of two ways: by ensuring that your winning trades are meaningfully larger than your losers and/or by ensuring that you have meaningfully more winning trades than losing ones. Without clear stop-loss levels and profit targets, it's very easy for the average size of winning and losing trades to converge or even turn unfavorable. That puts a lot of pressure on a trader to be right much more often than wrong.

I think that asking whether you should risk $X or Y% on a trade is useful for general risk management, but not the right question to be asking for the placement of stop-loss levels for specific trades. It gets back to the idea (see link below) that every trade reflects an underlying hypothesis. You stop yourself out when objective evidence tells you that your hypothesis--the idea underlying your trade--is not being confirmed.

I've illustrated this above with one of my own trade setups from Friday's trade. Note in the top chart how we came sharply lower in the early morning in the Dow Jones Industrial Average (DIA), hitting a low around 9:08 AM CT (first light blue arrow), bouncing, and then making a new low around 9:25 AM CT (second light blue arrow).

I had no thoughts of buying the market on this first bottom: all major indexes were participating in the decline, and many more stocks were trading at their bid price vs. their offers (bottom chart). Catching those falling knives and trying to call bottoms before market action confirms a turnaround is a perilous occupation.

By 9:25 AM CT, however, the market's situation changed considerably. As the Dow moved to marginal price lows (top chart), the S&P 500 Index (SPY; middle chart) failed to record new lows. We also failed to make new lows in the Russell 2000 (IWM) and NASDAQ 100 (QQQQ) indexes and their respective futures contracts. Volume (dark blue arrow) declined significantly as we made the new low, suggesting that large market participants were not joining the downside. At 9:25 AM CT also, we had many fewer stocks trading at their bid vs. offer (NYSE TICK; bottom chart). In short, the Dow was traveling alone; nothing was confirming its weakness. This is one of my key setups for a reversal trade.

The hypothesis behind this trade is that selling is drying up and that we should see buyers come into the market and produce a healthy bounce. My initial price target is the set of price highs we made during the bounce between 9:08 AM and 9:25 AM; my next targets are the price highs around the 9:00 AM period before the market's selloff.

I want to enter the market as close to the hypothesized lows as possible so that my trade has a favorable risk/reward profile. I want to make more money on a winning trade than I would lose if I were stopped out. For that reason, I want to enter the trade as soon as I see buyers coming into the market, lifting offers out of the unconfirmed lows. I don't try to catch the exact low; I wait for buying to surface and quickly join in.

So now the question of where I put my stop becomes clear: I stop the trade out if we make new lows in the indexes that had been non-confirming, such as SPY. I stop the trade out if we make new lows in NYSE TICK. I stop the trade if the initial buying out of the expected lows leads to a reversal on enhanced volume. In other words, I stop the trade when my idea is not supported: when the unfolding evidence of the market is not meeting the expectations of my hypothesis.

It is in the sizing of the trade that I ensure that I am not risking an undue proportion of my portfolio on any one idea. In my own trading, if I'm risking the equivalent of 3 S&P points as the distance between my entry and my stop-loss, I'll size the position so that the loss of the 3 points won't draw my portfolio down by more than a fixed fraction of portfolio value. That fixed fraction is determined by the amount of portfolio value I'm willing to lose in a day, which is determined by the amount of value I'm willing to draw down in a week and a month. Each trade should risk a fraction of what you're willing to risk in a day; each day should risk a fraction of what you're willing to risk in a week; etc. That gives you the opportunity to battle back when your hypotheses are disconfirmed on one trade after another.

What I hope is clear is that setting stop loss levels is not a simple matter of saying, "I'll risk $1000 or 3 points on this trade." The stop-loss level is integrally tied into the clarity of the trade idea; the execution of that idea to maximize reward-to-risk; and the trader's overall risk management. When you're clear about your trade ideas, it's easier to be clear about stop loss levels, and that makes it easier to keep losses small relative to wins.

RELATED POST:

Trade Like a Scientist
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Those Who Fake It Never Make It: Notes on Faking Reality

After noticing Trader Mike's update regarding a doctored interview with Dave Mabe of StockTickr, I decided to leave a comment on Dave's site. Here I'd like to amplify that comment, because it gets at the heart of trading success and failure.

We talk about losing discipline in trading as we might talk about losing our car keys or our way out of a forest. But losing discipline is not about a simple act of forgetting. It is an active process of refusing to act upon one's knowledge, of blotting out uncomfortable realities. It begins in small ways: talking about our winning days, but remaining mum about losers; convincing ourselves (and others) that we're "doing okay" and "breaking even", when in fact we've stopped looking at the red P/L; ignoring a profit target and taking small gains; violating a stop-loss level and substituting hope for planning on a losing trade.

Out of such small fakes of reality come the larger ones that lead to blow ups: the breaking of risk management rules, the rogue trader's futile attempts to cover up losses.

The really good traders? They don't present themselves as gurus. They're all too keenly aware of the market's way of humbling such pride, and they keep their hard-won lessons firmly in mind. Reality is their best grounding. It's the boasters and self-promoters who have to fake reality to sustain their images in the public mind. But if would-be gurus can't be faithful to reality, how can they remain true to you?

Years ago, when I was in Syracuse, I met with a trader who wanted coaching and counseling. He had sustained major losses in the markets. During his description of his trading woes--and his grandiose plans for making the money back--he casually noted that his home life was tense because he had hidden the losses from his spouse. I declined further meetings with the gentleman. His problem was not trading and, strictly speaking, it wasn't psychological. It was his lack of integrity: his unwillingness to be true to his wife, his plans, and his perceptual process. I had no doubt that his marriage would blow up the way his trading had blown up--and for precisely the same reasons.

As part of writing my new book, I asked over a dozen bloggers and traders to share their ideas about self-coaching and what has worked for them. A dominant theme in the responses has been a relentless drive to keep score: to learn from losing trades and winning ones; to assess performance and guide risk taking accordingly; to clearly identify strengths and weaknesses and adjust trading styles for those. These are experienced and successful traders who have met with success largely because they've been unafraid to sustain the look in the mirror.

Now when I first start working with a trader or a firm, I will toss out a simple homework exercise, such as keeping regular journal entries. Some traders go out of their way to make the most of the assignment; others fulfill it with minimal effort; still others fail to follow through at all. It's the difference between those who work hard at trading and those who hardly work: one seeks earned achievement; the other seeks the unearned. One is grounded in plans, the other in fantasies.

Show me a person's relationship to reality and I'll show you their character--and their success. Contrary to the popular saying, those who fake it never make it.
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A Site Seeing Excursion: Checking Out Financial Blogs

I thought it might be interesting to try something different and link to a variety of financial blogs featured by Newsflashr, many of which you might not be familiar with. Newsflashr updates each post on each blog, so that you can stay on top of your favorite sites easily. In this post, I'm also covering sites reviewed by Abnormal Returns, which does an excellent job of staying on top of financial posts.

* Coaching Yourself - John Forman offers three best practices. Here are Chris Perruna's top three self-coaching practices.

* Daily Commentary - Bill Cara summarizes the market day, but adds his own unique take on the action.

* Intermarket Relationships - Afraid to Trade tracks several changes in intermarket themes.

* Setups on Different Time Frames - MaoXian offers a multi-time frame view of the MER trade.

* Live Trading - Brian Shannon has begun broadcasting his market analysis and trading live.

* Choppy - Market Sci takes a look at daily follow-through.

* Presidential Cycle - The Stock Advisors site offers a perspective.

* Where to Put Money - Andrew Horowitz offers his $100,000 portfolio in MSN Money's Strategy Lab.

* Biotech on the Move - VIX and More notes a breakout.

* Housing Inventory - Peridot Capitalist notes expansion of inventory, but some improvement in CA.

* Equity Idea - If rates go up, Random Roger offers a possible equity trade.

I'll have more links from diverse sources shortly.
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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.
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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.

RELATED POSTS:

Four Qualities of Successful Traders

Ten Lessons I've Learned From Traders
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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:

MATERIALS (XLB): -100
INDUSTRIALS (XLI): +40
CONSUMER DISCRETIONARY (XLY): +20
CONSUMER STAPLES (XLP): +120
ENERGY (XLE): -360
HEALTH CARE (XLV): +120
FINANCIAL (XLF): +20
TECHNOLOGY (XLK): -40

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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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