A look at Stock market Breadth.

The market, true to form, did what it always does--fool the most people, including me.

We have rallied over 10% in a week. I have been somewhat skeptical of the rally, and at the start of the month, began getting into long term put positions. Needless to say, the move has caused me to look closely at my investment thesis that this is a bear market rally.



As you can see from the chart, market breadth is a very reliable indicator at major turns, while the broad market averages can sometimes be misleading. At the top of the market in 2007, market breadth indicators screamed sell 5 months in advance, while the cheerleaders on CNBC were proclaiming even higher highs. At the 2000 peak, market breadth diverged over 2 years before the top. Similar things have occurred at the peak in 1929, as well as the bear markets in the 70's.

Market breadth, particularly the diffusion indicators, which I will show, indicates if the capitalization weighted averages are being pulled up by just a small number of stocks, or if the rally in the indexes is supported by a rise in most individual issues. It is all to easy to "paint the tape" by driving up a few large cap stocks, in order to induce the average speculator that all is well.

The chart has 2 components--the top window is Worden Brothers indicator T2107--percentage of NYSE stocks above the 200 day moving average. The middle window is something of my own design. Worden Brothers also has other diffusion indicators--T2111--percent of stocks 2 deviations above the 200 day moving average, and T2115--percent of stocks 2 deviations below the 200 day moving average.




What I do is plot a relative strength line (smoothed by moving averages) comparing Overbought stocks (green) and oversold stocks (red line) to the percentage of stocks in an uptrend. Then you can easily see how many stocks are in uptrends, downtrends, overbought, and oversold, and how individual issues are moving from the categories.

A strong market should see more and more stocks make it into overbought territory, causing the green line to trend down below the yellow average. Likewise, we should see the red line trend up. The signals should be fairly consistent. Likewise, in a weak market, we should see the red line trend down, while the green line trend up.

When the green line is "too far" away from the yellow average, those are areas to look to buy. When the the red line is "too far" away from its average (purple), those are times to be looking for tops.

When I looked at this today, I was pretty shocked--either we are at the start of a new bull market (hard to believe), or we are setting up for a nasty sell off.

Generally, these signals correlate well, and do not diverge for very long--both are long and short at the same time.

What is strange--at the start of the uptrend in March, they contradicted each other. So few stocks were overbought at the March low, that any uptrend was likely to cause T2107--sustainable uptrends, to outperform, giving a false sell signal. The RS line vs deep oversold stocks was more accurate.

Now, we are going to have another contradiction--the Green line is trending down, giving a buy signal, while the red line is also trending down, and probably going to give a sell signal soon. Almost 85% of NYSE stocks are in uptrends, and 38% of those are in overbought territory. Likewise, the number of deeply oversold stocks is under 1%. Do you want to jump on board an uptrend when a third of all stocks are overbought, and virtually none are oversold?

Sell on Goldman's good news

It shouldn't surprise anyone that Goldman's trading gains greatly exceeded expectations. Typically make about a quarter of NYSE trading volume passes through Goldman (Zerohedge: Goldman Principal Transactions), and that share has been growing.

What is somewhat revealing is the action of the futures this morning--up before the announcement, flat to slightly down afterward. What do the charts suggest?

SPY--Probably a good time to short:



QQQQ: Still probably a good time to short



The Diamonds (DIA) are the weakest of the bunch, and look like they are in the best position to get short.

Michael Covel's Trend Following review

I just posted a review of Michael Covel's book Trend Following. Take a look at my other blog
Open Source Tools for Traders.

The Dollar Dilemma, Treasuries vs. Corporates, and more

I remember having an argument with someone last year about inflation vs. deflation. I had been solidly in the debt deflation camp, and expected a rally in the dollar and treasuries. He was solidly in the "sub-hyperinflation" camp, our exchange went something like this (Circa April 2008):

Me: The losses in the banking system are massive. Credit is contracting, we are going to see debt deflation.

Inflationist: How can you believe that? The government is printing money like mad. Look at oil! Look at commodities! The hyperinflation is obvious.

Me: I have a hypothetical for you. Suppose someone had a printing press. They ran the printing press, created currency identical to what the legitimate authority would produce, in every way. But suppose that currency was placed in a hole in the printer's backyard. Would it have any effect on the economy?

Inflationist: In your crazy world, if the money remained in the hole, no. But if it leaked out into the rest of the economy, then it would be inflationary.

Me: Lets get our terms straight. Inflation for me is a drop in the purchasing power of the currency. A rise in commodity prices can be the result of inflation but is not necessarily evidence of it.

Inflationist: I agree that inflation is a decline in currency purchasing power, and that decline is evidenced by a rise in prices.

Me: Commodity price rises can be caused by things other than simply increasing the quantity of money. For example--a stupid government policy of using corn for ethanol reduces the supply of corn, and boosts corn prices. Through substitution effects, that causes the prices of other crops and livestock to rise as well.

Inflationist: We have a fiat currency. The government will simply print money to solve its problems. We do not have a gold standard, where prior inflation is offset by higher rates, and a contraction in in the future.

Me: Lets look at this another way. In an inflationary environment the demand for cash is low, and its velocity high. People would prefer to purchase goods, services, and investments, rather than leave cash idle.

In deflation, there is strong demand for cash, and little incentive to spend. Velocity of currency is low.

Consumers, pressed by stagnant wages, crushing debt burdens, and rising commodity prices, education, and health care costs, have a high demand for cash.

State governments, with shrinking sales tax, income tax, real estate taxes, a huge unfunded pension demands, not to mention their spending on police, fire, education, and health, are also scrambling for cash.

The Federal government, with its ballooning entitlement spending, its military obligations, and the interest on past debt, also has a high demand for cash.

The internal need for U.S. dollars internally is extraordinarily high. A drop in commodity prices and a rally in the dollar is only a matter of time.

The deflationary thesis turned out to be right on target. But it is time to look at it again.



Both the weekly and daily chart suggest that while the dollar may rally from its current level at just above 80, the primary trend is down, and until otherwise, dollars should be sold on rallies.

Does that imply it is wise to buy stocks? I don't think so.



On an intermediate term basis, it would look as if the Dow is topping out, with the trend line indicator (bottom) crossing below the zero line, Volume has been weak, and the volume numbers from the DJ-30 do not match up well with those from the DIA. I would put more trust in the ETF numbers, as that is based on something that is actually traded, while the Dow industrials index numbers are aggregated from the exchange, and probably do not reflect actual trading activity.



The area to keep an eye on is the corporate bond market. They are the key to estimating the risk appetite in the market.

Currently, they are outperforming treasuries on a relative basis. That isn't something likely to go on forever. If you are fearful of inflation pushing up yields, I don't know how you can hold onto corporates in this environment. If yields on treasuries spike (and TLT drops), corporates will spike worse, pushing LQD down faster than treasuries.

What I fear is if the U.S. continues to double down on trying to inflate its way out of this, we end up with the worst of all worlds. First, our import costs will skyrocket, causing an already stressed consumer to get squeezed even more. Corporate profits get crushed both on the reduction in demand, and the increase in input costs and debt service. This assumes the system of international trade continues to function, and we don't see tariff wars, and protectionist measures of all sorts.

Second, if the U.S. dollar drops, that would probably lead to a spike in U.S. treasury interest rates, causing all other interest rates to rise. The credit markets would contract again, and this time, there isn't a whole lot the government can do. It has already backstopped the banking system. If its costs increase, and people lose confidence in the dollar, stocks, bonds, and commodities could all get real ugly, real fast.

In that scenario, any further intervention would be counterproductive--even in the short term. Printing more money simply causes the market to demand even higher interest--a vicious positive feedback loop that won't stop until the bad debt is defaulted, and misallocated capital is placed in the hands of those who can do something profitable with it.

Can you trust anyone in the market????

Can you trust anyone in this market?

Although it seems obvious to me that data vendors and brokers of all sorts might mine their customer data and attempt to
profit from it, Goldman Sachs now makes it part of their EULA for their institutional portal 360.gs.com.

"Monitoring by GS: Your use of the products and services on this Web site may be monitored by GS, and that the resultant information may be used by GS for its internal business purposes or in accordance with the rules of any applicable regulatory or self-regulatory organization."

If you aren't convinced that this data snooping might be to your disadvantage, the following legal disclaimer is surprisingly clear

"You acknowledge that we may monitor your use of the Services for our own purposes (and not for your benefit). We may use the resulting information for internal business purposes or in accordance with the rules of any applicable regulatory or self-regulatory body and in compliance with applicable law and regulation.

Thanks again to Zerohedge for posting the story. Follow the link for more documentation.

I can't imagine a better reason for small traders like myself to switch to custom programming and open source solutions. For more info--check out my other blog Open Source Tools for Traders.

CAUTION: MARKET BEING MANIPULATED

Here is a must see video from Bloomberg on Youtube:



Thanks go to Zerohedge for this story.

What are Exchange Traded Funds telling us?

A few days ago I came across an interesting article from economist and investment advisor Mark Skousen, who wrote an article on the Friedman Effect that struck me as superficial.

What particularly irked me: "The stock market will probably continue to push higher for now, due to the lag time in the Friedman Effect. The Dow might even reach 10,000 by the end of this year. "

The dominant belief on Wall Street, and in the Ivory Towers of the academy, is that the central bank can minimize the pain caused by growth slowdowns by inflationary policies (dropping interest rates, backstop the banks, support increased government borrowing), and then later reverse those policies once the economy is growing again.

In contrast, Frank Shostak (Fed May Have Painted Itself into a corner) writes:

A major concern for Fed policy makers is a visible weakening in the US dollar against major currencies. If the Fed were to allow the dollar to fall further, the US central bank runs the risk that major holders of US-dollar assets will divest to nondollar assets. This could push long-term rates and mortgage rates higher, thereby igniting another crisis.

I am of the view that the markets may do what the Fed is incapable of -- raising yields on long term U.S. government debt, that will cause yields on other assets (particularly corporate bonds) to spike, killing whatever recovery is underway.

Instead of looking at the select individual markets I'm currently involved with, I decided to slice and dice the ETF universe to see what has really happened since the March 2009 low.

The swift turnaround in the major stock indexes since March 2009 remarkable, and more consistent with Skousen's outlook than my bearish one. Of the 17 major U.S. stock market indexes, only4 of them are not in what I would consider to be primary uptrends (a triple cross of the 21, 55, and 200 day moving averages). The remaining laggards are the Dow transports, Dow Utilities, Dow Industrials, and SP-500 value. But they are not too far away from putting in bullish primary trend crossovers of their own.

Of the U.S. markets, the QQQQ has held up relatively well throughout the downturn, as the following chart (click to enlarge) shows.

When a broader segment of ETF's, including the most liquid U.S. and foreign stock index ETF's (but excluding bull, bear, and commodity funds), more than 2/3 of them (23 out of 32) are also in probable primary uptrends. Of the foreign, unlevered ETFs, the strongest performers are Asian, including China (FXI), Taiwan (EWT), Singapore (EWS). (Click on chart to enlarge)

There is a distinct pattern--the reflation trade still appears to be on. Risk appetite has returned, with beaten down financials leading the way.

In spite of this remarkable turnaround, caution remains in order. As Shostak predicted, yields on long term U.S. treasuries continue to rise, and the "recovery" has come at the expense of government guarantees and backstops of the financial system. The Federal Reserve's easy monetary policy, coupled with massive government deficits continue to erode the value of the dollar. Job losses in the U.S. continue to mount, and that can only mean more stress in the banking sector.

In spite of the positives, there are some troubling symptoms about the sustainability of the current uptrend. Volume continues to decline for most markets, even as prices rally. This is not what you would like to see at the bottom of a bear market. Volume needs to expand on breakouts, and it simply has not.

This is not a "normal" recovery from a bear market and recession, and the government cannot protect everyone from loss. The real question revolves around figuring out who will benefit,and who will lose from the regulatory changes sure to come.

How to profit if you are a short term trader.

It would be wise focus on the relatively strong performers--technology, foreign ETFs, and precious metals for those who desire to be net long. I would prefer to be long the QQQQ and short the DIA.

For speculative position trades, I would enter on retracements, and avoid chasing breakouts, although that has worked on the long side for the past 3 months.

The magnitude of the rally from the lows, the lack of volume at these levels, and the relative uncertainty in the current environment warrent a cautious approach that favors missing out on potential trades, rather than chasing a breakout for the next big trend. When in doubt, stay in cash.

Message of the Markets Resurrected

I had the idea for a blog -- Message of the Markets over 3 years ago, long before the burst of the housing bubble, the credit crisis, or global depression captured the headlines, or the public imagination.

Back then, I could see the U.S. and the rest of the world were headed on a dangerous path. World leaders had sewn the seeds of economic decline decades ago, and those “green shoots” are now bearing their poisonous fruit. But seeing where the world is likely to go, and writing about it consistently are two different things. In general, people (especially my fellow Americans), do not like to hear about decline and hardship, nor being told to prepare for the difficulties that lie ahead. They prefer the sweet lies of the politicians, to the honest truth.

So, I stopped writing about it—until now.

While there has been much commentary on the economic situation, most of it has been flat out wrong, even by those who should know better. Leaders around the world continue to reward the failures who caused this mess. Authorities, who failed in their duty to protect the public in the first place, now say they need even more power and new laws, to prevent future disasters.

We keep hearing, even from pundits who claim to be friendly to free markets, that the government has to “crack down” on financiers, on executives, and on entrepreneurs of all sorts -- in order to “prevent this disaster from happening again.” They claim that “extremists” who favor “ radical deregulation” are the cause, and that “better, stronger, honest” regulators are the solution.

The question I pose to them is simple-- who shall watch the watchmen? How should individuals, who are supposedly too ignorant to look out for their own interests, decide when lawmakers or regulators are doing a good job, or when they are doing a bad one? And if they can accurately decide what policies are good and bad, why do we need the regulators in the first place?

I have little hope of persuading those who cling to their faith in government and regulation that they are fundamentally mistaken. I have more faith that understanding the flaws in conventional thinking will lead the way to profits in a treacherous market environment—if the government permits us to keep them.