Stock Market Updates – Quantitative, Fundamental and Technical Analysis… In That Order!

Stock market updatesIt has been some time since I wrote a Stock Market Updates blog post and it feels good to share my opinions in this format again!

Today’s post deals with my “order of analysis” and it stems from a conversation I had with a colleague regarding how I approach the myriad of investing and trading decisions in the course of trying to narrow down the best possible vehicles where to deploy capital.

Stocks go up, go down or stay flat in price. If you are long (own the stock) and the stock goes up, you are going to make a profit. If you are long and the stock goes down in price, you are going to incur a loss. If what you own stays stagnant in price you will lose the opportunity cost of allocating your capital elsewhere but in real dollars and cents, beyond the transaction costs, you will not have incurred a gain or a loss. Simple right?

Well it is! What is not simple is this:

How do I know what and when to buy a stock and when to sell it?

First let’s consider some well know facts. Stocks in the long run have about a 70% to 75% chance of being higher or flat on a daily basis. That is a very powerful statement of fact and the primary reason why most individual investors should stay far away from shorting stocks. Shorting stocks is when you borrow shares on margin in hope of closing the trade at a lower price point. Or simply stated, when your bet is that the stock will go down.

So if we agree 75% of the time stocks go up or stay flat, then it follows that our job as investors and traders is to choose those stocks that have a better probability of going up! Of course easier said than done… and in there lies the topic of this post.

 

Quantitative, Fundamental, Technical…

As a market participant I always chuckle at those debates of who is right or wrong or which discipline is “best”, Quantitative Analysis, Fundamental Analysis or Technical Analysis. If you click on the links, you will get a more in-depth description of  each but for the purpose of this article, lets look at it as such:

Quantitative analysis, tries to arrive at an answer by evaluating questions of “How much”.

 

Real buy and sell figures at various price points over time. Some folks out there have begun calling this “evidence based” investing. I am good with quantitative analysis. No need to rename something that has been around for many years just for the sake of launching a new marketing campaign.

This is a factor that I consider paramount. I want to buy a stock that is in the beginning of an accumulation phase. No matter how good a stock may seem from a fundamental or technical basis, if no one is buying the stock, it will languish and remain flat. Do we want our limited allocation of money to be deployed to a stock that will more than likely remain flat? The answer is definitely no. As individual investors we have a limited amount of cash to deploy to our investment positions and a flat stock does us no good.

Many so-called “value” stocks fall under this criteria. Often a stock looks great from a fundamental point of view but for some reason or another it goes unnoticed by the market. If no one is buying it does it matter if it’s a great fundamental story? What is the point of holding a stock for years with the hope that the market will eventually recognize what you have?

Once we find stocks that pass our quantitative analysis and screens, the next thing we look at is the fundamental merits of these stocks. In other words we look to answer the following:

Do I agree with the fundamental reason behind the quantifiable buying of the stock?

Fundamental analysis refers to a company’s business metrics. Is the company earning a profit? is it over valued versus its peers? does it have a price to earnings ratio above the broad market benchmark and so forth. I want to own stocks that are beginning to move higher whose fundamental story makes sense to me. Does the company make a product or offer a service I support and believe in?

Some traders will say this doesn’t matter. “who cares if it’s a “good” company or stock…it’s moving so just buy it” Well this may work in the near term but a stock will eventually trade-off of reality. A hyped up stock with poor fundamentals may fly high quickly but will fall just as quickly. I for one prefer to own stocks I believe in and understand from a fundamental point of view.

 

Technical indicators and pattern recognition

Lastly and least important of all in my opinion is technical analysis. Technical analysis is esoteric in the sense that it can be referred to as art just as easily as it could science. Patterns and the action of traders, (buy or sell) when these patterns are recognized in charts can and do move markets.

Over the years, many quantitative indicators have been lumped into the broad category of “technical analysis” incorrectly. At its pure sense, technical analysis is the study of price action. Technical analysts use price charts to try to determine when both short-term and longer term price inflections are about to occur. In the near term, an understanding of technical analysis can help better an entry or exit point once you are ready to place your trade.

So there you are! Quantitative + Fundamental + Technical analysis. All three have their place, some more so than others. Keep your analysis to this order and watch your profits grow !

 

 

 

Market- “Sterilized, Conditional and Unlimited ECB Bond Buying Program”

Market- “Sterilized, Conditional and Unlimited ECB Bond Buying Program”

I had high hopes for today’s ECB announcement and I was disappointed that Mario Draghi and the ECB central bankers chose to use a sterilized bond purchase plan and failed to lower rates. A sterilized purchase plan, particularly one that is conditional, even if “unlimited” in size, is basically taking from “Peter to give to Paul”. Because they are not expanding their balance sheet, the ECB is basically going to divert funds away from the performing countries to support failing ones.

The German courts will decide on the legality of the ESM (European Stability Mechanism) in the next week or so. I am not an Economist nor do I play one on TV but in my humble opinion, the EU needs to allow the ECB to expand their balance sheet. Europe needs growth and they need both monetary and fiscal actions that support economic expansion. To tie these emergency efforts to austerity is not going to help get these economies moving which is what is desperately needed across the European continent .

The market’s initial reaction primarily focused on the words “unlimited” and “bond buying” and risk assets took off to the races. I had anticipated this initial reaction yesterday and reason why we added the bullish call spread on the DIA and It may very well be that we rally for a couple of days. The mega caps of the DOW should outperform if that is indeed the case. The weaker shorts are covering positions in mass today and it remains to be seen if there is some “buy in” from investors over the next few days. From a technical standpoint, I still think there may be some downside ahead before the next major leg higher.

We have not made a test of support at the bottom rails of this channel since early August and we are very much short term overbought with the SPX well within 3 standard deviations above its 40 period MAs on the hourly charts. It remains to be seen if the “conditional” and “sterilized” terms which in my opinion are bearish aspects of the ECB announcement, get some more play over the next couple of sessions.

Headlines abound with the NFP (Jobs report) out tomorrow, the Fed next week along with the German court decision on the legality of the ESM which could theoretically put all of today’s gains in question. Tomorrow’s NFP number is expected to come in at around +120,000 jobs. Again it is very much a day by day market as traders react to the headlines “du jour”.

 

 

Markets- All About The Central Bankers These Days

Markets- All About The Central Bankers These Days

Residents of South Florida dodged a bullet with tropical storm Issac. The storm jogged just slightly west after crossing the eastern portion of Cuba which placed its trajectory just outside of the Florida Keys into the Gulf of Mexico. The storm brought plenty of rain and some strong gusts but in the scheme of things, South Florida can breathe a sigh of relief. The storm is now heading NNW and on track to make landfall in the Louisiana/Alabama Gulf Coast in an area that has had more than its fair share of natural disasters over the past 10 years.

Markets opened this morning in a relatively subdued fashion with really very few sectors showing definitive relative strength. Apple (AAPL) shot higher after its win in the court battle with Samsung over patent infringement and that seemed to be enough to at least early on, keep markets slightly positive. Breadth at midday is terribly narrow and perhaps as expected, many traders are going to take a wait and see on what comes out of the Fed this coming Friday when Bernanke is expected to make comments following the symposium at Jackson Hole, Wyoming. The ECB is also potential on the verge of announcing easing measures at their next scheduled meeting of September 6th.

My take is that markets may go into this volatile period of headline risk at the midpoint of the regression channel from the recent lows of June 4th at about SPX 1400. We are trading at around 1413 at the moment so we will probably chop lower over the next few days on an absence of buyers and in extremely light summer volume. Support at 1400 should contain any downside push as participants take positions ahead of the Central bank announcements.

Additional QE may or may not be in the works for next month. The probability of more easing has certainly dropped over the past couple of weeks as opposed to earlier in the summer as economic indicators have suggested that perhaps the economy is weak but not at the pace yet where the Fed will take a very heavy handed approach additional easing particularly so close to the elections. It really is a 50/50 probability in my opinion and good arguments are being made on both sides of the spectrum.

As I have mentioned before (and often) what the ECB does here over the next couple of weeks is much more important for the immediate well-being of the equity markets than what is announced by the Fed. The ECB is reaching the end of the rope as far as market confidence is concerned and they need to bring forth a very strong and credible plan to stem the rising of sovereign interest rates for the periphery countries. The ECB needs to send a clear message that they have the will and firepower to stem the crisis. Failure at this juncture could really bring forth an acceleration of the euro crisis. On the other side of the coin, should they (ECB/FED) wow the market and succeed in keeping the bond vigilantes at bay, the equity market should again kick into high gear.

With growth slowing across the globe, the prospects for higher equity prices are tied to the hip of more central bank intervention and fiscal reform. In the near term at least, the likelihood of the former is still better than the latter.

 

 

 

Markets-Talk Of The Death Of QE Is Premature

Markets-Talk Of The Death Of QE Is Premature

Talk about the death of QE is premature. Lots of chatter today on the financial media channels about the diminishing likelihood of additional stimulus measures by the Federal Reserve and the reason for this is that there has been some very minor improvements in a few of the economic data points of late. Here is why I think the Fed will go ahead with further easing at some point over the next couple of months if not at their next scheduled meeting of the FOMC in Sept.

The Fed operates under a dual mandate, price stability and full employment. The troublesome issue for Bernanke is that employment has been stubbornly high and, according to his views on these matters, the only tool on their tool belt to deal with this issue is to ease further. Although fiscal policy would better address employment concerns, he is well aware that fiscally, we may be in paralysis for the remainder of the year.

The Fiscal cliff should be one heck of a standoff later in the year and it threatens to create such anxiety that unless they (the Fed) resolve to do something now, the economy may very well come to a screeching halt. The recent peek at inflation shows that based on the criteria used by the Fed, we have very little current inflationary pressure to deal with which opens the door for the Fed to consider additional stimulus.

The one upcoming factor that could materially change my opinion on this would be if the Aug non-farm payroll report came in much stronger than anticipated. That could very well put the Fed on ice for the next couple of months although I am not of the opinion we are going to see a significant pick up in hiring.

Another point to consider here is that I would be very surprised if the Fed did not coordinate intervention with the ECB and the ECB seems much more poised to act in the near term. Again, it is not a matter of right or wrong, it is just a matter of trying to anticipate what is the most likely action out of the Bernanke led FOMC and their cohorts overseas.

A couple of points on the VIX as there seems to be some confusion as to what exactly does a cash VIX print below 15 mean. Is it bullish on is it bearish? I mentioned before that a single days print on the VIX does not do a good job analyzing the level of fear of participants unless you also consider the near term trend. If you take a look at the weekly chart below of the VIX (blue) it is clear that the “trend” lower from higher levels has meant a rising market but also that the sub 15 level has signaled some important tops in the market for the past several years.

This is factual and plain to see. Could the VIX push lower here while the market trades higher? Sure it can, but much upside from here based on this metric alone is much less probable based on how this index has influenced the price action of the S&P 500 over the past 4 to 5 years.

So why do these “low” relative levels signal trouble for equities? Basically these are levels where generally the market has become overly complacent to risk. Complacency is expressed by participants taking off hedges and exposing portfolios to more directional risks in order to capitalize on the rally. Look at it this way.

If you are properly hedged whether via being long/short positions or simply hedging via options, you are not likely to run to the exits at the first signs of trouble because your hedges (hopefully) will offset some of your long bullish exposure allowing you more time to weather the storm. If you are not properly hedged and an event or catalyst of some sort hits the market (usually overnight), you will probably not be able to hedge portfolios quickly enough and will opt to head for the exits much quicker even with core positions. A complacent market is dangerous because of the type of reaction (quick trigger finger selling) it usually engenders when things begin to turn sour.

The market is complacent here because of the expectations of the FED easing. Like I mentioned above the likelihood for more QE is great but if it does not materialize in September, the market may be poised for a swift but relatively shallow drop.

 

Coiled Spring Ready To Snap

8/13/2012 5:48:15 PM

The market is set up for an outsized move in either direction. The VIX has collapsed and the narrowing trading ranges for the past 2 weeks point point to a tightly wound market which like a spring, will snap strongly to the path of least resistance. The VIX at this level (below 14)has been a solid bearish signal for 4 years now.

The hourly chart below is of the SPY for the past 3 months and shows some of what I mention above. The SPY touched the top of a trading channel range but instead of immediately pulling back, it has digested the previous move over the past couple of weeks basically going nowhere.

What jumps out from this chart is the very narrow bollinger bands which as I mentioned, is a clear signal that directional pressure is building in the market place. The implosion of the VIX which now is printing at 13.70, supports this notion of a market ready to “wake up” once again. If we look at the second chart below, we notice one very important factor. My volume histogram has not “confirmed” and by confirmed I mean that it has been atypical of the past several higher highs on the SPYs. The volume histogram (as per my settings) has been well correlated to the price oscillator peaks which clearly shows internal churning and rotation becoming ever more focused on the “heavier” mega caps for the price momentum we are seeing as opposed to a broader based advance. Makes perfect sense as participants want to take profits out of the “secondary” and “terciary” names into the most liquid, “first string” names (AAPL, GOOG, XOM etc) as we trade to the top of the trading channel.

The power of the mega caps pushing markets higher even without the participation of the broader market secondary names is very real and we don’t have to go too far into the past to confirm this. Apple single handedly proppeled the NDX and SPX higher during the 1st and 2nd quarters of this year. With a new iphone product cycle around the corner, we have to be aware of this dynamic and remind ourselves that we have “seen this movie before”.

Should we breakout, the action should take us at least to challenge the highs of the year at 142.21 and still be within the current trading channel. A breakdown takes us down to 138.42 initially and possibly as low as 137.00 before support kicks in. In my opinion, we will breakdown to support on this trading channel here as opposed to a breakout above it although as I mentioned, the S&P500 can move to 1422 and still be well within this current pattern.

C.J. Mendes

cjm

Trading Options For Income
8770 Sunset Drive 201
Miami Florida 33143

http://www.tradingoptionsforincome.com

 

RUT Vs. SPX Perspective

The chart below is one I have been keeping my eye on for some time. It is a weekly chart of the SPX in comparison to RUT. The SPX is representative of the 500 largest companies in the US while the RUT is representative of 2000 small cap stocks. Combined these two represent a sizable chunk of the U.S stock market landscape. Analyzing the relative performance of these indices is valuable for getting a “feel” (a real technical term there) for the broad market.

I highlight a couple important points to consider. First going back to late 2007, the RUT small caps index failed to confirm the last push higher of SPX. While SPX did manage a new “higher high”, RUT did not and that perhaps was the earliest sign things may be going sour in the broad rally. Late in extended rallies as was the case back then, what we typically see is rotation from small cap leaders into larger cap “safe” names of the S&P 500. Later, as the “lower highs” pattern plays out in the small caps we see rotation pick up progressively out of ‘risk” into fixed income as opposed to large cap names which eventually collapse as well.

In relation to the above, we can also take a look at what ensues following the crash of 2008. The RUT small caps index has outperformed on a relative basis versus SPX large caps with both indices making a series of “higher highs” over the past few years. This pattern ended for the RUT small cap index in July of last year when it failed to make a “higher high” after peaking in late April of that same year. This failure did happen to both of these indices and the market fell precipitously as we are all aware. What happened next is very important to my analysis of the market because as we can see, the RUT has failed to break out of this lower highs pattern while the SPX was able to make a recent “higher high” of April 2012.

There are several ways to view this price action but in my opinion, it has to be viewed as a bearish “shot across the bow” for participants. The underperformance of the RUT here is primarily a sign that liquidity is flowing out of small caps names into the safer large cap “artificially” stoking the broad market large cap SPX and of course bonds. One can also view it in the contrary as the RUT being undervalued versus SPX and that it is bound to “catch up” to the SPX. While this may be true in shorter term timeframe analysis where we usually formulate our trade ideas, it is not what is expected when analyzing longer term trends.

So while we are trading a short term bullish retracement channel for our short term positions, we have to keep in mind the longer term dynamics of the markets. Today, from an analysis of the price action, I am bearish stocks in the long term timeframe horizon. Short and intermediate term, I remains bullish although recognizing the tops of these near term trends. Obviously many things could change the dynamics presented here. A change in the political landscape could do it as could more intervention by the Central banks around the world.

Just because the train tracks are laid in a certain direction doesn’t mean that the train has to necessarily head that way. It could go off the rails! Either way, these longer term price trends have to be watched carefully particularly at important resistance and support levels. Longer term technical trends generally take precedence over shorter term studies at inflection points.

C.J. Mendes

cjm

Trading Options For Income
8770 Sunset Drive 201
Miami Florida 33143

http://www.tradingoptionsforincome.com

 

Why Markets Are Broken and Very Vulnerable

Why Markets Are Broken and Very Vulnerable

Hope everyone is having an enjoyable weekend watching the Olympics or enjoying some R&R with family and friends. I wanted to write a quick note as some of our new subscribers have inquired about my trading strategy and overall philosophy. Some of you who have traded with me for some time have heard this before and I apologize for repeating myself ahead of time.

I started my career in financial markets in the mid 1980’s and I have lived through many different market cycles since. My career involved periods spent on the trading/money management side of the business for proprietary funds, institutional investors and private individual HNW clients as well as periods on the product development side of the business. This broad experience has given me a diverse background in the financial services industry which over the years has shaped my philosophy on trading and investing.

It should be of no surprise to anyone following the market for the past few years that the cards in the financial services “stack” are firmly stacked against the individual investor. Specifically, the traditional passive individual investor who is not involved in the day to day overseeing of their portfolio but one who dutifully invests in 401K mutual funds, pension funds and the like, with the hope that over time, the returns of “managed portfolios” managed by “pros” will beat both the returns of the broad static indices and other less risky alternatives such as bonds. For sake of this note, we will call these folks “retail” as this is the nicer of the many terms used today to describe this segment of the market which by the way is the largest segment of the US market.

For context, many of the issues that we are dealing with today have been in the making for over 70 years. It is important to understand that the investment landscape in the united states changed drastically in 1940 with the introduction of the “Investment Company Act of 1940”. This act gave rise to what we today refer to as “mutual funds” and” separate managed accounts”. If you can recall your parents and maybe grandparents attitude towards investing in stocks, I would bet that it fell into a couple predictable buckets. Following the Great Depression most individuals wanted nothing to do with the stock market.

This generation of Americans wanted nothing to do stocks following the collapse of 1929 and can we blame them? This group comprises the first bucket and these are the folks who would put their money into nothing else besides FDIC insured Cds and U.S Treasuries. The other, much smaller bucket is comprised of folks who embraced stocks but were determined to do their own research and really trusted no one to do it for them. These folks used a broker to only complete the transaction and really blamed no one but themselves for their failures or their success.

I  can remember my grandfather and others family members who belonged to this group. These folks and those of like mind really dragged us out of the depression and set the course back to prosperity in the US. Ask them details about the companies they owned and they would spit them out like if they worked there!

By the late 30’s the power barons of the stock market realized that without greater participation from those folks in the first “bucket”, the US stock market would face a long and tough road back to prosperity. The creation of the investment company “mutual fund” allowed folks to invest in the market under the premise that their funds would be managed by a “professional” who would ensure diversification and proper allocation… Here is precisely where things begin to go awry for retail investors. Folks now turned over the responsibility of due diligence to an investment manager. The “set it and forget it” generation was born and fund flows back to the stock market embarked a multi decade long period of expansion.

While I don’t mean to say that the concept of mutual investment companies is necessarily bad, I do mean to say that the concept of mutual funds was created to get funds from mom and pop into the stock markets for a variety of reasons that benefitted the industry first and the investor second, many times, a very distant second.

Many funds performed well from the get go and many Americans made fortunes investing alongside professional managers. The Glass Steagall act of 1933 delineated the separation of banks and brokerage firms which went a long way to help bring back the retail investor to the market. The structure of the market was solid then and while not perfect, it did engender trust that America was again open for business and that business in America was conducted in a fair and equitable manner.

This period of expansion saw more and more Americans give up their investment decision process to a third party and even today, ask any mutual fund investor and 401K investor to name the top company in their mutual funds and I bet 8 out of 10 will not know the answer. They may guess “Apple” which is a good guess these days but the fact remains, the majority of investors in these programs have no clue what they are investing in.

There are many flaws to the investment company model or really any model today but an important one in my opinion is they invariably downplay real risk, risks which cannot be mitigated in traditional long only mutual funds. The mantra of diversification along asset classes alone is a failed risk management proposition but still today, risk is undersold to retail clients creating a false sense of security and true diversification.

Where the train really went off the tracks in the market came in the late 1990’s when the depression era Glass Steagall act was abolished with the Gramm Bliley Leach act which, along with many other things, allowed brokerage firms, banks and insurance companies to be owned by the same holding companies. What was created to prevent the events that led to the Great Depression was now torn down and replaced with deregulation and a lack of oversight of financial markets that is the direct cause of many of the issues facing us today in the marketplace. I again assert, here was a change that put profits and broad market liquidity needs first ahead of investors best interests.

This change in structure which along with decimalization of the market and many other factors, has increased overall risks to market participants. This change in market structure along with increases in computing speed have given rise to an automated market maker system which is part of what we today refer to broadly as HFT. HFT today accounts for a substantial percentage of the volume in the market and its sole function is to capture inefficiencies between the multitude of exchanges popping up all over the country.

A byproduct of this activity is that it artificially keeps bid and ask spreads narrow and provides “liquidity” for the broad market. I am not an expert on HFT and there are many in the market much more well versed on the subject. If you have not yet picked up a copy of “Broken Markets” by Joseph C Saluzzi and Sal L. Arnuk, I highly recommend you do so. The present issue facing the market is that because of the tremendous outflows from equities of the past several years following the second of two major crashes in a decade, the market finds itself highly illiquid.

The HFT volume has replaced a tremendous amount of “real” trading volume and without this participant, markets could be in for a tough period of readjustment. It is a double edged sword but one that in my opinion cuts much deeper on the HFT side than the one without it. A highly illiquid market along with poor structure is a recipe for disaster.

My point in all of this is that I do not believe investors are fully aware of what this entails. Most investors today should not be invested in capital markets because of this issue and because our industry is one that is driven by “invested assets under management”, this risk is often not fully represented to clients by their fiduciary advisors. The embedding of risk assets in non-risk wrappers have been in vogue for several years now. These so called structured CDs and notes some of which offer FDIC insurance on principal and promise to eliminate downside risk to the investor while promising a participation in equity returns are some of the most dangerous products being hocked to mainstream investors today.

Not necessarily because they are bad products, many are not, I know they are not because I designed many myself during my career. The problem is that these instruments were designed for accredited investors, not for mom and pop retail. They are highly illiquid and because of this a mark to market never represents an the actual market value for these instruments. Clients are lulled into a false sense of security every month when they open their brokerage statements and see their instruments marked to par value.

There are many traders, investors, pundits and general participants that swear by so called “trend” following systems, exotic, reactive portfolio management and even the tired plain vanilla long/short strategies most Hedge Funds employ. These along with other assorted systems are designed to do one thing and that is to supposedly reduce risk and to lull you into forking over your hard earned money with the promise that “this is the one”, the one that will allow me beat the market while reducing “risk” to manageable levels.

This is the “holy grail” of the investment business, to generate steady, above market returns while keeping risk to tight, manageable levels. I am sorry to tell you that while I agree proper risk management tools are better than none, in the end the issues that put any portfolio at the highest risk today are not addressed by any portfolio risk management strategies. The JPM so called “London Whale trader” is a testament to that, so is the flash crash of May 2010, so is the “Knight” trading scandal of last week and so will be the next event, whenever that may be. I can’t tell you when that will be but mark my words, we will have other large scale dislocations of the market in the future due to these issues.

In general, the retail investor has gotten the message and gotten “out of dodge” over the past few years. A 50% haircut to your retirement portfolio will do that to you. Nonetheless many participants are still engaged in the marketplace with very unrealistic expectations and following a false reality. This is not a popular position to take on Wall Street. It attacks the asset under management model and calls for investors to take a hard look at “real” risk.

Most investments managers, brokers and pundits have no clue what an option is besides what they may have learned in their series seven examination. Most aren’t encouraged to learn about the benefits of options because firms are afraid of the exposure that large option derived losses present. For the average firm on Wall Street, it is preferable to keep the retail client in the dark about such things while keeping them engaged in “the game” hoping the next “Holy Grail” will come along to save them. My personal philosophy is very simple, I believe the best course of action for participants today is to engage the market with smaller, more aggressive target broad market options/futures positions while maintaining the bulk of assets away from market risk .

The options strategies offer a much clearer and advantageous risk reward profile and allow the opportunity to lower “at risk capital” in the absolute. Obviously this is what works for me and not a recommendation to anyone. After all the best way to not lose money at the casino is to not go into it in the first place!