Thursday, August 28, 2008

Still no trend

The S&P 500 is well above the bear market low of 1214 that was reached on July 15. The only clear trend formation that has formed since then was broken on August 19th, producing a bearish signal. However, the market hasn't settled on a new trend yet, and most of the market indicators are neutral.

So far my prediction of a boring summer conclusion is panning out.

Friday, August 22, 2008

Which way will it go?

The market hasn't yet found a solid trend, but I think we'll know more early next week. The lower support line which was broken on Tuesday has intersected a potential declining tops line today.


If the S&P 500 rises through the declining tops line, then a medium-term rally will probably follow, with the old lower support line becoming an upper resistance line. Otherwise, if the new declining tops line holds next week, then that would confirm that a new downward trend has begun.

Regardless of which direction the market turns, I don't expect it to move very far one way or the other. With the exception of sentiment, which is mildly optimistic (bearish), most of the important market indicators are neutral right now. The last month of summer could be a boring one for the stock market.

Tuesday, August 19, 2008

Tangled Trend Lines

The S&P 500 is breaking trends almost as soon as it forms them. Earlier this month an ascending triangle formation resolved less than a week after I identified it. This morning I described a new wedge formation, and this afternoon it's already finished.

The lower July-August trend line was decisively broken today, which forecasts a decline from here. That means it's time to get back into SDS. Given the recent chaotic behavior and lackluster optimism in the market, I'm only going to purchase a 50% stake in SDS for now.

Monday, August 18, 2008

Return of the Wedge

The S&P 500 has formed the second ascending wedge formation of 2008. (The first one spanned in late March/early May.)

These formations usually end with the market breaking down through the lower trend line, so that places a pretty strict limit on the current rally at about 1350 on the S&P, the level at which the two trend lines meet. In all likelihood the next sell off will begin before that point, meaning the rally has less than a month to go.

Sunday, August 17, 2008

Bear Fund Comparison: SDS, BEARX and GRZZX

Thanks to some helpful pointers from readers following the earlier Armageddon Fund post, I've been able to compile a more complete set of data about the top bear-market alternatives to SDS, the ProShares Ultrashort S&P 500 ETF.

To review, SDS uses derivatives in order to make its price move in the opposite direction of the market, and at a magnified rate (2x). My concern is that a potential financial meltdown could undermine the derivatives market and hurt the returns of SDS (and every other leveraged and inverse ETF) during the darkest days of the bear market. The potential solution is to find a fund that uses actual short selling of stocks, and there are two funds that do this: BEARX, and GRZZX.

Unlike SDS, which is an exchange-traded fund (ETF), BEARX and GRZZX are mutual funds, so they are less flexible and more expensive. They require minimum initial investments, charge higher fees, and impose additional penalties for short-term buying and selling. In addition, whereas SDS is indexed to the S&P 500, these two mutual funds are operated by managers who only use a subset of U.S. stocks, meaning the managers might pick the wrong stocks and hurt the returns. For these reasons, I would only consider using the mutual funds for a one-time financial emergency; SDS is still the better choice for normal bear markets.


SDS BEARX GRZZX
Min. Invest None $2,000 $10,000
Min. IRA None $1,000 $1,000
Derivatives
Major part
Some
None
Expense 0.95% 1.73% 2.86%
Trading penalty None 1% (30 days) 2% (5 days)
Long stocks No Yes No
Selection
Indexed Managed Managed

Although the Prudent Bear Fund (BEARX) is cheaper than GRZZX, there are disadvantages that make it risker in a financial emergency. Long-time readers of this blog know that I've been keeping tabs on BEARX for over a year now. One of the things that attracted me to BEARX at the start was its ability to make money in a bull market, which is the result of having some long positions in selected stocks. In other words, BEARX is not a pure bear fund. The mix may work well for pre-correction defense in a bull market, but it just drags the fund down in a bear market. In addition, BEARX actually dabbles in the dreaded derivatives market, and since the whole point of this exercise is to find a derivative-free fund, that's a deal-breaker for BEARX.

As far as I can tell, the Leuthold Grizzly Short Fund (GRZZX) is the real deal. It only shorts stocks, and there appear to be no derivatives or long positions. Unfortunately GRZZX is the costliest of the funds, requiring the highest initial investment ($10,000 for non-retirement accounts) and charging the highest yearly fee (2.86%) and trading fee (2%). Even so, if I thought that there was going to be a crash and derivative meltdown on Tuesday, I would put everything into GRZZX on Monday. The extra costs might end up looking small compared to the slip that SDS would suffer.

The icing on the cake for GRZZX is obvious in the charts. Since the October 2007 peak, GRZZX (yellow) has actually outperformed SDS (blue) for buy-and-hold investors:

This should be impossible. SDS is leveraged so that it moves twice as fast as the S&P 500, yet GRZZX, which uses no leverage, has done slightly better during this bear market. Apparently the managers at Leuthold know how to select the best stocks for shorting! Meanwhile, BEARX (red) has been seriously lagging.

So GRZZX is now my choice for the Armageddon Fund. This doesn't necessarily mean that I'll use it - only that it's my choice if it looks like the derivatives market is about to collapse.

Update (February 1, 2011): There's an even better bear fund now, in the form of an ETF.

Friday, August 15, 2008

Long Term Forecast vs. Market Timing

Several people have asked me about the significance of my long-term forecast of Dow 8500/ S&P 940. This prediction is based on a theory which has little to do with my current market timing strategy. I love to use analogies on this blog, so here's another one: hurricane forecasting!

Every year the Climate Prediction Center (CPC) of the National Oceanic and Atmospheric Administration (NOAA) makes an all-encompassing forecast for the upcoming Atlantic hurricane season. This year they're predicting an "85% probability of an above-normal hurricane season," and they even go so far as to predict that there will be 14-18 named storms, 7-10 Hurricanes, and 3-6 Major Hurricanes.

Now, what does this hurricane forecast mean for residents in the Southeast and Gulf Coasts? Suppose that 10 hurricanes occur by September, which is the top limit of the forecast; should people in Florida breathe a sigh of relief and toss their emergency kits? Of course not. After all, this forecast ends up being wrong more often than not. By the same token, if zero hurricanes have occurred by September, that doesn't mean that 7 will suddenly pop up in order to achieve the forecast number.

The truth is that NOAA's long-term forecast is essentially useless to someone living in New Orleans, Brownsville, or Tampa. It's the short-term weather data that saves lives, and it comes from satellite images of the Atlantic Ocean, weather radar, and humidity, temperature and pressure measurements from the storm-chasing planes. The bottom line is that if a hurricane is heading your way, then you should "invest" in a hurricane strike. However, if the Atlantic and Gulf are clear, and it's November, then don't bother.

So think of my long-term forecast as NOAA's interesting but not-so-practical seasonal hurricane forecast. Sure, if the market ends up bottoming exactly where I predict, then I'll be crowing about it. But my buy and sell signals, and bearish vs. bullish stance, come from the market indicators that I scan every day, and aren't affected by the forecast.

Wednesday, August 13, 2008

BEARX: The Armageddon Fund

It's time to talk about the biggest risk factor for Proshares Ultra ETFs like SSO and SDS.

These ETFs, and all of the other leveraged and inverse ETFs like them, use derivatives, which means they are not invested in actual stocks. Derivatives include things like options, futures, and swaps, which are contracts between two parties that set forth rules for one party to pay the other party in the future, depending on the price of a stock, commodity, market index, etc.

I've thought of a quasi-analogy for comparing derivatives and stocks which I hope will make this easier to understand. Buying a racehorse is kind of like buying a stock. If the horse that you own wins a race and collects a prize, that's like having the stock pay you a dividend. If you then sell the horse for more than you paid for it, that's like buying a stock low and selling it high - you've made a capital gain.

But you can also make money by betting on a horse in a race. The only trick is that you need other people to bet against that horse - otherwise, whose money will you take when the horse wins? Now, at the racetrack, all of the bettors have to pay their money ahead of time, so you know that the winning bets will indeed collect their rewards. Thus, you can make money on a horse without ever buying it, selling it, or collecting any of the prize money.

Derivatives are the stock market equivalent of betting on a horse. For every person who makes money on the winning side of a derivative, there is someone on the other end who loses that same amount of money. The problem is that, unlike the racetrack, there is no central holding area where all of the potential derivative payouts are kept. Most of the time this isn't a problem, but in the event of a stock market crash accompanied by a major financial meltdown, it's possible that some derivative participants on the losing end will run out of cash before they meet all of their payoff obligations to the bearish derivative "winners."

Thus, derivatives buyers, and ETFs like SDS that use derivatives, may see people on the losing end default on their obligations, much as banks are seeing homeowners default on their mortgages. These derivative contracts would then be devalued or "written down" just as mortgage-backed securities have been. Inverse ETFs like SDS, which use derivatives to move in the opposite direction of the market and to magnify their price swings, might not go up in price during a major crash. In fact, if there were a major financial catastrophe, SDS might actually go down in price during a market crash when it should be skyrocketing.

Scary stuff indeed.

But there is a way to make money during a catastrophe without having to bet with derivatives: it's called shorting. Shorting a stock seems rather strange and complicated at first, but it's actually pretty simple. When you short a stock, you replace someone else's stock holdings with cash by selling their stocks on the market (that's why it's also called "selling short"), and then agreeing to replicate the price motion of their former stocks by either adding your own cash to their account if the price goes up, or taking money from their account if the price goes down. Shorting is easy to do in practice with an online account, because you don't have to actually manage any of the things I just described; all you have to do is click "sell short" to open a short position. If you short stocks and the market crashes, the simple result is that you end up taking money from the people who think they own the stocks. There's no contract involved. The cash which is owed to the short seller is actually sitting there in an account, and is not just an I.O.U.

For those of us with tax-free or tax-deferred retirement accounts, shorting isn't allowed, but there is one mutual fund out there that you can still buy that will do the old-fashioned shorting for you. It's called the Prudent Bear Fund (ticker symbol BEARX) and I'm recommending it as the "Armageddon Fund."

Now, BEARX isn't an ETF, so this is not a day-trading vehicle. In fact, BEARX penalizes investors 1% if they cash out less than 90 30 days after buying it, but that small penalty would be well worth the price if we ever experienced a simultaneous crash in stocks and derivatives. So, I may end up using BEARX instead of SDS if things start to look really bleak. Keep this in mind when the next wave of negative financial news arrives.



Update: Thanks to some helpful comments here, I have identified a better Armageddon fund.

Tuesday, August 12, 2008

Not going long in a bear market

Why don't I invest in SSO, SPY, or any other long ETF during a bear market rally? That's been the most common question in blog comments and e-mails recently, so it's worth putting one of my replies here in an official post:
We're in a bear market right now. During a bear market, the downward phases are bigger and take longer than the rallies, so a rally is a small target to hit compared to a retreat. The opposite is true during a bull market.

Sure, there's a tiny possibility (ha!) that I could make a mistake in the timing of an SDS purchase, but it would be no big deal, because I could just sit tight and wait for it to eventually go up in price when the bear market resumes.

But were I to make a mistake with the timing of an SSO purchase, (maybe the rally ends sooner than I expect) then there's no way to recover. I'd have to sell at a lower price and eat the loss.
Another way of wording this is that, in a bear market, the risk is higher and the potential rewards are lower for a regular (long) stock fund position than for an inverse (bear/short) fund like SDS. Higher risk with a lower reward is a double-whammy that I choose to avoid.

Monday, August 11, 2008

Breakout

As predicted, the S&P 500 has broken through the upper resistance line at ~1293.
The Dow has also broken out of its own triangle formation, so I'm reasonably confident of this interpretation.

The further this rally climbs before eventually turning around, the better it will be for my next SDS (inverse S&P500) purchase. Sentiment is already moderately optimistic, and each additional up day from here will help to increase the optimism among traders, which will increase the downward pressure on stock prices. I don't know how much higher the market will climb before the next bear market slump begins, but I am willing to predict that it won't reach the previous peak of S&P 1440, Dow 13,100.

I'm almost tempted to put a little bit into SDS right now in case this rally comes to a quick end, but there are too many non-sentiment indicators saying that the rally isn't finished. So I remain in cash.

Saturday, August 09, 2008

Fools, Fundamentals, and Fibonacci

People who study the stock market tend to form very strong opinions about how it works.

Fools

My stock market education was inaugurated by the Motley Fools, beginning with their first book and ending with a couple of newsletters. The Motley Fools are fundamental investors, meaning they are concerned about things like earnings growth, price to earnings ratios (P/E), and management of individual companies. Their investing strategy is to pick individual stocks that have the best combination of low price and high future earnings potential. Although they have developed a dizzying array of sub-strategies and newsletters, their goal in every case is to choose a set of stocks which, on average, will beat the market in the long run.

The Motley Fools have pure contempt for other methods. They view technical analysis as the equivalent of reading tea leaves, and market-timing as an impossible dream. The irony is that the Fools often recommend buying strategies which contribute to the very support lines that technical analysts look for. Most of the stock recommendations in their newsletters include recommended purchase prices; in other words, "buy at price X or lower." When there's a population of potential buyers who only buy a stock below a certain price, then that price will show up in the chart as a support line.

The 'Fools have managed to beat the market with their methods, but this is not as great an accomplishment at it might seem. Beating the market in a bear market like today means you can still be losing money -just not as quickly as everyone else is. Remember, cash beats the market in a bear market!

More to the point, their yardstick for measuring success is questionable. The 'Fools like to compare their returns to the S&P 500 when it isn't appropriate. Their small-cap newsletter is beating the S&P 500 by 22% right now, (cumulatively, not even annually) but anyone could have done almost as well by simply purchasing a Russell 2000 ETF, which contains all of the small cap companies in the U.S. Their flagship newsletter, Stock Advisor, has been beating the S&P 500 mostly because it picks mid-cap stocks, which anyone could have accomplished with a single mid-cap fund. In this latter case they don't even acknowledge the mid-cap selectivity of the newsletter.

Fundamentals

Fundamental analysis may work more often than it fails for finding superior individual stocks, but it's almost useless when it comes to predicting the future behavior of the overall market. In the past 25 years alone, the P/E ratio of the S&P 500 varied between 8 and 42! Even if it were possible to accurately forecast the future earnings (E) of the S&P 500 companies, (it isn't) there's still a factor of 5 uncertainty in the future P/E ratio. Yet despite this incontrovertible evidence, there are legions of investors out there trying to predict the market based on fundamentals.

Not all fundamental analysis is equally useless, however. The dividend yield of the S&P 500 is a concrete measure of cash actually returned to investors, whereas earnings (profit) can be fudged with accounting tricks and wasted on stock buybacks. Not all earnings numbers are alike, either. As-reported earnings are more conservative and generally more accurate than operating earnings. For instance, the projected P/E ratio of the S&P 500 for the end of 2009 is 18.7 using as-reported earnings, but only 11.6 using operating earnings!

So you can see why I've chosen to side with the technical analysis camp over the fundamental one.

Fibonacci

Alas, technical analysis (TA) is equally vulnerable to human misconceptions and wishful thinking. One of the most widely used art forms in TA today involves Fibonacci grids and the related field of Elliot Wave Theory.

A Fibonacci grid is an attempt to predict lines of support and resistance before they occur, using the number .618, which is also known as the golden ratio. (By contrast, I only identify a support line on a chart after a price has already bounced off of it at least twice.) Without going into too much detail, the number .618 arises from a sequence of mathematically- related numbers called Fibonacci numbers. Presumably it is the pure mathematical origin of the golden ratio that makes it meaningful to people who use Fibonacci grids.

Here's how the simplest Fibonacci grid works: Suppose a stock price or market index has been rising for a while. When it eventually changes direction, a line is drawn across the most recent peak price, and a second line is drawn at the earlier low price which occurred at the beginning of the rally. This chart of the S&P 500 will be used to demonstrate:

I don't claim to be doing this by the book, and I'm sure some purists will complain, but this is just to demonstrate the basic idea to non-practitioners.

Now two more lines are drawn between these two extremes, one at 61.8% of the way through the interval, and another at 38.2%. (100-61.8)

Remember, Fibonacci practitioners don't draw lines at .6 and .4, nor even .62 and .38. They draw them at exactly .618 and .382.

The idea is that these lines might be support lines off of which the S&P 500 will bounce and change to a bull market. As you can see from the above chart, the upper line didn't hold in this case. That leaves 1076 as a possible turning point for the S&P 500, according to this theory. The problem is that, were the S&P 500 to continue rising from today's price, Fibonacci followers would probably claim success, since the bounce was close to the 1267 line. I'll demonstrate this with some actual examples.

The following stock charts appear on websites where Fibonacci grids are treated seriously, and where they already have the lines drawn on them. (I haven't added anything.)

There are two things to notice in the above chart. First, there is another line drawn in at the 50% mark. All Fibonacci charts seem to include this extra line, even though .50 is not related to the golden ratio in any way. I suspect that it's used in order to increase the chances of a successfully-predicted bounce.

The second thing to notice is that, despite the closely-packed triad of lines, the stock price failed to bounce off of any of them. In fact, the two bounces occurred exactly in-between the lines, which is a perfect miss in my book. Even so, this chart is not seen as a failure of the Fibonacci system by the faithful. Typically a charter will say that a bounce was "close to" a line, which is validation enough:


It's perplexing that a bounce close to a line is significant, given the precision (.382!) with which the lines are drawn. If "close enough" counts, then why bother with lines at all? In practice, the Fibonacci grid users that I've seen are satisfied if a bounce occurs anywhere in the middle 30% of the range or so, which means that the golden ratio (.618) really has nothing to do with any of it.

In an apparent attempt to further improve the odds of a Fibonacci bounce, some people add even more lines to the chart. This one adds lines at 78.6% and 23.6%, which come from additional permutations of the golden ratio:

The next one replaces the 23.6% line with a 25% line, (I guess it's close enough!) and adds another line at 88.6%:

It's comical that even with seven lines and no fewer than seven bounces in the above chart, only two bounces managed to hit a target. One wonders how crowded a Fibonacci grid would have to be for a believer to question the relevance of the lines.

Confidence Versus Belief

I only use market indicators that have objective and provable track records of predicting market behavior. I don't fudge sentiment data or trend lines, and I spend considerable effort to keep my own biases and wishes out of the interpretation of the signals. The day may come, for instance, when the S&P 500 stops forming channels and stops bouncing off of support and resistance lines. (I don't know why it would happen - this is just by way of example.) If sufficient evidence were to accumulate indicating that this had happened, then I would stop using these lines in my analysis. However, I doubt that Fibonacci fans would even notice. That's the difference, I suppose, between confidence and belief.

Wednesday, August 06, 2008

Ascending Triangle Formation

The S&P 500 has officially created an ascending triangle formation.
In this situation, the price usually breaks through the upper resistance line instead of the rising bottom trend, so this suggests that the S&P 500 index will reach higher levels from here before resuming the bear market slide. It's good news if turns out that way, because I'll be able to get back in to SDS at a substantial discount to my selling price.

On another note, David Rosenberg at Merrill Lynch reported today that "300 point moves in the Dow only occur in bear markets." Thanks for echoing my earlier post, David!

Tuesday, August 05, 2008

Big up days = big trouble

The Dow rose more than 300 points today, which is nearly a 3% gain. However, don't let the excitement fool you.

One of the ironies about the stock market is that single large days are contrarian indicators for the long-term market trend. Big up days like today occur almost exclusively in bear markets; whereas bull markets often experience large down days during minor corrections.

The following chart of the S&P 500 is a classic example:

The bull market rally from July 2006 to February 2007 resulted in a healthy 15.5% gain, and it was gradual and relatively smooth. There was not a single day's gain higher than 2%. Yet the correction which followed was punctuated by a whopping 3.5% loss on February 27. The next rally that followed took the S&P 500 even higher, but again, there were no up days of the magnitude of the February 27 loss. In other words, that terrifying day in late February was actually a sign that the bull market would continue for a while.

Today it's the opposite situation. The market's most recent decline from May to July was relatively gradual, and there have been numerous up days of 2% or more over the past several months.
Gradual declines and quick rallies are classic bear market behaviors, so today's message is that the bear still lives.

Saturday, August 02, 2008

No change and no trend

There's not much to say at the end of the week, except that little has changed. The S&P 500 has been pretty flat, and hasn't yet formed any concrete price trend to follow.

The market indicators are still mixed. Money flow and breadth are both bullish now. Sentiment is moderately optimistic, which is bearish for the market. The lack of a double bottom in the chart up to this point hurts the chances for a sustained rally.

So I'm still in cash. Were I to anticipate anything at this point, it would be the beginning of the next downturn. If and when the indicators give a consistent topping signal, that would be the time for me to get back into SDS and profit from the decline.