Buy or sell the stock market? Price action will tell us: 8/6/15

We are trading around a critical Origination Point (OP) right now, The price action will tell us whether to buy or sell

The potential FH1 on the daily chart tilts us toward a short bias, BUT if we don't break below OP and fail to form value zone below the OP, we are looking for BOT to take long. PRICE ACTION WILL TELL US WHAT TO DO.

How to trade the PM long, AXP short play: 8/5/15

Below we have what we're looking for from an execution stand-point for the long Philip Morris International, short American Express trade.

Acronyms are discussed in prior posts. If you would like details on anything discussed in this post, please post a comment and we will respond promptly.

Long PM

Short AXP

Long signal forming on stock market: 8/5/15

It looks like our low may have been put in at 17,319 temporarily on the Dow Futures. If BOT is successful, that statement will be strengthened. We had a pullback to OP of up move last week on Tuesday. We had a bear trap- failure to continue lower (blue circle) after hours last night and today we have a potential break of trend long on the 1 hour Dow Futures with a down trend line retest.

Below chart has details:

Long Philip Morris International, Short American Express

We are suggesting going long Philip Morris International (ticker: PM), and short American Express (ticker: AXP). This is yet another longer term, defensive, pairs trade idea that should benefit from overall market action that is either sideways or down. 

The charts for both PM and AXP are classic. PM is consolidating near the high end of a long term range after an uptrend. We feel that enough time has been spent in this range to warrant a decisive breakout, especially when considering that other tobacco stocks such as BTI, RAI, and MO have exhibited powerful relative strength of late. 

PM

The reverse is true for AXP. Instead, it is exhibiting all of the characteristics of a stock ready to break down. Here we see a long term trendline break with action near the bottom of a consolidation range that should finally give way to more downside.

AXP

Disclosure: The author took this pairs trade yesterday.

Bottom on the DOW for the day 7/31/15: OP retest and Low trade volume (trap)

OP retest and low trade volume trap could signal that the DOW bottomed for the day. If not, it's given us enough of a move in our favor on the short-term BOT that we're risk-free on the trade. So, it's considered a good "attempt" now.

First, the Origination Point (OP) retest, highlighted with blue circles. We wiped out the up move gains, stopping traders out the caught that long leg starting yesterday.

Second, low trade volume at low of day, 4 contracts traded; circled in green on the right of DOM.

If we hold a higher low today from yesterday, the long BOT longer-term is still intact. Being that we set a new high today compared to yesterday, the structure is still in place for the long BOT.

Why the Market Could Continue Higher: Temp Trap Break Will Direct Us

We broke prior day's high by a tick and sold off this morning. Market was able to clime back and we're trading right below the trap level. Historically, a temp trap break leads to follow through, so we're adding to our position on the break of the Bull Trap (in the blue circle).

Here is the 1 hour chart showing the potential bull trap at HOD (high of day).

Update on long trade:

We were stopped out of a portion of the position earlier today, being that we went risk-free. We had around half of the position size remaining and added on the 1 Hour BOT. Below is the current position and stop placements.

As you see, all stops are above our average price, so we are risk-free on this trade. Our highest stop is at the FL1 bar. Once again, this is a failed short bar that if one shorted, should take heat prior to being correct on the trade; sometimes this is a lot of heat against the failed trade signal. Therefore, we believe that that's a critical level for a stop placement. The rest of the stops are below there and will be adjusted accordingly as more price action develops.

Previous Day High Bull Trap: Why we're cautious and trading Risk-Free 7/30/15

Don't need to say much about this. We had a Bull Trap at previous day's high (blue circle). This is why we're "Risk-Free" on our long market trade.

Our stops are spread above entry price on the long, so we have no risk. If we get stopped out, we locked in some profits. If we don't get stopped (or stopped on some), that's cool, we traded the "pull-back" stress and risk-free- and have potential to make larger gains and add to position.

How to trade with NO Risk (eventually): Long U.S. Stock Market BOT example from 7/29/15

We discussed the simple concept of trading "risk-free" in previous posts. When we say "RF" in any posts, this means "Risk-Free". So if we say "moved stop to RF", we moved our stop above (below) our entry price on long (short).

It's based around the idea that there are always uncertainties when trading in the markets. We feel that if you can get into a high number of "risk-free" positions, the ones that work out will really work out well! A lot of times, we see that a month is made from just a couple of trades that really took off for us. Trading "risk-free" results in a large amount of break-even trades, but also ensures that we never let a winner turn into a loser.

Here is a real-time example of trading risk-free with our Long U.S. Stock Market call from 7/29/15.

So, here is how to trade risk-free (eventually):

1) You start out with you max risk on a trade: Dow example was 150 points, on previous post

2) Once you get movement in your favor, move stop above entry price

3) If continues moving in your favor, spread out your stops so that you can lock in profits above break even

4) As days close and price levels set, move your stops accordingly. For example, if trading a BOT long, keep stops below prior day's low. As higher lows form, move stops higher.

Long U.S. Stock Market and Long Oil- BOTs: 7/29/15

1 hour Break of Trend (BOT) on Dow and Oil. Calling short to medium term long on both as of 7/29/15.

We were watching for BOTs in our post from yesterday, Long U.S. market soon? Testing top of downtrend channel right now, waiting for BOT- 7/28/15

Dow

HH / HL setup

Target 1: ~300 points

Target 2: ~600 points

Stop: ~150 points

Oil

Bear Trap Setup

Target 1: ~$3.50

Target 2: ~$7.00

Stop: Below $47.50 level (conservative) $46.70 level if longer term target

Pounding the Table: Long EWJ versus ... well ... Almost Everything

Just a quick "tweet" here. There is a risk that the post from Friday July 24th had a misleading title. Keep in mind that the post served two purposes: to update readers on our long EWJ:ADRE spread trade, AND to recommend other defensive trades that seem to be in even earlier stages of development. In a nutshell, we like:

Long EWJ versus the following ETFs short:

IJJ, IJS, IWN, HYG. You could probably add MDY to the mix (the S&P Mid Cap 400 Index Fund). Perhaps soon we will add the S&P 500, the Dow, and the Nasdaq. However, Tim is starting to notice some bullish potential on the "Major" indices, so for now, we wait. Should the "Majors" resolve bullishly, that still would NOT invalidate our defensive call to go long EWJ versus ... well ... almost everything!

Long U.S. market soon? Testing top of downtrend channel right now, waiting for BOT- 7/28/15

We're testing the top of the downtrend channel right now. Looking for a BOT long signal as next potential trade. As mentioned before, we need to patiently wait for the following setup:

- BOT (break of trend)

- Should have a bear trap or higher low from previous day before the BOT occurs. The current potential setup would have a higher low pre-BOT signal as is indicated by the higher red line from previous day on chart

- Once a BOT occurs, we need a pullback to OP or opposite of trend line test. If neither occurs and the break is quick, the FL1 (failed short) is what we look for as entry signal.

Here is the 1 hour chart showing the trend with potential BOT long. We will keep you posted.

Crude Oil: Still waiting on BOT Long, short trend holds- 7/27/15

Update: 7/27/15- 10:00am EST

No trigger long on oil yet, still waiting on BOT long. Bear trap did not hold, but using our trigger / entry rules of requiring a BOT for entry never executed a sweep in long entry. Once again, we need a break of prior day's high for confirmation, this is where long orders are pending when a signal forms. The break of prior day's high is the "trigger" / execution point.

We will keep you posted once a BOT long occurs. As of now, still short and not worth trying to catch a falling knife.

Update: U.S. Stock Market (DOW) Short Call Targets Met

Update: 7/27/15- 9:45am EST

Both targets met on the short call from 7/17/15 (link below).

U.S. Stock Market (DOW) Short Call 7-17-2015: 1st target 300 points, 2nd 650 points

We will update when we get our next signal. Looking for a bear trap or FL1, followed by BOT long to confirm. Stay tuned!

 

Part II: Long Japan, Short Emerging Markets

We update our post from May 9th where we suggested a defensive Long Japan, Short Emerging Markets trade. Since then, the spread between the two indices widened by over 10%. The market, as measured by the S&P 500 has gone essentially nowhere.

Ratio chart of EWJ: ADRE daily ("dollarized" versions of MSCI Japan and BoNY EM 50 Index):

Same chart weekly:

The trade still seems to have legs, but we will now highlight some additional defensive (re: negative beta spread trades) that appear to be in even earlier stages of development:

Long Japan, Short S&P MidCap 400 Value Index via EWJ/IJJ:

Long Japan, Short Russell Small Cap Value Index via EWJ/IJS:

Long Japan verus Russell 2000 Value Index via EWJ/IWN:

All of these trades have, or are beginning, to confirm long term trend reversals to the upside. These are long-term thematic reversals that should last for years to come.

Another idea that looks promising is long Japan, short U.S. High Yield:

Remember, we are not suggesting to go long the ebullient Nikkei. We are pairing EWJ, which is long Nikkei AND Yen, against higher beta shorts. The Yen is an historically defensive currency. 

Update: Pullback to OP on Crude Oil Bear Trap Long Signal: 7/21/15

Update: 7/21/2015 - 3:00pm EST

We pulled back to OP levels identified in 10:30am 7/21/15 post: "Long confirm: Pullback to OP with a Break of Trend".

OP pullback with "aggressive" long signal on 1 hour bar is shown on chart below. Break of today's high will confirm BOT mentioned in quote above from earlier post. BOT is point for addition into current position and/or "conservative" initial long entry depending on whether aggressive initial trade was taken or not.

Stop: Currently remains below bear trap, but can place below OP if risk is a concern.

Target: Remains unchanged.

Crude Oil Bear Trap Long Signal: 7/21/15

Crude oil potential Bear Trap long signal on 7/21/15

The first chart show the break of prior day's low with no follow-through. This is a sign that bears tried to short the break out down, but are now trapped short at those low levels. Historically, traps end trends at least for the short term to provide a leg up. If a BOT long occurs, this can be further fueled by short covering (even though there are no fundamental reasons for price to advance).

Horizontal lines are OP pullback retest levels. A pullback to OP with a break of prior day's high would confirm the BOT long signal which is strengthened by the Bear Trap if it holds and we trap at / above OP.

Second chart shows trend line that will trigger BOT and target zone (horizontal green line) due to OP of down move from June 26th.

What is an OP?

OP stands for origination point. It is the level / point where an up move or down move started / originated from.

Long confirm: Pullback to OP with a Break of Trend (BOT Signal- detailed in earlier post)*

Target: Approximately $9.00, over 17% to upside. Around OP of down move starting June 26th.

Stop: @ July 21st 4:00am low of day.

*If there is no pullback to OP, we would be looking at entry on BOT following failed short.

 

Confirmed FH1 Short 7-21-2015: U.S. Stock Market (DOW) Short Call 7-17-2015: 1st target 300 points, 2nd 650 points

Update: 7/21/2015 - 9:30am EST

FH1 short triggered on daily chart.

Short entry / addition point to current short: 17,980 - Break of prior day's low

Stop 18,059 - Break of prior day's high (above FH1 bar)

Targets hold from prior trade entry / 7-17-15 short call post

What is an FH1?
An FH1 is a failed long signal, confirmed by a short trigger. The chart above provides a real-time example. Here is the syntax:

Low today < Low 1 day ago AND
High today <= High 1 day ago AND
High 1 day ago > High 2 days ago AND
Low 1 day ago >= Low 2 days ago AND
High 2 days ago <= High 3 days ago AND
Low 2 days ago <= Low 3 days ago

Update: Triggered, LH LL - Bear Channel Forming: U.S. Stock Market (DOW) Short Call 7-17-2015

The break of prior day's low triggered the short call. Price structure is still intact as you can see from the 15 minute chart below. I highlighted the trend lines (top of bear channel) and Bull Trap bar. With bear channel formation beginning, we are in short to medium-term shorting territory here.

Being that we're at the top of the minor bear channel with the a lower high and lower low today compared to yesterday, I would look for FH1's (failed long signals) to short. We have historical posts about our FH1 and FL1 signals, but we plan on doing another post with details.

As mentioned in the earlier post, stop is above prior day's high, make sure to trail the channel swings once we print more prices. Targets hold at previously stated levels.

* If there is a BOT long out of here, this would become an FL1 with bias to long side and potential reversal of trade from short to long if the FL1 did occur. The short would be closed on the BOT by out stop management system and a long signal could trigger.

U.S. Stock Market (DOW) Short Call 7-17-2015: 1st target 300 points, 2nd 650 points

7/17/2015 - 9:20 am EST

* The call confirmation requires the following conditions which can occur today or next week, but need to trigger to make the call:

1) We do not break a prior day's high

2) If we do, only a bull trap would allow the signal to still be valid

3) For short trigger, we need to break below prior day's low

4) For trade confirmation / to add to position, we need to close below prior day's low to began the bear down

We pulled up to the expected resistance on the widening bear channel down on the daily chart. On an hourly chart, we have a bull channel within a major bear channel. The daily chart below shows the top line channel resistance and the move expectation:

 The 1 hour chart below has the conditional requirements for the call.

Targets:

1st target: Origination Point of up move, around 300 point profit, ~17,700

2nd target: Bottom of widening bear channel, around 650 point profit, below ~17,350

Stop:

Above prior days high to start. Recommended to go Risk-Free if sufficient leg down then trail the channel.

Buy or Sell, Long or Short? How to know which direction to trade: Break of Trend will tell you!

To start my post series, I want to share a major concept that we implement on every single trade, the "break of trend" or "BOT". We will refer to this concept as BOT on our charts and in posts. I will discuss our process in future posts, but I wanted to start with something that you can research and see on your own before we get into further details regarding specific signals, chart setup, etc. It's important to understand the BOT concept as it will tell you when to ignore certain triggered signals and when to focus on the high probability ones.

Here are a few chart rules that we have before I get into details on the BOT concept. I will also make a post regarding chart setup and what we use, in a future post:

Rule #1: NO Indicators!
Rule #2: Plot prior day's highs and lows and current session's highs and lows.
Rule #3: Analyze price structure to determine if bulls or bears are currently in control

So, pretty simple, right? All that a chart can tell you is executed trades and volume of trades on an instrument, nothing more! Why have a bunch of indicators on a chart? Is it that hard to see what's actually going on?? No! The hard part is setting yourself up in high probability trades, and a lot of times a good trade goes against our psychology. We "want" to buy low (super low), we want "the best" price, and want to sell at the highest price possible. But think about this, what is "the best" price? There is no such thing, it's just a number. So, what we believe is to trade in the direction of the trend because this will "help" your trade. I will get into psychology deeper in a future post, this was just a quick comment.

Now, the break of trend: When lows continue to be broken, sellers are in control. When highs continue to be broken, buyers are in control. When you see both in one day or on a selected segment, there's a battle for control. The BOT signal applies on every time-frame. For trading purposes, we like to glance at daily bars, focus on hourly bars, and analyze 15 minute bars. Essentially, there can be a trend within a trend within a trend. What I mean by this is that there could be e.g. 5 BOT signals on a 1 minute chart that are within 1 BOT signal on a 15 minute chart, mini BOTs within a more significant BOT.

In the above chart, there was a BOT Long confirmed by the HL/HH setup I discuss below. But, this was also strengthened by a Bear Trap at Low of Day from 9:00 am on the chart!

Here are the rules to determine BOT:

BOT to Upside for Long Trades
Rule #1: Connect highs sloping downward for a downtrend with potential BOT to upside. *
Rule #2(a): HL/HH pattern BOT: Look for 1) Higher Low and then 2) Higher High with break out of the downtrend
Rule #2(b): Trap BOT: Look for 1) Bear Trap at Lows (I will do a post on traps) and then 2) Higher High with break out of the downtrend
Rule #3: Look for trade signal confirmation in direction of BOT

BOT to Downside for Short Trades
Rule #1: Connect lows sloping upward for an uptrend with potential BOT to downside. *
Rule #2(a): LH/LL pattern BOT: Look for 1) Lower High and then 2) Lower Low with break out of the uptrend
Rule #2(b): Trap BOT: Look for 1) Bull Trap at Highs (I will do a post on traps) and then 2) Lower Low with break out of the uptrend
Rule #3: Look for trade signal confirmation in direction of BOT

*Don't focus on exact details of tails, you want to determine the general price action.

When to know what signals to consider and which to ignore:

Quoting what I said above, "It's important to understand the BOT concept as it will tell you when to ignore certain triggered signals and when to focus on the high probability ones."

Referencing the chart above, the blue arrows represent our FL1 long signal (to be discussed in detail in future posts). Since the FL1 is a long signal, why would you take a long signal in a downtrend, you wouldn't! Knowing the direction of the trend using BOT will help you avoid low probability trades.

The application is very simple: Do not take FL1 long trades in major downtrend. Take them once a BOT Long occurs, on the break of the trend line drawn, and is confirmed by Rule 2 above.

Hope this helps and please let us know if you have any questions!

Buy, Sell, or Hold? When, Why, and How? What to Expect From HT Trading Going Forward

Just want to post an update on what we plan on doing going forward. As we mentioned before, Bryan and I have specific experience in different areas of investing, trading, and money management. Recently, Bryan has been posting very thought-provoking analysis. We will be splitting the type of content that will be posted, focusing on our expertise during specific posts. We will both offer opinion and analysis on the other’s post if our added content adds value to the post. To give an example, Bryan might post regarding a specific industry and offer stocks that meet his criteria. I might then jump onto that post and continue, explaining what setup to look for and how to best execute the trade. Regarding futures trading, I will be focusing on “the market”, using the Dow E-mini (YM) as “the market”. To start, my first few posts will detail the following:

• Our trading process
• How we setup our charts (time-frames, indicators, etc)
• How we analyze price movements
• Our take on trading psychology and behavior of markets/investors

Following this, I will focus on:

• Specific setups / signals (I will teach you our “jargon” and what we look for)
• Entry, exit, and risk management

After all of the foundations are explained, it’s time to trade! At the moment, we have the idea of posting a weekly “outlook” on “the market” and then update during the week with signals that were triggered. We will include posts if a trade was filled, stopped, and/or met target. The idea is to have a trading plan for the coming week, monitor signals, post triggered trades, and show where stops and targets should be placed.

Aside from the above, I will throw in random posts related to trading the Dow E-mini Futures (YM). This could range from posting code for our signals to automated trading progress/results using our system.

Thanks and looking forward to the coming months!

A Lower Risk Way to Play Defense: Part II

We follow up on last week's post A Lower Risk Way to Play Defense. In that piece, we highlighted the fact that stocks with high long-term momentum that have recently had a period of consolidation or weakness tend to outperform stocks with poor long-term momentum that have recently had a period of strength. We demonstrated that this is especially true during bear markets. Obviously, we are not in a bear market, but if one is looking to start building a defensive portfolio, it would, nevertheless, make sense to implement the strategy. Normally we don't highlight the reasons "why" a strategy works, but instead let the market tell us "what" is working. We are interested in making money, not in becoming tenured professors. But... if one insists on finding a reason, one might realize that stocks that have performed well over the last year tend to be higher "quality" companies. Buying such companies after a period of weakness or consolidation becomes even more alluring when investors emphasize investment quality during a choppy or declining market environment.

The stocks listed as buys all rank in the top quintile based on this price momentum factor (12 month return minus 3 month return minus 3 times last month's return). The stocks listed as shorts are in the corresponding bottom quintile.

Short idea:

ASEI - A breakdown that is currently revisiting prior support at the '12 and '14 lows. Wait for the stock to reject those lows as new resistance, and short as it begins heading lower again.

Long ideas:

INUV - A new value zone has clearly been established and re-tested above the tops at $3. Therefore, the stock appears to have asymmetric risk to the upside:

VUZI - Ditto for this stock. The new value zone appears to offer at least $10.

A Lower Risk Way to Play Defense

We've been cautious on the U.S. Equity Markets since publishing our April 24th Piece 'Tread Lightly'. Since then the S&P is virtually unchanged (-0.5%). Our rather defensive suggestion to go long Japan and short the Emerging Markets on May 9th has worked out well, with the exchange-traded fund EWJ outpacing ADRE by about 5%. See: Long Japan Short Emerging Markets.

For readers that are interested in another low-risk way to get defensive, we suggest looking at a 'Price Momentum with Reversal' Factor. We take the lead from Ford Equity Research and define this factor as being a stock's: 12 month return minus its 3 month return, minus 3 times its 1 month return. Thus, the factor scores high when a stock has been performing well over the last year, but has recently taken a breather.

To test the strategy, we form long and short portfolios by buying stocks that score in the top quintile based on the factor, and shorting the corresponding bottom quintile. We begin in March of 1999 (193 months), form equally weighted portfolios, and re-rank and rebalance on a monthly timetable. At first glance, there appears to be no relationship between the S&P 500 and the performance of this factor:

But if we look at this factor only during bearish periods, we see that the long-short portfolio performs well. We define the bearish periods as occurring during the following 51 months:

• The Tech Bubble Burst from 4/1/2000 - 9/30/2002 
• The Global Financial Crisis from 11/1/2007 - 2/27/2009
• The aftershock of the Global Financial Crisis from 5/1/2011 - 9/30/2011

Why not just short the market? Well, we could be wrong. This factor doesn't lose money during bullish periods (not shown), but it performs well during bearish periods. That sounds pretty close to a win-win!

In a subsequent post, we'll highlight individual names that look interesting on the long and short side of the factor. Stay tuned!

Long Japan, Short Emerging Markets

A long-term trade that looks particularly interesting to us is to buy Japan and short the Emerging Markets. But there is a twist... The suggestion here is to do a "dollarized" version of the trade, which is to say, go long the Yen and short a basket of Emerging Market currencies versus the U.S. Dollar. The easiest way to do this is to go long and short the exchange-traded funds EWJ and ADRE, respectively. The former gives one long exposure to the MSCI Japan Index, and the latter gives one short exposure to the Bank of New York Emerging Markets 50 Index. There are several reasons why this trade is appealing:

1) The ratio chart of EWJ:ADRE is carving out a bottom that is almost a decade-long in the making.

The chart above depicts one measure of the relative performance of EWJ versus ADRE. It has all of the characteristics of what some might call a "bearish to bullish reversal". What we see is a trade that was under pressure for several years that is now "coming to life". We have a "breakout" of sorts, and a "throwback" to a very long-term trendline. The expectation is that a new valuation zone is beginning to emerge, one that is above the tops of 2013 and 2014. Admittedly, the "reversal" was in its early stages in 2013, but if one were to "zoom out" on this chart (not shown), and go back to the early 1990's, one would see that, relative to this time period, the trade is still in its early stages.

Shown above is a ratio chart. The ratio chart is especially popular among market technicians and economists alike. Historically, it's been used by market participants to track the price of the S&P 500 in Gold, the price of Gold in Oil, or to track Gold in Euros or Yen. In fact, a graph of any currency pair is a ratio chart of the respective currencies, each in terms of another base currency. There are some subtleties that are beyond the scope of this post that make it, mathematically, not "perfectly the case". But keeping the bigger picture in mind, the ratio chart is a useful tool to track the relative prices of just about any pair of securities.

So a ratio of the price of EWJ:ADRE looks interesting. The next step is to make sure that the "parts that comprise the whole" also look interesting (or to at least, make sure they don't contradict the message of the ratio chart). To do that, we take a look at the component securities. What do the MSCI Japan Index and Emerging Markets ADR 50 Index look like on their own?

MSCI Japan Index

The chart above spans several decades and depicts a breakout of a large consolidation zone that began in the late 80's. 

The chart below spans several years, and is completely neutral, that is, without any particularly bullish or bearish interpretations. 

Bank of New York ADR 50 Index

By looking at the parts that comprise the "whole trade", long EWJ, short ADRE, we certainly don't see anything that would give pause by posing any sort of contradiction to the larger message.

2) We've been cautious on the U.S. Markets beginning in late April. See our earlier post here:Tread Lightly! By taking an equal dollar amount long EWJ, short ADRE, the trader is actually statistically short the S&P 500. This is because the beta of EWJ is about 0.75, and the beta of ADRE is about 1 versus the S&P 500. The net beta is about -0.25.

3) EWJ is implicitly long the Yen, and ADRE is implicitly long a basket of Emerging Market currencies. Thus, by pairing EWJ:ADRE, the trader is implicitly going long the Yen versus the abovementioned basket of currencies. The Yen tends to rise with market weakness, and Emerging Market currencies tend to fall with market weakness. Thus, this is also a defensive currency trade that is in-line with our cautious stance.

4) Should the broader commodities market resume its downward long-term trend, Emerging Markets should follow in-tandem.

5) Japan is at least 11 years ahead of the U.S. in its fight against powerful deflationary forces. They appear to be "all-in" from a fiscal and monetary standpoint, while the U.S. appears to be lacking any meaningful fiscal support. This is a sign that Japan has finally come around to garnering the "political will" to fight deflation, while the U.S. seems stuck in its own political "red tape". Our bout with deflation shares many similarities to Japan's, but time-wise, the U.S. is probably where Japan was in the early 2000's, politically speaking. Japanese equities did not perform particularly well in the 2000's.

Housekeeping

Just a housekeeping item for this post. We wanted to let the readers know that Tim will be posting regularly starting around mid-June, and that we plan to use the blog in the following ways:

1) Tim will write about major markets such as the S&P 500, Oil, Gold, Euro, etc. on a weekly basis (approximately). The focus will be on short-term setups.

2) Tim will also piggy-back off of my posts, expanding on how to trade the longer-term setups that I've identified, but helping us out with the tactical timing of these trades.

3) I will be writing about long/medium-term sector/industry/country themes, and will be identifying individual securities as candidates for going long or short (approximately bi-weekly)

4) I will try to write a well-researched, deeper macro piece that incorporates principles from behavioral finance and quantitative analysis (approximately monthly).

So basically, we just wanted to let the readers know that we are excited to provide a lot more material in relatively short order!

Tread Lightly!

I generally leave it up to my partner Tim to ascertain overall market direction, but I'm going to "Break Bad" and infringe on his space to make a strategic observation about the market as a whole. Tim usually makes shorter term observations, but this is a longer term one. I'll sum up the thesis with perhaps the most memorable line from the hit series "Breaking Bad", and say what Walter White said best "Tread Lightly". That is how I feel about the market. By now, most readers in the investor-oriented blog space have seen all the "lines" : bloggers whose drawings show the overall lack of breadth in the market, the disparity among market sectors, the decline in the number of new 52 week highs despite the market itself making new highs, a six year bull market historically being "long in the tooth", the relative performance of "Safe" vs. "Risky" markets, the surge in the dollar... and in treasuries ... and the collapse in commodity prices. Certainly, all of that is concerning. My attempt here is to do a little more "digging" and add yet another data point supporting the conclusion that everyone (silently or boastfully) believes, that is... all is not well with Mr. Market.

Here, an observation is made with respect to both fundamentals and market psychology simultaneously. It is, in a nutshell, the market's "voice". Consider the following thought experiment. If one were to become more and more concerned with holding stocks but were, nevertheless, forced to hold them (i.e. all of your long-only mutual fund managers), what would one do? One would play defense, of course. One would seek only the highest quality investments: those with reliable cash flow, dividend growth, low volatility, low leverage, and conservative accounting practices. Right? So what happens to the opposite investments, say, the unreliable cash flow and dividend growth, high volatility, high leverage, and aggressive accounting companies in this environment? They begin to lag.

What we show below is the compounded growth of two markets: The blue line is the market itself, as defined by the Russell 3000, the green line shows the performance of those companies in the bottom quartile based on their quality of earnings. We define a company's lack of earnings quality as one that has higher working capital accruals scaled by its average total assets over the last year, relative to its industry. So we have, in fact, captured a fundamental data point (earnings quality), and related it to a psychological data point (the actual buying and selling of high or low quality shares). What we see below is concerning. The market continues to make new highs, while low quality companies fail to keep up. They are failing to keep up at an accelerating rate. The last two times we saw this was between January and March of '00, and August and October of '07, the last two major market tops. Only now, this phenomenon has been occurring for a longer period of time. That might be a reason to become even more worried.

Russell 3000 (Blue Line) Vs. Low Earnings Quality Companies (Green Line)

Pill Bottles and Oil Barrels: A Perversion of Mean Reversion and Excursion Part II

We're following up from the last post to give you some actionable ideas on both sides.

In terms of individual names, the following setups look interesting to us based on classic “Edwards and Magee”-style pattern interpretation (the charts use weekly data):

For those betting on an acceleration in the relative performance of Biotechs versus Oil Services companies (Excursion):

Interesting Biotechs on the long-side:

PBYI – A classic break of trend to the upside after a period of consolidation following a heavy volume up-thrust:

NWBO – A classic long-term “basing” pattern, with a failed short candle last week:

Interesting Energy Services Names on the Short Side:

NR – A classic topping pattern. Merely revisiting the point of breakdown where “pissed-off longs” generally want their money back. Be patient here and wait for a close below this week’s candle:

OGE – Ditto, but wait for a close below this week’s candle.

Now the flipside. For investors patient enough to wait for the mean reversion (possibly already in progress), here are some long Energy Services and short Biotech ideas.

Interesting Energy Services Longs:

GTLS – A classic break of trend with a new swing high. Stop out if trade quickly reverts below $40.

MTRX – A classic break of trend near long-term support levels:

HP - A classic break of trend with a new swing high. Stop out if trade quickly reverts below $70:

FI – A classic break of trend:

Interesting Biotech Shorts:

CELG – A classic break of trend to the downside:

AGIO – A classic break of support around $100. Disclosure: Author is Short AGIO in his personal account:

What this means for the market as a whole you might wonder?

Notice that the last two times we reached this extreme we were either near a trough (’09) or near a peak in the market (’00). So there is precedent that we are near an important inflection point for the market as a whole. Given that we have been going up-Up-Up for over six years, one might guess that the next major move is down. Classical market wisdom posits that when there is great “disagreement” between important industries (re: Biotechs and Oil Services), this is “unhealthy” for the market as a whole. Think back to Energy and Materials versus Financials in ’07-08. Think back to Technology versus Consumer Staples in ’99-’00.

For the Theorists …

An area of future work might include examining all sector-sector combinations for max excursion to see if there is anything more specific that we can conclude about 1. how long such phenomena last, and 2. what implications, if any, such extremes have for the market as a whole. Keep in mind that, of late, Biotechs have had lower betas than Oil Services companies. If we were to mean-revert, that would mean low-beta biotechs declining and high-beta Oil Services companies rising. Since beta is a measure of correlated market volatility, the mean reversion scenario might argue for more market strength. Continued excursion might argue for an imminent crash. What I find interesting is that the performance differential between Biotechs and Oil Services accelerated after the U.S. Fed ended its Quantitative Easing Program. And… as I write this, we are about two months from a “jawboned” interest rate hike in June. But the market will likely make its move in advance of the June Fed meeting. Whether the Fed actually raises rates in June probably matters less in terms of subsequent market action than what happens leading up to the meeting.  This is why we study price action. Much to the chagrin of our newspapers, financial statements, periodicals, and journals, we use those to kindle fires.

Bryan