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

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

I never thought my inaugural piece in BlogoLand would be without a conclusion. Nevertheless, there IS a trade here, so my only attempt would be to find actionable ideas given that one of two possible situations must unfold.

1) Biotechs continue to massively outperform Oil Services companies (Excursion)  OR

2) We’ve reached (or are soon to reach) an extreme, and it all comes crashing-in (Reversion).

Here is a chart of the Amex Biotechnology Index (BTK Index) from Inception:

And here is a chart of the S&P 500 Oil Equipment and Services Index (S5OILE) from Inception:

Here is a chart of the ratio of first chart divided by the second chart, a measure of the relative performance of the two industries:

Clearly we are at or near an extreme. For aggressive investors, there is precedent for such extremes to become even more extreme. For patient investors, there is just as much precedent that we are near the point where it all comes crashing in.

Here are the facts:

• The BTK has outperformed S5OILE by more than 100% for five weeks in a row (currently 104%).

• This has only happened four other times since the inception of the S5OILE index in 1989.

• It happened between 12/5/08 and 2/20/09 and lasted 11 weeks for a max excursion of 161%.

• It happened between 12/31/99 and 2/25/2000 and lasted 8 weeks for a max excursion of 245%.

• It happened between 12/6/91 and 1/10/92 and lasted exactly five weeks for a max excursion of 144%.

• It happened between 9/13/91 and 9/20/91 and lasted, well… 1 week, for a max excursion of 142%.

• Max excursion is defined to be the peak relative outperformance of BTK vs. S5OILE.

• The time that this excursion “lasted” (mentioned above) refers to the instance when this outperformance first breached 100% until it reached its highest peak. Thus, we are looking at just the extreme part of this outperformance. 

So… if you are highly tactical and aggressive and think there is another 50-100% of Biotech outperformance (entirely reasonable based on the facts), then you go long Biotechs and short Oil Services for the next several weeks.

From the above we see that, in terms of time, we are right around the middle of this pathetically small sample (5 weeks). From a price perspective, we are nowhere near the extreme which has averaged 173%. The biggest caveat here is that it is possible we have already reached our extreme this time around in early March - at 124%. Thus, there has been some reversion already. We don’t know if this is “IT”, as there is also precedent for the reversion to exceed 20%, only to go back into excursion mode and reach a “higher high”. We define a reversion as having officially “crashed in”, when it exceeds 40%, as it has every time, after every peak.

Bryan Franco

Introducing Mr. Bryan Franco: A "Real-World" Quant

After a lot of emails requesting that I start the blog back up with regular postings of ideas and market analysis, I have decided to dedicate the time and effort to continue providing content that previous visitors said they enjoyed and appreciated. Even better news, I'm very happy, proud, and excited to announce that Bryan Franco has partnered up with me in accomplishing this task and sharing his knowledge, experience, and expertise! So, introducing.. Mr. Franco:

Here is the part where I say I, I, me, me…

Hi, my name is Bryan Franco, I am Tim’s blog partner. I have worked as a fundamental analyst, a “Quant” portfolio manager, and as a trader/pm for a hedge fund. Currently, I am a portfolio manager at Flexible Plan Investments, a RIA in Bloomfield Hills, Michigan. Previously, I co-managed a hedge fund at Oppenheimer in New York. Before that, I managed a small quantitatively-oriented long-only fund at Northpointe Capital in Troy, Michigan. My first job was covering Real Estate Investment Trusts for Dividend Capital in Denver. I received the right to use the CFA Charterholder designation in 2008. I received a Bachelors and Masters Degree in Industrial Engineering from the University of Michigan in ’03, and ’05, respectively.

Ok, enough of the mundane…

Over my career I've found myself increasingly underwhelmed by work that is either overly scientific or overly artistic. Much more inspiring to me is to be able to combine the two professions. My only interest in this pursuit is in making money. As a result, you won’t get much theory from me. What you will get are actionable investment ideas that come from taking a balanced and humble view of the markets.

Tim and I are much more interested in studying price action. Much to the chagrin of our newspapers, financial statements, periodicals, and journals, we use those to kindle fires.

Bryan Franco

Price structure and trading levels- Monday 4/14/2014

We are in a longer term bull price structure, currently at the lower range POI trend line, on the DOW futures. We have two major POIs right below PDL from Friday. 1 hour chart below details structure.

How to trade this:
In a bull channel, our highest probability trade is buying the lows of the channel. Here are the potential setups that will trigger an entry for us on an intermediate term basis.

1) LONG- Bull channel remains in-tact and we never break PDL or have a seller failure at PDL
-Buy failed short signal, FL1 followed by H1 for the entry trigger

2) LONG- We break below PDL and trend towards 15,900 level and POI break traps or institutional level holds
-Buy failed short signal, FL1 followed by H1 for the entry trigger

3) SHORT- We retrace in the bear channel within the bull
-Short once retracement completes and we have a bull trap, high potential at OP of the down move from Friday

4) SHORT- We never retrace in the bear channel and continue down with pressure.
-Short failed long signals, primarily bull traps at CDH after 6pm tonight and short support breaks within current day's price structure

If attempting to trade the short-term down then capitalize on the intermediate-term long potential, trade down until we trap at LOD and/or the POIs on chart. Once bear trap occurs, signalling temporary bull move, exit short and reverse long with stop below bear trap.

Long Term Outlook

Rising long term interest rates and the FED’s actions have sent the markets in a tailspin. We have been in a bear channel for the last month and a few days ago attempted to break out of it. We are now back in the bear channel and will likely continue to do so until we have a confirmation that markets have reversed. Look for a push in the NQ  past the 2900 zone. There is a lot of open room and we will likely fill the bear channel gap. Use the pullback as an opportunity for another big short run, but play both sides. Trade the trend and don’t pick tops or bottoms. 

3 Pushes to End a Trend

The 3 push pattern is a very high probability end of trend pattern. I like it most when it occurs at HOD and LOD, that way we know that bulls or bears are exhausted on the 3rd push to set news highs or lows and the ones that trade the 3rd breakout are trapped.

Here is a live example from today's price action:

You never want to assume that a 3rd push is going to happen. The main use of the 3rd push pattern is utilizing the concept of strategic stop placement. After the 3rd push your directional bias changes and the 3rd push is used as your stop placement area since a break of the 3rd push level would invalidated the trade.

How to Trade 1 Hour Price Structure- Bull Channels

The 1 hour chart is in a strong and steadily reconfirming bull channel. In bull channel price structure, you want to buy the lows of the channel and sell around the highs or OPs. It is the opposite for bear channels, but the concept is completely the same. Continuing with bull channels, you want to stay away from shorting the lower range and buying the upper range because those are low probability trades. You want to wait for a breakout of the range before you start doing that.

I took profit on both contracts @ the origination point of the down move from yesterday in my main platform. The reason is because this is line of first resistance and high prob of stopping he shorts that went RF yesterday and then continuing in original longer term direction.

I still have 1 contract running with target above OP @ HOD in my other platform just in case this does pull up to the extreme top range of the bull channel price structure:

Trading the Range

The March 17^th sell-off broke the origination point of the up move and quickly reversed back to the range between the highs of the year and the double bottom. A second sell off broke the double bottom but was unable to reach the origination point. This was a strong bull signal. We are now at the double bottom point of interest and moving in a tight range. If that point doesn’t break, than we believe the break out to the upside will occur and test the highs once again. It’s very possible that we’ll see a swing up, fail at the highs, and then reverse back to the double bottom point of interest. If that point breaks it’s likely the trend will continue to test the origination point. We’ll have to see at that point the signals for the next move. The range is very large and it’s very important to maintain your points of interest as the market makes its moves.

Waiting for major zones to dictate direction

The NQ has been in a steady range for the past 4 days. We failed to break out of the range on Friday, with the 1 hour candle closing back in the range. We wait for critical points of interest to break and follow through to give us sustained moves.

- Break of previous day's low from Friday could signal profit taking and a move to the bottom of the range and possibly breaking out to the downside.

- Break of POI at top of range could signal attempt to test PDH and possible final bull trap up there.

I highlighted the zones on a 1 hour chart below. You really want to wait for sentiment to develop a move and then trade in that direction. Right now, the signals are yielding 2-5 points on average which is not enough to build a position, but it is enough to take profits repeatedly. You need to make sure that you are reasonable with your targets and wait for a significant move to develop for position building. Green zone is where we are looking for bulls to succeed and upside movement. If there is a buyer failure in that zone, we are then short the breaks of the range. The red zone signals possible shorting pressure. If we break that range to the downside, we are looking for shorts. If we have a seller failure there, we will look to buy with stop at SF.

News Announcements for Monday
***No major US announcements

2:00am JPY   Prelim Machine Tool Orders y/y                                                               

3:00am EUR  German Trade Balance                                 

3:45am EUR  French Industrial Production m/m                                           

4:15am CHF  Retail Sales y/y                                 

7:50pm JPY     BSI Manufacturing Index                                             

             JPY     Monetary Policy Meeting Minutes                                                           

             JPY     Tertiary Industry Activity m/m                                  

             JPY     CGPI y/y                                                             

8:01pm GBP    RICS House Price Balance                                                                            

8:30pm AUD    NAB Business Confidence                                                           

12th-14th NZD REINZ HPI m/m