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

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.