Archive for January, 2012

Another Resistance Level Broken

Friday, January 20th, 2012

Resistance Levels

In my blog post titled Mark\'s Rule of Three (click this link) I mentioned that the next overhead resistance was at 1293 on the S&P 500 Index, which represented the October 2011 high. You can see that something got a hold of the investment community and we are on day three of a move above that level.

In that post, I mentioned that we’d be adding to our pure beta SPY position (the ETF that represents the S&P 500 Index) if we successfully broke above 1293. My plan is to do just that once the overbought situations as identified by the RSI indicator and the Stochastics indicator have cleared. You can see the two green circles on the graph above.

In previous posts, I’ve written that these overbought situations clear either through prices going down or through time passing, so we will wait for the one or the other to occur before we make a move.

What’s next? The resistance level of 1370 on the index which represents last year’s high posted in May 2011. At this point, we are about 80% of the way there from last year’s lows around 1070, so there is no reason to get too aggressive here with the cash we have on hand – we will invest what we see based upon the price action and the indicators of investor sentiment we follow. The stop losses may protect us on the downside, but we will likely raise cash and book profits if we move up toward that level.


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Mark

Stop Losses – The Good, The Bad and the Ugly

Wednesday, January 18th, 2012

Successful Completion of Rule of Three

In an earlier post, I mentioned that we were committing cash to the market because it had successfully completed one of my most reliable patters: The Rule of Three. You can read more about it here: Rule of Three

In the chart above, you can see the difference between the previous attempts to break through overhead resistance when they did not successfully complete the rule of three and the most recent one that did – the market has moved higher.

But in that moving higher process we have a number of holdings that are up more than 10% year-to-date. So that we protect those gains to the largest extent possible without prematurely selling a company that will move higher, we’ve added 2% trailing stop losses to each of those companies. What this means is that we are giving the company a 2% downward movement buffer before they are automatically sold. If the stock continues to move higher, then we will adjust the trailing stops so that they are reset to higher levels as well.

Here is a sampling of stocks that we are using this technique on. I’ve listed the name, the

    Year To Date

gain when the trailing stop was placed and the current status:

Agilent Technologies +15.32% :: Stock has moved even higher: +17.38%
Agrium +15.24% :: Stock has moved even higher: 16.79%
General Cable +15.76% :: Stock has moved even higher: +19.47%
Borg Warner +16.24% :: Stock has moved even higher: +17.54%
CF Industries +18.26% :: Stock has moved lower: +15.88%
Cummins, Inc +14.47% :: Stop Loss hit, sold for +12.45% gain
Eaton +13.43% :: Stock is slightly higher: +13.63%

This is a sampling of the holdings we have stops under, but what I wanted to talk mostly about is expectations for stop losses:

The Good: When it happens like Cummins, the stop acts exactly how you want it to. It moves down and on the first trade below your stop price, your shares are liquidated and you book the gain.

The Bad: Sometimes, like with Cummins, the stock’s move down is temporary and it is shortly thereafter higher. Cummins is up 2% since the stop loss hit.

The Ugly: Sometimes, you will have a news-related event that pushes the stock price down significantly and your trade is the first trade to hit. Look at the chart below of Annaly Capital:
Annaly Capital

If you had a stop loss set on Annaly and a news story hit that drove the price down significantly during the day, you would have been sold out significantly below where the stock closed that day. This is one of the things you risk when using stop losses, particularly with companies in a sector that is having so many issues as the financial sector.

There are a lot of misunderstandings about stop losses and they are not

    in practice

as good as they are in theory, but for the most part they work if you are careful in their usage and have realistic expectations.


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Wouldn’t You Like To Be a Copper Too

Thursday, January 12th, 2012

Copper Break Out of Triangle

I’ve been watching for signs that the current move in the stock market could be confirmed by other sources – what we don’t want to see is a head fake that gets us ready for a positive year (like 20111) only to turn around and the gains turn into losses.

Here is a link to an article on “Dr. Copper” from 2010 at the MSN website you might be interested in reading: What \'Dr. Copper\' says about the economy

Basically, copper is a key “tell” for the state of the global economy as it presages moves up and down in economic changes. Because copper is such a key input to so many industrial and construction projects, it is one of the first things put on order as projects get underway. An increase in copper demand pushes prices higher pretty quickly due to its relative scarcity – unlike coal in Kentucky, the copper coming out of the ground isn’t of the same quality or quantity any longer- and shows up before statistics on economic growth are calculated and released. For this reason, when we see the price of copper rising, it is a confirming indicator that economic growth numbers should be strong in coming releases.

Greg Harmon is to thank for noting that Copper has found some strength. I’ve annotated a graph above to show you what is happening.

First, you will see that I’ve drawn a blue triangle pattern on the price graph. You want to not two important things here: (1) we’ve broken above the downtrend resistance line, and (2) we’ve also closed above the 50-day moving average. Both of these a re significant and support the strong showing we’ve seen in stock prices recently.

Second, for this breakout above the downtrend line to be considered a valid break of the pattern, you need to have a confirmation from volume. You can see I’ve drawn a green V on the volume bars to show you that: (1) as price was consolidating within the pattern, demand for the metal was waning; but (2) demand for copper started to increase steadily until it pushed the price above the downtrend line.

Third, I always like to watch the institutional cash flow, and you can see that it has also turned positive.

The price action in Copper is giving me some comfort that the move we are seeing in the stock market with the “risk on” assets leading the way should have some legs to it – always barring any disaster coming out of Europe.


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Mark

The Fed Model

Saturday, January 7th, 2012

The Fed Model

In yesterday’s blog post, I gave you a technical picture of the market and how it seems to have turned a corner in the eyes of investors.

Today, I thought I’d give you a look at another series of charts I follow that helps me know when stocks are undervalued compared to bonds. The series of charts above represent what Edward Yardeni has coined as the Fed Model – they are provided courtesy of Portfolio 123 but I’ve annotated them so you can more readily see what I see.

The Fed Model originated from the work of Alan Greenspan – in 1997 he stated that changes in the S&P 500 Earnings Yield have been inversely related to changes in treasury yields. You can see that exact correlation in the bottom of the three graphs above – you can see that I’ve noted that the spread between the two is wider than at any point in the past decade.

To understand what this ratio is telling us, you have to understand what the S&P 500 Earnings Yield means: its pretty simple actually – its the earnings of the S&P 500 divided by the current index value – or you can think of it as the mirror image of the P/E ratio on the S&P 500. This ratio is giving you the percentage of each dollar invested in the S&P 500 that is being earned by the companies that comprise that index.

The theory goes that treasury notes are a risk free investment and that investors in equity securities should receive a higher total yield than treasuries for the extra risk assumed. That total yield is represented by the net earnings of the companies in the index and NOT just the dividends – the net earnings represent the composite of the dividends they company pays and the retained earnings that are held by the company as capital to support future growth. The difference between the risk-free treasury yield and the earnings yield on equities for assuming stock market risk is called the Risk Premium.

The wider the spread between the lower treasury yield and the higher earnings yield, according to the theory, the greater the potential return on your equity investments in coming months.

Conversely, when the spread narrows or even crosses, you know that stocks are likely overvalued on an earnings basis – long-time clients will remember that this was one of the primary indicators we used to reduce stock market exposure prior to the NASDAQ crash at the beginning of the past decade. When earnings aren’t there and risk free yields are high enough, investors make the rational decision to move money out of stocks because they aren’t being paid enough to assume the risk.

If you look at the middle chart above, you can see that we have a decade high in corporate earnings for the S&P 500. Putting that number in the numerator of our ratio logically will give us a higher earnings yield than recent years, but you also have to look at the denominator. In this case, we have all lived through the 2008 stock market crash and we know that we are only about 2/3 of the way recovered from that crash as you can see in the chart below:

long-term-trading-range

The combination of a decade high in earnings and an index that is 33% below its peak is what gives us such a high earnings yield.

The question you should have is whether this actually has translated into higher stock prices when there is a relationship like we see now.

Take a look at the top graph above – this shows the S&P 500 Index price (the blue line) compared to the difference between the Earnings Yield and the Treasury Yield (the black line called the Risk Premium).

– (1) When the Risk Premium is at a high (high earnings yield and low treasury yield), the stock market is generally due for a rally because investors are being paid to assume the risk of being in the stock market, and

– (2) When the Risk Premium is at a low (low earnings yield and high treasury yield), the stock market is generally due for a correction because investors are not being paid enough for the risk they are assuming in the stock market.

I’ve circled two instances so you can see this relationship – the first set is from the March 2009 post-crash lows – and the second set is where we are currently.

This indicator tells me that investors are at the point where they will look at the comparative value between stocks and bonds, and make a rational decision to allocate their investment dollars to stocks given their superior earnings instead of bonds that are paying them less than the rate of inflation.

Am I expecting stock prices to hit the highway like a battering ram and skyrocket higher? Not likely, but I definitely believe – absent some major catastrophe in Europe – that we can see six to seven percent upside based upon yesterday’s technical study. After we get that under our belt, we will see what the market and corporate earnings are telling us – remember, invest what you see, not what you believe.

Have a great weekend! I’m headed to the ILL V Nebraska game shortly and hope to see many of you there!


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Mark

Mark’s Rule of Three

Friday, January 6th, 2012

Rule of Three In Action

For long-time readers of this blog, you know that I talk about the Rule of Three on occasion relative to support and resistance levels.

On the chart above, you can see the blue circle – we have successfully closed above the 200-day moving average on the S&P 500 Index for three successive days. The 200-day moving average has been a big resistance level for several months. As you can see on the chart below, we have been turned back twice in previous months only to see the market fall back to lower levels.

Annotated Rule of Three

These previous attempts did not have investor confidence so they were unsuccessful – you can’t see this on the chart, but if you look at the sectors of the market that were strong during that time, it was the defensive sectors – high dividend paying stocks and consumer staples. You cannot have a sustained market advance with those sectors leading the way – it just doesn’t happen.

Look at what has been leading the way since the beginning of the year:

Risk-On Sectors Lead The Wy

If you look at the performance bars, you can see that the sectors with the highest returns are the least defensive sectors: Materials, Biotech, Industrials. The Consumer Staples sector is actually in a losing position so far, and down for the year.

What is this telling me?

First, since we successfully passed the Rule of Three, the 200-day moving average has changed from resistance to support. It would not be surprising to see the market fall back and test support, but it would have to successfully pass the Rule of Three and close below support for three successive days, which as you can see on breaking through resistance, is not an easy thing.

Second, because the least defensive sectors are leading the market, investors’ appetite for risk is increasing and we could see a pretty nice rally in the near-term — subject to any disasters coming out of Europe, obviously. We are very near the October 2011 high of 1293 which may serve as minor resistance but the real first goal would be to hit the July 2011 high of 1357. That is only six percent away so it seems an achievable goal. The next goal after that would be the May 2011 high of 1370 which is only seven percent away – another achievable goal and it would mean that we had retaken the post crash highs – a technically and psychologically significant event.

Third, as I look at the chart at the top, I see that we have the institutional money coming into the market. If you look at the red horizontal lines I drew on the graph, you can see the trends are up in these indicators. These indicators represent the money flow in the market – and since the institutional traders dominate it, you get a good feel for where the hedge funds and high frequency traders are headed, and that is moving money into the long side of the market.

Fourth, as I look at that same chart, I see that we have moved up very fast and are due for a down day or two. If you look at the two green boxes I drew on the graph, these are short-term indicators and both are at or above their top ranges and need to pull back a bit. That means that either the market needs to stay at current levels for a period of time for the indicators to pull back or it needs to have a couple of down days to pull back.

Don’t fear the down days – in fact, if you are sitting on cash you want to have it pull back a bit so you buy in as close to the support level as possible – but there are never any guarantees that it will in fact revisit support.

What is my strategy?

We have a bit of cash on hand in client accounts that we will be putting to work in a pure beta investment, a SPDR ETF that simply tracks the performance of the S&P 500.

We used rallies in the fall to raise cash going into year end so that
– (1) we would have an opportunity to reinvest if the market gave us a sign it was ready to move higher or
– (2) we would have a cash cushion in case something ugly happened in Europe to send the market back toward the September lows.

We are going to commit some of that cash to purchase shares of the SPDR ETF today given the softness in the market and keep the rest on hand waiting for
– (1) the market to retest the 200-day moving average resistance level or
– (2) to move above the October high resistance level.

So far, the confusion of 2011 in the investment markets looks like we are seeing a clearer path ahead. If for some reason we break support via the Rule of Three and the market appears headed lower, we will again be raising cash to buy back lower. However, right now it looks like investors are putting more value in non-defensive equities and willing to push the market higher.


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Mark