Chinese Market, Gold, and More About the Right Side of the Trade

Last week we posted some possible break out/break down scenarios in equity markets.  The US markets are holding up well, though we still anticipate them moving down in this correction.  Targets remain the same.  The Chinese Shanghai Composite did not fare so well, however.

As a recap, this was the picture last week:

A close up of the recent breakdown:

We're watching that red support line closely.  If the market breaks below that level, it could spell trouble for other equity and commodity markets.  However, we're not so sure it's going to happen.  To explain why will take a little time...

Earlier today, we discussed staying on the right side of the trade.  That is, is the intermediate term trend intact, or is there a large risk in the intermediate term?  We have a proprietary indicator called the WPA that we use for this.  For the record, it has called every significant top in the US equity markets having been backtested as far back as 1896 and in many global equity markets except one: it called the 1987 stock market crash too late.  That particular event was unique in that it was orchestrated by (then) new electronic trading run amok.

For most market tops, it sends a warning signal roughly six months in advance and a definitive sell signal just after the top, but before more than a few percentage points below the top.  That is, this is the indicator that protects you from the big crash with a warning and several follow-on signals up until its absolutely time to get out.

We noticed that in most emerging markets for which we have data, the signals come a bit later than we'd like.  Those markets are volatile.  However, it still does a good job.  Here's a glimpse using a 10 year view of the Shanghai Composite...

It can be difficult to follow if you're not sure what it is, but after some examination, reading it is quite simple.  In short, the purple wave shows critical levels.  If it breaks down below the zero line (right hand side scale), you absolutely *must* sell.  Once it bottoms and turns up, crossing zero to the upside, you should buy.  Note that fell and has quickly started turning up again--even with this large move down yesterday.  The implication, we believe, is that we will soon see a bottom.

Let's apply the same indicator to the last 10 years of the S&P and see how it did...

A simplified discussion of how the indicator works is on the chart.  In a nutshell, you're looking for a pattern of lower highs/lows when the indicator itself is in a high range.  Those are the warning signs that you have 4-7 months before a possible top.  With rare exception do you have periods where you do not get a lower high before the indicator falls below zero.  Note that this chart covers 20 years, and in that period of time you had 9 sell signals.  The worst performance for the indicator was during the 1987 crash.  Aside from that, the indicator would have at least spared investors from losses.   In two cases, it would have spared investors from the 2000 and 2007 crashes.  There was never a downside to selling when the indicator flashed a sell signal.  In 1987, it was realistically too late to have avoided the main crash. 

Also note that it produced 8 buy signals.  One was a false positive, but could have been avoided if buying only occurs once the price of the underlying security was above a long term moving average.  Filtering those results using that criterion, you have an excellent bottom caller with no losses.

Also note that we have recently seen a peak in the indicator and the beginning of a major decline.  We're still far from the zero line where we'll sell, but we have what may be the first sign of a market top within the next 4-7 months.  At this stage we're looking for a higher low in the indicator, along with a higher high in the equity markets.  That will be the negative divergence we're waiting for and the second sign we're nearing a top.

Perhaps one day we'll publish the complete study to those on our mailing list.  But for now, this should help put the idea of "the right side of the trade" into perspective.


Finally, gold and currencies are tracking almost exactly as predicted last week.  We should know if we're going to get a short term bottom to gold and the euro this week.  The euro is going to need to bottom here or face a bigger sell-off.  Of course, we'll post as the situation develops.

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The Intermediate Term - Staying on the Right Side of the Trade

Another bit of commentary regarding some trading and our general philosophy.

Any time you invest in anything (or for that matter, opt not to invest), you're taking a risk.  Our goal in trading is to move in alignment with the fundamentals, accumulating assets that are gaining in value and only moving out of those assets when there's a solid reason to do so.  Let's contrast this viewpoint with a few other strategies, and in our opinion, the pros and cons thereof.

Short term traders range from day traders to swing traders and try to capitalize on very small moves in the market.  Short term traders attempt to make profits by price arbitrage in a short timeframe and with leverage.  In this manner, making $0.02 on a large number of shares purchased with borrowed money can be a profit making bonanza, but the risks are high.  Every time someone enters a trade, there's a risk that it's the wrong move.  Short term traders must make frequent trades, and given the high leverage involved, need a very strong money management strategy to protect themselves from the leverage going against them.  Very few are consistently successful.  As one's timeframe becomes shorter, the risks become greater and the market becomes more unpredictable.

In contrast, long term investors that buy and hold often have to endure vicious corrections to the downside and significant periods of loss.  Over a long enough period of time (the fundamental timeframe), most trends are predictable.

We tend to trade in the middle--in what we refer to as the intermediate timeframe, which occurs in the 6-12 month period.  Over this timeframe, we use short term technical analysis to build or reduce our positions, the long term trend to make sure we're in alignment with the fundamentals, and the intermediate term trend to avoid substantial losses and manage risk.  It is the intermediate term timeframe that is key in our analysis, which is primarily a combination of daily and weekly data.

With rare exception, knowing the intermediate term trend ensures you're in the right side of the trade.  What that means is that if the intermediate term  for an asset is positive and upward moving, we would not bet against that asset even if it is correcting.  Instead, we add to positions when the short term is weak and the intermediate term is positive.  If the intermediate term appears to be weakening, then during a short term correction, we reduce our exposure.  If the intermediate term turns negative, we exit the position and go short when the short term goes negative.

This has protected our positions since this cyclical bull market began in 2009.  Longer term, we still expect to see the markets turn over.  But as so many bears have come to realize, if you go short on a market that has an intermediate term bullish strength, you can be taken out quickly and painfully.  At some point, when the markets show that over the intermediate period they are vulnerable, then we will switch sides of the trade.  Until then, the trend is your friend.

If you want to know a bit more about how to determine when the intermediate trend is changing, send us an email.  We're actively working on building a mailing list for those interested in more detailed information than we tend to post on the blog.  We will not sell, distribute, or otherwise divulge any email addresses or other information sent to us.

Stay on the right side of the trade.

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Commentary on the Goldman Scandal

We had a couple of questions regarding whether or not the Goldman fraud story implies that the US administration is now going to crack down on the dirty dealings of the banking industry.

Typically, we avoid these types of discussions here and try to stick to just the technicals with a fundamental outlook.  However, it may be time to cut to the chase on the politics of the situation more frequently.

In a word, "No."  Wall Street owns Washington.  The City owns London.  When times are good, greedy politicians support greedy banks with inside dirty dealings.  That's the normal course of events when money is something that the private banks create from nowhere and the government forces people to use it.  The normal state of being is corruption, whether you see it or not.

On the other hand, when the ship starts listing and gets ready to sink, the various colluding factions splinter and each tries to save itself.  In this case, don't expect bad Goldmans news, or some ridiculous notion that the SEC is going to crack down on banks, or any other such political rhetoric to make any real difference.  Politicians are in the business of paying themselves--just like everyone else.  They will ultimately not kill the goose that lays the golden egg for them.  However, they know they need to make an example of things to boost their election efforts this autumn, so someone is going to have to be a sacrificial lamb.  That's it.  There's nothing more to it.  In good times, there will be no attacks on the Bernie Madoffs of the world.  In bad times, a few have to take it on the chin so that the larger group can continue to fleece the public.

This game continues around the world until the stock of a major country, ie, it's currency, gives.  Then the game is up.  Then you can count on the blame for problems falling on foreign enemies as a way to distract the public from the real criminals (their own government officials).  That's what wars are for--to provide politicians 'an out' for their behavior when their actions finally catch up to them.

So, if you're of the crowd that justice by the benevolent hand of your government is coming soon, then you had best just go line up behind the barn.  After all, you are a sheep to be shorn by your government and those that control your money.  That is your purpose in life.  Now you know, and you can stop searching for meaning in it all.

The markets are overbought short term.  The public is holding cash in banking accounts paying virtually nothing and has flocked into government bonds fearing "deflation" and has run away from stocks out of terror.  Only institutions and large investors are in the markets.  That's how you know it's not ready to fall apart yet.  The sheep have not entered the fray to be fleeced.  That time will come, and your beloved politicians and bankers will know when to sell overpriced paper to the sheep.

Wake up.

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April 18, 2010: The Week in Preview

Last week's big news involved Goldman Sachs' fraud allegations and how that began a downslide in the markets.  The bears are already out in droves calling tops and declaring the end to the stock market run.  It is precisely this attitude that makes us believe that this market will continue to run farther--the bears have not yet thrown in the towel.  One day, it will turn over.  But we're not so sure Friday was that day.

As reported last week, the markets were already overbought and due for a correction.  The real question is "how much of a correction?"  Here's what we're watching.

As we've said many times before, the burden of proof must lie with the bears.  For over a year now, every market correction has been met with top calling by the bears, but they have no ability to turn it over.  Until then, you must assume this is a bull market--until the trend changes.  For now, keep an eye on the 1105 - 1145 range.  We're inclined to believe that this particular move will end at the 1145 range, but it may move as low as 1105.  If it were to move lower than that for more than a day, then the bears may be gaining the upper hand.  Until then, we'll leave the top calling to the bears and ask for some follow through...  It's a shortable move if you're trading, and perhaps some hedging of long positions may be in order.  If you'd like to know exactly why we believe this is what the S&P 500 will do, send us an email.  We're trying to better determine who's reading.

We're more predisposed to believing that the next down leg in the stock market will be due to rising interest rates, but it's still a bit premature to call for a bear market in Treasuries.  Though the long bonds are perched precariously on an inverse head on shoulders for its yields (see chart below), we know the Fed can also read charts and will defend the bull market in Treasuries as long as it can through whatever mechanisms it can.  A substantial rise in yields is exactly what the US cannot afford.

The gold and currency markets are behaving largely as expected.  Though we expect range trading between EUR/USD pair for a few months, it appears they may have bottomed/peaked, respectively, per the key Fibonacci retracements on the charts below.

Note that the dollar has fallen below its simple trendline from the rally in December, and though it will likely stay near its current levels this week, we believe this move to the upside may be over.  Behavior this week will be important as the dollar is short term oversold, and if its bull rally is over, it should not set a new high during this short term move as the stochastic works its way to overbought.

The reverse is true for the euro.

The euro may have set a double bottom.  It is overbought short term still, but should not make a new low as the stochastic works its way to being oversold if it has bottomed.

That leaves us with gold.

Gold has already hit its first area of support, but it is still dramatically overbought.  Typically, the bullion banks take this opportunity to try and break gold down below this first level of support when these conditions occur.  For a longer term move, this is a reasonable buying area, but be prepared to average down to as low as 1100 level.  We believe that level will now hold and gold will quickly return to break through the 1165-1170 level, then move to challenge 1225.  At this stage, it's not clear whether or not gold will break through that level at this time, or if it will succumb to its seasonal tendencies and not move up strongly until September.  A failed challenge of 1225 would not surprise us, and though every deflationist would come out of the woodwork at that point, it would not negatively affect gold's longer term bull market.

That's it for tonight...

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