I've waited patiently all summer with a reasonably hedged portfolio. I needed and got the summer off.
After the May-June erasure of 3.9% of portfolio value, the summer rally has brought it all back. The major indexes made lower highs by Labor Day than in early May, but the porfolio got back to just above May highs. This is what I hoped for: to reduce downside risk by increasing quality so that the upside remains possible. I shorted indexes (RYTPX, RYVNX), as Hussman does (HSGFX), and concentrated on quality stock pickers. Tice (Prudent Bear- BEARX) tries to pinpoint the weakest stocks for shorting.
This was not just an academic exercise. I expected a drop into the normal four year cycle low which coincides with the presidential mid-term congressional elections. I've shown the chart of SP constant forward futures all summer. The Reverse Point Wave patterns have been set up for another leg down. The largest degree is a 4 point wave forming under the May high. This is normally four to one odds in favor of resumption of a meaningful continuation downward.
Also within this last leg up there is a five point reversal (solid blue circles) and a larger degree five point reversal for the entire move up from the June low (red numerals). So all three patterns favor a decline.
In addition to the election and four year stock market cycles the SP futures annual cycle or "seasonal" pattern since 1982 favors a significiant September drop into October lows. The same is true of the Dow Jones 30 seasonal since 1928. Labor Day in the US is often a turning point in stocks, as in 2000. Even September 2003 ended lower than it started.
Sentiment, as I measure it, has become overdone on the bull side, adding to odds of a decline which may be starting today. "Moorso", a colleague on an internet chat site, produced this chart of the inverted 2CS so that bullish sentiment is measured as the five day running total of daily VIX times daily CBOE call/put ratio. I have done this indicator daily since 1996, and have found at least two ways to benefit from it. At highs one can simply look at the current level as compared to levels of the 2CS at historic highs. In Moorso's inverted version, when 2CS gets over 50, we should start looking for a top and reversal down. Another observation which was unexpected when I began looking ten years ago was that there is often a "sentiment divergence" at important turns. According to sentiment lore, sentiment should be the most bullish at the very top, but one sees that the most bullish time is several weeks before the high. Of course the 2CS is a five day reading so it is in a sense always a week late. But the divergences are greater than a week ahead. If you look at this year, the divergence has gone on all year! This what I refer to as catching a glimpse after dark of the smart boys getting out of Dodge City while the citizenry is asleep. And this is why I have been cautious and getting more hedged all year. The one day sentiment oscillator is also in the clouds again.
One small benefit of a summer off is reading. A friend sent me a copy of Robert Taylor's "Paradigm", a financial conspiracy thriller novel. The novel isn't as well written as Eric Ambler, Graham Greene, Lawrence Durrell or even Martin Cruz Smith. But it is about the financial markets and the fortuitous rediscovery of an ancient method of market timing, previosuly onlty known to “them”. To some of us this makes for a more exciting book than a political or archaeological thriller. Even my wife who is a real reader and a real writer-- and not a trader--found it fascinating.
“Paradigm” is worth a read is the same way that movies about trading are always interesting. But Taylor also presents his trading model from ancient Egypt based upon ocean tides, and he proposes that gravity is the primary cause of market movements. I was intrigued at once because of a paper I read several years ago by Ilia Dichev and Troy James of the University of Michigan Business School (2001), “Lunar cycle effects in stock returns.” This academic study of world stock markets may still be available at http://papers.ssrn.com/abstract=281665 This is the only citation I have ever seen which confirms the oft-alleged connection of lunar cycles with human sentiment and markets.
Since solar-lunar cycle gravity is largely responsible for ocean tides, Taylor’s book and theory interests me. You can buy Taylor’s book at Amazon or at Border’s, but if you buy it from him he will give you a year’s worth of weekly updates of his gravity/market prediction. http://taylortrends.com/ If you order it, tell them you were referred by a current reader of the Xyber9 site. You needn’t give my name as I get nothing personally. Taylor plans to extend the current one year free subscription if he gets enough book referrals. The book is $26 plus shipping. It may be a total lark, but it was a fun read and his predictions have a been as good since March as he said they would be: about 80% as to time and direction. File this under “keep an open mind”.
Hi there, Tom
As ever, a delightful trip off the beaten path rewards my visit here, particularly, your ad hoc review of Taylor's book, and of course, a pointer to his work, which I haven't seen before.
As a related aside, you might enjoy the thread linked below, at elitetrader.com by "yoohoo", a trading collegue who actively uses lunar "stuff" in his intraday trading. I've seen his work first hand over the past two years and aside from any justifications of "why", he simply applies the ideas in real time, successfully.
"Trading the Moon" thread:
http://www.elitetrader.com/vb/showthread.php?s=&threadid=76224&
Posted by: Ana Maria | September 09, 2006 at 01:25 PM