Putting the pieces together...

Seasonal considerations

The seasonal or annual price pattern for SP500 futures has been upside down for most of this year. Normally, based on 1982 to date, the market tops in February, and it bottoms in October.

The pattern for the DJIA from 1928 to present is similar except for a tendency to double top in February/March and double bottom in September/October.

These are averages of when the market has bottomed and topped, and are useful.

Norman Fosback, building on earlier work by Arthur Merrrill, has cleanly documented in real time that there are smaller periods with the year which correspond to profitable, tradable, rising periods compared to all other patterns. you can read a bit about it at his website http://www.fosback.com/  I won't give away his proprietary and trade-marked method but many of the favorable periods are around month ends and major US holidays. We are in one right now and November and December have several others. Also there are four year and election cycles which you can Google and read about elsewhere.

The sum of all these statistical observations and cycle divinations is that the market should continue up from here. The sceptics and outright bears have all been wrong, and the markets have risen despite all of this and despite sentiment indicators and most certainly despite economic "thought".

I do believe that sentiment is often useful, but not always. This year has been a lot like 1993 or 1995 when volatility subsided or remained low throughout long advances. Also traditional sentiment analyses of stock and index options and futures open interest have not been helpful. These data are double-edged. It is well to remember that large scale buying of short hedges (put options and short futures) often accompanies the buying of stocks by large institutions and can be read as bullish, as are margin debt levels. 1995's do occur!

About a year ago I and several people I know discussed a ten year or decennial pattern wherein the mid part of the decade has a flat high consolidation follwed by a low volatility and very generous bull market. The range bound consolidation lasts one to more than two years before the breakout. Until the breakdown in May I was a big fan of this pattern, but I thought August was too late for it still to be operative. Well it wasn't too late, and the pattern may still be operative. I'll just show you the charts from the 1930's,  1980's 1990's and now, without comment.

Short term I expect a pullback, but it's possible we could see an extension of this low volatility breakout since August.

Random walkers laughing up their sleeve?

The SP500 is up ~3.0% since the end of September while my "hedged fund" is up only 0.65% .  So I was wrong about the short term expectations of a correction. In fact I have been wrong almost all year, and my total portfolio is up only 6.0% as of Friday. In my own defence, part of my "error" was an experiment in volatility reduction. As often explained here earlier, one can do that partly by selecting funds with histories of low volatility gains by diverse methods, and partly by putting on index hedges .  In 2006 the index funds themselves have been leaders as money gravitated back to large caps which are heavily represented in capitilization-weighted market indexes. I have only had the direct hedges since May, and the indexes only began to outperform later in the summer as the new craze for dividends began, but the hedges nearly outperformed the "hedged".

Also in my defense is the fact that my total portfolio never drew down more than 3.25% from any new high value during this year: that despite my still holding some metals and energy positions. So volatility capping has its rewards as well as its costs. The reward largely is "peace of mind" or a low "ulcer index". 

I am still looking  for a decline during which--hopefully at the end!--I can remove the active index short hedges  which have tied up less than 6% of assets but which hedged at a 10% rate due to their leverage.  Given the innate hedging of the diversified portfolio, the low volatilty funds largely employed by me, and a good bit of HSGFX from Hussman, additional active hedging with indexes is probably overkill on my part.

So I have proven sufficiently to myself that volatility capping is truly valuable to me but that it can be overdone. Since I will living on the portfolio after transitioning to retirement (unemployment) in a year or so, I needed to reposition and get a feel for these c0ncepts. I think of poor souls with high volatility index funds and stocks who retired at the end of 2000 and saw their equity decline by 20-40% in the first two years of retirement. That is a complete destroyer and a big  NO-NO for any investor at that point. And that is exactly where the random walkers like John Bogle are completely wrong.

However, most people reading this page are probably in asset growth mode rather than retirement. So I want to spend some time over the next few months explaining how their portfolio composition and approach needs to be entirely different especially if they are--as they should be-- putting new money in each month, quarter or year. When you are adding new money and automatically reinvesting dividends, volatility is your friend over the long term.

Waiting for Gold Stocks

Ten years ago at Kitco, my first internet trader site experience, Glenn Kafka taught me the value of the gold/XAU ratio. I had been a gold futures trader, gold analyst, and publisher for some years, but Kafka's ratio pointed out a new way for me to capitalize on sentiment, which I was just discovering.  Gold stock buyers tend to have greater emotional and price swings than gold metal traders. Largely this is due to the fact that a lot of bullion and gold futures players are non-emotional commercial hedgers, both long and short.

>p>

In my view, gold is a story of the Kondratieff Wave, but Kafka's method, also backed by John Hussman more recently, is a decent way to capitalize on intermediate term (months to a few years) swings within the decades long Kondratieff Wave bull and bear markets. Whether or not you trade gold stocks or gold bullion or futures, the gold/XAU ratio is a good sentiment measure.

The two charts show the history of the ratio over the past few years. They suggest that gold stocks have not been crushed enough yet to be buys, which in turns says that gold has further down to go at some point.

These charts were made at different times with faciltities available to the public at StockCharts.com, but the ratio ranges are remarkably consistent since the new gold bull market began in 1999.

Another factor that tells me gold stocks or gold are not yet buys is the premium over net asset value (NAV) being paid by buyers of Central Fund of Canada (CEF) which holds gold and silver bullion. As of today the premium is still 7.5%. At the 2005 lows one could buy CEF at a discount to NAV. The chart shows CEF price and NAV going back many years.

John Hussman is an academic economist, and economists do not accept Kondratieff. The Long Wave is simply too long for data frameworks used by economists. But Hussman is also a money manager and has some excellent analysis for tradeable shorter term gold cycles:

http://www.hussman.net/html/gold.htm

Hussman currently is bullish on gold, and has gone to his maximum level of ~20% gold stocks in his Hussman Strategic Total Return (income) Fund. Read his well reasoned approach to gold. We differ in that he is expecting a period of staflation whereas I see a relatively less inflationary interlude in a long term inflationary bull market in which gold has and will continue to be weak for a while. In the longer term I think we both agree that gold will be stronger.

Patterns and Fibos

Looking at the Euro Currency versus US Dollar we have to wonder why it didn't make a higher high above the late 2004 high  this May when gold and copper and crude petroleum were making extreme new highs. 

The obvious answer is that Europe also suffered from shooting star prices of crude commodity goods. And, to be sure, Europe still suffers from high unemployment relative to North America and has immigration problems, out sourcing "issues", etc.

Whatever the reason, the lack of an upside breakout denotes real weakness for EUR/USD, especially with commodities collapsing since May, along with US interest rates.

The chart merely documents that weakness. It shows a "head and shoulders" top whose traditional target is double the dxrop  down to the "neck line" (thick red horizontal at about the 1.16 price level). The Fibonacci divisions of the EUR/USD bull market since 2001 demonstrate that the low exchange rate of late 2005 was at the 0.382 level, and the rally since went up to the 0.146 Fibonacci level. "Fibos" are beloved by currency traders worldwide. If the head and shoulders projection were to hold true, it would go to the .764 (2 * .382) level which is close to that other Fibo of .786.

Why am I saying these things when I am a long term inflationary bull? Because it has been five to seven years (from 1999 or 2001) for inflation, and let's face it: it got very wild in May. Commodity markets are just as crazy, or more so, than equity or interest rate markets, and they do not go in one direction for years and years without major corrections. Remember human nature?

Then there was my favorite: the formerly deflationist gold bug nut cases finally got to be inflationists again, as before 1997. They are perfect! (Now they will have to revive the bank conspiracies to explain why gold is going down when the world is such a bad place and should tank.)

It's just a normal correction, although it could look very nasty before it's over.

Download hnsfib.gif

Gold Stocks

In the weekly charts gold stocks remain in a correction that was signaled as early as February of this year.  Relatively hedged ABX remains stronger than unhedged NEM, and gold remains stronger than the XAU Index.  Until we see a change there isn't one, as Yogi might say. http://twocents.blogs.com/weblog/2006/03/gold_follow_up.html#comment-14999451

Inflation Takes a Holiday

 

Daily Stock Market Sentiment

It's a long long way from May to September....

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”.

 

Secondary High Forming?

An EL is what xxxxx called an xxxxxxx. It is the low of the last bar up after an advance into new high ground that had several long white up bars. There are 3 or 4 of them in this chart and 2 of them have really played out classically by rejecting price each time it passes through the horizontal line from the EL.

Yesterday the 3 month constant forward "perpetual" SP futures matched the January 11 high and closed below the EL of that high January 11 bar. another rejection. Also yesterday's bar exceeded the June 2 high setting up a 1,2,3,4 Reverse Point Wave (RPW) UNDER the May high. This is a fantastic bearish setup for a continuation of the bear move off the top. At the same time the leg from the black 3 to the black 4 of the RPW is itself a smaller degree 1,2,3,4,5 point RPW. Odd numbered points (5,7,9,etc) are reversal points...so the shorter term implies reversal down and the larger degree suggests resumption or continuation of the down move.

One method of targeting says 1188 for Sept or December SP futures. rule of 7's says 1222.3, 1193.6, 1145.7, 1049.9. If we have seen waves A and B (Ellliott) of a three wave correction, a 1.618 extension beyond A to C would carry to 946.9. My guess is 1146 for September/October unless panic ensues.

Most sentiment watchers are missing the fact that a "range shifting" is taking place in most sentiment measures. For the past few years the 2CS (5 day sum of daily VXO times CBOE p/c ratio) has been topping out, even in secondary highs, with 2CS well under 60 and often even under 50. In the previous bear market it was commonplace for 2CS to top out in the mid 60's. And that's what is happening now, and it implies we are making the transition to a real bear market, just as the opposite range shifting occured at bottoms in the summer of 2003.

Understanding sentiment changes at secondary highs and lows, after long runs in a trend direction, is of immense importance for intelligent asset allocation.

Getting tired at point 5 of Larger Degree 4?

The Vacation Hedge

Three weeks in the watering holes of  the Arizona, New Mexico, Colorado, and Utah mountains, at the height of lowlands summer heat and the monsoon storms, is a treat. So you may not hear from me until late in the month. I am not bearish generally, and I have tried gradually but persistently to reduce volatility in my overall portfolio in all the ways I have described in the Portfolio Ideas section, and still capture upside gains. But I won't be watching the markets very closely if at all, even though I just upgraded to the new Sidekick 3 from TMobile which is such a delight compared to lugging laptops around. I can slip it in a pocket and I can do 80% of what I could do on a laptop or desktop computer.

But I do see some grounds for caution if one is aggressively long. A four point triangle under new high points (see the 1-2-3 in back numerals ) can be a failure point early in a bear move. Also the May/June decline was steeper and deeper than any we've seen since 2004.  There are powerful resistance lines above which I have labelled "EL" from a mentor/teacher I had in the 1990's. And tomorrow there is a time line for change of trend from another teacher of mine.

I am not wanting or trying to be short,  just a bit more hedged because of vacation and the TA concerns. I use a combination of BEARX and RYTPX which are short funds of two different types. In a rather low volatility total portfolio I am about 1/3 hedged in addition. As with health and car insurance I hope my paid premiums for this  insurance are wasted.

At Last

Sentiment has been compressed for weeks, not making lower lows, and the markets finally exploded today.

It's possible that a correction has been in effect in SPX and other indexes since 2004. The chart below shows that the recent correction is almost identical in percent as the one in 2004: about 9%. It's plausible that it is done. The  bullish percent of  NYSE charts more clearly shows the correction I am talking about.

However, I am a realist and  live on my money. I will be away for most of July. So I have sold some of my more agressive long positions on today's close and redeployed along the lines I have discussed in some of the recent portfolio posts. I am still long and committed, but I have decided to reduce volatility further as a prudent provider. Plus, who can argue with 5% money market funds at Vanguard for part of the portfolio while on vacation?

ISEE and Sent Osc

http://webreprints.djreprints.com/1350371205823.html

Sentiment Oscillator

2CS and 2SO

The main contribution of sentiment gauges is to tell you whether the market is in either a excessively bullish or bearish phase. In the past ten years I have run the 2C Sentimemeter (2CS) which is the five day running total of the daily product of VXO times the CBOE combined put/call ratio. A lower number indicates options buyers are bullish, and a higher number that they are bearish.

In the 1990's and up to 2003, tops were made when the 2CS was in the 60's. Since the bull market began in 2003, there has been a "range shift" so that it takes more bullishness to turn the market down and less bearishness to turn it back up than it did from 1996 to 2003.

A reading from 90 to 120 has always been sufficient for a low except during the 1998 crash, and 2002 and 2003 lows when readings exceeded 200.

Thus if the drop from May is a "normal" correction in a continuing bull market, we should turn up before long.

In late 2000 I started looking at a new indicator on a daily basis to see if I could improve on the slower 2CS. It evolved by spring 2001 to include an "amplified" options component plus up/down volume and breadth (up/down stocks) components in a "cocktail" of my own.

In this daily Sentiment Oscillator, under -3 and over +13 have indicated excessive bearishness and excessive bullishness respectively on a short term (days to weeks) basis.

In sentiment work there is always a danger of a "range shift" when longer term sentiment is changing. We saw that for the upside when sentiment ranges expanded upward in 2003-2004. this trapped a lot of bears who expected a resumption of the bear market when sentiment got "too" bullish on a short term basis. Instead all we got were modest corrections to the new bullish trend.

That can happen to bulls too, and it demands honesty and thoughtful observation. If this decline drags on with sentiment staying down under zero or -3, and/or a rally fails to be robust, the market may be telling us that the longer term trend has changed to down. I don't see that happening yet, but this drop is a bit deeper and quicker (momentum) than we've seen since August 2004, so it's best to be careful and to be honest with oneself.

More Up

Sentiment got very bearish in the past few weeks, so much so that I suspect we have a good rally yet to come. I am working on putting my daily sentiment oscillators (2SO) into Excel so I can begin to show it. Normally it needs to get to 12-14 at least to signal that a downturn is coming, and under zero for an upturn. It got down to -9 and is still only up to 7.5.

The 2CS, which is a five day running total of the daily product of VXO and the CBOE P/C ratio, and which is "upside down" compared to price and the 2SO, got to a high of 100 the week before last and is now at 78. The 2CS has been reaching the 50's or 40's regularly at highs.

The ISEE ratio of their in house buy-to-open put /call ratio (kept by long time cyberfriend Chairman Mao) reached levels not seen since the 2004 swoon.  MaoXian's eclectic blog can be seen at: http://www.maoxian.com/ He always puts an index or ETF chart with his sentiment charts, but it is just a chart of interest and not directly related to the ISEE chart data.

I have put together a portfolio of mutual funds which have decent gains but low volatility. Money in retirement funds and money earned in the futures accounts are invested in this long term failry conservative manner. I have had a lot of help from FastTrack's fine website

Gold: Back from Mexico

I'm just back from a whirlwind tour of lower Sonora, northern Sinaloa, and western Chihuahua states.  I saw a lot of mining startups, many of which are reworkings of mines originally from the 16th to 19th centuries. Even in southern Arizona we are seeing the same phenomenon, particularly in copper.

Although the gold juniors and flyers are getting development funds by banks and venturers, they have a lot of competition for stock price support from the very large gold and silver metal ETF's in the US and elsewhere. Metals stock investors have long and bitter memories of the scams and failures of  the 1980's and 90's, so even if penny stock traders are willing to risk it on golds as well as on techs, the gold  majors are losing support as their costs rise and large portfolios get re-balanced. Holding the metals instead of always problematic stocks is appealing to those who are hedging portofolios rather than going for lottery-sized payoffs.

For nearly a year and a half I have expected to see a third wave high (second upwards push) from the 1999 low in gold. Gold's action has extended greatly, and the move from a year ago has comprised two thirds of the entire run from the 2001 secondary low.

From my perspective Elliott Wave is a way of describing events rather than being a highly probable predictive tool. Nevertheless it is a useful schematic diagram of where gold has been.

The first chart runs from the very large degree second wave low of 1976 to the present. The bull market from 1968 to September 1980 I have outlined in detail in this 2001 article at Gold Eagle: http://www.gold-eagle.com/editorials_01/drake043001.html

Since then we have had two major waves up with a corrective wave down from 1999 to 2001. I believe we are in a new bull market  since 1999 which will likely last another 15-20 years. However, with the recent retest of the orthodox high of 720 at the September  1980 high, one must acknowledge that very long term bears have a point in calling this current spike an X or B wave in a continuing bear market.

Given convincing evidence from all markets that the Kondratieff Wave bottomed from 1998 to 2003, I give the bears very low odds.

The second chart is a closeup of the bull move from the 1999 low with my Elliott description. (The gold data are continuous one month forward COMEX gold futures.) If this labeling is correct, I would expect gold to decline at least to 560  at the end of the correction, and it could go lower during some part of the correction, and it could last many months. Recent sentiment, which I have discussed, suggests some sort of correction which may have begun this past week or two. One must be aware of the fact that runaway markets can subdivide their last wave and keep going after minor corrections, so it is never wise to close one's mind on a wave label.

I did lighten up on metals stocks in the week before last but did not and will not sell metals holdings.

It had to happen.....

Gold was grossly overhyped,  and 720 was the orthodox Elliott Wave top of the last bull market in September 1980. 723.45 is 35 times the pre-Roosevelt gold price from 1824 to 1934. Perhaps gold will just go on up anyway, but I cut back to 60% of peak price levels both on the metal stock fund and energy fund. No gold bullion was sold, nor will it be.

Practically every asset class went down yesterday and today, except GM. :) George Slezak, an ex CBOT bond pit  trader, says it  reminds him of the 1980 top when everything went down for weeks. I was trading commodites then, and I remember it vividly. Personally I think it's facile to compare that market and this one, although there are superficial similarities for sure.

My guess is that in the US stock indexes we are in Elliott wave c of a larger degree running wave 2 after the completion of wave 1 up from last October. I read and listen a lot, so I know  all the arguments about valuation, commodity wars, geopolitics, derivatives, US politics, the real estate flop, etc., etc. And there is no accounting for human panic. But I remain positive on the markets until we would see a low, a failure rally, and a new lower low.

Technically, yesterday and today in the SP500 futures June contract we had what's called a "three gap play" where three inter-day (overnight) gaps have been left behind in a rush to  the highs. Old timers from a hundred years ago knew that these will often get filled in a short term smash. Two were filled today. The third gap is from 1292.90 in the June contract, just below today's low of 1293.50. If my Elliott and "three gap play" ideas are correct we will fill that gap Monday, and maybe even take out the bottom  of that April 17 daily bar at 1286.70, and then go up.

I'm gone to Mexico for ten days tonight, so I'll miss all the fun of the market next week.  I feel fairly comfortable in funds which have all weathered previous severe bear markets pretty well, the bulk of which are themselves hedged in some manner. I feel better having cut back or "re-balanced" 40% of energy and metals stock funds.

A good place for ideas in markets like these is Carl Futia's site. We don't  always agree, but he trades a variety of markets and stocks I don't  trade, and we use a lot of similar methods from the past. He's also very steady and reliable under stressful conditions, a must. http://www.carlfutia.blogspot.com

See you week after next.

Breakout

Click on image for larger popup or for a very large version http://img200.imageshack.us/img200/7426/red97ho.gif

Aunt Nellie's Dog

Dollar sentiment is hyper bearish everywhere I look. The usual anti-dollar talk is  of gold, commodity prices and the trade deficit. But every currency I follow is drooping in the face of a gold bull market. The following two charts present some technical analysis for a contrarian view to the bears and aunt Nellie's dog.