No Man’s Land, Again

SPX – 1071.25

DJIA – 10,154

July 20, 2010

“Bull markets, it is said, climb a wall of worry…Bear markets, on the other hand, fall into what I like to call the pit of doom. Forget about worries- actual bad stuff happens, until nothing bad is left to happen and the market bottoms as there is no one left to sell.”

-Andy Kessler, The Wall Street Journal, June 16, 2010

Headlines last weekend summed up the fundamental predicament, including Skating closer to deflation in the Los Angeles Times and Deflation Worries Stir as Consumer Confidence Slips in The Wall Street Journal. Policy options range from bad to worse, the battle on between spending more and spending less, zealots on either side fighting for each scrap of advantage, the U.S. long past the point of optimal solutions.

From The New York Times, Wealthy Reduce Buying in a Blow to the Recovery, citing Gallup statistics that consumer spending by those making more than $90,000 a year increased 33% year-over-year in May to $145 per day but in June after the stock market cracked, fell to $119. In another article, Floyd Norris pointed out that the unemployment rate for those out of work more than six months is the highest since the government started keeping statistics in 1948.

Technically, and after the S&P 500 (SPX) successfully tested its May 25 low and held by the skin of its teeth, the headline on my June 15 letter read No Man’s Land. The bears took that battle in the back half of the month but once again, there’s barbed wire strung along the front lines, the bounce-back high (1131.23) ended June 21 and the July 1 low (1010.91), mixed technical indications in between, intermingling with land mines, high frequency trading and untold graves, willing volunteers on either side, myopic bulls with little conviction ignoring the 24,000-pound elephant (a government spending over $30 billion a week it doesn’t have) and the bears, too bold for my liking, at least those poking their heads up for the press, wounded as well, chopped up by their own deserters in a contrary market lacking momentum.

There’s no change in the separate net volume readings, NYSE net volume on the last short-term rally reaching a peak of  +74.0to overcome a (61.0) hurdle rate while NASDAQ net volume didn’t, a peak reading of +56.8 unable to overbalance its (60.1) hurdle.

My favorite tool to identify and follow trends lasing weeks to months, the Market Trend Indicator (MTI), is NEUTRAL, positioned to swing either way. The New York Advance/Decline line 1,326 net advances above its 18% weekly exponential moving average while the SPX and DJIA are each just below their 18% averages, 1086.06 and 10,207 respectively. Beyond that, the 21-day rule would signal uptrend if the SPX trades above its June 21 (1131.2), a development that would also break the downtrend reading in the SPX’s 3-day swing chart.

From April’s cyclical bull market high (1219.80), the SPX 3-day swing chart started its seventh swing yesterday. If this swing drops below the July 1^st low without reversing, it would confirm other technical indications the primary trend is down, including price and time overbalance for the SPX and a bear market pattern from the grandfather of technical analysis largely ignored by most but not by me, Dow Theory. If the SPX holds above the July 1 low and rallies above the June 21^st high, it increases the probability of even higher prices and a possible summer trading range. Such a move, if it occurs, would not contradict the bear market message revealed in May, but that message only indicates the top is in, not the extent, duration or pattern to follow.

Turn-on-a-dime short squeeze rallies aside, the cyclical bull market’s leaders, including small cap stocks, Basic Materials and Financials, are weaker than the broad market, particularly small cap falling more two weeks ago and bouncing less last week than the SPX. Defensive groups dominate the top ten group list (as measured by relative strength) including utilities and addictions, Tobacco, Brewers and Vintners. Despite last week’s clobbering, Gold Mining remains the number one group.

One surprise newcomer to the bottom ten group list is Platinum & Precious Metals, drug down over the past month by weakness in palladium and platinum and a handful of poorly performing gold mines, bringing to mind Mark Twain’s observation, “A gold mine is a hole in the ground with a liar standing in front of it.” Defense dropped to the bottom ten list as well, joining Home Construction which has been there six straight weeks and counting and both known for their ripple effects on other businesses.

Long-term government bonds remain strong and look to be heading higher despite a reduction in holdings by China and Japan, the largest foreign buyers. I expect near-term action to remain highly coordinated with the stock market and I think it’s too early to initiate short positions. As for corporate bonds, a Washington Post article quoted Standard & Poors that about $1.7 trillion in non-financial corporate debt comes due in the next three years, much of it junk-like and probably difficult to refinance if the economy slips.

Weakness in the U.S. Dollar index is greater than I anticipated, it’s 3-day swing chart in its eighth swing, but I still think a ninth swing is possible, carrying the dollar above its February 2009 high. Gold backed off as well, below its 50-day moving average and starting today just below a rising trendline from its December 2009 low, I suspect shaking out weak hands and potentially setting the stage for a rapid rise. A 2^nd London fix below 1136.50 would warn me I may be reading the pattern wrong. My recommended trailing stop sell levels are just under the February 5 low ($1058 2^nd London fix) for more recent purchases and under last September’s low ($989.50) for long held investment positions.

Last week at the Global Hunter conference, I met with a Chinese company attempting to roll up a fragmented industry, cash rich from a recent public offering when it promised investors accretive acquisitions. The game is afoot but it warned the acquisitions won’t be accretive because the private companies are selling for more than its public valuation.

From the miscellaneous file, airline charges for food, headphones and bags brought in $7.8 billion in 2009. From The New York Times this morning, Amazon reported that electronic books outsold paper editions by more than 1.4 to one over the past three months.

A Primer For Planned, Deliberate Speculation

Whatever strategy you choose, make sure it’s in synch with your own personality. I favor planned, deliberate speculation, a matter of self control, money management and market analysis. The strategy is relatively easy, the trick is working on the psychology, discipline and money management. The emotional burden is substantial, requiring balance to avoid seduction by the successes or being carried out during the inevitable “oops.” The three most important speculative attributes are discipline, discipline and discipline. Whether trend perception, timing or tactical error, success demands accepting responsibility for mistakes, guarding against certainty to execute on what must be done. Rigid long-term views lead to mistakes.

The rules are simple- trade with the trend, cut losses and let profits run. The three most important technical factors are trend, trend and trend. If you want to trade counter to the trend, take of walk or lie down until the feeling passes. While I favor ETFs, if you’re buying individual stocks, buy strong stocks in strong groups during uptrends and short weak stocks in weak groups when the trend is down. It’s a relative strength approach that works best in strong trending markets.

Plan ahead. It’s easier to put on a trade if you’ve done your planning and anticipated market moves either way. Forget about the ego of being right. The object is to make money. There only one side to the market and it’s not the bull side or the bear side; it’s the right side. The market wields the ultimate scale of profits; no one is smarter.

Figure out in advance the amount you are willing to lose on a trade. There will be losing trades; accept this fact. Losses shouldn’t bother you. What should bother you is poor risk control when you put yourself in a position of having to take a large loss. If you don’t manage your risk, you will be carried out. Keeping your risk small and constant is crucial. Always honor your risk points. This discipline enables you to establish and build aggressive positions.

The time to act is when something is happening. Buy the breakout. The action should have been planned in advance, so don’t over-analyze, procrastinate or hesitate when it’s time to act. You want the trade to go in your favor from the start. Buy or sell more as the market moves in you favor. Buy and average up on the long side on breakouts and as reactions pass, and just the opposite when trading the short side. The dollar amount of each additional purchase should be steady or decreased. Don’t lose site of the importance of money management. Move up stop sell orders as a stock moves higher. Don’t let winners turn into a loser.

Handling profits can be a hard as handling losses. It takes discipline and patience to stick with positions. I think it’s foolish to trade with time horizons under one month because big winners are needed to overcome losing trades, skid and commissions.

Money management is more important than timing. The most important question is what percent of equity to risk. In general, the risk per trade should be 1-2% of core equity, never more than 5%, including skid. Do not overtrade by buying too much in relation to your capital. Core equity is equity minus the risk in open trades to the stop point. Every time a position is added, core equity declines. Performance is generally optimized when the risk of the overall portfolio is around 25% of core equity. Returns tend to decline when the risk level is greater than 25%. When the risk is less than 25% of core equity, returns aren’t maximized.

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

July 22*               (Thursday)

August 3*           (Tuesday)

* An asterisk denotes a dynamic SPX price square in time; different factors account for the other dates.

Conclusion:

My recommended stop level for short positions is above the June 21 high (SPX-1131.23); I wouldn’t place them any higher. If stopped out, the plan is to short again on the next signal. I’ll defer counter-trend trades on the long side, leaving that to nimble, short-term traders. I think short positions tied to small cap indices, Basic Materials and other economically-sensitive sectors and groups make the most sense. A tighter stop above the July 13 high (1099.42) could be appropriate for newer positions.

As for investors, money can be lost in more ways than won. Winning investors in a bear market are those who lose the least. I think professionals should stay as defensive-minded as possible, keeping in mind valuations and the operating realities of the underlying business.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.