Tactics and Discipline Matter

SPX – 1022.58

DJIA – 9,686

July 6, 2010

“The bears have had the upper hand for two months, yet we don’t see the shorts  pressing their bets. The bulls argue that earnings are good, companies have clean balance sheets, and growth is supposed to slow after the initial post recession surge. Yet they don’t seem to back up their arguments with cold, hard cash.”

-Barry Ritholtz, July 1, 2010

A quiet session kicked off last week’s trading, followed by lopsided selling Tuesday, teaching traders that the rule to never short a dull market doesn’t apply when the primary trend is down, as is the case now. Most of the mainstream research I peruse still believes stock market weakness, peeling off more than $2 trillion in U.S. market capitalization alone and counting, is merely a correction, at least in print, each pointing out that bearish sentiment is too widespread. They’ll figure it out eventually but that’s the nature of markets. What really counts are tactics and discipline, trading but not overtrading with the trend, cutting losses and letting profits run.

The Market Trend Indicator (MTI) has no predictive value, designed instead to identify and follow trends lasting weeks to months. It is signaling DOWNTREND, a reading that stays in effect until one or more of the MTI’s three key indices close above their respective18% weekly exponential moving average. The SPX’s 18% average this week is 1093.51 and the DJIA’s is 10,238. Down five trading days in a row and 11 of the last 13, the New York Advance/Decline is 4,091 net declines below its 18% average.

Net volume indications often reveal a change in trend before the MTI but both remain in synch with the downtrend, peak net volume readings increasing slightly on last week’s break to (61.0) from (60.6) for the NYSE and to (60.1) from (57.3) for NASDAQ. These peak figures need to overbalanced (surpassed) by larger positive readings on the next short-term rally to indicate a potential change in the intermediate–term trend. Peak readings for the cyclical advance starting March 2009 were recorded early in the advance,  +73.2 for the NYSE and +70.2 for NASDAQ, each of which was overbalanced by negative readings of (80.6) and (74.0) respectively in early May.

Here’s how I figure and use net volume. Keeping demand and supply simple, there is a buyer and seller on every trade, prices rising when buyers outnumber sellers and prices fall when sellers out number buyers. Net volume is my attempt to measure the battle between these two forces, helping resolve which way the market is likely to trend and serving as one of my most important technical tools.

Advancing volume is the volume of all stocks that advanced for the day and declining volume is all the volume on stocks that fall each day. To determine net volume, I subtract declining volume from advancing volume and divide by total volume. The result is a percentage, either positive or negative territory. For example, if advancing volume was 780 million shares and declining volume was 525 million shares and total volume was 1.4 billion shares (including the volume for unchanged issues), net volume for the day would be +18.2. If declining volume were greater than advancing volume, and using the same numbers reversed (525 million shares advancing volume and 780 million shares declining volume) the result would be a negative percentage (18.2).

I always had trouble “reading” bar-type volume charts, so I started experimenting in the mid-1980’s. The idea to chart net volume horizontally came from George Seamans; a technical analyst in the 1930’s and 1940’s who charted total volume horizontally. These are interesting charts in their own right, known as “Equivolume” charts. I experimented with various moving averages to smooth out the daily volatility, settling on three days as the best balance between smoothing results and identifying change early in the cycle. I just use the numbers now but when charting, the percentage change in net volume is charted horizontally to the right, colored in green for positive net volume and red for negative net volume.

Over time I discovered that net volume holds the key to the intermediate-term trend lasting weeks to months. Specifically, as long as the peak net volume on each short-term rally stays above the peak net volume reading of each prior short-term decline, the uptrend remains intact. In a typical rally, net volume peaks early or in the middle of a move. The uptrend remains intact as long as the peak net volume reading on the rallies exceeds the peak net volume readings on the declines. Markets can bottom on a peak reading but do not top on peak readings.

Net volume is not a tool to pin point tops and bottoms but rather it typically confirms a reversal early in the move. For example, once the peak net volume on a short-term rally exceeds the peak net volume of the preceding short-term decline, the trend change is confirmed. The net volume signal typically precedes 3-day swing chart patterns and moving averages that I use to confirm the change in trend. I also maintain weekly net volume readings following the same methodology with three weeks worth of volume. The signals come too late for trading intermediate-term swings, but are helpful in determining and confirming the primary trend.

The way I’m counting, the May 25 low ( SPX-1040.78) ended the first section down in the bear market and the June 1 high (SPX-1131.23) ended the intervening reflex rally and marking the start of the second section down. Peak weekly net volume readings during the first section were (28.7) for the NYSE and (29.8) for NASDAQ. Peak weekly NYSE net volume readings during the second section are (17.9) so far and (20.7) for NASDAQ. If my section count is correct, we’ll likely experience weekly net volume readings larger than the first section figures before the next meaningful secondary reaction.

The first sign that I’m reading the pattern wrong would require enough follow through buying to sharp, interim short-covering spikes be to overbalance peak net volume readings now in effect, (61.0) for the NYSE and (60.1) for NASDAQ. Another important issue with regards to net volume is the shift of trading in NYSE to alternative markets. It hasn’t impacted results yet but bears watching. I track net volume records for the S&P 500 and S&P Small Cap 600 as well but don’t have the history with those indexes.

As for sections, the rule is to count three and expect a fourth, at which point we’ll apply the rules for price and time overbalance to watch for first indication a new bull market is underway, particularly if the sentiment and valuation backdrop is amenable. Meanwhile, how long the bear market lasts and how far the stock market drops are unknown, dependent on the interplay of fundamental factors and investor psychology yet to happen. I suspect prices fall enough (bias) to return stocks to their rightful owners, causing the financial press to regularly shift its focus to the most dire forecasts. The bulls would retort that is already happening, including a Robert Prechter interview in last Friday’s New York Times. I am in agreement with one of Mr. Prechter’s statements, “It’s pretty benign advice to opt for safety for a while.”

For the record, I think the top in 2000 marked the end of a secular bull market starting in 1974, followed by an “A” leg into the 2002 low and a liquidity-driven “B” leg into the all-time high the 2007. The “C” leg since has yet to finish, the March 2009-April 2010 cyclical bull market an “echo” rally in a longer-term unwinding of financial excess. Whether it finishes above or below the 2002 low remains to be seen. In any event, the outside reversal on the SPX quarterly candlestick chart is a particularly negative pattern warning that lower prices lie ahead.

Groups that were in the top ten list (as measured by relative strength) not long ago now dominate the bottom ten list, including Consumer Electronics, Home Construction, Recreational Products, Home Improvement Retailers, Recreational Services, Mortgage Finance, Automobiles, Travel & Tourism, and Business Training Employment. The top ten groups as of last week’s close are Gold Mining, Reinsurance, Brewers, Waste Disposal, Mobile Telecom, Multiutilities, Water, Fixed Line Telecom, Computer Hardware and Computer Services.

The performance differential between the two groups narrowed for much of the decline as investors (particularly those forced to stay fully invested by charter) shifted at the margin to more defensive areas that had lagged. Now that the switch is well underway, the worst performing groups started to fall more last week. Gary Anderson at Equity PM (www.equitypm.com) explains, “When the volatility of laggards approaches that of leaders, as it is now, the likelihood of crossover, and a subsequent episode of downside momentum increases.”

In other markets, the action in bonds presents a conundrum of sorts, with strength in long-term government bonds bringing up thoughts of a “double dip” while the performance in riskier bonds is barely beginning to discount such a possibility, as reflected in my credit spread chart based on differentials between Barclays Government and Corporate Bond indexes and iShares Investment Grade and SPDR High Yield Bond ETFs as well as the Confidence Index. In 2009, 151 issuers defaulted on a record $118.6 billion in bonds, a 13.7% default rate. Through the first five months of 2010, nine issuers defaulted on $1.7 billion of bonds, a full year default rate under one percent (www.paul.kedrosky.com).

Dealogic reported that second quarter stock and bond offerings by U.S. investment banks totaled $1.36 trillion in the second quarter, down 33% year-over-year. The slowdown started in mid-April and it doesn’t bode well for brokerage profits in the back half, as is starting to be reflected in the charts of the StreetTRACKS KBW Capital Markets ETF (KCE) and DJ U.S. Broker-Dealer ETF (IAI).

PowerShares launched a triple-leverage long-term treasury ETN (exchange traded note) and a 3x short ETN as well. LBNB is symbol for the PowerShares DB 3x Long 25-yr+ Treasury Bond ETN and SBND for the PowerShares DB 3x Short 25-yr+ Treasury Bond ETN. When it comes time to short, there’s also the ProShares Short Barclays 20-yr Treasury (TBT) and Direxion 30-year Treasury Bear 3x (TMV).

As for gold, the uptrend remains intact and I suspect a “blow off” move lies ahead, a thesis I plan to stick with until its parabolic uptrend is broken.

According to National Association of Realtor data, pending home sales fell 30% in May from April after the homebuyer tax credit expired. I suspect there was a lot of forward buying in prior months, much like what happened to automobile sales following the “cash for clunker” expiration. Unfortunately, I don’t have much hope for meaningful recovery in the housing market buying my take on the stock market. I am including an outstanding long-term chart of home prices from Novato, California-based money manager, Ken Winans (www.winansintl.com).

Dealogic reported that second quarter stock and bond offerings by U.S. investment banks totaled $1.36 trillion in the second quarter, down 33% year-over-year. The slowdown started in mid-April and it doesn’t bode well for brokerage profits in the back half, as is starting to be reflected in the charts of the StreetTRACKS KBW Capital Markets ETF (KCE) and DJ U.S. Broker-Dealer ETF (IAI).

According to National Association of Realtor data, pending home sales fell 30% in May from April after the homebuyer tax credit expired. I suspect there was a lot of forward buying in prior months, much like what happened to automobile sales following the “cash for clunker” expiration. Unfortunately, I don’t have much hope for meaningful recovery in the housing market buying my take on the stock market. I am including an outstanding long-term chart of home prices from Novato, California-based money manager, Ken Winans (www.winansintl.com).

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

July 9              (Friday)

July 14*          (Wednesday)

July 16            (Friday)

July 22*         (Thursday)

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

Conclusion:

I recommend maintaining stops on short positions with stops above the June 21 high (SPX-1131.23). The plan is to maintain short positions until the bear market is over, adding to positions if and as secondary corrections fail. My favorite inverse ETFs include the ProShares Short S&P 500 (SH) and for double leverage, ProShares UltraShort S&P 500 (SDS), ProShares Short Russell 2000 (RWM) and ProShares UltraShort Russell 2000 (TWM). Other leveraged inverse ETFs I think could fall more than the  general market include ProShares UltraShort Basic Materials (SMN), ProShares UltraShort Consumer Goods (SZK), ProShares UltraShort Financials (SKF) and a little further out the risk curve, the iPath S&P 500 VIX Short-Term Futures exchange traded note (VXX).

For investors who followed my advice, doesn’t it feel better to be in cash, waiting to put money to work after the downtrend is over? For professionals who stay invested, remain defensive-minded as possible, never overlooking 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.