Reward and Risk Increasing

I believe being positioned correctly over the next couple of weeks will have a great impact on 2010 returns. I believe that both the reward for being right and risk of being wrong is elevated right now (I’ll make my point below). I’m starting off today by doing a summary of the moving averages and taking a look at certain sector ETFs.

MOVING AVERAGES

Notable changes in the moving averages are as follows:

1. Commodities: SLV, NIB (Cocoa), BAL (Cotton) are now trading below their 200 DMAs. JJN (Nickel) is trading below its 100 DMA.

2. Bonds: LQD, JNK and HYG are now trading below their 100 DMAs.

3. Currency: EUR/USD (FXE) remains in bear mode. My target for FXE is in the $132 range. It is quite oversold right here, so I would expect a bounce before we hit the target. However, the break through horizontal and MA support makes it unlikely that we’ll see a reversal. I must admit that I am having less confidence in my 2010 prediction of a sideways USD based on the FXE chart as well as some of the other currency pairs.

Other notable currency observations:

GBP/USD (FXB) is also trading below its 300 DMA and is now solidly in bear territory with EUR/USD.

4. Volatility: $VIX is trading above its 200 DMA after breaking out from a bull flag. Note that we have not seen volatility above its 200 DMA since March-April 2009. Volatility is expanding.

INDEX ANALYSIS

On Friday, the market was down over 10 S&P points the entire day and reversed during the last hour. It is not surprising to see the bounce based on many of the weaker ETFs hitting their 200 DMA.

The following indexes bounced off their 200 DMA: XLE, XLF, SMH, XLB, XLU, XME and EEM.

Some might read this as a pivot point. After all, the market was down and the market reversed strongly once these indexes hit support. My argument against this being a buy point is that it would be pretty unlikely for these indexes to not find some support at the 200 DMA. With that in mind, I don’t put much weight in the fact that the decline found support. I would have been surprised if they didn’t bounce here. But how significant will the bounce be and how long will the duration be? I don’t see anything that makes me believe this bounce is more than just a short lived support bounce.

If we look at the major indexes (DIA shown above), I also see that the major indexes bounced of the infamous “Lehman gap” (see Oct 2008). Again, not a surprise that the indexes did not simply cut through such a strong support level.

CONCLUSION

EUR/USD (FXE) is getting crushed and is in bear mode. Moreover, GBP/USD (FXB) is also in bear mode and appears to be headed to $152 (another way of saying the dollar is in rally mode). As we might expect, commodities are getting crushed. Whether it is agriculture or precious metals, the currency reversal has deflated commodities. Additionally, the bond funds (LQD, HYG, JNK) are all breaking down below their 50 and 100 DMA and look poised to test their 200 DMAs. Volatility is also expanding (the $VIX) and now above the 200 DMA.

We’re getting close to a juncture whereby both reward and risk are increasing. The reward is timing your buy off the 200 DMA. If it holds, you get a fantastic entry point. It becomes the perfect “buy the dip” opportunity. Of course there is no free lunch. That reward does not come free. As I have written previously, the largest declines often come when volatility is elevated with the market indexes trading around or below their 200 DMA. So if this European  sovereign debt crisis actually does have teeth, it is possible that you might be buying right before a deep selloff.

For now, I think it is best not to buy this selloff. Here is what I don’t like:

1. Bearish Euro an Pound. The currency markets tend not be as fickle as the stock market. If these charts are in bear mode, I don’t want to bet on them quickly reversing. This means I expect a strong or sideways dollar. This is bad for stocks and commodities.

2. Bond Funds. Everybody has been calling a bond bubble, and we’re finally seeing these funds breakdown. Weakness in the bond market often precedes weakness in stocks. Or in this case perhaps more weakness in stocks.

3. Volatility. Volatility appears to be breaking out. While extreme volatility can be a contrary indicator, I would not call the VIX at 26 to be hitting extremes. Rather, I would say that we’re seeing an expansion of volatility. This is when things can get dangerous.

My plan would be to reevaluate many of the indexes discussed above when the main indexes (SPY, DIA, IWM, QQQQ) hit their 200 DMA. I would be surprised if Friday turns out to be the low. We’re simply too close to the 200 DMA on the main indexes and I would expect the 200 DMA to act as a price magnet.

I mentioned that XLE, XLF, SMH, XLB, XLU, XME and EEM hit their 200 DMA on Friday. Let’s see if the indexes hold here. If the market is going to continue higher, these indexes should hold while the stronger indexes should trade down (that’s how the main indexes will get down to the 200 DMA). Put another way, we’ll see a mean reversion where the weak indexes flatten out and the stronger indexes (e.g, IAT) trade down.

If these weaker indexes breach their 200 DMA, I would expect them to be leading indicators that the market will continue its slide. Let’s see if they hold. In particular, let’s see if FXI finds support off the 300 DMA. Remember, I don’t think this market is going anywhere without a healthy China.

(FXI nearing the 300 DMA)

Ultimately, playing the market at this critical juncture should mean scaling into it. If I do see conditions that make me believe that support will hold, I would start by entering a position of 10-15% of my total capital. I would only add to it once profits started to accrue. Adding a large position size on this pullback is tempting because of the potential reward but it is a risky proposition for the reasons referenced in my post hyperlinked to above.

Meanwhile, if I start to see confirmation that the market is heading lower, I would wait several weeks to get short. If this is something bigger, there will be plenty of time to get short. I don’t want to be early because the move lower through critical support will undoubtedly be sloppy in both directions. I would rather wait for a definitive break to let me know we are in bear mode. Trading through that slop would be very very difficult.

I’m busy doing other things today since I remain 100% in cash, but I did want to chime in with the market moving strongly lower again. The bull flag on the VIX has broken over the 200 DMA. The VIX is also ticking up close to 30.

I’ll do a rundown over the weekend, but I definitely would not buy into the close today. Internals are very weak (TRIN is over 1.50 as I type this).  I mentioned before that the indexes were headed to their 200 DMA. We’re not there yet.  Once we get there, a decision will need to be made whether to buy the correction or whether this is something bigger. Next week could bring big risk/reward opportunity. If the indexes do make it to the 200 DMA, it could be a great buying opportunity if this is just a correction.

However, buying at the 200 DMA carries a lot of risk. Remember my post titled “Don’t Fear The One Day Crash” Well, when you buy around the 200 DMA with an elevated VIX it is the precise point in time when the market is most vulnerable to a big one day event.

More to come over the weekend.

JNK is down 2% today ($.80) trading right at its 100 DMA. Let’s see if it holds. Note that an $.80 move is 2x its ATR. We’re also seeing the decline on high volume like we are seeing in many of the major indexes.

Bull flag on the $VIX. We breached the 200 DMA briefly at the peak of the flag and it looks like voltatility is making another run.

GLD with a solid breach of the 100 DMA. GLD appears to be on its way to horizontal support and its 200 DMA at $100.

I’ve been noticing over the past few weeks that yields have come down ever lower on CDs. I didn’t even think it could go much lower. We’re at the point now that Schwab doesn’t even broker CDs for 30 or 90 days. A 1-year CD only offers a yield of .4%. Just a short time ago, you could get a 1% yield on a 1 year CD. Anybody have a good hypothesis for why banks have stopped issuing CDs?

I’m not Nostradamus, but one possibility that I am keeping on my radar in 2010 is a sovereign debt crisis. Handicapping the importance of news is difficult. What stories are pure fear mongering and what stories should we take seriously?

We’ve been reading about a debt crisis in Greece, Spain and Portugal for months. I wrote about it previously on December 9, 2009.

While I’m not an expert on handicapping the impact a sovereign default by Greece, Spain, Portugal or any combination thereof,  I will say that the repetitive nature of the story gives me cause for concern. Many people tend to think that economic crisis occurs overnight, but the truth is it usually takes a long time to unravel (see “Discounting One Day Market Crashes”).

This sovereign debt story is starting to get my attention because it is becoming repetitive and it is showing up in the charts.

  Note that EURUSD bottomed out at the March 2009 bottom and topped out in December 2009 when we first started hearing about the sovereign debt crisis. As I mentioned previously, the EURUSD pair is in bear mode which is not good for stocks.

We have to look no farther than August 2007 to illustrate an example of a story that jilted the market for a few days, hid itself for a while, but kept coming back like a bad cancer. This story was written pre-Lehman in August of 2008.

On August 9, 2007, it became clear that fear had paralyzed the world’s credit markets. The question was no longer only about the quality of assets or the availability of cash. Everything was suspect and no one was willing to take any chances.

Early that August morning in Paris, BNP Paribas announced that it was stopping investors from withdrawing money from three funds because it could not determine the market for their holdings.
"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating," the bank said in a statement.

Source: Portfolio by Jeffrey Cane, The Great Panic, August 8, 2008

So how do I evaluate this story? Well, back in December all of our US indexes were technically sound. Objective indicators such as moving averages were pointing up and the market was trading above its 50, 200 and 300 DMAs. In many cases, it was even trading above shorter term MAs. I’m not going to get spooked by a story when the technicals are solid.

It is now two months later, and the story is starting to repeat itself. The major US indexes have broken below their 50 DMAs and are clinging onto their 100 DMAs. Meanwhile, China stocks, which were the engine driving the market higher, are arguably in bear mode already. And I don’t think any technician could disagree that if it is not in bear mode, that it is on the precipice of falling into bear mode.

(A complex head and shoulders top with a throwback to the 200 DMA. Note the volume on the breakdown)

So as I try to figure out the themes in 2010, the potential for an event originating from Greece, Spain and Portugal (and perhaps Italy too) seems like a real possibility. Let’s watch and see if the story continues to repeat like the credit crisis story did after August 2007. Let’s watch EURUSD and other cues that might confirm the story.

There is an article in the New York Times about a growing group of homeowners choosing strategic default.

New research suggests that when a home’s value falls below 75 percent of the amount owed on the mortgage, the owner starts to think hard about walking away, even if he or she has the money to keep paying.

Source: New York Times

My problem with the financial industry is that all of this is 100% foreseeable. Here is a quote from an executive at Wachovia:

An executive with Wachovia, one of the country’s biggest and most aggressive lenders, said during a conference call in January 2008 that the bank was bewildered by customers who had “the capacity to pay, but have basically just decided not to.”

Bewildered? On the front end, lenders couldn’t figure out that if a borrower had negative equity they might not walk away? Come on. Why would anyone sink money into a property that is worth substantially less than you paid if you can walk away and get a fresh start?

It makes sense to do so. The current regime permits borrowers to shift their losses to the bank. The stakeholders in the bank don’t feel the pain either since it is ultimately backstopped by the government. So ultimately, the current regime permits borrowers to keep the upside and externalize losses on society (ie., the taxpayer).

In places such as California where loans are non-recourse, the only incentive not to walk away is harming your credit score. If your credit is already in the dumps, then there is literally no incentive to keep paying.

Strategic default is always a worry in commercial lending and precautions are taken on the front end to prevent it. Similar precautions should be taken with residential mortgages and we would not be in this mess. Two simple fixes:

1. Full Recourse. Residential loans should be full recourse loans in all states. In many states, residential loans are fully recourse. So even if the borrower sends “jingle mail” to the lender, the lender can still pursue the borrower personally for the total amount of the indebtedness less the amount of proceeds received at a foreclosure sale.

Keep in mind that even if the lender does not want to deal with suing the borrower, there are vultures out there that  do. There are companies out there buying these notes for pennies on the dollar and pursuing borrowers. My point is that a full recourse loan would provide a tremendous disincentive to simply walk away. It would also force home buyers on the front end to carefully analyze taking out a loan for hundreds of thousands of dollars.

Imagine if borrower’s had to carry this risk during the bubble years? If an “investor” knew they might have their wages garnished or other assets seized if the house lost value and the investor defaulted (either on a voluntary or involuntary basis), many of these investors would not be lining up to enter the house flipping business. The investors would have to carry the risk of loss rather than the federal government.

This may sound a bit harsh, but it should be a big deal to take out a loan for hundreds of thousands of dollars. In this country, there are people that cannot afford a $1,000 LCD TV yet are able to “afford” a $250,000 house because of the government’s intervention in the housing industry.

2. Equity. Homebuyers need to come up with a 20% down payment. The homeowner must have a skin in the game. If the home declines in value, the homeowner needs to take the hit first. Not the bank (or the FHA, Fannie or Freddie). It is not that I care about banks, but the problem is banks (and GSEs) are ultimately supported by the government meaning if the bank picks up the bill than it means there is a high probability that the loss of value is being externalized on society rather than on the homeowner.

I’ll end my rant by saying that it a joke that many are bewildered by how this housing mess occurred. Besides the obvious structural problems with home loans I have mentioned above, the government’s intervention in residential lending will continue to cause bubbles and financial instability.  Two other changes we need:

1. Abolish the FHA. Loans with 3-5% down breaks the equity requirement I mentioned. The FHA cannot exist because the risk of borrower default is carried by the government (and externalized on society) rather than the borrower. We then end up with the strategic default problem when the loans go into default.

2. Retool Fannie and Freddie. The original mandate for the GSEs was to package mortgages into a pool and sell them to investors. Under no circumstances should a GSE be allowed to hold mortgages for their own account. Because of scumbags like Barney Frank (the guy should be in jail), the government owns by some estimates over 50% of the residential mortgages in this country. So the losses are taken on by the government rather than by the originating lender and the borrower. Put another way, how do we have a system where the government takes the risk on a home loan? Shouldn’t 100% of the risk be allocated between the lender and the borrower? Why should society pay?

I mentioned on December 12th that I expected a range bound market in 2010. I mentioned 2004 as an analog.  We’re now a month into the new year and my big picture view remains in tact. On 12/31, SPY closed at $111.34. At 3:52 ET, SPY is trading at $110.47. So with all the market talk, the major indexes haven’t moved yet in 2010.

I’m much more of a trend/swing trader than a scalp/day trader. It is not surprising that my gains have been modest in 2010. Only the short term traders have really had the opportunity to do well (emphasis on opportunity). There might be a few others that were able to ride it up in mid January and short the market at the opportune time but I’m willing to bet that is a small group.

So what is the plan? I continue to be patient. I’m don’t like missing opportunities but I also don’t like losing money. My “pyramid plan” has arguably been a good one in 2010. It got me a piece of the move up in early January and got me out during the drop.

I’m hoping that the primary trend remains up. If the market goes higher, I’ll be able to start adding positions again very soon. I’ll recommence the pyramid plan. There won’t be as much sitting on the sidelines. If the market goes down, I believe I’m likely months away from changing from a long disposition to a short disposition.

I’ll conclude by saying that I’m keenly aware that writing a blog post about sitting on the sidelines has no sizzle in it. I’m bored as well. But I believe this boredom is also the best recipe for success in this market.

I’m fortunate that I don’t have anything pressuring me to come up with ideas (even if crappy) everyday. That’s the benefit of not being on TV (e.g, Cramer), not running a fund with rules requiring me to be invested, not running a subscription service for readers, etc. You get the point.

This morning I quickly went through the strongest sectors (trading above 20 DMA) and the weakest sectors (trading near or below their 200 DMA).

Strong: IAT, IBB

Weak: FXI, PGJ,  IAI (below 200 DMA), GDX (trading at 200 DMA) XLE, XLK, SMH, XLB, XLU, XME

Most traders are trying to make a judgment right now whether the recent weakness is a pullback (and a buying opportunity) or the start of a bigger move down. Put another way, will we see SPY firm up here or will we see it test the 200 DMA (about 8% lower from here)?

Besides being deeply focused on China, I’m watching several of the weak ETFs mentioned above. If the market is going to find support, I would expect to see the indexes trading near their 200 DMA to firm up. If these weaker indexes drive through the 200 DMA and China continues to be weak, it makes it highly likely that the major indexes such as SPY will test their 200 DMA as well.

With respect to the indexes trading below their 200 DMA, I’m watching to see if the dip below the 200 DMA is just a “stop overrun” or something more. Will indexes such as IAI, FXI and GDX trade up through their 200 DMA or will the 200 DMA become resistance?

I’m starting out tonight by taking a look at the moving averages. I have provided an updated table below.

There was more technical damage done last week. The 100 DMAs were broken on SPX, QQQQ and IWM. PGJ (China ADRs) broke below its 200 DMA by just a touch joining FXI (state owned China) which was already trading below its 200 DMA.

Other notable breakdowns were GLD breaking below its 100 DMA and $USDUPX breaking above its 200 DMA. Speaking of currency, FXE (EURUSD) is now trading below its 200 and 300 DMAs and is in total bear mode. At the end of 2009, I said that I expected a range bound USD but I have to admit the total breakdown on FXE and breakout on the $USD index over its 200 DMA is pretty bullish for $USD.

So what does it all mean? I have posted multiple times that I do not want to be long in this market with China broken. FXI has cleanly broken its 200 DMA and PGJ is trading just beneath it. I objectively label China to be in bear mode based on FXI and PGJ trading below their 200 DMA. I remain particularly pessimistic about the China charts because of the complex head and shoulders top on FXI.

With the major indexes breaking down below their 100 DMAs, it is looking more likely that we’ll see a correction to the 200 DMAs. I am personally comfortable waiting out the correction on the sidelines if this scenario plays out rather than trying to short the market down to the 200 DMA.

I label an index to be in bear mode if it is trading below its 200 DMA. If the bear market does reappear, there will be a ton of time to trade it after the indexes breakdown below their 200 DMAs (after I have deemed these indexes to be in “bear mode”). That is when the real bear party would start. Not just yet. Meanwhile, if this is just a correction, it is unlikely that I’ll be able to play the move down and reverse course well enough to make shorting the market now worth my while. I’m not saying it can’t be done, but for me it is simply not worth the risk and frustration. I’m willing to sit the market out for months if I need to do so. Put another way, I’ll wait for the market to regain a solid up trend or I will wait for a solid downtrend to commence.

The $VIX is sporting a bull flag. Another warning indicator for those with long positions.

If you believe this is just a correction, there are a few bullish stocks still left in the IBD 100 (which is where I often hunt down momentum stocks).

Medical Devices: ISRG, KCI, VAR. The IHI medical device ETF is also an option.

Health Care Plans: HUM, CI

I definitely prefer the medial devices over the healthcare plans. I’m not enthused about trading health care plans due to the headline risk. They may shoot up like a rocket, but it is hard to sleep at night owning these stocks with Obama lurking in the background. We’ll know more about HUM and CI this week. HUM reports tomorrow and CI on Thursday.

Full earnings and economic calendars are available from briefing.com (see right hand navigation pane).

That’s all for now.

On December 8th, I mentioned the relative strength from Japan and the weakness from Germany, Australia and Canada.

I was reading IBD this morning and the paper has a graphical representation by country of the returns year to date of the benchmark ETFs for the countries in the table below. Note that Japan was the only country in the green in January and the extremely weak performance turned in by Germany. Germany is a mature economy compared with the higher growth countries such as Brazil and China. The weakness in Germany therefore sticks out more to me than the weakness in Brazil and China.

If you pickup your average financial publication or listen to a talking head, they almost always beat the drum of increasing international exposure.  The conclusion almost always has fundamental underpinnings based on the belief that these smaller countries will grow at a higher rate than the United States.

The part that is not conveyed to the average investor is that these countries can also suffer deep recessions and depressions with much greater velocity than in the United States.

The average investor needs to know that the world economies are highly correlated most of the time. I think many novice investors have the unreasonable expectation that they can buy a/an (insert non-US ETF here) ETF and have a legitimate shot of generating a positive return even if the US market goes down. The reality is that the world markets will generally move together.

I think a better way to view foreign ETFs is simply as a levered bet on the S&P 500. In boom times, you’ll  get a lot more bang for your buck investing in countries that have potential for high growth (think Brazil, India, China Russia). When the world economy is weak, expect that leverage to work against you in a big way.

Sophisticated traders already know this. But for the newbie investor/trader, I want people to know what they are buying when they go international.