One Month Replay and Going Forward

One strategy I’ve been employing lately is buying strength. While many have been successfully “buying the dip",” buying the dip can kill you if you’re wrong. I often prefer buying strength. Buying when the market is up and internals are strong.

I only started buying this rally on March 2nd. I mentioned that it was tempting to buy in early February when many of the major averages hit their 200 DMAs, but that it was also the time of the highest risk. The traders that bought back in early February have been rewarded for taking that risk. I took a pass and waited until China improved technically. In terms of timing, I don’t believe there was a right choice in buying back in early February or waiting until last week. It is really question of risk tolerance (although in hindsight, I do of course wish that I had bought in early February when I wrote the post linked to above).

Because I just got started on March 2nd (after being long in early January as well), I’m only 25% invested. At this point, I generally have my stocks and etfs picked out and it is just about increasing position size and timing it. And of course adjusting stops incase the music stops.

So what is the plan for deploying more capital? We’re starting to run up against resistance levels on the major indexes. The fib lines on this SPY chart highlight the resistance in the 115-117 range.

If we can break that resistance, we might be able to jump into the next box from 117-130. There will be bears that try to short this resistance as another top. There will be longs that bought in early February that want to take off profits. Momentum indicators such as RSI show that the market is overbought. A reason to sell? Not from my perspective.

I’m not going to make real money by buying a wiggle on March 2nd with 25% of my capital and riding it to March 12th. It’s been a great 10 days, but it is not going to make my year. What I have built over the last 10 days is a very nice cushion if the market sells off. I now have insurance. I can use this profit cushion to trade using profits rather than dipping into my capital.

So I’m passing on the option to sell here. My goal has always been to catch a multi-month trend rather than a 10 day run. Ultimately, that is what I’m gunning for. If my profits over the past 10 days evaporate than so be it.  But do I add to my existing positions at these levels?

I would say that I’m going to take it easy here. I’m going to see if the major indexes can consolidate and break through this resistance. If the market continues higher, I’m only 25% invested but I’m in some high beta names and I believe I’m in the right names. So I’m still getting some pretty nice bang for what I’ve got deployed.

The dream scenario? I like to imagine a situation where the market starts consolidating at resistance over the next 2 weeks or so. We get a breakout over resistance in late March/early April. April gives us a good ride. In mid-May, after accruing a bag of money, I sell and go away for a while.

I’m putting myself out there a little bit with this post. I had a very simple thought today about the relationship between volatility and demand for stocks. “Wow, I can’t believe CC has not put 2+2 together before.” I’m surprised I’ve never had this thought before, but I’ll share it for the benefit of others that have not thought about the relationship between volatility and demand.

While I’m somewhat embarrassed for never having this thought before, I also have not read about it in a book, on a blog or heard about it on TV. Here it is.

Think of yourself as a portfolio manager for a hedge fund. Let’s say in the back of your head you are targeting a 20% return for the year. When the VIX is at 35, you can maintain high cash positions and still achieve great returns because of the large swings in price. But what about when the VIX is at 17? You have days like today where ES is trading within a 2-3 point range. If you want to generate a big return, you need to buy more stock to make up for the smaller price movements.

So I would make the argument that as volatility goes down the demand for stock increases. Likewise, if there is an economic shock and an increase in volatility, the demand for stock goes down since the need to magnify returns goes down (you’re getting more pop from each position when the VIX is higher). Note that I’m ignoring other variables. If there is an economic shock, besides portfolio managers reducing position size because of increased volatility, they are also likely selling to reduce exposure out of fear. I’m just focusing on the relationship of volatility and demand.

If you think about things in extremes, it further illustrates my point. If the VIX is at 80, you could be 10% invested and generate excellent returns. You’re getting a ton of price movement. In contrast, if the VIX is at 5 you would likely need to deploy leverage to generate large returns.

So what does it all mean? It means that if things stay quiet and the VIX makes new lows, portfolio managers are going to need to deploy more cash (or leverage) in order to make big returns (ie., more demand for stocks). Likewise, when volatility spikes we’ll see a reduction in demand for stocks based solely on increased volatility (putting aside reduced demand due to other factors – fear, etc).

This is also somewhat of a chicken/egg problem because volatility is only going to go down if demand drives stock prices up. I get that. Still, I believe the lower volatility adds fuel to the rally. How do I prove it? Because I know that I’ll deploy more cash (or even leverage) in a lower volatility environment. I would have no problem being 80-90% invested right now if I was able to get there. But when the VIX was a 40, I would never take it that high. I had plenty of bang without deploying most of my capital. Put another way, just like a portfolio manager, I need to deploy more capital in this kind of environment to get a decent return.

Whenever I cruise the world of trading blogs, one common theme I often read about is how the government is propping up the market and that impending doom is coming to the stock market. Many of these posts come from individuals with substantial trading experience. It might come from a well known blogger or posters.

Here is an illustration of a typical post:

“The market is moving higher, but the volume is very low. Smart money is luring the dumb retail traders into the market but will pull the plug soon. I’m short from (fill in level here).”

OR

“These rallies are just fake pumps by Goldman. They’re looking to unload some positions to the idiot retail traders. All of my signals are telling me that this is a big pump and dump by Goldman.  I’m loading up on puts. There is no way $SPX will go above (fill in level here).

The question I pose is whether these “sophisticated retail traders” are really the very suckers that they post and comment about? After all, it is the traders with this kind of attitude that missed out on the rally and shorted the market for the past year. Are these “sophisticated retail traders” really the dumb retail traders? Is it possible that the “sophisticated retail trader” suffers from certain biases that cause them to be the dumbest group of all? Here are a few that I can think of.

- Trading in fear. A constant belief that a “black swan” 1987 like crash is imminent without a sound basis. This kind of fear causes a trader to miss being long when the market is going up and often causes them to be short during a bull market. Similar to trading in fear, being afraid of being the “sucker retail trader.” Being afraid of “buying the top.” And not being afraid of buying the top because of financial loss, but because of ego. The “sophisticated retail trader” can’t deal with the possibility of buying the top and letting “Goldman take advantage of them.” 

- Overconfidence. You have several years of experience under your belt and laugh at the guys at working talking about buying Apple because they love the new iPhone. Sure, the guys at work may not be sophisticated traders, but does your few years of trading experience make you a trading genius? But the guys at work read Smartmoney and Kiplingers and I read Zerohedge and Karl Denninger. “They’re idiots, I know the real deal.” Is the joke really on the “sophisticated retail trader?” Is reading all of this doom and gloom just causing the sophisticated retail trader to either miss good long opportunities or short the market at the worst possible time?

- Being a contrarian for the sake of being a contrarian. When I was in high school, some kids sported a gothic look. Other kids wore their jeans around their ankles. I hope I don’t offend anyone that did this, but these kids looked like idiots. I always suspected that kids dress different than the mainstream crowd so that they could have a theme. It is a need in some people to feel different and unique. I think many “sophisticated retail traders” like to be contrarian just for the sake of being contrarian. It is more fun to win when everyone else is losing.

In high school you just look like an idiot if you dress like a fool. If you need to be constantly against the grain in the stock market to satisfy the need to be different, you will likely lose a lot money. Sure going against the grain pays off big sometimes, but usually the herd is right (despite the misguided thought that you make money “running against the herd”). You have to pick your spots carefully. More times than not, the herd is right.

I’ll close with the following illustration. Picture a smart money trader like Steven Cohen. Step into his shoes.  When he thinks of the dumb retail trader, who does he picture? Sure, there is the guy at work that buys Apple because he likes the iPhone. But many novice traders don’t make that many trades. A large proportion of these types are buy and hold investors. So they’re not trading everyday. Is it possible that he pictures someone else? Is it possible that he pictures the “sophisticated retail trader?”

Is it possible that the "sophisticated retail trader” is the dumbest of all retail traders?

This post is an addendum to yesterday’s post on big picture trading themes. I picked up a copy of the IBD 100 today. IBD is a great way to shortcut the process of locating momentum stocks and I highly recommend investing $3 to pickup a copy on Saturday morning.

The point of this post is to plug the IBD 100 stocks into the trading themes I mentioned yesterday. Before I get started, let’s briefly take a look at our moving averages. Moving averages are not a holy grail, but I do find them to be an effective tool to provide an objective big picture view of the market. I mentioned last week that I upgraded my view on the market. I’ve upgraded my view for two reasons. First, the moving averages are trending up again. Second, because I’m able to find stocks and sectors to buy again.

Major indexes: All are trending up.

Precious metals: Trending up.

Commodities: A mixed bag. Oil and the base metals are trending up. Livestock and Cotton are moving up. Grains, coffee and cocoa all continue to decline.

Currency: The FXE (euro) and FXB (pound) are in bear mode trading below their major moving averages. FXE does appear to be basing as I predicted it would. FXB moved through my price target but has since come back to my downside price target. FXF (franc) is also in bear mode. This is just another way to say that the euro zone is weak. In terms of strength, the currencies of the commodity based economies are strong. FXA and FXC are in bull mode.

Bonds: I always watch the bond funds as an indicator. We saw a little dip during the recent correction, but they are all trading above their MAs again.

Conclusion: It is no accident that I started adding long positions last week. I’ll let the market dictate, but it is possible that we’re beginning a leg higher. 

TECH

I mentioned Tech as a primary theme. Not only is traditional tech performing well, but biotech is also moving.

IBB is in the process of taking out its August 2008 high. So if you buy the QQQQs to pick up the tech theme, you also pick up biotech.

The largest component of the QQQQs, AAPL, had a breakout over its all time high on Friday after a multi-month consolidation.

If you look at this 5-year chart of the QQQQs, it is somewhat tricky where to pick an entry point. The 50 DMA seems to be the best choice at $45. I expect resistance in the $48-49 range so building at position at $46.50 doesn’t seem like a great idea. If we do get a leg up in the market in the coming months, I would expect to see leadership from the QQQQs. Why? From a fundamental point of view, I believe the broad category of tech is in a bull market. From a technical perspective, the IBD 100 is littered with tech stocks.

Approximately (it is somewhat subjective classifying companies) 20% of the IBD 100 can be labeled as tech. Many of these names are in the QQQQs:

AAPL, PCLN, NIHD, CTSH and SNDK. You also pickup ISRG and a bunch of biotech stocks which in part comprise IBB. If we do get a leg up in the market, the QQQQs are an index I want to own.

CHINA

12% (12 out of 100) of the IBD 100 is comprised of China stocks this week. And trust me, if the market goes higher, the percentage will increase. I’ve said before that I don’t have a feel for any of these Chinese companies and that I won’t buy them directly. PGJ is a great way to get a piece of many of these high fliers while diversifying risk. Moreover, if there is a change in sentiment, you can be out of China in a couple of clicks.

I had also mentioned that I believe the commodities trade is really just a derivative theme off the China primary theme. If China moves higher, I think we’ll also see Brazil, Canada and Australia move higher. I think it is fine to simply buy China since I see buying commodities in any form as just a derivative bet on China. However, some diversification never hurt anyone and we might get a little more pop out of some of these derivative/secondary bets.  Therefore, I added a position in EWZ on Friday and I would be looking to diversify my China bet by purchasing EWA and EWC as well.

BANKS

I also mentioned that I considered beaten down bank stocks to be a primary theme. You won’t see these guys in the IBD 100 because fundamentally they don’t meet IBD’s earnings criteria. I consider the banks to be value plays rather than momentum plays. I’m playing the regional banks through IAT and may supplement this theme by adding a few select financials. I already own some C and GE.

THE PLAN

My trading plan is very simple. I started adding positions last week using the framework I have laid out in this post and in my post on Friday. I believe there is a good chance that we’re going to get a leg up over the coming weeks (and hopefully months). My primary vehicles will be PGJ, QQQQ (don’t own yet), IAT, EWZ, EWA (don’t own yet) and EWC. I’m currently only 15% invested. I’ll be looking to scale up my positions as profits increase. For example, if next week goes well, I might scale up to 30%. If next week is a stinker, I’ll either get stopped out of my current positions or I’ll wait to add until the market goes higher.

When I trade, I always try to keep a bigger picture in mind. While I trade on technicals, I still do keep a broader fundamental view. But unlike fundamental traders, I let the technicals tell me what the major trends/themes are and then I may read up a bit to understand the bigger picture. Many fundamental traders take their own view (dangerous) of the big picture even if the charts are telling us something much different.

For those that have been reading over the past week, I’ve made a shift from the sidelines to adding long exposure. You might say that I’ve upgraded my view on the market.

Here is how I see the big picture. I have spotted only three primary trends. First, is the China story that we are all so familiar with. Second is tech. Third is financials. I rank those in order of importance. China is really a super trend.

China is the engine behind the world economy right now. Flowing out of this primary trend are smaller secondary trends such as commodities and globalization. With respect to commodities, take a look at Australia, Brazil and Canada. China’s growth is fueling the need for commodities from these countries which is subsequently causing economic growth in these countries. In my view, investing in Australia, Brazil and Canada are really just derivative bets on China’s growth. If China declines, I believe it is a safe bet that commodities will deflate and that Australia, Brazil and Canada will suffer as well. Even gold is really just a derivative China bet in my eyes. I know many would strongly disagree. Many believe gold is some kind of special money store. I’m not buying it. When the market declines, all boats are lowered including gold. It isn’t a special safe haven. So it all comes back to China.

Another secondary theme from the China theme is globalization. When you look at the S&P 100, most of the companies have some kind of China story. Remember how Google tanked when they announced that they might pull out of China? So if China tanks, the globalization story for the S&P 100 (and many other smaller US companies too) goes down the tubes. This is why FXI and PGJ are the first two ETFs that I always look at. From a fundamental point of view, if those ETFs are not working, everything else is going to stop working too.

My next primary trend is the broad category of tech. Many of us that follow the US economy have a sense of disappointment. We look at our economy and see an economy of credit and services. We don’t see tangible industrial production like we see in China. We’ve got Boeing, GE, a weak auto industry (but getting better) and some other names to be proud of, but we’re not the export economy that we desire to be.

I think one major theme passing under the noses of most people is Tech 2.0. So many people got burned by the Internet bubble, that they are not seeing the second coming. Amazon is now a primary retailer for most people. Apple has changed the entire media industry. For a while, it looked like services such as Napster would ruin the music industry (and really film too). But then Apple came out with the iPOD and made it so convenient to pay a buck for a song that it simply made more sense to pay than to dig through Napster for a pirated version of the song. Apple again changed the web with the iPhone. Until then, we bought clunky devices with a Microsoft operating system. These smartphones locked up just like Windows at the worst time and the interface is and was a joke compared to the iPhone. There are many out there that believe that the iPhone will become the primary device for Internet access for many people (and I’m sure it already is for many). Meanwhile, Google changed advertising with its Adwords platform. Google is responsible for killing old media and moving advertising dollars to the Internet. Because of Google, we now have services such as Facebook that can be profitable by selling advertising. Of course there are many other examples. But the point is that this tech revolution is driving the QQQQs higher and there is a fundamental basis behind it. While Detroit may be suffering, all is well in Silicon Valley. The VC firms are flushed with cash and bringing new ideas to the market everyday. While many tech stocks tanked with the rest of the market, I also noticed that these companies never really felt the pain that the broader economy did. Apple stock tanked, but nobody seemed to stop buying their products and the innovation continued. In fact, it is quite possible that the tech trend could continue even if the China trend breaks. A secondary trend off the tech trend is India. If you follow momentum stocks (e.g, IBD 100), you will often see names such as WIT on the list.

My final primary theme is financials. I’m not talking about JPM and WFC that are already trading back near their highs. I’m talking about BAC, C , GE (partly a financial) and many of the beaten down regional banks in the IAT ETF. Sure there are risks, but none of these institutions are currently in jeopardy of failing. You have KEY and RF trading at around $7. Both of the names once traded north of $30. Things can change quickly, but the solvency issue is currently off the table. Because financials are not real companies and don’t produce anything, their stock price can change much faster than a company that actually makes goods and has factories.

Here is an illustration. Before Bear Stearns failed, it was trading north of $60 per share. In a matter of days, it went to $0. I’m not saying KEY is going to $20 tomorrow, but these financials can move quickly in both directions. Just like Bear lost all its value in days, it is quite possible for estimates on these beaten down financials to be raised drastically over a short period of time.

This is how I see the big picture. Because I only started opening positions earlier this week, I’m currently only 15% invested but I’m looking to scale up so long as profits increase (see my post from earlier this morning). My current holdings:

China

Primary: PGJ

     Globalization: V, MA 

     Commodities: EWZ

Tech

GOOG

CTSH

Financials

IAT

C

GE

To make money this year, I’m going to need to catch at least two waves. I’m defining a wave as a period of time where the major market indexes trend without correction (ie., a shakeout).

Here is a visual:

In 2009, the big wave was from March-May. There was another good opportunity during July-August. There was a little nugget during September as well. You’ll notice that we’ve basically been sideways from October 2009-February 2010.

This is a very simple trading strategy. It requires a lot of patience and generally sitting on the sidelines during consolidation periods (if you’re good at trading ranges, go for it). You might do nothing for 6 months although you still need to watch the market so you are not caught flat footed when opportunities arise.

When you believe a wave might be starting, you dip your toe in and take a position. If and when the initial position goes green, you add to the position. I methodically continue the process increasing my exposure 5-10% each time. Obviously, the longer the trend, the better. It gives you more time to aggregate up your exposure. When the wave ends, factor in on the front end that you will lose some profits as your positions are stopped out.

With IWM breaking out, I’m now starting the process of looking for a wave to ride. I added my initial positions earlier this week.

Note that part of the process is jumping off “aborted waves.” In early January, I collected a small profit before the market turned down. I was hoping for a longer ride, but before I was able to aggregate up the trend fizzled out. An aborted wave will not make you rich, but it doesn’t have to end badly. Like I said, I did walk away with a small profit even though the trend fizzled before it got any steam behind it. Sometimes an aborted wave will be a small loss.

The point is that we never know ahead of time whether we’re jumping in on a longer term trend that we can ride (a 3-4 month move) or a little 2 week blip (what I term an aborted wave). So dealing with these aborted waves is part of the process. There will likely be a bunch of them through the year before you catch a real trend. I suppose this strategy is somewhat akin to fishing.

The jobs report was received well this morning so we’ll start with an upward bias. With my latest positions turning green, I may nibble a little bit today. Most likely, I’ll look to add exposure next week.