Monthly Archives: February 2012

2/2/12 to 2/21/12

Posted by C.J. Mendes on

February 21th, 2012

I have been leery of the broad market advance since late January. The advance started out from a very oversold level in October and combined with favorable seasonality, traders were able to push stocks higher through year end and right up to current levels. The magnitude of the move higher has been pretty incredible and without pause which is concerning and becomes more concerning as the market pushes higher without a breather. The broad market indices are all trading at overbought levels we have not seen in some time. As I have mentioned before this is not always a bad scenario. Markets can stay overbought for extended periods and continue to push higher. In these scenarios which many technicians call “good overbought”, the advance is complemented with a general increase in participation and volume, both of which have not been there since the beginning of the year. In evaluating the trading activity over the past month, the volume has expanded heavily into pullbacks and collapsed into rallies. The breadth of the market during this advance has narrowed tremendously as well. What started out as a broad based advance has narrowed to include only a few sectors and within these sectors, only the very best performing companies. Again this is not what we look to see in an expanding rally.

No rally is ever perfect and there are always factors that will go against a thesis. There are always going to be issues that make us worry and climbing that “wall of worry” is par for the course in today’s marketplace. The problem here is that there are so many factors pointing to a reversal that it is hard to ignore them. I could rattle a bunch of stats for us to chew on such as increased insider selling activity, complacency evident in the volatility markets, sentiment studies, commitment of traders reports, the rising price of oil etc. etc. The fact remains, the market continues to inch ahead…

While the domestic economic picture has improved, is the improvement necessarily a boost to stocks? Obviously in the near term it has been but considering the back drop of the fed and the enormous injection of liquidity over the past few years, is a rapidly improving economy something that may warrant some inflationary concerns for the fed making QE3 a much more dangerous and unlikely probability? I certainly believe that is a real risk to the forward projections for stock prices. Corporate earnings this quarter have also not been as good as many had expected. I mentioned the ex-Apple earnings picture for the S&P 500 and the facts are that earnings are slowing down.

Too be fair, the narrow advance has also not brought out sellers in full force yet. Catalysts have not been dire enough to create much of an appetite to sell into the one way market. The path of least resistance has been to drift slightly higher but what has happened here is that the one way market action has progressively made markets vulnerable to a swift pullback. In fact, I know many bulls on Wall Street who would welcome a pullback here to again bring some “balance” back into the market.

The pullback will come. The exact catalyst and exact moment for this move is up for discussion but not whether it will happen. Grinding, narrow markets do not correct by grinding lower they correct by making decisive and sharp moves against the prevailing trend trapping in the latest to the party.

Today we closed just below the highs of 2011 of 1363.21. Lots of overhead supply at this juncture and we continue to churn around this broad level of resistance.

February 16th, 2012

Wanted to review the current positions and share what I am looking at in regards to targets etc. The Euro has been on a downtrend weak or so when we entered our bearish FXE spread. Looking at the 10 min chart below, we see the neat step down ladder pattern particularly during the past few days making incursions into the 3rd standard deviation below its 40 period moving average and subsequent weak surges to the 1st standard deviation below the same average and back down. Note that as we have pushed below 130, the surges have reached a bit higher into the 40 period meaning that there is a bit more buying interest on the rebounds.

If we take a wider lens look at the FXE using a daily chart, it becomes a bit clearer why the 129.50 level will probably act as a bit of a speed bump on the decline. It falls exactly on the 40 day moving average which has recently flattened and is actually beginning to trend just so slightly higher. I think from a short term standpoint, I think there is downside exposure to the FXE to around 126.80 to close an open gap but at the same, the current news flow and day to day happenings in Europe obviously will dictate how we trade. The way I see it, Greece leaving the Euro would be a positive for the European currency and more bailouts keeping Greece in the union would serve to weaken it. The knee jerk reaction to either event will probably be exactly opposite that but I think eventually, this is how this plays out. I like this move to take us to around 128.50 before a pause.

On Gold and our GLD position. The recent breakout in the GLD was a true breakout above the short term wedge pattern. The metal is unwinding some of the excess refreshing before a move higher. The 40 period moving average in the daily charts should hold as support particularly as it is rising rather rapidly. This is our near term target for the GLD and depending on the magnitude of the moves over the next few days that should put us around 163.00 or so. Gold is also obviously closely tied to the moves in the currency market as today it trades much like a currency. The fact that our domestic economy is improving (ie: lowering the probability of QE3), is bearish for Gold but the credit crisis in Europe and demand from India and China should keep Gold well supported and on an upward trajectory.

The QQQ bearish spread. Over the past 24 hours we have gotten a favorable move in Apple but Microsoft, up over 2% today, is keeping the QQQ relatively subdued. To say that the index is overbought is an understatement. Yesterday’s blow off move in Apple may be the beginning of a corrective move lower in the technology sector in general. The QQQs are trading solidly 3 standard deviations (have been for 3 weeks now) and in the past this has usually meant a corrective move as sector rotation takes its toll. Keeping the rising trend line from the October lows we see a move to anywhere between 58.00 and 60.00 depending on how quick it develops. If we take a look a similar periods in the past as the weekly chart demonstrates below, we can clearly see that when the sector sells off it does so very quickly.

February 15th, 2012

Valuation and forward multiples are always in focus at the end of the earnings announcement cycle. The assumption for most perma bulls on the street is that stocks should be valued at the higher end of the historical averages and perma bears feel that stocks should be valued on the lower range of historical multiples. The reported earnings per share of the S&P 500 on an annual adjusted basis is currently around $96 per share. The way I have always values the market is simply to adjust the multiple based on both a measure of projected earnings and current macro risks to the general global economy.

The average earnings multiple based on consensus for the past 50 years is 15 but if we take a look at the chart below we can clearly see that the actual variance over time is substantial. In other words, multiple averages are not static numbers that can be used across the board to value equity. Many pundits who cross the airwaves of CNBC and Bloomberg claim that the market is “cheap” because it is not trading anywhere near the historical multiple average. They simply take the current annualized earnings for the S&P 500 which should come in at around 96 dollars for the 4th quarter of 2011 and multiply it by the historical average multiple of around 15 times to get a year- end target of 1440 on the S&P 500. Some even proclaim that because the forward earnings projections are so great, a higher multiple needs to be used (anyone remember the Tech, dotcom bubble?). So that is where we get the ridiculous projections of that we are currently exposed to in major financial publications and from prominent economics professors… Here is problem, we have to calculate under what macro-economic realities and circumstances these earnings have been generated. We all know that the current rally has been predicated on the immense liquidity programs of the Fed and on favorable exchange rates on profits generated overseas (debasement of the currency). All well and good so far and it is what it is. From a trading perspective we have participated in this fantasy and generated profits. At what point do we begin to add a greater measure of risk to the Fed being able to land this ship intact? I don’t want to go into the merits of this action because this post is not meant to put my two cents in on whether or not the actions of Ben Bernanke and the Fed have been appropriate ( I am not an economist and don’t pretend to be one) but to say that this action, like it or not, has to be used to handicap current earnings and forward earnings projections.

I am of the opinion that from a fundamental valuation, as I see it, markets today are fairly valued at a multiple of 13 to 14 times annualized earnings. At 13 we get a number of 1248 on the S&P 500 and 14 we get 1344. Not a coincidence that we are currently sitting near this relative value. If we would grant that earnings will grow between 4% to 5% from this point over the next year we get a figure of $100 EPS and multiplying that by 13 and 14 respectively we get a forward price target on the market of 1300 to 1400.

February 14th, 2012

I wanted to talk a bit about the concept of “Dark Pools” of liquidity in response to a question I had from a subscriber. Basically the question went this way. “Could the low volume we are seeing in the market be a result of non- reported, dark pool transactions?.

First I think a current definition of “Dark Pools” is necessary. I say this because dark pools have changed quite a bit over the past 10 years or so and in ways that have affected market transparency significantly. Dark pools of liquidity are just as the name implies, transactions that occurs between two parties, usually between two institutions cleared by a crossing broker in the dark (not open to the general public). These traditionally encompassed large bloc transactions between institutions. In the “dark” refers to the transaction being done away from the exchanges or bypassing the “tape”. The reason these pools came to being many years ago was to allow large institutions such as mutual funds and hedge funds to move large blocks of stock without creating major price moves in the intraday trading of the underlying security. The original dark pools of liquidity such as Instinet were run by the exchanges and although the exact nature of the transactions were never clearly reported, the basic information such as total volume and high and low prices was reported to the Consolidated National Tape. This system “worked” for many years and although I was never a big fan of off exchange transactions, it did provide a way for institutions to buy or sell large blocks of stock without causing major price swings.

Enter the “new” definition of dark pools of liquidity. Changes in regulations early in the late 90’s allowed these institutions which previously relied on the exchanges for their “dark” transactions to cross these same transactions between clients in-house bypassing almost any reporting standards. What was initially created as a way to protect the average investor from undue volatility was subverted to game the system. Whereas previously these transactions were reserved for large blocks of 50,000 shares or more, now firms could cross orders at volumes as low as a couple hundred shares. The deregulation of markets allowed for much weaker reporting standards and where previously the main concern for those participating in these dark exchanges was anonymity and price stability, now proprietary trading desks were creating a two tiered market where savvy institutional investors crossed their orders with the “non” sophisticated investor in obscure “dark” transactions.

Now this has been a major topic of discussion for years and obviously those who are interested in keeping the status quo are those large players who benefit from the scheme. I have always been a proponent of clear and transparent markets. For “fair” price discovery, we need to see all transactions immediately after they occur. I would also argue that even the original intention of these dark pools subverted the transparency of the market. Not sure about you, but if an institution takes a position in a security or on the other hand unloads a bloc of stock, I think that I have the same right to that information when it happens not later in day after hours or in many cases days and weeks later. It is a question of fairness and I think that if more of the general public was aware of these practices and actually understood what was going on, maybe changes would ensue.

Dodd Frank is supposed to address some of these issues and although I have very little hope of it actually fixing anything as the enforcement of these rules will fall to the SEC which is hopelessly unprepared and understaffed to handle the additional burden.

So from a trading perspective we have to adjust and adapt to this reality as we (I) have tried to do over the years. There are many ways to try and gauge the activity in the dark market and that entails access to expensive exchange feeds and doing some homework on the web. The leaking of information on these dark transactions are frequently reported on sites such as Zero Hedge and others. The speed of information today helps to make what were “dark” pools in the past, maybe, well “gray”.

Without going into major depth on what really has become a very complicated and difficult problem for regulators, It is fair to say that because of the overall drop in retail trading activity, the problems associated with this practice have been magnified. The emergence of ultra-fast computing speed has given rise to firms that specialize in capturing inefficiencies between these exchanges and off exchange liquidity pools. The exchanges in order to take back some of the revenue lost to these new off exchange pools, have resorted to selling access on the floor of the exchanges for these very high speed trading computers which benefit from being right there “collocated” with the exchanges to maximize their speed advantage.

To answer the question posed, I say that the market structure is broken, but to be fair, it never was completely transparent to begin with. There is no standard mechanism that is fair and transparent enough to ensure “fair” price discovery. Traders can get a good picture of what is going on if they know where to look and/or pay for the access. All and all today we get a distorted picture of what is going on at best. That is better than it was in the recent past but far from fair…

February 13th, 2012

The tense weekend in Greece, complete with riots, burning buildings, and rock throwing youth gave way to a parliamentary approval of the austerity measures which perhaps pave the way for the disbursement of some $170 billion in aid. I say perhaps because as we have seen, the Germans have been all too clear that they are not in a giving mood and remain skeptical of the austerity measures ever coming to fruition. Already, the presumptive next elected leader of Greece has said that Greece will try and renegotiate the terms of the package…Again, this is an evolving and revolving story…

Markets, at least at this hour, are not in major rally mood as the major indices are only marginally higher. The S&P 500 and NDX obviously supported by the surge in Apple. The Euro had strengthened overnight but has since backed off and the FXE is only up 1/3 of 1%. Gold is also only marginally higher and the GLD has dipped a bit lower early in the session. Again, I highlight that the market is still dealing with resistance at 1350 which has proven to be rock solid. With earnings mostly in the rear view mirror, the market will have to depend on continued economic surprises to keep any momentum. This morning S&P downgraded the tech sector on valuations and although I am not often in agreement with S&P, this time I believe they got it right.

As I mentioned before I am not bearish on an intermediate time horizon, but I am bearish within the short term timeframe used in our trading. A pause is needed from which to build a sustainable move higher on stronger participation. On the S&P 500 I believe a pullback to around 1300 or so would not be out of the question with downside from there at around 1270 and best case scenario in my opinion at 1320 or so.

The downside to this type of thesis (and this is always the case) is when the overall demand for stock is so overwhelming that it suppresses the technical considerations which is what a “good overbought” condition is all about. In this case we would see strong broad support for stocks instead of the narrow and tepid demand we are currently experiencing. Should that change, we will obviously change our view.

The pick-up in volatility is also constructive the markets prospects. A low volatility environment is a positive when markets are not near important resistance levels. When volatility collapses as the market is struggling with resistance, it is a clear sign of overall complacency to risk. The pick- up in volatility is indicative that participants are beginning to reverse some of this complacency and are opting to buy some downside protection. The theory here is very clear. When traders have hedged their exposure, they are not likely to sell their core positions as fast. If they are properly hedged that is. They have the luxury of riding out some of the near term volatility because of the appreciation of their hedges. That is why important tops in the market are commensurate with lows in the VIX.

From a technical perspective, based on my view od the crystal ball, we are reaching very overbought levels. The last time we reached these levels based on the parameters I have set for my S&P500 studies, was back in mid- February of 2011. Again at that time we had been overbought on the weekly charts for nearly 4 months before a meaningful pullback brought markets down from the highs set early last year into the weak late spring and late summer lows. Actually my volume and momentum studies are actually better this time around but only slightly so.

This week we should get a much better feel for the domestic economic situation as many important releases are on tap. It is difficult to argue against the improving domestic economy but from a market perspective, an improving economy and the rate of change on these improvements could be an indication that the Fed may not be as likely to sponsor any more easing measures or “QE3”. The market has traded based on this Fed driven liquidity for several years now and a rapidly improving economy may prompt the Fed to take their feet off of the liquidity pumps. Certainly the market will begin to price in this probability which means giving more credence to actual company specific fundamentals as opposed to a broad “tide that lifts all boats” approach to the market. As I and many others have noted, the earnings and forward guidance issued by the majority of S&P 500 component companies have not supported the much higher valuations and multiples that many have been calling for. A companies market valuation has to be measured against current risks and not based on historical averages. Stocks may be cheap against historical averages on multiples but on a risk adjusted basis, they certainly are not all that cheap. I believe there is upside potential to this market but I am not nearly as giddy as many others who are calling for a moonshot to catch up to historical multiple valuations.

February 8th, 2012

So the kool aid continues to pour on Wall Street as the market grinds higher on historic low levels of participation (considering the season) and on lackluster earnings from a majority of companies. Skewing the overall outlook is the fact that a select group of companies have beat expectations by a wide margin. For example, if we take away Apple from the S&P 500, it would paint a very different picture, not necessarily awful, but much less “giddy”.

Most analysts and money managers that come on the financial TV shows are painting a far rosier picture to investors than what is truly ahead for the market and I think it is fair to say that most of these folks have a vested interest in coaxing investors out of the sidelines and back into the market. Financial Institutions need to generate trading revenue and commissions and these have dried up very sharply.

I mentioned earlier that the volume and overall participation rates have been atrocious. They are certainly not an indication that these same money managers and financial analysts are putting their money where their mouths are… Because the New Year has failed to bring investors out of the sidelines, money managers have pushed the market higher by pilling on the AAPL trade and a few other select names. Because these companies are heavily weighted in the indexes, they can create an aura that the market is doing much better than it actually is. Their hope is that money will come rushing in to the market from the retail investor, particularly those investing in their 401Ks and mutual funds, trying to get in on the hoopla and that this rush of liquidity will create sustainable momentum higher. It is true that if this scenario did play out, the momentum would propel markets much higher. The problem is that so far, even at these lofty levels, this has not been the case and markets are getting to very dangerous levels. Folks when you see these guys and gals on the financial shows screaming “buy now!” be wary…

So let’s take a look at the at the S&P 500 and the NYSE Composite. The S&P 500, with all of the hoopla and fanfare of the past month or so, is only at 1349 and we have been stuck at this level for about 4 weeks now. This level has proven to be stiff resistance as this was the last major level to catch investors in this same situation back in the summer of 2011. Many investors who bought at this level back then are certainly going to be considering selling at breakeven here and this “supply” is certainly causing this churning back and forth. These are folks that bit on the head fake at the resistance level last summer and saw huge drops in the index (from 1350 all the way to 1070 or so). I mentioned before that the longer we stick around at these levels without a broad push forward, the greater the risk of a strong move lower. Markets grinding higher do not correct by grinding lower, they correct by declining sharply, trapping in those late comers to the rally.

The fact that the high relative strength stocks are such an expressive percentage of the current indices adds to the concern. Take away the monster move in AAPL and the S&P 500 would be at even lower levels. This in general is the reason I am cautious here and hesitant to drink the giddy juice…Where are the volume buyers? If all these money managers are doing what they are saying, “where is the beef??”…They know this party is on its last legs and they want us, the retail crowd to be the last ones holding the bag…When the “you know what” hits the fan, they will then happily take those shares off your hands, 8 to 12% lower than they are now… It is what it is folks…they know it, I know it and you should as well. We will not see sustainable participation until we unwind these overbought levels.

With that being said, I have been wrong on the timing of this move. The parameters that I have set for this current market environment failed me and we have been early on the thesis. We successfully rode the rally higher from October and I think that perhaps I faded it 2 to 3 weeks too soon. Our new Nasdaq 100 spread position is a further out maturity and will give us a nice boost when this market finally corrects. Moving on, we generated a bearish alert on the FXE today. We traded the FXE successfully on the last rebound higher and also faded it a bit too soon, but it has now reached a level where I believe we will see some give back. This move higher has been predicated on extreme short covering and this trade is now sufficiently unwound, that I believe the weak fundamentals supporting the Euro will once again weigh on the FXE.

February 3rd, 2012

Over the past several years I have harped about market volume, or better said, the lack of it. Over the past several years, participation in the market has dropped tremendously and recently we have set some new 10 year lows in total NYSE trading volume.

Below is a monthly chart of NYSE volume along with a 12 month moving average. The moving average peaked around the middle of 2006 and has been on the decline ever since. The debacle of late 2008 ushered in period of sharper declines as many participants, particularly “long” term investors just packed up and by all estimations have not returned to the market. Each bar below marks a months’ time and to the extreme right we see the current month. What I want to point out here and what is really astonishing are the figures for last month, the previous to last bar on the chart… January of 2012 is going down as the lowest volume month since September of 1999, when average volumes were actually on the rise.

Many have said that this is due to money being on the “sidelines”, to use an often cited sports analogy befitting the day after the Super Bowl, and that this capital will eventually return to markets when we finally work our way out of the economic morass of the past few years. Some analysts on the other hand say that current volumes are likely to be the “new norm” and that we need to discount the average volumes from the prior decade simply because, in their estimation, this increase in volume was due to strong retail participation both in 401Ks and general trading both of which we are not likely to see for some time, if ever.

Since early 2009, I have been inclined to agree that this drop off in volume would not be permanent and that eventually we would see animal spirits once again take hold and we would finally see this “sidelined” capital enter the market. In fact, I believed that we would see a sharp increase in trading volume during the first few months of this year. While it certainly is early in the new year, the trend in volume has not improved at all and in fact, has worsened. To some degree I believe many investors, who saw their retirement accounts halved by the tech bubble in 2000 and then again in 2008, will never return to the market no matter how low interest rates get or whatever form of financial engineering Ben Bernanke and the Fed concocts. Fool me once shame on you, fool me twice shame on me.

The problem is that markets today are not the markets of the late 90’s, prior to the abolition of the Glass Steagal Act, the depression era legislation that kept banks, brokerages and insurance companies from each other’s business in a way preventing the “too big to fail” disasters of the past few years. The structure of the market is also not the same. Today, markets depend on HFT (High Frequency Trading) shops for liquidity and narrow bid/ask spreads, something that was handled by the Specialists on the floor of the exchanges prior to decimalization. These HFT shops are not required to make a market or provide liquidity and can at any time switch off their computers when the trading environment does not suit them causing major volatility in times of stress creating liquidity crunches leading to events such as the Flash Crash of a couple years back. If these HFT players account for 60% of trading volume these days, then it is clearly obvious that when they “switch off the machines” the market is bound to suffer major adverse effects from the liquidity drop off.

My point is that it isn’t nearly as simple as many would propose to ignore the volume of the past decade and instead focus on longer term historical averages. It is like comparing apples to oranges. In my trading models and studies, I have several times over the past few years adjusted for this drop off in volume. I had high hopes that this year we would see increased participation and that the sharp turn in the 12 month moving average we saw during the second half of 2011 would carryover to 2012. That has certainly not been the case. The low volume adds a clear measure of risk to the market and because we are dependent on the “machines” for liquidity, we are vulnerable to sharp contra trend move particularly when the market is so complacent such as is the case today. I would urge any of you with either stock or mutual fund positions to consider buying some insurance in the form of put contracts on the broad market ETFs or indices alike. Protection is again very cheap and recent history suggests that when they become this inexpensive, the market may be reaching an important top.

Maybe it is different this time and things are indeed turning around, I just don’t see it. Hopefully I will be proven wrong here and we will see a marked improvement in participation and resume a healthier path forward. So far, I am not impressed…

C.J. Mendes

cjm

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