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Tharp�s Thoughts

Market Update for June 30, 2005

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Look for these monthly updates on the first issue of each month. This allows us to get the closing month data.  In these updates, we�ll be covering each of the major models mentioned in the book:  1) the 1-2-3 stock market model; 2) the five week status on each of the major stock U.S. stock market indices; 3) our new four star inflation-deflation model; and we�ll be 4) tracking the dollar.

Part I:  Market Commentary.

The market seems to be continuing its trend of the last 18 months of doing nothing but going sideways.  This is always a possibility in an inflationary bear market.  For example, from 1962-1982 we had a market (i.e., DOW 30) bouncing between 500 and 1000.  Perhaps in this climate it will bounce between 7000 and 11000 over the next 15 years. 

The 1-2-3 Stock Market Model IS IN RED LIGHT MODE.  BE CAREFUL.

What the market is doing.  Currently, all three major averages are now 1) down for the year and 2) slightly down over the last five weeks.  I don�t like this market at all.  It�s just being a very subtle bear, making it hard for anyone to take much money out of the market.  It�s probably nibbling most of you to financial ruin � but just a few percent each month. 

The table below shows the five week status of each of the major markets.

Incidentally, this data is calculated by hand based upon last Friday�s close (i.e., July 1).  There is always a possibility of human error in our numbers.

What�s a good strategy for the month?  Homebuilding and energy stocks continue to lead the market.  Valero was the stock of the month in June and on July 5^th it set new highs and was up over 3 points.  Ironically, Google was the stock of the month in July, finally moving over 300, but its was only about 295 on July 4^th.   However, my overall bias for the stock market during the summer is probably down.

One positive force for the stock market is that the dollar is looking very powerful right now.  That means that the U.S. stock market is looking good to international investors. 

However, there are a number of serious factors on the down side.  First, this is typically not a strong time of the year for the stock market.  Second, oil has gone over $60 per barrel and that is not good for the economy as a whole � it certain is a major inflationary force.  And, lastly, most people seem to be putting their money into real estate.  Chris Anderson put up his preconstruction profits web site and suddenly became swamped.  In addition, I spent a few days in Tennessee looking at property and discovered that property managers did most of their business with outside investors from California.  Apparently, cheap houses in the $50K to 100K range in Tennessee seem super cheap to California investors who could pay $700,000 for the same house.

Part III: Our Four Star Inflation-Deflation Model.

So what�s our new indicator telling us about inflation.

1)      The CRB index

2)      The price of Gold

3)      The CPI and

4)      The trend in interest rates.

1)  The CRB Index.  I already said that I believe that the CRB index is the one we have currently that is the least manipulated by the government.  But what�s the best way to measure it?  For consistency, I plan to give two measurements. 

• Is the CRB index higher than it was six months ago? 

• If it is, we are on track for inflation.

• Is the CRB index higher than it was two months ago?

Now there are several ways to monitor these two indices.

�        If both differences are higher, we�ll count one star for inflation. 

�        If the six-month change is higher, but the two-month change is not, then will only count � star for inflation. 

�        And if both the two and six month changes are lower, then we�ll be minus one for inflation.

�        However, if the six-month change is lower, while the two-month change is higher, then we�ll be minus � star for inflation.  Obviously, the two minus scores will point to deflation.

2)  The Basic Materials Sector ETF (XLB).  In an inflationary environment, basic materials will definitely go up.  And, this sector, to the best of my knowledge, is not manipulated by the government.  Thus, we will use this sector to monitor inflation and we�ll use the same measurements use for the CRB.  (1) Is the XLB higher than it was six months ago; and (2) Is the XLB higher than it was two months ago.  These two measurements give us four possible results.

�        If both differences are higher, we�ll count one star for inflation. 

�        If the six-month change is higher, but the two-month change is not, then will only count � star for inflation. 

�        And if both the two and six month changes are lower, then we�ll be minus one for inflation.

3) The London PM Gold price at the end of each month.  Although Gold can be manipulated by the government, I still like to look at monthly gold prices.  However, to be consistent, we�ll use the same two measurements that we�ve used for the other indices that we are monitoring.  1) Is the price higher than it was six months ago and 2) is the price higher than it was two months ago.  Again, these two measurements give us four possible results.

�        If both differences are higher, we�ll count one star for inflation. 

�        If the six-month change is higher, but the two-month change is not, then will only count � star for inflation. 

�        And if both the two and six-month changes are lower, then we�ll be minus one for inflation.

4) The Fourth Measurement we�ll use is related to the Financial Sector of the S&P 500.

The financial sector (XLF) tends to do well when we have deflation and poorly when we have inflation.  Martin Pring, in fact, has used an index in which he divides the XLB by the XLF.  Since we already use the XLB, we�ll use the XLF by itself as well.  Again, we�ll use the change over six months and over two months.  However, the four possible outcomes with give us a different interpretation.

�        If both differences are higher, we�ll count one star for deflation. 

�        If the six-month change is higher, but the two-month change is not, then will only count � star for deflation. 

�        And if both the two and six month changes are lower, then we�ll be plus one for inflation.

Okay, so now let�s look at the results for the year.

We�ll now look at the two-month and six-month changes over during 2005, so see what our readings have been.

It�s interesting that the CPI for May (which we get a month late) also showed the same downtrend that are model clearly slowed last month.  However, this month seems to be resuming the inflationary process.  The first four months of the year each showed signs of inflation, with a huge jump (+4) in March.  But look what has happened since March.  We showed a clear decrease in April and in May we showed our first signal for deflation.  And if this becomes a deflationary market, you�ll want to avoid debt and you�ll want lots of cash.  Let�s see if this trend continues next month.

Part IV: Tracking the Dollar.

Look at the next Table, showing the dollar index over the last five months and comparing in with its price at the close of the last three years.

The dollar is now much higher than it was at the start of the year and its gone up every month of the year � with the biggest jump in June.  The dollar has probably bottomed out against the Euro.  In fact, with the European Union constitution now in doubt, the Euro is now in trouble.  However, this is still only comparing the dollar against the Euro � which is a major component of the dollar index.

However, my guess is that it will continue to be weak compared with commodity currencies such as the Canadian Dollar, the New Zealand dollar, or the Australian dollar.  Fundamentals (i.e., with the main factor being the US debt) suggest that the dollar has a long ways to go on the downside.  However, we could have made that argument for much of the last ten years. 

What this all means.

Our big picture still suggests a long-term BEAR market.  And it looks like a flat, inflationary type market for equities.  For example, all three major averages are down slightly for the year, while the CRB suggests that prices have gone up 4.5% during the same period.  This is not good for the economic well being of most Americans.  However, let�s continue to watch the market for more signs.  Until the July update on the market�..this is Van Tharp.

About Van Tharp

Editors Note: Throughout the issues you will see certain words with odd spellings, such as Fre-edom and mort-gage. This is because spam filters are likely to block message that contain certain words and this is one solution.

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Trading Tip: 

Swing Trading � What�s Working Today?

by  D. R. Barton, Jr

�Maybe the trend is your friend for a few minutes in Chicago, but for the most part it is rarely a way to get rich" --Market Wizard Jim Rogers

Last week we looked at an overview of swing trading and how it combines the best attributes of short and long-term trading.  There are many styles, systems and strategies that you can use for swing trading.  Today, we�ll look at a couple that are working quite well in the current markets.

Market background.  The market has basically been trading in two narrow ranges for the last 18 months.  From the beginning of 2004 until early November of that year, the market traded within a 100-point range, from 1060 to 1163 (these numbers represent the S&P 500 cash index).  It then broke above that range (but modestly so) and has been trading in yet another 100-point range ever since, this time between 1136 and 1230.

By almost any accounting, this has been a market stuck in very tight ranges.  For comparison, the ranges for the years 2000, 2001, 2002 and 2003 were 300, 400, 400 and 300 points, respectively!

Here are the best ways that we have found to play these tighter market conditions:

The best of the best � fading short-term extremes.  The market still has strings where it runs up or downs and forms an intermediate trend.  In general, it then reverses after these quick runs.  So we have had success fading (trading against) the short�to-intermediate term trend.

Most folks agree that trading within a channel or fading tests of channel highs and lows are good plays in a tight, generally trend-less market and we have found this to be the case.  The system we have been using to make some nice gains will be discussed at length in a future �Tharp�s Thoughts�, so stay tuned for that.

Short-term breakouts.  Playing breakouts has been a very tough game in the last 18 months, but under specific circumstances there have been some good plays.  The best conditions have been to reverse a failed channel tests and playing breakouts on hot sectors (like energy and housing).

We continue to like finding intermediate term over-extended points in the market and then watching for a confirmation that the over-extension is correcting itself.  That becomes our entry point.  For breakout players, we can only recommend caution and reduced position size for now.

D. R. Barton, Jr. will be teaching the upcoming Proven Tactics of Swing Trading Course, August 2005 and is a featured speaker in the Van Tharp Institute Course, Make Money Work for You. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

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Listening In... 

Recommendations People Give 
Author: Van
Date: 07-03-05 00:01

One of the tasks we plan to do in the future is a Consumer Guide to systems. If you look up systems in Google, you'll find that there are numerous sites promising you the world through black box systems. 

Most people in my opinion get taken to the cleaners through such systems. But we also find that we cannot compete with them -- i.e., I tried with the systems course -- because they promise everything even though most probably deliver nothing at all.

In fact, I'd be interested in your comments on wasted money on systems. My guess is that most experienced traders have numerous stories of wasted money on systems.

Now for an ALERT. If someone posts information about a system, they are basically trying to get free advertising. I don't mind it when people ask questions and others (especially established posters) recommend software they like.

But when people just post their magic system in this FORUM...pretend it is magic. You put your money in and in disappears faster than you can imagine.

Van


Re: Recommendations People Give 
Author: PMK
Date: 07-03-05 20:17

Van,

First a disclaimer: I have never purchased a trading system, but I am a full-time (mostly) systematic trader and I have evaluated a few commercial systems and also receive them as junk mail (electronic and postal) every week - so I feel I am qualified to comment :-)

I must agree with tm that most of the systems available are not really complete 'systems'. Once you understand the many components of a complete trading systems, the development process, the lifecycle a system goes through, and the market types that it works in, you realize that there is much more to trading systems than an entry and exit. In fact, I think tm is actually being generous saying they have entry and exit signals - most of the ones I have seen are little more than glorified 'buy' recommendations. Exit signals are implied (i.e you go bust, another better 'buy' signal comes along, the system vendor goes bust etc.), and position sizing is aggressive to say the least (100% risk on every position is not uncommon, 10% risk per position is considered 'conservative').

Also, historical performance is mostly theoretical, and usually based on unrealistic (i.e stupid) assumptions (e.g. buying at the absolute low after a signal, and then selling at the absolute high). Since reward and risk always go hand-in-hand, if you have the chance of making 3000% in a year, then you will also have a (probably much greater) chance of going totally broke over the same time period; that is not my idea of successful trading. When considering laying out real cash to buy a system I consider the following:

How can a purchased system match my own trading objectives and personality?
How can I have the confidence to trade a system I either didn't design or don't even know the rules to?
Why would I sell a system if it was a money maker rather than trade it myself?

Due to these rules buying a system is highly unlikely for me. If I was forced to come up with a reason to buy a system it would be to get a new idea in a market I was unfamiliar with - I would only consider buying if the system rules were fully disclosed so I could test, evolve, and implement my own system based on the idea rather than as a 'black box'. In short, I probably will never buy a system so I can't comment on losing money on one - it is easy enough to lose money trading systems you designed yourself, so why pay someone else :-).

I would be very interested to hear from successful traders that actually use a commercial system they did not design themselves (if they exist).

Paul

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