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Market Update for December
 Market Condition: Volatile Bear

by 
Van K. Tharp, Ph.D.

I always say that people do not trade the markets; they trade their beliefs about the markets. In that same way I'd like to point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, then you may not find them useful. I find the market update information useful for my trading, so I do the work each month and I'm happy to share that information with my readers. 

However, if your beliefs are not similar to mine, then this information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp�s Thoughts each month. This allows us to get the closing month�s data. These updates cover 1) the market type (first mentioned in the April 30 edition of Tharp�s Thoughts), 2) the five week status on each of the major U.S. stock market indices, 3) our four star inflation-deflation model plus John Williams� statistics, 4) tracking the dollar, and 5) the five strongest and weakest areas of the overall market.

Part I: Market Commentary

Since this market update is coming out early, it only includes data through December 26th and that includes the month end changes. I�ll do a year end review in the middle of January. 

I don�t plan to extensively discuss what�s going on because I�d prefer to end the year with a little optimism. For example, some of the biggest years ever for the stock market occurred during the Great Depression. 2008 was certainly one of the worst years in the history of the U.S., so perhaps 2009 will be much better.

On December 15th, the Federal Reserve effectively lowered its interest rates to zero for the first time in history. It basically shows that we have the potential for another depression like era. Bernanke was a student of the Great Depression and will do anything he can to avoid deflation. Well, he�s now done everything he can, so we�ll have to see what happens. One good thing is that mortgage rates have now hit 30 year lows.

Part II: The Current Stock Market Type Is Volatile Bear

I have now substituted my new market type for the 1-2-3 model (which is still red light). I�ve done this because the 1-2-3 model has now gone below a certain PE ratio (that has turned Steve Sjuggerud quite bullish) and that automatically turns one of the three signals to go. However, I expect us to be in a secular bear market until the PE ratios of the S&P 500 reach single digits. Thus, the 1-2-3 doesn�t really fit my current beliefs. 

My advice, once again, is that secular bear markets usually end when the PE ratios of the S&P 500 hit around 6-8, for example, 1932, 1942, and 1982. We�re in the worst crisis since the Great Depression and perhaps in one that is worse. Are you willing to risk the PE ratio of the S&P 500 dropping to single digits? My advice, get in the market when prices are above the 200-day moving average and get out when they are below (or at least stay out until our market type turns bullish for at least two weeks). That would have kept you out of this market throughout 2008.

I�ve now changed how we measure volatility. Using the ATR, as I had planned, did not work because the ATR gets bigger as the price of the S&P 500 goes up. Thus, the market, based upon historical ATRs, has been nearly 100% volatile since 1996. As a result, we now look at the ATR as a percentage of the close and that does the trick on an historical basis. In the table below, notice that every week in 2008 is volatile on an historical basis. The last quiet markets were before August 2007. However, volatilities have shrunk to about one-third of what they were. In my opinion, we need to form a base for quite a while before we can shift to sideways. 

Let�s also look at the daily market type. Here, the change over five days is used versus the five day volatility during the month of December.

Notice that we�ve had some periods that could be called bullish based upon shorter term market type measures. However, the 13-week market type is a long way from anything but bearish.

It looks like the markets will finish down 40% or more for the year. Can you remember when pension funds expected their pensions to be up 10%? In fact, corporate accounting almost required it. So what are they doing now?

In January 2008, I did a workshop for an emerging market mutual fund. They were complaining about how much they were down at the time. But they were required to be fully invested and to be long. That room represented $51 billion in assets. They wanted to know about position sizing, but they were not in any position to practice it. And they were not interested in psychological work. I wonder what their thoughts are now. 

Part III: The Strongest and Weakest Market Components

I have a new model in which we track the relative strength of the various ETFs representing the economy of the entire world. I will be publishing this once a month. Ken Long, who developed the algorithm we use, publishes a similar report every weekend at www.TortoiseCapital.com. If you�d like more information, then I�d suggest you attend our ETF workshop, which is held several times each year. Ken explains how these numbers are derived in this workshop.

Click here for larger chart

The areas in green are strong and those in brown are very weak. By the way, I usually consider strong to be in the 70s and there is obviously nothing in that range on this particular chart. The rest of the chart is located below.

This world view looks a little better than the world view presented last month. Now there are some strong countries with ratings above 60:

1. Mexico (62)
2. Spain (61)
3. South Africa (61)
4. South Korea (60)

U.S. biotech and REITs sectors are relatively strong. And some of the currencies are quite strong:

1. The Swiss Franc (66)
2. The Euro (64)
3. The Yen (61)

The next part of the chart shows commodities, real estate, and interest rate products.

Among the commodities gold is gaining strength at 64 and agriculture is gaining strength at 62. Among the real estate areas, Asian Real Estate is doing quite well. And with the massive drop in interest rates, bonds are doing well.

The last chart shows the top ETFs and the bottom ETFs. Gold mining shares (GDX) are showing nice strength and none of the ultra short ETFs are in the top sectors. However, short funds and energy are strongly in the bottom ETFs.

None of the markets are anywhere near their 12 month highs, so don�t get too excited about jumping into green areas. However, at least we are no longer dominated by the short ETFs being the only top performers.

So what are the best performing areas? It�s obvious when you look at the chart. First, interest rates are doing well across the board. This means that interest rates are going down so that bond prices go up.

Part IV: Our Four Star Inflation/Deflation Model

Once again, we are in credit contraction mode, so it is not the inflationary bear market I once thought we were going to get six or seven years ago. The entire world is experiencing a credit contraction. We�re in a second stage deflation which typically is supported by governments and ends when the governments fail.

Yes, the Federal Reserve and other central banks are printing money like crazy, but they cannot print it as fast as money is disappearing in the credit crunch. What happens in a credit crunch is that cash is king. Once again, cash is king, but it must be safe. When all of the bankruptcies play out, then money will be printed like crazy to stimulate what�s left of the economy. And at that point, gold is the king. This is my personal opinion. 

So with that in mind, let�s now look at our measure of inflation/deflation.

We�ll now look at the two-month and six-month changes during the last six months to see what our readings have been. The CRB is now reaching levels not seen since 2005.

Our model is clearly showing the credit crunch that is going on and the potential for deflation. And the magnitude of the drops is amazing. However, the effect is weakening.

Part V: Tracking the Dollar

The dollar is continuing its uptrend because of deleveraging.

People are still paying off debt so they must acquire dollars to pay off the debt, but at the same time the dollar started to fall immediately after the Fed lowered rates to zero. I now think we�ve seen the peak on the dollar. How is the U.S. going to fund its massive debt with interest rates at zero? Expect the U.S. dollar to stop being the world�s reserve currency in 2009 or 2010 at the latest. 

Incidentally, gold�s performance is excellent when you measure it in most other currencies beside dollars. And now that the dollar is falling, gold is going up.

What You Should Do

Crisis always implies opportunity. And if you watch, there is plenty of it. For example, at the bottom of the crisis you could buy the virtual banks yielding 20-25%, and at a time when the risk was now guaranteed by the government. Today those stocks have gone up so much that they are only yielding about 15%. If you had bought at the bottom, you�d have gains of 30-50% and still be getting a 25% yield on your original investment.

I predict there will be many more such investments in 2009. Until the January 2009 update, this is Van Tharp.

P.S. I received an email with some pretty funny new financial terms. If you'd like a chuckle, click here. 

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

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Trading Tip

Volatility: The Real �Back Story� in Today�s Market, 
Part III

by
D. R. Barton, Jr. 

The more I dig into volatility measurements, the more intriguing the journey becomes.  There are lots of thoughts on measuring it, mitigating its effects, and even capitalizing on it.  But, in fact, there is really no standard definition for volatility in the financial community. 

A general definition might be �the measure of variation in the price of a security.� But this is a little too broad to be useful.  I just saw it defined as �variation of price over time� and �rate of change of price� and as �change versus a standard or mean.� Perhaps the simplest definition that resonates with me is �the relative rate at which the price of a security moves up and down.�  But there are definitely lots of different ways to define this elusive concept.  And almost as many ways to measure it.

In our quest to better understand volatility, one logical way to try to get a handle on this idea would be to see how the pros react to expanded price ranges and increasing rates of change.  In our previous articles on volatility, we�ve looked at beta and Average True Range (ATR) as measures of volatility.  But there are folks who look at volatility and its effect all the time�options traders.  Since these folks watch volatility ever so closely (because it has a significant effect on options pricing), understanding how they see volatility should be a useful concept.

A professor from Duke University named Robert E. Whaley thought that tracking option pricing information was a good way to quantify volatility.  His paper from 1983 formed the basis for the CBOE Volatility Index or VIX. 

VIX has been called a �measure of  investor fear,��when the index is at its highest levels, volatility and investor fear are high.

By the CBOE�s description, VIX is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.  Next week we�ll dig into the details of how VIX is calculated.  But for today, I wanted to focus on the current usefulness of VIX.  As we have seen, �beta� has a difficult time adapting to market changes because of its time horizon.  ATR is much quicker.  How about VIX?  Let�s look at a chart.

At first glance, we can see in this weekly chart that as ranges increased, VIX expanded significantly.  This is a very good first sign. It gave useful information during the range expansion.  As you can see from the smaller arrows, VIX has also given some useful indications in the past about high fear levels leading to intermediate market lows.

Next week we�ll look more deeply into VIX, talk about its big change in 2003 and investigate some ways that we can use it that are more useful (and some that are less so!).  Until then�

Great Trading,
D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  �drbarton� at �iitm.com�. 

D.R. is presenting the upcoming How to Develop a Winning Trading System That Fits You Workshop, January '09.

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