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Market Update for the Period Ending November 30^th, 2009

Market Condition: Strong Bull

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, you may not find them useful. I find the market update information useful for my trading, so I do the work each month and am 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, 2008 edition of Tharp’s Thoughts), 2) the five week status on each of the major US 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:  Van’s Commentary—The Big Picture

Within the next year, the U.S. treasury needs to find $3.5 trillion dollars.  That’s nearly 30% of the GDP.  And many folks (Porter Stansberry, Bill Gross, and even the writers at the New York Times) are wondering where the U.S. will get that money.  Well, there is one option that I mentioned in an earlier update and it’s a serious situation.

I have mentioned several times that in 2006 the Federal Reserve Bank of St. Louis published an paper by Professor Kotlikoff of Boston University stating that with $66 trillion of debt and current directions, the US was heading toward bankruptcy.  (Here is the link to that paper: http://research.stlouisfed.org/publications/review/06/07/Kotlikoff.pdf)  If anything, we have accelerated towards that destination as the national debt, including future unfunded obligations, now totals around $100 trillion. 

Can you predict when a country will default or go bankrupt?  In 1999, Alan Greenspan and Paul Guidotti published the Greenspan-Guidotti rule:  To avoid default, a country must maintain hard reserves equal to at least 100% of the debt maturities in the next 12 months.  In other words, if you cannot pay off your short term debt, speculators are going to target your bonds and your currency.  The result will be an assured default.

The U.S. is the largest holder of gold (with about $300 billion worth).  We have about $58 billion worth of oil and about $136 billion worth of foreign currency.  Let’s see, that totals $494 billion, and we’re stretching things by adding in the foreign currency reserves.  We have about $3.5 trillion to finance.  That’s a deficit of about $3 trillion.  So based upon the Greenspan-Guidotti rule, we are supposed to default within the next 12 months. In addition, foreigners own about $880 billion of debt that is due within the next 12 months—almost twice our reserves.

I have thought the end was possibly near before though—like when I first heard our official debt hit the trillion dollar mark around 1990.  Somehow, however, the U.S. has muddled through for many years since then and it did so with a huge stock market boom.  So maybe a national default is not imminent in the next year.  Still, where is the $3 trillion going to come from in 2010?  Here are scenario factors to consider.

Step 1: The Federal Reserve continues to print money to buy the debt, which totally debases the currency. 

And how do the countries holding massive amounts of U.S. dollars react to this as they watch their holdings fall in value?

Step 2: JP Morgan needs to buy $57 billion worth of T-bills each day to hedge its derivative position. 

I never understood JP Morgan’s derivative position until I read that statistic.  JP Morgan is one of the largest OWNERS of the Federal Reserve— a privately owned bank.  Somehow JP Morgan’s derivative position and their ownership of the Fed might produce a sidestep to an economic crisis next year. 

Nevertheless, I would expect the dollar to lose its world reserve status within the next 2-3 years.  Look at this chart.  Have you ever seen anything that rises in a parabolic manner to then not fall precipitously? And the chart is several years old (the debt is now $11 trillion and doesn’t include the unfunded future obligations, which puts it at about $100 trillion).  In my opinion, the fortunes of tomorrow will be made by those people who understand this serious problem and determine the best way to profit from it rather than being devastated like most Americans could be.

Part II: The Current Stock Market Type Is Strong Bull Again

The SQN^TM for 100 days has moved back to a strong bull market and has been bullish since July 2^nd.  The 25 day SQN is neutral again. And the ATR as a percentage of the close is normal.

It’s beginning to look like the SQN based market type is much better than I would have dreamed when I first started working on it.  For example, it signaled the bear market in January 2008, which would have been a good date to go short.  And it signaled the bull market in August 2009, which was a great time to go long.

Let’s look at what’s happening in the three major US indices.  The next table shows the Dow, the S&P 500, and the NASDAQ over the past five weeks.

All three indices are showing nice gains.  Notice that all three markets are up on the year with the NASDAQ 100 up impressively.  We’ve already said that the gains off the bear market bottoms are huge and by no means normal.

Part III:  The Strongest and Weakest Market Components

By this time, most of you understand how we track the relative strength of the various ETFs representing the economy of the entire world.  I publish this model 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 one of Ken’s workshops, which are held several times each year. The next one will be held in New Zealand in February (details about those workshops are available on our website).  Ken explains how he generates these numbers in this workshop, and he covers numerous trading systems that have System Quality Numbers™ above 5.

The November 30^th data are given below.

The areas in green are strongest (the total rating is at least one standard deviation above the mean); those in yellow are the next strongest (above the mean).  Those below the mean are in brown, and those more than one standard deviation below the mean are in red.  I’ve taken out all the double leveraged funds from my database, which means that the top and bottom funds are not devoted entirely to those groups.

The strongest countries are Brazil (67), Latin America Largest (66), Mexico (63), and China/India (61).  Other strong areas include the Yen (64), building material (53), Health Care (64-62), Pharmaceuticals (62) and  REIT (61).  The DOW itself is pretty strong at 59. 

The weakest countries are Emerging Europe (39), South Korea (42), and Austria (42).  Other weak areas include broker/dealers (36)  Networking (39),  Currency Harvest (not sure what’s measured here at 36),  Oil and Gas Equipment (36), and Oil and Gas Exploration (38).  The U.S. dollar is also pretty weak at 40.

The next chart shows the futures, real estate, bonds, and the strongest and weakest ETFs.

Here base gold (78), precious metals (76) Base Metals (71), silver (70), and steel (70) all stand out.  The weakest areas are internet b2b (17), natural gas (18), building (29), Russia (33), nuclear energy (35), and home construction (36).  You get the picture, I’m sure.

Part IV: Our Four Star Inflation-Deflation Model

Once again, we are in credit contraction mode, so this is not the inflationary bear market I once thought we were going to get awhile back.  But I suspect that we’ll be in one starting sometime in 2010.  Gold is certainly suggesting that.

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 at its highest level on the table and so is gold. 

The picture here signals clear inflation, plus danger for the U.S. dollar.

Part V: Tracking the Dollar

The dollar is heading down again, with its weakest showing this year.  Part of the weakness is because of a massive carry trade in the dollar.  People are borrowing the dollar and using it to buy assets (like gold, oil, and commodities) at very cheap prices.  In addition, they are profiting from the fall in the dollar.  However, this massive “carry trade” will reverse one day—just like the yen carry trade did—and that could be an interesting time.  In addition, the U.S. has to refinance a huge amount of debt in the next 12 months and that really is bad for the dollar.

General Comments

Crisis always offers opportunity as well.  Those with good trading skills can make money in this market—a lot of money.  But this doesn’t happen by just opening an account and adding money.  You probably spent years learning how to perform your current job at a high skill level and the same goes for trading.  Trading also requires massive self-work to produce consistent, large profits under multiple market conditions. 

Until the next update, this is Van Tharp.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books 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

Dubai World Restructuring: 
Beginning of the End . . . or a Bump in the Road?

A Tale of Two Markets – Part III (The Dubai Interruption)

 by 

D.R. Barton, Jr.

It was the first day of basketball practice tryouts for the 5th and 6th grade team. Like many folks, I have a natural tendency to watch the players and “size them up” during the informal shoot around to see how they look before the formal tryout starts. On this day several years ago, I was watching a bunch of new players tryout for the team I was starting.

One big kid looked great: he was smooth around the basket, had an even shooting stroke and great agility for his size. Several others were pretty good players who would most likely make the team. There were also many that clearly had very little skill and wouldn’t have much of a chance making the team.

And then there was John (not his real name). He was pretty short and very skinny. He moved athletically enough, but when he took his first shot—my, what a disaster! It was the worst form I’d ever seen. His right arm awkwardly crossed his body sending the ball on a trajectory so low and flat that it had very little chance of going in. When I saw that shot, I immediately moved on to watch the other 60+ kids that had come to try out. He wouldn’t have much of a chance making the team.

Then a funny thing happened during the tryout. John, the skinny kid with the funny shot turned out to be a tenacious defender. He shut down everyone he covered. He was a great ball handler. And to my amazement, time after time that funny shot of his just kept going in.

By the end of the tryout, I realized that I had misjudged John’s abilities with my initial impression. Not only did he make the team, he became one of our starting guards.

I think we had a similar story in the financial markets in the past week where reality trumped the initial perception. Let’s take a look.

Dubai World Restructuring: Beginning of the End...or a Bump in the Road?

Last week, Dubai World told its lenders that it would delay its scheduled loan repayments. Then the United Arab Emirates (UAE) did not immediately step in and guarantee the repayment of the Dubai city-state.

Headlines blared. Talking heads puffed breathlessly. “What if there is a sovereign default?” Many opined that this would be the start of the next global credit and market meltdown. Last Thursday (Thanksgiving here in the U.S.), European and Asian markets took significant hits.

Then on Friday, Monday, and Tuesday, a curious thing happened in the equity markets— they did not collapse. While credit spreads did widen significantly after the Dubai announcement, they have already started heading back down.

When the markets “shake off” news with huge negative potential— better yet, when the markets head the opposite direction and actually make new highs—they are making a very significant point.

Several months back, I wrote in an article a little about Marshall Auerback, a hedge fund manager from Colorado. Marshall is an exceptional thinker who does great research on context. Judging his track record, he obviously knows how to trade based on his analysis. Marshall wrote incredibly insightful analysis on the Dubai situation. 

Here’s the summary of Marshall’s analysis: Dubai has problems for sure, but as a part of the UAE there really is a low probability of it actually defaulting (remember that so far, they’ve only told lenders that they are delaying payments).

A slightly deeper look: the UAE has plentiful oil revenue and huge oil reserves (future earnings) from which they generate cash flow. They have also stashed a good bit of their sovereign wealth in foreign currency reserves, which generates significant investment revenue. In short, there is an outside chance for Dubai defaulting, but it’s quite remote.

So despite the ugly news from Dubai, we’re making new highs. The most important message in the last week is that this is a breakout market until proven otherwise!

As always, thank you for your attention and please send comments and thoughts to drbarton “at” iitm.com.

Until next week…

Great Trading!
D. R. 

About D.R. Barton, Jr.:  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".

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Mail Bag

Position Sizing Using Mean Reversion Strategy

Q: I feel that I have a good handle on the concepts of limiting risk and position sizing as they apply to trend following strategies. However, I have a bit of a conflict when it comes to mean reversion trading strategies.

My objective for the mean reversion strategy that I trade is to look for ETFs that are in a long term trend and have deviated from that trend on a short term basis. For example, a particular ETF may clearly be trending upwards on a long term basis but is experiencing oversold conditions on a short term basis. The short term pullbacks have proven to be a good entry point for short term trading. If the position moves against me, that means the ETF would have become even more oversold. As long as the initial conditions for an upwards trend are in place, this would be an even more advantageous point for me to enter the trade, so I would typically add to my position. This seems like a paradox, but it has proven successful.

I limit myself to no more than 3 or 4 entries due to increasingly oversold conditions, and I typically pyramid the size of my position as the ETF becomes more oversold (for example, I may buy 100 shares on my first entry, then add 200 shares as it becomes more oversold, and finally add an additional 400 shares for my third and final entry.) 

This method has given me both a positive expectancy and a high probability that the trade will be successful (often in excess of 80% correct.) I exit the trade either when it is no longer oversold on a short term basis (usually locking in a profit) or when the ETF is no longer giving me the signal of a long term upward trend. This serves effectively as my stop loss. It has happened, but it is rare.

Unfortunately, since I look for strongly trending ETFs, they need to drop a lot before I no longer get a signal that they are trending. If I use this basis as my maximum R and limit my maximum risk to no more than 1% or 2% of my trading account, I end up with exceptionally small position sizes which are not worth trading for the small profits that they typically yield. Using smaller stop losses at arbitrary points does not improve my expectancy, and it is in conflict with the philosophy that as long as the basic long term trend is in place I can typically expect it to revert after a pullback.

What is your advice for position sizing in a case like this when using a mean reversion strategy? Thanks.

A:  You didn't give me enough information to provide you with valuable position sizing advice, so what if I give you some things to think about? 

As I say frequently in the Definitive Guide to Position Sizing, your objectives determine your position sizing strategy. What are your objectives? You did not say. Are they clear and fully defined? Have you put a lot of effort into thinking about them? Crafting a position sizing strategy is much easier after you have done enough work on your objectives. 

As for a scaling-in strategy, first determine the maximum risk per position you are willing to accept. Then divide that into the maximum number of times you want to scale-in. Something else to consider: what happens if you have max positions on and the market type changes from bull to bear and you start losing 50%+?—Van

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