Trader’s Narrative

According to a June 1st press release from Dow Jones: “The Travelers Companies, Inc. (TRV) is taking the place of Citigroup, Inc. (C) and Cisco Systems, Inc. (CSCO) is going in for General Motors Corp. (GM).”

The changes will go into effect on the opening of trading next Monday - June 8, 2009. The last time the Dow Industrial Average was changed was about a year ago when Bank of America and Chevron (CVX) replaced Altria (MO) and Honeywell (HON) (Dow Jones Technical & Fundamental Analysis)

There is an ongoing debate between ‘passive’ vs. ‘active’ portfolio management. Very few money managers are able to beat wide indexes over time. But when you think about it, we don’t really have passive portfolios. If the Dow was truly passive it would still be comprised of companies like Standard Rope & Twine (a component from 1898). But obviously, such an index would have long ago ceased to exist; just like its component companies. To continue to exist and be relevant, an index must evolve along with the stock market. And that makes it an actively managed portfolio.

The only real difference is that a ‘passive’ investment portfolio like the Dow Jones has a much lower turnover rate than more actively traded portfolios managed by you or a hedge fund trader or a mutual fund portfolio manager. So the debate is really about turnover. When you start to buy/sell at a furious pace, not only do you have to deal with transaction costs but shrinkage due to spreads, errors and taxes. Unless you have an edge that can beat those costs, you’re trying to get out of a hole by digging faster.

The funny thing is that although these index changes are necessary, most of them result in lower performance. There have been a lot of studies done on indexes like the Dow and the S&P 500 which show that in the short term, companies that are removed provide higher returns than those which they were replaced by. Which means that GM (GMGMQ) and Citigroup (C) are probably going to outperform Cisco (CSCO) and Travelers (TRV) going forward. So the price that you pay for having an index like the Dow or the S&P 500 continue indefinitely is that their performance is actually lower than it would be, had there been less interference with their composition.

In poker, a “tell” is any change in the pattern of behavior by a player that gives insight into their strategy. It could be anything: how fast they bet, how they throw their chips in, feigning ignorance or interest, etc. You can’t really win at poker if you don’t have a mastery of tells.

In the same way, the stock market provides “tells”. If you know where to look. Today’s market tell, as I mentioned yesterday, was obviously, Citigroup (C).

Let’s take a look at today’s intra-day action to see what this market tell offered us. As you’ll see from the chart, Citigroup acted as a reliable tell by breaking down from its morning range before the market did.

It then continued to lead the market in sinking lower. So if you were watching Citi, instead of, or at least in conjunction with, the general market indices, you would be able to react much faster.

The concept of a market tell is a useful one but just like in poker, the “tell” itself can change from hand to hand. So while today’s market tell was obvious, tomorrow’s may not be.

As I previously touched on, we had a 90-90 down day on Jan. 4th 2008. According to the Lowry’s study, all we need now is a 90-90 up day for a market bottom.

90-90 Day
Today wasn’t it. Although the market went up, it did so lethargically. Volume did flow in the right direction: advancing stocks in the NYSE were 1,003,680,000 compared to 401,066,000 declining stocks - a 5:2 ratio. And on the Nasdaq, almost 3:1. But we need much more excitement than that to forge an inflection point.

On January 7th, the S&P 500 put in a hammer-like candle (if you squint) with normal volume as traders came back from holidays. This was two days after I wrote Rally around the corner :

And although we still haven’t taken out those lows, the market is coiling into a tight range. If it reacts to the recent oversold conditions and breaks out, then the probability of it continuing and regaining lost ground is high. But it can also break down to retest the lows. Or even go lower.

The market is. No one can predict or control it. I’ve shared a thesis of where things may be, but I’ll let the market prove me wrong or right.

Stocks vs. Bonds
Right now, by several measures, bonds are expensive and stocks are cheap. I’ll go into this point more in depth in a few days. What matters though is that this important relationship is skewed towards a rally. But this is a myopic market. The only thing it can focus on is what is immediately in front of it. Which happens to be Tuesday’s expected announcement from Citigroup (C).

Being the market tell for the day, I’d suggest keeping a watchful eye on Citi.

This week the financial giants Goldman Sachs (GS), Bear Stearns (BSC) and Morgan Stanley (MS) will be releasing their quarterly earnings reports.

I’ve been patient and hopeful with this sector since it has been showing the classic signs of oversold extremes.

But each time it is given a chance to bounce back, it only musters a meager step or two forward… and then falls back.

You can see this in the bullish percent index of the sector:

In July it reached an extreme oversold level of 25% but couldn’t gain any traction. Then again this November the index fell to 20%. But after a feeble “dead-cat” bounce it has rolled over again. This behavior is a marked contrast to the previous years when the bullish percent index remained at very high levels and only sporadically dipped lower.

Looking at the price chart itself (the Philadelphia Banking Index) we see the same thing. A classic downtrend pattern of lower lows (green) and lower highs (red):

No question that things are downright ugly. Within the sector, only 17% of the component stocks are now sitting above their 200 day moving average. This is extreme. But it has been the case for most of the time since the swoon in July. Only 4% closed above their short term, 10 day moving average and a paltry 13% above their 50 day moving average.

But when oversold levels don’t lead to lasting rallies, you know something is wrong. The banks and financial stocks are acting very tired here and I would either wait to see a dramatic washout (the kind that has you gasping) or a miraculous sign of strength before giving them the benefit of the doubt again.

At the end of July I mentioned that it was time to consider the battered financial sector. Back then, the bullish percent chart for the sector approached 25%, a level which usually means oversold. But yesterday, this same indicator dipped to just 16.13%:

After I mentioned the opportunity to go long the sector, banks and financials did recover but in a very limited way. Even so, the paltry rally was enough to push the bullish percent index to almost 80% - which was a sign that things had swung to the other extreme and it was time to exit.

Getting back to the present, the bullish percent index has not been this low since early 2000 - when the Philadelphia Banking Index (BKX) was more than 30% lower:

Things are very stretched to the downside here and we are ripe for a snap-back rally. Although it is extremely difficult, the best time to buy a bargain is when everyone else is running for the hills, screaming in fear.

See this link to learn more about how I time the stock market using bullish percent charts (based on point and figure charting).