Trader’s Narrative

More than a year ago I called it: We are in a recession!

It was rather foolhardy to go out on a limb like that but with the help of hindsight we now know that that was quite a prescient call. What I didn’t expect was that we would be entering one of the most serious recessions we’ve seen in recent history.

Since the National Bureau of Economic Research has been keeping track of them, we’ve had 22 recessions (including this one). However, only 4 have been longer in duration:

Source: Chart of the Day

It may be just as foolhardy to now do an about turn and declare that the ‘Great Recession’ is over. But we are seeing some indications of that. The bad news is that the sharp contraction in inventories that we’ve seen has been unprecedented in recent economic history. The good news is that such drawdowns have historically signaled the end of recessions:

Souce: Doug Kass at theStreet.com

Yesterday I wrote about utility stocks being on sale. Today most of them gapped up in a technical snap back but finished the day poorly.

Still for nimble traders there was ample opportunity to take advantage of the short term oversold condition in this sector. Here are two charts from FPL Group (FPL) and Entergy (ETR) which are representative of what happened in this sector today:

We still have quite a ways to go to fully work out this oversold condition. Eventhough it won’t be straight up to new highs, this sector bears watching. Especially the high prices stocks which present good low risk opportunities when they contract in range and volatility.

I find the fractal nature of financial markets fascinating. You can look at a minute chart, a 30 minute chart, a daily chart, a weekly chart and you will see basically the same formations, the same elemental forces of support and resistance and the same setups.

As a trader, you can use this to your advantage. Switching time frames can help you avoid a “noisy” market. It’s also a great trick to avoid looking at the same charts that everyone else is looking at. It can, in fact, be an edge if everyone is looking at the 15 minute chart, for example, and you’re looking at the hourly chart or the 40 minute chart. You will see things that others will simply miss.

To illustrate what I mean, let me show you an example of a trade executed following the basic rules of the dummy trading setup: look for a thrust (expansion in price), then a contraction or pullback and hop on as the contraction is taken out by the continuation of the trend. The dummy trading setup is meant to be executed intraday but knowing the fractal nature of the markets, there is no reason we can’t trade it at a higher time level. This example is a swing trade using daily charts.

Metalico Inc. (MEA) is in the hot metals sub-sector. It put in a stable, long base for over 4 months. Then in early April it broke out with unusually high volume. It consolidated a little around the $5.25 breakout area and continued higher. If you missed this first opportunity, the next one came on April 18th 2007 as price pulled back significantly. It formed a hammer like candlestick with a very long tail. This was a tell that price was being supported as a second wave of buyers saw their chance to get in on price levels they had missed before.

The next day there was a contraction as it printed a narrow range, inside candle. This is what a “dummy trader” looks for! The break-out of this contraction (green line) then took price to the previous swing high and beyond. Notice also that the volume shrank significantly as price pulled back in mid April. This was another tell that people really weren’t interested to part with their shares but rather to accumulate more (blue rounded box).

How you trade this setup is really up to you. You can wait for a tightening of the price range or you can wait for a real pullback. Traders like Tony Oz only get in on a deep pullback, preferably all the way back to the break out price. But as you can see with Metalico’s example, you may not get such a deep pullback when faced with a strong trending stock.

I don’t think anyone can say one entry setup is better than the other. Ultimately it is up to each trader to fine tune the setup to their liking and temperment. But keep in mind that such setups are merely starting places. Take them and build on them with your own ideas.

In any case, getting back to the point about different time frames… take a look at M&F Worldwide Corp. (MFW) on a weekly chart. Yes, weekly. And then count how many “dummy spots” you notice!

Last week I wrote about the emergence of solar stocks and the solar sector as a white hot (pun unintended) area of the market. You should always pay attention when a group of stocks in a sector acts alike - like a school of fish or a herd of gazelles darting in one direction. This is a strong signal that has a terrific track record in pinpointing tremendously powerful thrusts in price action.

After I wrote that review, Shane sent me a note over the weekend pointing out that I had missed out on JA Solar (JASO). I was thankful but shocked! I still can’t believe I missed this one because it is one of the few that have recently come public and I made a special note to pay extra attention to recent IPO’s in this sector.

This is something I’ve learned from William J. O’neil’s class “How to Make Money in Stocks” (I know, cheesy title, but brilliant book). O’neil says that new stocks (IPOs) are ‘fresh’ and have a new constituency. The fact that an IPO has 100% happy holders is a very important element of a sustained uptrend.

So which stock do you imagine rocketed higher? Yup, the one that I somehow missed:

JASO went public just a few months ago in February 2007 and since then it went into a tight trading range between $20 and $16. Then late last week it broke through resistance with a wide range bar and massive volume. The next few days saw even more extreme price expansion with run away gaps and wide range candles as momentum players piled on. As far as I know, there is no news. This is a pure technically driven move.

Look at that intraday price action! You can’t get any more beautiful than that chart. There were so many contraction areas that offered a low risk entry. If you’ve missed the move so far though I think the prudent thing is to wait for a pullback. There will be one as some of the longs will want to ring the cash register. Even if there isn’t one, you never want to chase a parabolic move.

Have you noticed that often at inflection points in the market, before a new trend is started, we see a sort of ‘thrashing’ about in the breadth figures?

You can see what I mean in this chart of the daily advancers and decliners for the Nasdaq index:

Notice that before the recent market top, there was a contraction in the market breadth. The trendlines I’ve drawn by the way, are not 100% accurate, they’re just guideposts. But see how the internal workings of the market were getting squeezed? Becoming less volatile and smoother. Until it went plop!

It might seem imperceptible to you, especially if you’re new to charts in general and especially to the crazy looking advance decline charts. But depending on your natural visual abilities and the amount of time that you spend training your visual acuity, you will find the subtle contraction and expansion taking place.

Another example was in the summer of last year when we had another expansion (in June and July 2006). To see a closer look at the breadth at that time, take a look at my previous mention of the advance decline numbers.

So why do does the market exhibit this characteristic?

I think it is because at times of panic we see extreme herding take place. The market rushes towards one direction: sell!

But then, paradoxically, it immediately turns on its heals and goes the other way within a short time frame. This is exactly the sort of behaviour that studies like Lowry’s 90-90 day or Marty Zweig’s 9-to-1 pin point. If you are in the market at these times it can be jarring. You see wild swings in your portfolio and it seems almost random. But it isn’t.

The market is simply doing what it must to flush out the weak hands, to throw the maximum number of people into the wrong positions, so that when the new trend is established, it has fuel to propell it. Unfortunately for those who are on the wrong side of the emerging trend, the fuel is their capital going up in smoke.

As the incorrectly positioned player slowly realizes their mistake, they begin to close out their positions. As they do, the trend is given fuel to continue and intensify. Of course, there is also a lot of money that simply stands aside and waits this out. Their contribution as mo-mo (or momentum players) is to jump on the trend once it is established and to squeeze the losing side for all they’ve got.

So which do you want to be? The one that gambles or the one that stands aside and lets the dust settle before riding a trend?

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