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.

As mentioned yesterday, the market tell everyone was watching today was the Lehman Bros. CDS auction. The results were not unexpected with the bidding coming in at just under 10 cents on the dollar.

The market continues to slide lower with the VIX volatility index reaching an eye-popping ~72%+

As I hinted yesterday, LIBOR may have topped because today it is down very slightly (at least it didn’t go up!). The overnight LIBOR rate is down to 2.47% from Thursday’s 5.09% - the chart below is for 3 month LIBOR. But the TED spread continues to creep up. What makes this wealth erosion devastating is that we are stair-stepping down in the stock market, rather than free-falling in full crash mode.

Something that has been pushed off the radar by the financial crisis is the dismal state of both Ford (F) and General Motors (GM). There was a time when Wall St. looked at GM as a barometer of the economic health of the US. The stock is now trading at single digit levels it was during the 1950’s when the Dow was trading at the 200 level.

Iceland, as you’ve heard, is now bankrupt and is listed on eBay. Their currency is worthless as banks refuse to even touch it.

Headlines are shouting: “The End of American Capitalism” and worse. Rothschild is purported to have said:

“It requires a great deal of boldness, and a great deal of caution, to make a great fortune.”

The trick is to be bold when everyone else is fearful and to be fearful when everyone else is bold. If you can do that, then come back and teach me.

If nothing else, all this will make for a great story for your grandchildren, in some Mad Max distopian future.

Yesterday, Maoxian left a comment about my use of a 2 minute interval to find a ‘dummy’ entry and I wanted to explore this topic a bit more.

Due to the fractal nature of prices, technical analysis can be applied with equal validity to almost any time frame: minute, hour, day, week or even monthly prices. Trendlines can be drawn, moving averages calculated, indicators plotted, etc… in fact, if we remove the reference to time, most people wouldn’t be able to distinguish a 5 minute chart from a daily chart or a weekly chart.

Of course, when you approach extremes (say, a tick chart or an annual chart) then things are either moving so quickly that you lose track of the bigger trend or things are moving so slowly that by the time you react, the trend is over. So there is a sweet spot. But the range it contains is quite large.

Alright, then how do we decide which timeframe to use? a 2 minute chart or a 5 minute chart? or how about a 15 minute chart? what is wrong with a 30 minute chart?

The answer I think is it depends.

There really is nothing wrong with a 2 minute chart, nor is a 15 minute chart inherently better than, say, a 30 minute chart. They all are snapshots of previous market action. And they each will present varying degrees of opportunity.

So why did I use a 2 minute chart?

Well, I knew that after the Fed announcement, the market would be a fast one with prices whizzing by with enormous speed and volatility. I wanted to zoom in on the exact opportunity that this volatility presented. And so, by default, I had no better option than a very small time frame.

Needless to say, the more short term your focus, the more rapidly you’ll have to react. Event driven markets, like yesterday’s Fed annoucement, are rare. For more normal market conditions, and a more leisurely pace, pick out a longish time frame. Say, 15, 20 or even 30 minute charts.

The point is that you have adapt to the market, not expect the market to adapt to you. If its a fast market, drill down to a smaller time frame. Otherwise, you may not even get a low risk entry.

As an example, consider a stock that lit up many a filter today: unusual volume, high trade count, gap up, and heavy premarket activity:

Premarket was very active with GM shares moving up extremely fast from $27.50 to $31 in no time flat. This is not a fiber optic company and I checked the calendar, it is not 1999. So this is your first hint that trading conditions are not ‘normal’ for GM today.

Towards the end of the pre-market session, we have an inverted hammer with a very long upper tail (red arrow). This is a sign of buying exhaustion. Right after the regular session, price begins to tumble down from the lofty mount it attained in pre-market. There were two pauses where a low risk short entry was possible (red circles).

Now take a look at GM’s 15 minute chart:

The only chance you had was to get short right at the open, based on the pre-market action - below the long tailed doji. Other than that you had no entry offered on the 15 minute chart. And if you were not watching the pre-market session, you would have even missed the signal right at the open.