Trader’s Narrative

Continuing to look at the energy sector, here is another chart that shows some interesting technical characteristics:

A shallow angle of ascent provides for an uptrend’s longevity. But as it ramps higher at a steeper and steeper slope, then the trend is either about to end or reverse.

You can see in the case of S&P Oil & Gas Exploration SPDR (XOP) ETF that the uptrend has changed slope three times. Each time becoming steeper. According to traditional technical analysis this is a sign of exhaustion. No trend can sustain itself for much longer once it has intensified three times.

Another important element is the formation of a shooting star candlestick formation on the weekly chart. This is another sign of impending trend exhaustion. It is significant only after an uptrend. You can find others on the chart, for example the first week of November 2007.

Think of shooting stars as inverted hammer candlesticks. Just as hammers are bullish when they occur after a downtrend, so are shooting stars bearish after an uptrend.

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.

So was that capitulation? I don’t mean today’s gangbusters market. I mean yesterday’s rollercoaster ride.

Let’s see…

Stop, Hammer Time!
The intraday reversal gave us a beautiful, textbook hammer candlestick. Using the traditional Japanese candlestick theory, after a downtrend this is a portent of the end of selling pressure. Although the low could be tested - especially with Friday’s gap - a hammer is a bull’s friend.

Market Internals
The market was deeply oversold. The NYSE cumulative intraday TICK reached levels only seen right after September 11, 2001 and during the bear market bottom in the summer of 2002.

The New High Lows Index for Nasdaq reached 2.29%. Simply put, almost no highs, and almost all lows. To find a more extreme reading, we’d have to go back to the fall of 1998. Which as you know was a major market bottom.

Only 9.4% of the stocks in the S&P 500 index closed above their 50 day moving average. And only 34% above their 200 day moving average. The NYSE McClellan Summation index got as low as it has been since the bear market bottom.

My Kingdom For T-Bills
During Thursday’s nail biter of a session there was an exodus from anything risky towards the least risky asset. Theoretically risk free Treasury Bills. The run on government paper pushed the yield down to 3.86% for 3 month bills. To make things worse, due to an unexpected rise in tax receipts the government issued less paper. This sudden imbalance is extremely rare. And it only happens during panics (which… say it with me now… form bottoms).

I felt uncomfortable agreeing with Cramer, but I think this is one of the reasons why the Fed acted this morning. Commercial paper was being shunned. They stood up and basically told the market We got your back. For a bit it was touch and go, but my world feels right as rain again.

Margin Bulletin
I got a message from my broker warning me that positions in VIX futures and futures spreads could face an increase in margin from the CFE. I’m thankful for the headsup but I don’t trade these securities. I did notice that margin tweaking is a sign of inflection points. Just something to tuck under the hat.

Retail & Institutional Fund Flows
This is fascinating. According to the estimates from TrimTabs, we just had the highest weekly outflow since right after September 11, 2001. For about two years now the US mutual fund investor has been shunning the US stock market. But this week they pulled $12.8 billion out of US equity mutual funds.

According to TrimTabs, since the beginning of year, mutual fund buyers have been net sellers of stocks resulting in outflows of $35 billion in the last 4 months. The only time we saw similar outflows of this magnitude was during June 2002 and September 2002. You know what that was, right?

Strangely enough, bonds are the most popular asset class along with money market funds. They are even more loved than international markets. Bonds have seen an estimated $92 billion inflow since beginning of year this year.

That’s the retail side. What about the institutional mutual fund asset allocators? I’ll give you one guess.

They’ve been diving into the US market with the same intensity as the retail side has been escaping from it. So the smart money is buying and the emotional, dumb money is selling. Watch the video for more details:

Commitment of Traders
The most recent COT report dovetails with the fund flows data. We are seeing a continuation of the commercials going huge net long and the small speculator going the other way. Whether the futures market or the stock market, the two sides have clearly outlined their positions. There is no doubt where they stand.

What, Me Worry?
Which gives me a possible explanation for the sentiment picture. Perhaps the reason we are not seeing a total all out panic and despair from the retail investors during this downturn is that they simply don’t have any real vested interest in the outcome.

If we go by the COT and fund flows, they have very very few chips on the table. So why would they care? why would they get scared? Most of their money is squirreled away in cash equivalent and bonds and international markets. Unlike the 2000 top, they have very little invested in the US. Why would they even really care if the US market ticks up or down a few percentage points?

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!

After reporting a disapointing first quarter, Joseph A. Banks Clothiers gapped up today on the news that sales in June had gone up 8.5%:

The first bar was a wide range down candle. The second was an almost perfect hammer candlestick which formed close to the low of the opening range with the lower tail of the candle going as low as the opening range’s low.

From there price rallied. A good low risk entry was above the second candle (hammer) with a stop loss just below the low of the opening range. With entries below the high of the opening range, it’s important to watch how price behaves when it again reaches resistance at the opening range high.

JOSB had a shallow pull back when it got close to the high of the opening range. You can see this pullback better if you look at a shorter time frame than 15 minutes. But even on the 15 minute chart above it is visible in the fourth candle’s tail. Price then continued to advance and broke through $25.17 decisively. From then on it just kept going, reaching the 38.2% Fibonacci extension and beyond.