Trader’s Narrative

The stock market’s resilience was in good form today as it inched ahead, managing to recover from the shallow pull back of 3 weeks ago. The Dow Jones even managed to put in a new high for the year while the S&P 500 index and the Nasdaq were not far behind. I’m not sure if this shallow pullback is what Lowry had in mind when they cautioned against jumping with both feed into their intermediate buy signal.

The tongue in cheek title of this post is inspired by the classic Kubric film, “Dr. Strangelove“. I thought of it when I looked at today’s chart of the day showing the subsequent returns for the worst yearly returns of the Dow Jones:

Source: Chart of the Day

The 15 largest annual declines in the history of the Dow usually lead to a reversion to the mean. But not always. The 1930’s were as you’d expect, a wild card where bad simply got worse. Of course, back then you didn’t have the Fed opening the liquidity spigots like today. The only other outlier is 1978 which was slightly down during the brutal 1970’s bear market. Not surprisingly, when we step back and get some real perspective, cycles are obvious and we tend to go from bad to better. This is basically what I argued that Why Long Term Investors Should Consider Buying:

Can things get worse? Of course. But at this point, if you have a long term time horizon, a cast iron stomach for risk, the data suggests you should be taking small positions and slowly adding to them cautiously, even if the market continues to tank. That may sound crazy, but where we are right now in market history, only comes about very rarely.

Boy did things get worse. And if you were foolhardy (or smart?) enough to have an unemotional take on the market and a long term view, stepping into the abyss wouldn’t have been all that horrible. You would have been buying into a decline but in 4 short months, it would be all over.

In fact, we’re starting to see signs of real strength in the market. For example, the number of new 52 week highs in the US markets has recovered to pre-crisis levels:

Source: Bloomberg

Usually any measure reaching bear market tops sends shivers down one’s spine but keep in mind that this metric has not reached an extreme level. For example, consider that it was much, much higher towards the end of 2003 or early 2000 (not shown on the above chart). Both extremely unfortunate times to be long the equity markets. Right now however, we’re just seeing some resilience not speculative mania.

Yes, yes, I know the market is pricing in some insane numbers, including ginormous positive GDP growth and totally ignoring unemployment and a half-a-dozen other factors. What you have to remember is that the market does this all the time. In a bear market, it ignores bullish arguments repeatedly - until it doesn’t. And vice versa. So why argue?

This is a guest post by Wayne Whaley (CTA):

Men Who Can Be Right and Sit Tight Are Uncommon.
Reminiscences of a Stock Operator

The S&P 500 has officially closed the month of September up by 3.68%. A few weeks ago I shared some statistics on the significance of a positive September: When September Flexes It’s Muscle.

To summarize my previous comments: September has a deservedly bad reputation. Since 1950 it has been the weakest month of the year, averaging a return of -0.61% with losses occurring 57% of the time.

Therefore, the market’s ability to buck this bearish seasonal trend in September should be respected and viewed as a sign of continuing strength. When September is positive, fourth quarter returns are positive 84% of the time with an an average gain of 4.84% over that time frame.

Only two of those 25 fourth quarters saw the market down more than 1%. Even “The Mother of all Crash Months” October was positive after positive Septembers 60% of the time for an average gain of 1%.

So now that we have a rare positive September, what now?

This is especially interesting since this September was the 7th consecutive positive month for the S&P 500 index. The inclination is to play contrarian and view this move as a sign of overextension. But, as Lee Corso would say, “Not so fast my friend”. The odds for an eighth positive month are 12-2.

Here is the full data for similar past instances of such “overextension”:

As you can see from the historical data, there is no mean reversion. Instead, stock prices continue their trajectory and tack on even more gains. The sweet spot is 6 months ahead, which from here would take us to February 2010, with a gain of about 8% (and 93% positive returns).

Moving averages are one of, if not, the first indicator that people are introduced to. They are simple to calculate, simple to understand and they seemingly smooth out the price on a chart, painting beautifully rounded hills and valleys. Most plot them right on the price chart and use them to show areas of support or resistance. See!, they say, price hit the 200 day moving average, that’s resistance!

Being a rebel, I use moving averages differently. First, I try to not plot them on top of my price charts since I prefer to keep the chart clean of any distractions. Price is the main feature and everything else keys off it. So why create distractions from the most important element?

Second, I refer to moving averages to find areas of extreme expansion. Think of price as an elastic band that can stretch above and below the moving average. As it does, it reaches a point where it just can’t stretch any further and starts to snap back. Mean reversion for the more mathematically inclined.

So what I do is modify the MACD to show this elastic character of prices. Moving Average Convergence Divergence (MACD) is probably the next most common indicator after moving averages. And yet most people have neither any understanding of how it is calculated nor how they should use it. To have the MACD indicator plot the movement of price away from a moving average change the default setting to: 1, X, 1 — where X stands for the period of the moving average you want.

Let me show you how I use this. I mentioned that I liked North West Company Fund (NWF.un) in June 2006 (note that in Sept 2006 there was a 3:1 split). Last year, the Canadian income trust market reacted with panic selling on Halloween as the Harper government reneged on their promise to not tax income trusts. Without any shame, they lied to the Canadian people. But what politician hasn’t?

North West wasn’t spared as it gapped down hard on very high volume. There was panic in the sector as the ground has suddenly shifted. Sentiment was very negative with many claiming this was the death knell for income trusts in general. I bought at $13.55 (all prices in Cdn dollars). That would be the green dot on the chart.

There was a momentary recovery and a second spike down. Such a move leads to a double bottom or a further decline - either way, a clear technical would tell me and I would limit any potential losses. It’s important to remember that North West’s business was humming along with great earnings. And I knew that I would be paid a distribution as I waited for cooler heads to prevail.

See the chart above the price chart for North West? That is the relative behavior of price to the 50 day simple moving average. By the way, there is nothing magical about the 50 moving average, it wouldn’t make a difference if you used the 33, 40, 43, etc. moving averages. Consistency is important though since we don’t want to compare apples to oranges.

Notice how the previous swing high in September 2006 was stopped as price was stretched to the upside (red rounded box). The November spike down was the mirror opposite of that situation. Of course, price simply can not bounce from one extreme (oversold) to the next extreme (overbought) within a short time. Especially when we’re dealing with a low beta security like an income trust. So I sat. And my sitting, as Jesse Livermore would say, made money. I got out a few days ago at $20.28 .

Here are the fills I got from Interactive Brokers:

NWF.UN 2006-11-13, 14:07:22 TSE 13.5500
NWF.UN 2007-04-30, 11:14:14 TSE 20.2800