Trader’s Narrative

A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.

The market is full of cycles. Some are fast and others like the inter-relationship between the small capitalization and the large capitalization subset play out at a glacial pace:

The stock market seems to go through these slow, vast cycles between large caps and small caps and they usually last about 5 years. Most surprisingly, they resemble a sine wave - with some noise thrown in - which is surprisingly orderly and predictable.

But we seem to be in a rare exception right now when the market can’t make up its mind who is winning and who is losing. Since 2005 we’ve been in a holding pattern with the ratio of small caps relative to large caps around the same level as 1994.

This is around the area where small caps have given up the fight and large caps taken over. Going back 30+ years the ratio topped out higher than this level (approximately 0.80) in 1984. So based on historical precedent, we should see large caps take the stage for the next few years.

The real question though is what does it mean? I’ve turned it over but I can’t detect any edge from this slow back and forth cycle. Especially for timing the market.

Having an idea of where we are in the over all scheme of things may be helpful if you’re going to go long one and short the other but it doesn’t seem to be all that helpful when you’re simply asking if it is a good time to short or go long either market by itself.

For example, while 1991 was a trough, it corresponded to the start of a period of years where the S&P 500 did quite well. But in 1994 where the ratio topped, that was arguably also a good time to buy. And then finally, in 1999 and 2000 when the ratio was pushed down again, that was not a good time to be invested in the market going forward.

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

As this annus horribilis draws to a close, we are left ducking shoe after shoe that drops or is flung at us. But this year’s abysmal performance has a silver lining. It offers a sumptuous buffet for those who finish off the year with a play on the January effect.

For the novice, this is the trading pattern at the end of the year which the efficient market hypothesis says shouldn’t even exist. Usually it is small or micro capitalization stocks which have declined and are then pushed down further by tax-loss selling. The opportunity is to play these for a short term bounce into the new year.

Personally, I focus on closed end funds (CEFs) and within them usually fixed income or municipal bond CEFs. I go into great detail explaining the background, rationale and several actual trades: My Year End Strategy

I won’t repeat myself because you can get all the info you need from the above link. This is a very high return, high probability trade but it depends on how poorly the target securities have fared.

This year, I feel like a kid in a candy store. While this abundance is great, it does make it a bit more challenging to filter all the potential plays and find the best ones.

You can sift through the CEFs through a publication like Barron’s which not only prints their prices but also their year to date performance and premium/discount to NAV. Online you can use the CEF Association’s database or check out ETF Connect and use their Fund Sorter or do an advanced search to only look at certain sub-sections of securities like municipal bond fund CEFs.

Here’s an example of the sort of securities to choose from:

Continue reading ‘How To Play The January Effect This Year With CEFs’

Here’s an interesting chart comparing two slices of the US stock market:

In early April, around the time the stock market recovered from the March bottom, suddenly the Mid Caps (right axis) and the Large Caps (left axis) parted ways.

This is rather strange because they walked hand in hand for a very long time. I’m not sure why exactly. Even more puzzling, the S&P 400 Mid Capitalization Index (MID) also outperformed the S&P 600 Small Cap Index (SML) - not shown on chart.

Any ideas why the Mid Caps are hitting the sweet spot now?

The market does tend to go through drawn out cycles when the large caps and the small caps take turns leading.

Here is an updated chart of this relationship showing that maybe, just maybe, the small caps are about to regain the limelight:

And here is the same chart, this time comparing the Mid Caps to the Large Caps. No question here which is leading:

As the Mid Caps and Small Caps battle it out, one thing seems clear, the big cap stocks look like they are the losers going forward. If you want to take advantage of this you can switch out of SPY into an ETF like Rydex S&P Equal Weight (RSP) (if you’re feeling like a hedge fund, short SPY and then go long RSP). Or you could just buy small cap or mid cap ETFs:

• MidCap SPDRs (MDY)
• Vanguard Mid-Cap (VO)
• iShares S&P MidCap 400 (IJH)
• iShares Russell Midcap (IWR)