Trader’s Narrative

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.

I suggested yesterday that the overnight and pre-market range would be a good market tell for what we had in store today.

I really meant what the market would do after it had set this range. The classic interpretation is that if it breaks down, a lot of people would be disappointed and in a loss, increasing the chance of another cascade down.

But on the other hand, if it breaks above the range, it would also set the precedent for the coming trading day and we would close the gap.

Which is exactly what happened:

As you can see, the range was quite tight. It broke down to 1255 but after several attempts didn’t break down any further. In the morning we had a spike up and in a furiously fast market we raced up. There’s something magnetic about gaps - they are almost always filled in.

The tell was clear but you still needed some nimble fingers (or preset conditional orders) to be able to get in and out.

If you’ve somehow managed to not learn about Mark D. Cook by now: he is a ‘Trading Wizard’ featured in Schwager’s series of books, a legendary futures trader and the winner of the 1992 U.S. Investment Championship (with a 563.8% return). His most famous contribution to trading and technical analysis is his self named, Cook Cumulative Tick Indicator.

This indicator is, as the name suggests, simply a cumulative count of tick throughout the trading day. The exact recipe is only known to Mark D. Cook but from what he has publicly divulged, we can try and estimate the Cumulative Tick Indicator to a pretty good degree.

First, separate the noise from the signal by ignoring any tick readings within the +/-400 range. We then record and aggregate those readings outside this range at a fixed time interval. We don’t know exactly what interval Mark uses so just pick a time interval: minute, hour, day, etc. The important thing is to be consistent. That’s it! Now you have the super secret Mark D. Cook, Cook Cumulative Tick Indicator. So what do you do with it? Watch the 95th and 5th percentile. If the Cumulative Tick Indicator is above the 95th percentile, sell; if below 5th percentile, buy.

Remember, this is a counter trend strategy so the more extreme the tick, the more vicious the snapback. As with all counter trend strategies, mind your protective stop loss! A trend can persist much longer than you can remain solvent. Never try and be a hero by playing chicken with the market.

But what if you don’t have access to such tick data? You can estimate the cumulative tick by calculating a simple moving average. This won’t be the same as Cook’s Cumulative Indicator, but it is still helpful:

The cool thing about this indicator is that it is quite accurate in pinpointing tops as well as bottoms (see how an oversold extreme in tick flagged the May 2006 bottom). After all, it is an almost real time snapshot of the market’s pulse, racing from greed to fear and back again.

Lets take a look a the recent action in this approximation of the Cumulative Cook Indicator. In early March 2007 it hit an extreme oversold level (-300). If you had any shorts or wanted to press the short side, this was telling you to both lighten up and to think about going long instead.

Then within just a few weeks in mid-March 2007 it reversed and went as high as +500! If you notice, it hit the overbought threshold (+400) when the Nasdaq reached 2450 and stalled. If you were long, it was telling you to lighten up and think about shorting. Remember that this indicator is quite hyper. Either adapt to such short term setups or use a longer moving average to get a more long-term perspective.

Mark Cook uses the NYSE tick, but personally, I think that the NYSE is so polluted with non-common share securities that the tick and any other indicator based on NYSE data has way too much noise to signal ratio to be useful. Thankfully we have the NASDAQ tick which is the same thing really - free of the ‘noise’ from bond funds, munis, preferreds, etc.

Cook has a few more tricks up his sleeve - would he be a Trading Wizard if he didn’t? There is the conjunction trade which relies on tick but is a bit different than the Cumulative Tick Indicator. First, you want a tick reading below -400 (the magical threshold). Second, you want the Dow Jones tick below -22. The ‘conjunction’ of these two gives you the signal (for the spoos). You give it a window of 21 minutes to work.

There are 3 possible outcomes:

• you run out of time (price meanders) and you exit
• you take a 3 pt profit
• you take a 6 pt stop loss

I’m not sure if it’s a great idea to have a 1:2 profit to stop loss ratio but I assume that Cook relies on the high probability nature of this setup to give him positive expectancy.

Finally, Mark D. Cook has a trading setup he calls a ‘tick buy’. This is the simplest one! The signal for a buy/sell is when the NYSE tick gets to -/+1000. That’s it. The thinking is, of course that you buy because market will snap back from such an oversold level. The wrinkle is that you watch and buy the index that cooperates or leads the most. Mutatis mutandis for an extreme overbought tick. So if the NDX is weak, and we get a sell signal (+1000 tick) we then sell NDX (not SPX or OEX which may be stronger).

If you’re interested to know What Mark thinks about the current market, you can read his most recent commentary here. But be aware that Mark tends to have a bias towards the bearish side