Trader’s Narrative

Here’s an interesting chart from Merrill Lunch’s recent “Hedge Fund Monitor” report. It shows that traditional long short hedge funds have returned to a historically normal market exposure after the shock late last year:

With the end of the year barreling closer, hedge funds, like any other money manager out there wants to coast to an easy finish and hang on to their gains to be able to bank their lucrative incentive fees. One safe strategy is to sell their long positions and replace them with calls to have the best of both worlds.

This may explain one of the only places where we’re seeing some cautionary signs of exuberance. In last week’s sentiment overview I mentioned that the options pits is showing an awful lot of calls being bought relative to puts. While I’m hesitant to outright dismiss any irksome metric, some of that can be explained away by the penchant to lock in gains via calls. However, not all of it can be attributed to portfolio managers trying to coast to large Christmas bonus. That’s because the ISE sentiment which exclusively measures retail option traders is showing similar indications of exuberance.

Another interesting tidbit from the ML report is that hedge funds have on average reduced their exposure to ‘high quality’ stocks since April 2009. That makes sense since retreating into safer issues is a tried and true strategy in times of distress. Right now though, more speculative equities are getting most of the love. And that’s exactly what we’re seeing in the breadth measures as almost every single Nasdaq and NYSE stock participates in the rally.

You can download the whole Merrill Lynch report from the FREE trading resource section (check in the Reports & Articles folder).

Groundhog Day is only a few days away! According to lore, if the groundhog sees its shadow, we’re going to have another 6 months of winter. If on the other hand, it fails to see its shadow, winter will end soon.

The January barometer can be likened to ground hog day but it has more historical evidence. The January barometer basically says that the performance in the first month of the year, predicts the market’s return for the rest of the year.

The S&P 500 Index (SPX) started January at 902.99 and ended the month at 825.88 for a return of -8.5%. The Dow fared worse with an 8.8% drop. For both indices it the worst January return on record.

So the groundhog has definitely seen its shadow and the bear market will continue.

The only faint silver lining is that the historical basis for a negative prediction is very flimsy. Probably due to the upward bias of the stock market over the very long term, the prediction quality of the January barometer is higher in bull markets. So this prediction of a continued bear market has only about a 40% chance of being accurate.

UPDATE:
Here’s an interesting related article by Nick Godt at MarketWatch

Last month I outlined a strategy using closed end funds to take advantage of the January effect in the stock market. The opportunity came and went, so here’s a brief review with a few specific examples.

In order to give you the right idea, lets start with a good example to show the pattern we’re looking for. The BlackRock Minicipal Bond Fund (BBK) is a great example of the setup:

Notice how it dropped right into the technical support previously found in mid October? That, along with the volume spikes in early December, make this a great example. As prices lifted off into the new year, it was attracted to the swing high which acted as resistance - making it a natural place to scale out (red arrows).

Here’s another example with an equity CEF, the RMR Dividend Recapture Fund (RCR):

I’ve highlighted the low volume because can be problematic if you step in with size and don’t use limit orders. Otherwise you’d do fine and pocket a +60% return. Even if we assume that you were able to squeeze out half of that, considering slippage and trading costs, etc. you are still looking at an astronomical annual rate of return.

Finally, I also wanted to show a less than perfect example to make sure that you don’t mistake this strategy as a sure thing:

I stayed away from this one because it isn’t a municipal bond fund but if you played it, it was difficult to come out unscathed. On the plus side, the loss was very small. But it serves as a reminder that even with a high probability setup like this one, you can’t ignore risk completely.

If you want to see even more example, take a look at My Year-End Strategy.

The beginning of the year is a special time that rightly attracts much attention. The January effect is mostly over by now and hopefully you were able to trade this phenomena profitably. It is too bad it only comes around once a year.

There are a few other similar patterns for January. Probably the best known is “as January goes, so goes the year”. Another says that the first 5 trading days determine the market’s returns for the whole year ahead. And another says that how January performs predicts the direction of the market for the remaining months of the year.

Mark Hulbert showed a few days ago in this column that the 5 first trading day pattern simply isn’t true. In fact, the only one that does have validity historically is the third one listed above. The January Barometer says that the performance for the first month has a predictive quality for the returns generated between the second and twelfth months.

Because of the positive bias of the market, this indicator works best when it predicts a bullish scenario for the remaining 11 months of the year. From 1940 to 2008, January’s return was positive 43 separate times. Of these, 86% of the time the next 11 months were also positive. On the other hand, in only 40% of the cases when January was negative was the rest of the year also negative. The overall accuracy of the January Barometer within that time range was 73.9%.

So with an almost 75% historical accuracy rate, we’ll have to wait until the end of this month to see what it augurs for the rest of the year.

Below is a look at the raw data from 1940 to 2008:
Continue reading ‘The January Baromoter’

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’