ETF HQ – Page 13 – (Will publish new research soon, sorry about the ugly site, it got hacked)

ETF HQ Report – Overcooked

March 14, 2010 – 10:00 pm ET

We saw new highs from the broad market over the last week as expected although from a technical stand point not much has changed. Volume flows remain very positive, and there is little negative that can be said except the ongoing concern caused by the under performance of the semiconductors.

It was a busy week at the office for us with the start of a new sector volume research project. While hunting down the data required a friend at SPDRs has gave me month end component data for the S&P Select Sectors back to Sept 2001, let me know if you would like a copy.

ETF % Change Comparison

ETF % Change Comparison

IWM (The Russell 2000 – Small Cap ETF) and IYT (Dow Transportation ETF) continued to show great strength and lead the market to new highs. SMH was the only one to decline over the last week and has been the worst performer over all the measured time frames. Unless SMH starts to participate in this rally then the broad market can’t go much further.

What the % Comparison Table Tells Us:

By comparing the performance of the economically sensitive (SMH, QQQQ, IWM, IYT) and the comparatively stable ETFs (SPY and DIA) we can get an indication of the true market direction. The more sensitive areas of the market tend to be the first to initiate a trend change. For example if DIA and SPY sell off heavily while SMH and IWM (Russell 2000 small cap ETF) sell of mildly or continue moving to new highs then this would be very positive and vice versa.

The ‘Average Rank %’ is calculated by subtracting the % change for each ETF from the maximum % change and dividing it by the range for each period. 1-((MAX(% change all ETFs)-ETFs % Change)/(MAX(% change all ETFs)-MIN(% change all ETFs))) The readings for each period are then averaged. This reading is provided because if one ETF was significantly under/out performing the others then a plain high or low rank would not accurately reflect this.

A Look at the Charts

SPY

Look at all that volume behind the recent rally, this is great to see and indicates that further advances are on the way. When we do see profit taking, if SPY falls back below the Jan high it will not be a cause for concern as long at SMH holds together.

QQQQ

QQQQs holdings are 35% in hardware and the key component for hardware is semiconductors. For this reason it is simply not possible for QQQQ to go far without SMH participating.

SMH

How this plays out will be very interesting. I have never see a time when everything else has looked so bullish while SMH has been so discouraging. As I said last week SMH must hold onto $26 or risk a test and likely break of the 200 day SMA. If that occurred then the broad market will almost certainly return to a bear market.

IWM

IWM is offering the broad market all the strength that SMH lacks and the performance of the small caps remains the strongest argument for the bulls. It is doubtful that IWM can continue at this pace for another week and it would be far better to see some profit taking or consolidation at this point.

IYT

It is great to see the Transports ending the week convincingly above their Jan high. In a weak economy less goods are sold and therefore less goods are transported making it imposable for IYT to perform like this.

OM3 Weekly Indicator

OM3 Indicator

All signals are bullish here.

How to read the OM3 indicator

The OM3 indicator as with most of our models primarily reads price action and volume. The strong/weak buy/sell signals are self-explanatory. ‘No Signal’ means that the component readings are in conflict and cancel each other out.

The alerts let you know if the cycle is speeding up or slowing down, so when you get at ‘Strong Buy, Bear Alert’ for instance it simply means that the criteria for a strong buy is in place but this weeks cycle reading is weaker (or more bearish) than last weeks reading (the same is true in reverse).

The number of weeks that a signal has been repeated is displayed. Historically a ‘Strong Buy’ signal has lasted for an average of 6 weeks and a maximum of 42 weeks, while a ‘Strong Sell’ has lasted for an average of 4 weeks and a maximum of 16.

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

TransDow & NasDow

This is interesting and unexpected; the Dow has regained dominance over the NASDAQ. Price action would not explain this but the dominance reading for the NASDAQ is taken from volume flows. The Transports remain dominant over the Dow.

What the TransDow Readings tell us:

The TransDow measures dominance between the DJ Transportation Index (DJTI) and the Dow Jones Industrial Average (DJIA). In a strong market the more economically sensitive Transportation Index should be dominant over the DJIA.

Historically the DJTI has been dominant over the Dow 45% of the time. The annualized rate of return from the DJTI during this period was 18.47% with the biggest loss for one trade sitting at -13.27%. The annualized return from the DJIA during the periods it was dominant over the DJTI was just 4.06% and the biggest loss for one trade was -16.13%. A 4% stop-loss is applied to all trades adjusting positions only at the end of the week.

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically sensitive NASDAQ should be dominant over the DJIA.

Historically the NASDAQ has been dominant over the DJIA 44% of the time. Taking only the trades when the NASDAQ is above its 40 week moving average the annualized rate of return was 25.47% with the biggest loss for one trade sitting at –8.59%. The annualized rate on the DJIA during the periods it was dominant over the NASDAQ is just 8.88% and the biggest loss for one trade was –12.28%. A 8% stop-loss is applied to all trades adjusting positions only at the end of the week.

LTMF 80 & Liquid Q

LTMF 80 & Liquid Q

LTMF 80 and Liquid Q continue to show open positions in QQQQ.

Historical Stats:

LTMF 80 & Liquid Q Stats

How The LTMF 80 Works

LTMF stands for Long Term Market Forecaster. It reads volume flows relative to price action and looks for out performance of volume measured on a percentage basis over the prior 12 months. During a sustained rally the readings will reach high levels (near 100%) making it imposable for the volume reading to always outperform price so any reading above 80% will maintain the buy signal. This system has outperformed the market over the last 10 years but performance has been damaged by some nasty losses. It only produces buy signals and only for QQQQ.

How Liquid Q Works

Liquid Q completely ignores price action and instead measures the relative flow of money between a selection of economically sensitive and comparatively stable ares of the market. It looks for times when the smart money is confident and and can be seen by through volume investing heavily is more risky areas due to an expectation of expansion. This system has outperformed the market over the last 10 years and remained in cash through most of the major declines. It only produces buy signals and only for QQQQ. We will provide more performance details on the web site for these systems soon.

Summary

It has been a great run over the last 5 weeks but the further the market goes without profit taking the sharper the eventual pull back will be. It would be a good outcome over the next week to see some profit taking occur and support established. Do keep an eye on SMH as its ability to hold together is imperative for the health of the market.

Any disputes, questions, queries, comments or theories are most welcome in the comments section below.

Derry

And the Team @ ETF HQ

The Devils Dictionary – C, Part 2

Counterparty – The name for the other guy or institution in a deal, otherwise known as he who is left holding the bag. If you lend me $10, we are each counterparties to the loan. A committee has been formed to find out why this word is needed.

Credit – Long ago, when she first appeared amongst us, “Lady Credit” was said to be attracted to a person’s character, probity and trustworthiness. With age, she has become less choosy.

Credit Default Swaps – A means for transferring risk. Lenders can now insure against the risk that a borrower goes bankrupt. Instead, they are now exposed to the risk that the seller of default protection, in an unregulated $30 trillion market, goes belly up. Loose translation from the original Latin “ubi mel ibi apes,” or “where there’s honey there are bees.” 1. A complex financial instrument vital to the functioning of a modern economy in the way it spreads risk among consenting parties. (Greenspan, A., pre-Sept. 2008.) 2. A complex financial instrument that nearly destroyed modern capitalism (Greenspan, A., post-Sept. 2008).

Credit Line – A set amount of borrowed money available only to those who don’t need it.

Crisis – A frequently occurring one-in-a-lifetime event, generally deemed impossible by those under the age of 28.

ETF HQ Report – And Violent It Was

.March 08, 2010 – 5:50 am ET

What a fun week to be on the right side of the market (although I closed my largest position which was short EWJ at small loss). Anyway, the breakout we were looking for occurred and as expected it was a violent one.

The target I set two weeks ago for QQQQ of the January high has been reached and IWM has convincingly surpassed this level powering on to a fresh high. This is all exceedingly positive but on the negative side the relative under performance of the semiconductors does raise concerns. Of the influential ETFs, SMH is the furthest from the January high bring the long term prospects of this rally into question.

ETF % Change Comparison

ETF % Change Comparison

IWM had a stellar week advancing 6.08%. IYT was the worst performer but had a strong week prior.

The data in this table that currently warrens the most attention is the ‘% From peak’ and ‘Days Since Peak’. In the ideal world we should see SMH and IWM leading the market to new highs closely followed by QQQQ and IYT while SPY and DIA are dragged along for the ride. The fact that IWM has set the example of new highs while QQQQ and IYT and not far behind is very bullish and indicates that we are likely to see new highs from the broad market. However because SMH is lagging behind it is imperative that the semis at least maintain support otherwise the advance over the last month will have just been a fools rally.

What the % Comparison Table Tells Us:

A Look at the Charts

SPY

With OBV at a new high and little resistance overhead the prospects for SPY are very positive. However a new high from SPY is meaningless without QQQQ also doing the same. A pullback will have to come at some point and when it does all eyes should be on SMH for an indication of whether it is just profit taking or (another) trend reversal.

QQQQ

QQQQ has reached the target set two weeks ago and volume flows suggest that new highs are likely.

SMH

SMH must stay above $26 if the broad market is to break through and stay above the Jan high. A close below $26 would cause the broad market to pull back significantly. SMH would almost certainly test and probably break through its 200 day SMA which would put an end to the bullish trend.

Arguably the broad market is due for some profit taking now. The problem is that the Semis lack the cushion between price and support that the other ETFs currently possess. So if the profit taking occurs now it will put real pressure on SMH.

IWM

Last week I said that IWM was “one of the Jewels in the bullish argument” and it has not disappointed. Small caps stocks lack the ability of the Large Caps to weather economic storms. However when the economy is expanding the small caps can grow at a speed that the large caps simply can’t for the same reason that elephants don’t gallop. That is why it is so positive to see IWM leading the market through the Jan highs. If profit taking occurs this week then I will be watching that IWM stays above $64. A close back below the Jan high at this point would be a major failure by the bulls.

IYT

IYT is not far from making a new high and closer to doing so than the Dow Jones Industrial Average which will make the Dow theorists happy. It will be important that IYT confirms any new highs by SPY and DIA particularly seeing as SMH is not showing much strength.

OM3 Weekly Indicator

OM3 Indicator

IWM has been on a strong buy signal for the last four weeks and has also been the top performer during that time advancing 12.40%. DIA has the weakest signal with a ‘Weak Buy’ which is actually positive because in a healthy market the Mega Caps should under-perform relative to the more economically sensitive segments.

How to read the OM3 indicator

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

TransDow & NasDow

The Transports remain dominant over the Dow and on Friday the NASDAQ also claimed dominance over the Dow. This is very positive as historically most bull markets have occurred when the NASDAQ and the transports were dominant.

What the TransDow Readings tell us:

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically sensitive NASDAQ should be dominant over the DJIA.

LTMF 80 & Liquid Q

LTMF 80 & Liquid Q

Both LTMF 80 and Liquid Q remain on buy signals and have clocked up some reasonable little profits so far. Internal reading on both remain strong.

Historical Stats:

LTMF 80 & Liquid Q Stats

How The LTMF 80 Works

How Liquid Q Works

Summary

The market is displaying many positive signs including healthy volume flows, dominance by the NASDAQ and the Transports, several active buy signals and leadership from the small caps. Indications are that new highs from the broad market are very likely.

I don’t know about you but I find it very easy to produce evidence to support my current outlook no matter what it may be. If I am bullish then I see everything through rose tinted glasses. If I am bearish then I find the sinister side of everything.

For this reason it is important to always look for arguments against your outlook, cracks in your logic. Not to cause analysis paralysis but to identify specifically what would need to happen in order for you to close your positions or make adjustments. This way in the heat of the market you have a game plan, you have a contingency strategy in writing and don’t have to make it up as you go along.

The #1 bearish argument from a technical stand point at the moment is the relative under performance of the semiconductors. If SMH closes below $26 then I will be rethinking all bullish positions. If IWM closes below $64 then we are probably stuck in a crab market. A a new high by SPY will be meaningless without QQQQ doing the same and will still be lacking conviction without confirmation from IYT (Dow Transportation ETF).

Have a good week.

Any disputes, questions, queries, comments or theories are most welcome in the comments section below.

Derry

And the Team @ ETF HQ

The Devils Dictionary – C

Carry trade – The act of borrowing cheaply and lending at a higher rate. Popular with hedge funds when short-term rates collapsed after the dotcom bust. Charlie Munger of Berkshire Hathaway, “Never have so many people made so much money with so little talent.” See Greenspan.

Cash Flow – The movement your money makes as it disappears down the toilet.

CDO – Certain Death Obligation resulting from a number of causes ranging from mark to market accounting to too many NINJA loans in a pool of securities. A dumping ground for loans off-loaded by banks, which are pooled, sliced up and stamped with investment-grade ratings. Take a bunch of commercial loans for which there is collateral of some kind or other, smoosh them together into one big loan or bond and voilà! You have a CDO. Whether you want the CDO depends on how good the underlying loans and collateral are. It appears that many of the investment bankers selling CDOs were too busy buying houses in the Hamptons to find out.

Conspiracy – The only possible explanation for certain types of irrational price action. There’s a government conspiracy to support the stock market; how else could it have rallied 70% since March? A crackpot theory held by nut jobs who can’t admit when they’re wrong. Have those conspiracy theory wackos never heard of an oversold bounce before?

Trading Psychology – Imperative Foundation For Success

An understanding of Trading Psychology is the imperative foundation for all the other skills required for success in the financial arena.

The inability of the masses to endure the psychological effects imposed by the market is the main reason why Wall St eats them alive and why there is so much money to be made by the emotionally intelligent minority. If you are aware of how psychology drives the market you can stand witness to it and maintain clarity of mind in the face of both jubilation and crisis.

Psychology is probably the most important factor in the market – and one that is least understood. – David Dreman (Author of “The Psychology of Stock Market Success”)

Studying Trading Psychology completely altered my definition of what the stock market is. (Before this realization I nearly whipped out my entire trading account). How you define the market defines how you approach it and the turning point for me came when I began to see the market through the following paradigm:

The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

If it were not for human emotion then all investments would be perfectly priced, the markets would be efficient and it would be impossible to beat the average return. In reality the market is driven by the twin emotions of Fear and Greed. When prices are rising, greed is the dominant emotion. When prices are falling, fear is the dominant emotion. Notice that logic is not a factor in the equation.

I’d be a bum on the street with a tin cup if the markets were always efficient. – Warren Buffett

The market consists of two main groups; the Smart Money and the general public. The general public ride on emotion and profit only by luck, while the Smart Money ensure they make decisions based on logic. As a result the Smart Money consistently profit over the long term.

When logic and emotion come into conflict, emotion always wins. If logic was the more powerful of the two then there would be no fat people. Instead the logic of eating adequate portions of food selected on the basis of health and a long life is not as powerful as the feelings/emotions experienced by eating gluttonous amounts of food selected on the basis of taste and convenience.

Valuable insight into Trading Psychology can be gained by studying the market during booms and busts because these are the times when it’s effects are most obvious. Huge groups of people will ignore their better judgment and seemingly go insane. Do you remember the height of the Dot Com boom; Oct 1999 – Feb 2000?

This is from the prospectus of VA Linux’s IPO – November, 1999: (now SourceForge, Inc. LNUX)

We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $29.9 million as of October 29, 1999. We expect to continue to incur significant … expenses… We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.^[1]

Based on this information how would logic suggest the IPO went?

Shares in VA Linux Systems soared eightfold today, setting a new record for the largest first-day gain of any initial public offering. – CNET News^[2]

A first-day price gain of about 700% and a closing price of $239.25^[3] gave Linux a market cap of roughly $9 billion.^[4] It went on to lose $728 million over the next 5 years before turning its first profit of $3.9 million in 2006.^[5] On November 25, 2008 it closed at an all time low of $0.58

Can the market get any crazier than this? You bet… Is was revealed by a Purdue University study that during the Dot Com boom companies could get a 89% jump in their stock price simply by switching to a Dot Com name.^[6]

The price of NEI Webworld, rose almost 1,170% in a day simply because it made news for its involvement in an Internet scam… NEI had no assets and was already in bankruptcy liquidation!!^[7]

In this kind of environment many people lose all self control, get swept up in their emotions and forgo the most basic due diligence into a companies fundamentals. Like in 1999 when AppNet Systems, Inc. filed for an IPO under the symbol APPN, at the time there was a company called Appian Technology, Inc. trading on the NASDAQ OTC Bulletin Board under the same APPN symbol. In a feeding frenzy people started buying shares of Appian technology thinking they were getting AppNet Systems before its IPO. Appian Technology shares went up 142,757% in the two days following the filing. Over 7.3 million shares were traded compared to just 200 shares the day before.^[8]

I can calculate the movement of the stars, but not the madness of men. – Sir Isaac Newton, lost a fortune in the South Sea Bubble

Perhaps the most hilarious examples of the utter madness that humans are capable of when driven by greed were seen during the South Sea Bubble. Capital was raised through stock offerings for, among other things; “a wheel for perpetual motion”^[9] and “The trading of hair”.^[10] But my personal favourite is a prospectus by one audacious con-man entitled:

“A company for carrying on an undertaking of great advantage,
but nobody to knows what it is.”

The man (who nobody has been able to identify) simply stated that the required capital was half a million. Just 5 hours after opening the doors for the IPO he had raised £2000. Then, that evening, displaying infinitely more intelligence than the people he had just robbed, he set sail for the new world (America) and was never heard from again.^[11] He knew enough about the psychology of trading to see the bubble and prey on those blind with greed.

Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.^[12] – Warren Buffett

This irrational behavior by people riding on emotion opens the door of profit to those that understand trading psychology. Crooks use it as an opening for their underhand tactics but the lasting profits are to be enjoyed by emotionally intelligent traders and investors.

It is important to distinguish between the Psychology of the individual and that of the crowd. It is not possible for large numbers of individuals to reach such extremes of irrational behavior simultaneously. This only occurs when individualism is lost and ‘Herd Mentality‘ takes over.

What examples of madness have you witnessed in the the market? Have you ever missed opportunities or made regrettable investments under the influence of emotion? Share your experiences in the comments section below.

Part 2 – Herd Mentality

Part 3 – Group Intelligence

^ VA Linux Systems, Inc. IPO filed with the SEC November 17, 1999. Page 7; Risk Factors, Paragraph 2; We have a history of losses and expect to continue to incur net losses for the foreseeable future.
^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
^ Meeting of the Federal Open Market Committee December 21, 1999. Page 12, Paragraph 2.
^ SourceForge Inc: Financial Statement, Income Statement – 10 Year Summary (in Millions).
^ A Rose.com by Any Other Name by: Cooper, Michael J; Dimitrov, Orlin; Rau, P. Raghavendra. The Journal of Finance, Volume 56, Number 6, Page 2379, Paragraph 1, December 2001. Department of Finance, Krannert School of Management, Purdue University.
^ In the wild world of Internet postings, sometimes bad news is good news by Rebecca Buckman, The Wall Street Journal, December 17, 1999.
^ Mistaken ID takes stock for a ride Briefly shared symbol caused AppNet mix-up by Terzah Ewing, The Wall Street Journal, May 9, 1999.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 58, #36.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 57, #14.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 53, Paragraph 2.
^ Chairman’s Letter 2000, Berkshire Hathaway, Page 14, Paragraph 2.

Likely To Be Violent

February 28, 2010 – 2:40 am ET

Last week we said that there were some “cracks in the bullish argument” yet “indications are that we have returned to the bullish trend but a test of support will be due soon.” Well, we did see a touch of healthy profit taking over the last week, support was found and things are still looking good. .

ETF % Change Comparison

ETF % Change Comparison

IYT (The Dow Transportation index ETF) had a fantastic week advancing 2.45% and smashing through its 50 day SMA. This is very positive from the perspective of the Dow Theory, the transportation industry is highly economically sensitive. IWM (Small Caps) also had a strong week and closed every session above its 50 day SMA. The poor relative performance by SMH would be more concerning were it not for the resilience seen by IYT and IWM.

What the % Comparison Table Tells Us:

A Look at the Charts

SPY

Currently sandwiched between support and resistance but with volume in a bullish trend indications are that SPY is headed higher.

QQQQ

A close below $44 by QQQQ and the situation will need to be reassessed but a test of the January high is still the likely outcome.

SMH

The volume behind the declines over the last week from SMH were reasonably heavy and OBV is not really in a clear trend. It is good however to see SMH finish the week above its 100 day SMA.

IWM

Volume is in a clear up trend on IWM and the 50 day SMA has been holding strong as support. This strength would be strange to see if we were about to return to the bearish trend.

IYT

Volume flows still point to a trading range but IYT is now just 1.99% below the closing high achieved 46 days ago. IYT will be due for some consolidation soon but its recent performance is a very positive sign for the broad market.

OM3 Weekly Indicator

OM3 Indicator

The OM3 indicator continues to find this market confusing and is producing indecisive signals with a bullish bias.

How to read the OM3 indicator

The alerts let you know if the cycle is speeding up or slowing down, so when you get at ‘Strong Buy, Bear Alert’ for instance it simply means that the criteria for a strong buy is still in place but this weeks reading is weaker (or more bearish) than last weeks reading (the same is true in reverse).

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

Transdow and Nasdow

As you would expect after its recent strength DJT (The Dow Transportation Index) has taken dominance over the Dow Jones Industrial Average. This indicates that the risk level in the market has been reduced as historically DJT has advance at annual rate of 18.47% while dominant. However the Dow remains dominant over the NASDAQ.

What the TransDow Readings tell us:

Historically the DJTI has been dominant over the Dow 45% of the time. The annualized rate of return from the DJTI during this period was 18.47% with the biggest loss for one trade sitting at -13.27%. The annualized rate on the DJIA during the periods it was dominant over the DJTI was just 4.06% and the biggest loss for one trade was -16.13%. A 4% stop-loss is applied to all trades adjusting positions only at the end of the week.

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically NASDAQ should be dominant over the DJIA.

LTMF 80 & Liquid Q

Both the LTMF 80 and Liquid Q remain on buy signals with strong internal readings.

Historical Stats:

LTMF 80 & Liquid Q Stats

Summary

No damage has been done by the slight profit taking over the last week in fact it has been a positive development because of the way that support has held and the strength we have seen from IWM and IYT. However the market remains stuck in a tight range between support and resistance. There is a lot of conflicting technical information but when the breakout occurs it is likely to be violent and indications are that the breakout should occur to the upside.

Any disputes, questions, queries… comments or theories are most welcome below.

Derry

And the Team @ ETF HQ

P.S If you get value from these newsletters please share the word with others. Thanks. If you are a new reader please subscribe using the form to the top right of this page.

P.P.S Go Canada, 13 Golds so far and some amazing curling!!! Can’t wait for the men’s Hockey Finals.

The Devils Dictionary – B

Bailout – A notorious regressive tax; the public underwriting of stupid bets made by overpaid morons. Can you believe their bonus pool was $16 billion a year after the bailout?

Bank – The place you’re money visits whereupon heads they win and tails you lose.

Bankers – People who lend other people’s money in exchange for a fee. Formerly concerned about the return of principal, but now only interested in the fee. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” (John Maynard Keynes)

Bear Market – A 6 to 18 month period when the kids get no allowance, the wife gets no jewelry, and the husband gets no sex.

Broker – What my broker has made me.

Bull – Politely speaking, the stuff and nonsense of Wall Street’s daily conversation.

Bull Market – A random market movement causing an investor to mistake himself for a financial genius.

Back To The Bull With Cracks

February 22, 2010 – 5:40 am ET

The market displayed some impressive strength over the last week. We were looking for several key technical achievements to occur in order to indicate a return to the bullish trend. They were:

New high from OBV on QQQQ
Close by QQQQ above $44
Close by SMH above its 90 day SMA
OBV Bullish trend change on SMH
OBV Bullish trend change on IWM

On Tuesday, the first day of the shortened trading week all of these milestones were achieved. Needless to say this is a very bullish sign.

ETF % Change Comparison

ETF % Change Comparison

IYT, the Dow Transportation Index ETF was the top performer over the last week followed by IWM and SMH. Although none of the ETFs lagged behind significantly.

What the % Comparison Table Tells Us:

A Look at the Charts

SPY

There is not much negative that can be said about SPY, with healthy volume flows, bullish RSI and an impressive recent advice. Although the 50 day SMA is yet to be convincingly surpassed and a test of support would not be surprising to see this coming week.

QQQQ

We were looking for a close above $44 and a new high from OBV and this occurred on Tuesday. With OBV pushing through to new highs it is likely that QQQQ is set to test the January high or hopefully break through it. The 50 day SMA remains an Achilles Heel and another reason why the market may be due for a breather and a test of support.

SMH

Volume flows on SMH powered ahead and are now in a bullish trend. There are cracks in the bullish argument however due to the under performance of volume flows until recently. A test of support will have to occur at some point and it will be interesting to see if that occurs before or after the 50 day SMA is broken.

Two weeks ago I said that in a rally I would expect AMAT to be the best performer out of SMH’s top three holdings. I certanly got this wrong; so far AMAT has been the worst performer of the three advancing just 2.21% while INTC is up 6.93% and TXN 8.88%.

IWM

This is fantastic to see, IWM is the only one of the influential ETFs to really leave its 50 day SMA in the rear view mirror. Now IWM is only 2.76% away from the closing high it achieved 31 days ago. This strength from the Small Caps is a solid indication that the broad market will also be able to break through the 50 day SMA.

IWM, rather like SMH, has had under performing volume flows until recently. These are cracks in the bullish argument that should not be ignored.

IYT

IYT powered ahead on Friday, no doubt to the cheers of the Dow theorists but again we see the 50 day SMA standing in the way. Volume indicates a continued trading range.

OM3 Weekly Indicator

OM3 Weekly Indicator

The OM3 indicator has conflicting internal readings resulting in most of the ETFs receiving ‘No Signal’ while SMH and IWM are both on a ‘Strong Buy’. It is positive to see SMH and IWM exhibiting the most bullish readings however.

How to read the OM3 indicator

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

TransDow & NasDow

The Dow remains dominant over the Transportation Index and the NASDAQ. Historically little ground has been made by the broad market under these conditions and most of the disasters have occurred.

What the TransDow Readings tell us:

Historically the DJTI has been dominant over the Dow 45% of the time. The annualized rate of return from the DJTI during this period was 18.47% with the biggest loss for one trade sitting at -13.27%. The annualized rate on the DJIA during the periods it was dominant over the DJTI was just 4.06% and the biggest loss for one trade was -16.13%. A 4% stop-loss is applied to all trades adjusting positions only at the end of the week.

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically NASDAQ should be dominant over the DJIA.

LTMF 80 & Liquid Q

LTMF 80 & Liquid Q

LTMF 80 and Liquid Q remain on buy signals and are both showing small profits for now. Their internal readings have strengthened significantly over the last week.

Historical Stats:

LTMF 80 & Liquid Q Stats

Summary

Indications are that we have returned to the bullish trend but a test of support will be due soon. IWM and SMH do however remind us of some cracks in the bullish argument, from a technical standpoint.

Semiconductor companies are extremely economically sensitive; they lead the business cycle and as a result tend to lead the market and reveal its true direction. In the Information Age semiconductors are like the railways of the Dow Theory during the Industrial Age. Likewise Small Caps are inherently more economically sensitive than Large Caps.

SMH was the first of the influential ETFs to peak 42 days ago while most of the others peaked 11 days later. Also from the beginning of September until just recently OBV has been significantly under performing the price action on both SMH and IWM. By OBV breaking below the November low earlier this month it indicated significant weakness and I was expecting a return to the bearish tend. However support held and now things are looking very good. This conflicting information points to the possibility that we are stuck in a trading range. For now however, the market is likely to have a bullish bias.

Any disputes, questions, queries… comments or theories are most welcome below.

Derry

And the Team @ ETF HQ

P.S If you get value from these newsletters please share the word with others. Thanks. If you are a new reader please subscribe using the form to the top right of this page.

P.P.S I hope this week leaves you feeling like Ivan Skobrev (left) did after seeing he had just posted the fastest time in the men’s 1,500m speed skating and not like Canada felt after losing to the US in the Hockey on home ice.

The Devils Dictionary – A

AAA – A credit rating which indicates a company has very little likelihood of default and therefore carries too little debt. By a process of financial alchemy, this rating now covers most of the riskiest corporate and consumer borrowers, which have too much debt. See Rating Agencies and CDO.

Accounting – An elaborate system of gibberish intended to describe the abstract theory of financial reality: how much money you have borrowed and can’t pay back (the balance sheet), how much money you are losing (the income statement) and how much worse this year is than last year (changes in financial condition); accounting has been integral to the history of civilization. Pacioli, a mathematician, published Summa de Arithmetica, Geometrica, Proportioni et Proportionalite in 1494, a year that closely coincided with Columbus’ discovery of America wherein the need to keep track of massive fraud, schemes, scams and other thievery was widely anticipated. An elegantly elaborate system of debits and credits known as ‘Double Entry Accounting’ quickly came to mean “two for me and none for you”. Without accounting there could be no fair system of taxation; this fact further highlights its failure because tax and fair remain like oil and water.

AICPA – The American Institute of Certified Public Accountants is the national, professional organization for all Certified Public Accountants. Its mission is to provide members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner to benefit the public as well as employers and clients. AICPA has a trademark lawsuit pending with the Absolutely Incurable Crooks and Perpetrators Association that it is expected to lose for imperceptibly different activities and mission.

AIG – The distressed vocalization of regulators upon examining the books and records of American International Group which was code for All Investments Gone; financial equivalent of “S.O.S – Mayday! Mayday!” While all the investments had gone to zero, incalculable liabilities remained as a result of an enormous unregulated gambling scheme known as Credit Default Swaps that left the U.S. Taxpayer holding a $200 billion bail-out bag that turned out to be heavier than a black hole.

Buy and Hold is not Dead – It was NEVER Alive

After the crash of 2008, many peoples faith in the Buy and Hold approach to financial freedom is on shaky ground. For a long time the Buy and Hold strategy has been pushed strongly by financial planners and the mutual fund industry.

To sell ‘Buy and Hold’ as the way to go, compelling statistics are produced about how historically stocks have outperformed other asset classes. How despite a few ‘bumps’ along the way “over the long term you can’t lose”.
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Buy and Hold

But never take anything that you have been told as fact until you have done your own research (especially when it involves your finances). As you are about to see, the reality is that Buy and Hold is not dead, it was never even alive and was simply dreamed up as a marketing ploy by those who would stand to profit from your believing in it. Perhaps a better description would be Buy and Pray.
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What is the Average Stock Market Return?

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When people talk about returns available for the Buy and Hold investor they generally quote the historical performance of the US market, specifically the Dow Jones Industrial Average. Several ‘Experts’ have told me that the average stock market return you can expect is 8 – 15% per year. To quote from ‘Money Secrets of the Rich’ by John Burley printed 1999:
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…compounded returns averaging more than 14%+ over the last 45 years…^[1]

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This is such a half truth it is a lie! To mislead people into believing that by simply using a Buy and Hold strategy they will achieve returns of this nature is irresponsible!

Over time Buy and Hold returns on a broad index like the S&P 500 will match the average earnings yield and GDP growth. Robert D. Arnott and Peter L. Bernstein found that the real stock returns over the past 192 years averaged 6.1% derived from three components; an earnings yield of 5%, per capita GDP growth of 1.7%, less 0.6% shrinkage of dividends relative to real per capital GDP growth.^[2]

From 1929 to 2008 I calculate the average stock market return on the Dow Jones Industrial Average at just 4.28% without allowing for inflation. That is far short of the 8-15% that most Buy and Hold investors promote as the investment returns that can be expected. The scary thing is that people are basing retirement projections on such forecasts; for the 380 companies in the S&P 500 with defined-benefit plans, projected returns average 9%.^[3]
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The U.S Was a Top Performer

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Another misleading factor is that during the 20th century the US had the worlds 4th best performing stock market after inflation.^[4] This history of stellar growth in the US is something that we take for granted but it is unlikely to continue. With no intention of being anti American I am simply stating a fact based on historical trends that it will be very difficult for the US market to be one of the top global performers during the 21st century.

Time brings many changes, 2000 years ago China and India combined accounted for 59% of the worlds GDP. By 1950 Western Europe and the US had taken command with 53.5%.^[5] That hold has since slipped and over the last 55 years China and India have grown their share of the words GDP from 8.75% to 22.07% (1950-2005), while the US and Western Europe now account for 38.24%.^[6]

The next 50 years are likely to bring change at a faster pace than at any other time in history and it will put to test the US’s commitment to the global trade system. The rising forces of China and India will cause disruptions to workforces, industries, companies, and markets in ways that we can only begin to imagine. In the 19th century, Europe had to go through a similar test when it realized that a new giant was emerging; the US. World leading corporate strategist Kenichi Ohmae said:
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It is up to America to manage its own expectation of China and India as either a threat or opportunity.

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As long as calamity doesn’t strike, most economists predict that China and India have the ability to keep growing at an annual rate of 7-8% for decades because they have younger populations, higher savings rates, and so much catching up to do.^[7] At current projections China is likely to take the No. 1 position from the US and become the world’s largest economy before 2020.^[8] By then, China and India could account for half of global GDP. If this takeover does occur then a Buy and Hold strategy on the US market is going to produce disappointing results.

Warren Buffett put the reality of the situation brilliantly in his 2007 letter to Berkshire Hathaway Inc. shareholders:
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During the 20th Century, the Dow advanced … 5.3% when compounded annually … Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow … would need to close at about 2,000,000 on December 31, 2099 … While anything is possible, does anyone really believe this is the most likely outcome? … People who expect to earn 10% annually from equities during this century … are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him … Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.”^[9]

“Buy and Hold and you can’t lose long term” …But how long is long term?

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Buy and hold advocates constantly remind us that if we hold a diversified portfolio for the long term then we can’t lose. Well, just how long is the long term?

One investment advisor told me that if you Buy and Hold for 20 years or more then your risk in the stock market is reduced to zero. Some say less… This from Mutual of America’s website:
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There has been no 10-year period in the previous 50 years that has resulted in a downtick in the S&P 500.^[10]

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As Benjamin Disraeli said “There are three kinds of lies: lies, damned lies, and statistics.” Mutual of America had revenue of 1.77 billion^[11] in 2008 and they boast of “strong portfolio management teams and significant research capabilities”.^[12] Yet despite their well funded research they can’t do simple maths. Before allowing for inflation there has actually been 6 (and counting) ten year periods over the last 50 years that have resulted in a downtick for the S&P 500 and the Buy and Hold investor:

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Buy and Hold Lie
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So what is the longest period with no growth for the Buy and Hold investor?

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Would you be shocked to hear that the US has had three periods longer than 57 years where the stock market has experienced no real growth including one period of 130 years? Robert Arnott in a stunning article called ‘Bonds: Why Bother?‘, revealed that the market drop from 1929-1932 was so severe that in real terms stocks fell below 1802 levels. This erased 130 years of market gains:^[13]
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Buy and Hold After Inflation

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Why do mutual fund promoters overlook this kind of research and mislead people into thinking that a Buy and Hold strategy is the best way to go? Because they make huge fees out of managing your money and the last thing they want is for you to withdraw your funds in a bear market. At the end of the third quarter 2009, equity mutual funds held $8.53 trillion dollars under management.^[14] That makes promoting the Buy and Hold myth worth HUGE dollars.
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Summary

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Here is a prime example of how in the financial markets more than any other industry, one must be very aware of who is producing the statistics that are being used to influence your thinking. (I am a trader so remember, I have a bias in the way that I present this information as well.)

Unfortunately the fact is that Buy and Hold as a strategy just does not stand up to scrutiny. Having said that, Buy and Hold as a strategy is certainly better than not investing at all. We may even get lucky and see the market embark on another 20 year period of above average growth like we saw from 1980 to 2000 when the S&P 500 advanced over 1200%.

But… you should never rely on luck when it comes to your financial future. The reality is that over the long term the return from the stock market must match the growth of the economy, whatever that ends up being. In the interim stocks undergo a constant battle between what they are truly worth based on the fundamentals and what the irrational, emotional, ‘Greater Fool’ is willing to pay.

If you are to ensure long term success with your finances regardless of what happens in the economy you must have an edge over the market.

Incidentally, if you don’t know what your edge is, you don’t have one. – Jack Schwager

So you have seen my research… Do you still believe in Buy and Hold? Share your thoughts in the comments section below.
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^ Money Secrets of the Rich by John Burley, 1999
^ What Risk Premium is Normal? by Robert D. Arnott and Peter L. Bernstein. Financial Analysts Journal, March/April 2002, Vol. 58, No. 2, Page 74, Paragraph 3
^ The Pension Crisis Revealed, 2003 by Frank Fabozzi and Ryan Ronald. Journal of Investing Volume 12, No. 3
^ Triumph of the Optimists: 101 Years of Global Investment Returns, 2002 by Elroy Dimson, Paul Marsh, Mike Staunton. Page 52, Table 4-1
^ Contours of the World Economy 1-2030 AD Essays in Macro-Economic History, 2007 by Angus Maddison. Page 261, Table 8b
^ Statistics on World Population, GDP and Per Capita GDP, 1-2006 AD, March 2009, Horizontal File
^ Why the world must watch out for India, China by Pete Engardio. Businessweek September 12, 2005
^ China’s Economic Performance: How Fast Has GDP Grown; How Big is it Compared With The USA? February 22, 2007 by Angus Maddison and Harry X. Wu. Page 1, Paragraph 1
^ To the Shareholders of Berkshire Hathaway Inc. February 2008 by Warren E. Buffett. Fanciful Figures – How Public Companies Juice Earnings, Page 19, Paragraphs 3-8
^ Mutual of America, Capital Management Report, Stocks, S&P 500, Paragraph 3 (Screen Shot)
^ Mutual of America 2008 Annual Report, Financial and Corporate Information, Consolidated Statutory Statements of Operation and Surplus, Page 51
^ Mutual of America 2008 Annual Report, Discipline, Page 19
^ Bonds: Why Bother? May / June 2009 by Robert Arnott, Rethinking Fixed Income. Page 2 Paragraph 7
^ Worldwide Mutual Fund Assets and Flows, Third Quarter 2009, Worldwide Assets of Equity, Bond, Money Market, and Balanced/Mixed Funds. Billions of U.S. dollars, end of quarter.

The World Economy Makes Contagion Go Round

Contagion is a concept that not many people are familiar with but it’s a very real, powerful and important force in our financial markets. We see contagion in effect every time a reaction in one market spreads into another. As Gordon Brown, ex-Chancellor and Prime Minister of Britain said:

. Contagion

No matter where it starts, an economic crisis does not stop at the water’s edge. It ripples across the world… Modern communications instantly span every continent. The new frontier is that there is no frontier, the new shared truth is that global problems need global solutions.^[1]

A vast amount of research into this interrelationship has been undertaken but still very little is really known about its causes. Unfortunately much of the information available on the subject is in the form of complex academic papers. In this article I attempt to briefly and simply cover what contagion is and what’s known about its major causes.

Definitions for contagion vary greatly and range from the broad:

Contagion is the cross-country transmission of economic shocks.

To more restrictive definitions:

Contagion is the transmission of financial shocks from one country to another that can not be explained by any fundamental or rational link.

My research suggests that contagion has many causes and find both definitions too restrictive. Examples of this phenomenon can be seen in good times and bad. Not just when shocking news is released such as a downward revision of GDP growth or a prolonged crisis like the credit crunch of 2008 (although situations like this do appear to amplify the effect).

Because contagion occurs in both bull and bear markets and has many different causes, I have given it the following very broad definition:

Contagion is the cross-country correlation of financial markets due to one or a combination of factors including: Margin Calls, International Counterparty Risk, Fundamental Links, Cross-Market Hedging and Herd Mentality.

Exactly which cause is responsible for contagion in each situation is difficult to prove but evidence suggests that it usually results from a combination of factors. I will cover the top five factors followed by a case study and summary of my research:

Margin Calls
International Counterparty Risk
Fundamental Links
Cross-Market Hedging
Herd Mentality

Case Study
Summary

1. Margin Calls

Margin calls can lead to contagion when two economies are connected by investors with holdings in both. News that leads to a drop in asset prices in Country ‘A’ can trigger margin calls that are met by the forced selling of assets held in Country ‘B’ even though Country ‘B’ may not be affected directly by the news.

Panic selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system. – UK Telegraph^[2]

In August 2007 Goldman Sachs’ 9 billion^[3] dollar hedge fund ‘Global Alpha’ saw its assets decline 22.5%. Was this because of exposure to mortgage backed CDO’s like so many other hedge finds that were running onto trouble? No, Global Alpha’s losses in that month came from positions in currencies like the Japanese Yen and the Australian Dollar as well as stocks holdings in the US, Norway and Finland.^[4]

As the housing market went south the funds that were exposed to toxic CDO’s needed to raise cash to meet margin calls. However redemption of these bad assets was almost impossible because the market for them had become illiquid and frozen. In a panic they were forced to close out of positions they had in more liquid assets. This caused declines in stocks around the globe and unusual behavior on the foreign exchange markets.^[5]

At the time Global Alpha was leveraged 6 to 1 and when the market started to behave in a way that the funds computer models had not expected it started to experience significant losses. This intern triggered more margin calls for Global Alpha forcing another cycle of selling on assets not directly affected by the original turmoil.^[6] Here you can clearly see how margin calls can set off a domino effect of more margin calls which lead to contagion on unrelated assets around the globe.

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2. International Counterparty Risk

If an institution in one country has obligations through the likes of debt, derivatives, or insurance in another country then its demise will have a global impact. No example of this is more profound than that of troubled insurance giant AIG. In early 2009 they held roughly 74 million insurance polices, issued in more then 130 countries.^[7] The notional value of their derivatives portfolio was approximately 1.6 trillion covering a counterparty base of over 1,500 clients. These clients included top banks, wealth finds, major corporations, governments and institutional investors.^[8]

Due to its integral position in the functioning of the global financial system Sen. Christopher Dodd, chairman of the Senate Banking Committee described AIG as having the “world financial system by the throat”.^[9] The US Federal Reserve Chairman, Ben Bernanke deemed them “too big to fail”, saying such large, interconnected financial firms pose a “systemic risk” to economic stability.^[10]

The failure of a company like AIG would cause turmoil in the U.S. economy and global markets, and have multiple and potentially catastrophic unforeseen consequences. This is a prime example of how counterparty risk can cause contagion in financial networks.

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3. Fundamental Links

Fundamental links are the most obvious and easy to understand causes of contagion. These links are usually the result of international trade where two countries trade with each other or compete in the same foreign market. A drop in the currency valuation of Country ‘A’ will eat into the competitive advantage of Country ‘B’, the likely consequence being that both Country ‘A’ and ‘B’ will end up devaluing their currencies to re-balance their external sectors.^[11]

Some fundamental changes have a global impact, such as fluctuations in the price of oil. Others financial links are the result of a direct investment by one country in another. In December 2009 China held $755.4 Billion dollars of US Treasury Securities which was 21% of the total outstanding.^[12] In 2009 The US also did $365.98 billion^[13] in trade with China of which $266.8 billion was a deficit.^[14] It is clear to see how the US and China are fundamentally joined at the hip and how this will lead to contagion between the two.

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4. Cross-Market Hedging*

Many global investment managers aim to keep their portfolios optimally hedged at all times. When a change is required due to the release of new information about macroeconomic risk factors or simply a change in asset prices this will alter the global balance of their portfolio. The required re-balancing transmits the effect from the source market to the other markets in their portfolio causing a correlation or contagion over the short term.^[15]

*I have used the term hedging instead of rebalancing (as used in “A Rational Expectations Model of Financial Contagion”^[15]) because rebalancing can occur for several reasons, only one of which is cross-market hedging.

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5. Herd Mentality

Herd Mentality is the result of a reaction to peer pressure which makes individuals act in order to avoid feeling ‘left out’ from the group.

French sociologist Gustave Le Bon developed ‘Contagion Theory’ (different from Financial Contagion). It assumes that crowds exert a hypnotic influence over their members. People find themselves in a situation where they are anonymous and can abandon personal responsibility. They get sucked up in the contagious emotions of the crowd and can be driven toward irrational, often violent, action that most isolated individuals would not attempt.^[16] However the main flaw of this theory is that crowd behavior is not necessarily irrational.

On the investment landscape people are notorious for acting in herds and those investing abroad are often the worst offenders. It is very hard for an investor to understand all of the economic factors in their home market let alone a foreign one. Rather than basing their decisions on fact, many will allow their decisions to be affected by the action they witness in the surrounding markets, regardless of any fundamental link.

For instance Indonesia was the worst affected economy in the Asian crisis, which is surprising because they had comparatively sound macroeconomic fundamentals. They had the highest economic growth in Southeast Asia, low inflation, a modest current account deficit, rapid export growth and growing international currency reserves.

Fundamentals alone do not explain the severity of the Indonesian problems in 1997. Indications are that contagion of the more real crisis occurring in Thailand caused the crisis to spread to Indonesia. What was happening in Thailand lead international investors to reassess Indonesia’s economic performance. Rather than base their decisions on real links, people just followed the Herd. This facilitated the contagion effect by fueling a spread of fear from Thailand to Indonesia leading to illogical declines in asset values.^[17]

Herd Mentality helps to amplify and perpetuate other causes of contagion as well. Good news that has a rational fundamental link between Countries ‘A’ and ‘B’ can be over compensated for due to the spread of greed throughout the Herd; no one wants to miss out on the rally. This greed can then spread through the Herd to Countries ‘X, Y and Z’ that lack a fundamental link to the original good news. Fear appears to spread around the globe much more effectively than greed however, and the resulting ‘death spiral’ can be difficult to stop. This is all typical of Herd Mentality; it helps spread panic and irrational exuberance around the globe.

The five causes I have mentioned appear to be the main causes of Financial contagion and each can be observed in many instances as having a measurable impact. However it is unlikely that we will ever been able to measure the relative importance of each cause and it appears as though the role each plays varies from case to case.

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Case Study

A prime historical example of contagion can be seen by the effect that the Russian bond default had on Brazil. But how much of the reaction toward Brazil after the 1998 crisis in Russia was due to margin calls and how much was due to the Herd Mentality facilitating the spread of panic?

Despite support from the International Monetary Fund, in August 1998 Russia defaulted on its sovereign debt, devalued the ruble, and declared a suspension of payments by commercial banks to foreign creditors.^[18] During this crisis the asset prices in Russia, Brazil, and the US despite having little fundamental relationship to each other, exhibited the following common patterns:^[19]

Market depth and liquidity decreased simultaneously.
The volatility of prices increased simultaneously.
The correlation of prices on seemingly independent positions increased.

For reasons no one appears to be able to agree on, the Russian devaluation prompted a capital flight from Brazil and eventually a significant loss in value of its currency.^[20] The concept of contagion was on vivid display in perhaps its most logic-defying form. For some reason the spreads on Russian and Brazilian Brady Bonds and reserves during this period became remarkably correlated.^[21]

The Russian contagion to Brazil crossed international borders to a country with a very different economy. Countries with fundamentals closely matching Russia’s did not experience a financial crisis so why would the events in Russia affect Brazil so profoundly? Brazil’s economy was much bigger than Russia’s^[22] and was more likely to benefit from low-oil prices than to suffer as Russia had. Nevertheless, the implosion of the Russian economy caused massive financial problems in Brazil.

There has never been such a pronounced example of market contagion where the markets that are less fundamentally related. Was this due to fear, margin calls, cross-market hedging or something else? It is hard to say but no one can deny that contagion occurred in a way that is impossible to quantify with the current model for economic logic.

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Summary

The power of contagion has been growing steadily for the last 20 years thanks to globalization and the growing speed and availability of information. Today, in the Information Age we live in a smaller, more integrated world and we look set to continue to move towards a truly global economy. Already we have the ability to work as a unit in real time. Communication, trade, employment, personal and commercial transactions are now occurring on a global scale. Largely, international and regional boundaries are being ignored;^[23] capital now flows far more freely between countries.^[24]

In some ways this globalization helps to stabilize things and prevent another world war. To go to war with countries that you depend on for trade and are so heavily invested in would be economic suicide. In other ways it means that when a recession occurs there are few areas that are not effected making it very hard to find a safe haven for your capital.^[25]

All of this leads to more contagion; it is real and will continue to have an impact on the financial landscape for a long time to come.

Have you seen the effects of contagion on your finances? What do you think the causes were? Please share your thoughts in the comments section below.

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^ New global deal needed to tackle recession, says Brown, Isish Times, March 5, 2009 by Denis Staunton
^ Hedge fund panic was behind global stock markets collapse, UK Telegraph, August 11 2007 by Helen Power and Dan Roberts
^ Did Genius Fail Again at Goldman Sachs’ Global Alpha Fund?, Seeking Alpha August 14, 2007 by Michael Shedlock
^ Goldman’s Global Alpha Fund Fell 22 Percent in August (Update3), Bloomberg, September 13, 2007 by Jenny Strasburg and Katherine Burton.
^ Quant Bloodbath Revisited, Lehman Brothers Stategist Becomes The Sage of The Subprime Contagion Theory, Deal Breaker, August 13, 2007 by John Carney.
^ Blowing up the Lab on Wall Street, Time – Business & Tech, Thursday, Aug. 16, 2007 by Richard Bookstaber, Paragraph 6
^ US takes another crack at AIG rescue, March 3, 2009 CNN Money
^ AIG: Is the Risk Systemic? Draft, March 6, 2009 Prepared by American International Group, Inc.
^ ‘Too big to fail’? More like ‘too unknown and scary to fail’, March 15, 2009 Los Angeles Times
^ Bernanke: Fix banks to get a recovery, CNN Money, March 10, 2009
^ An Evaluation of the Devaluation by Sam Vaknin, Ph.D.
^ Major Foreign Holders Of Treasury Securities, December 2009
^ Top Ten Countries with which the U.S. Trades, December 2009
^ Top Ten Countries with which the U.S. has a Trade Deficit, December 2009
^ A Rational Expectations Model of Financial Contagion, April 19, 2001 by Laura E. Kodres and Matthew Pritsker. Part III Contagion Through Cross-Market Rebalancing, Pages 15-23
^ The Crowd: A Study of the Popular Mind, 1896 by Gustave Le Bon
^ Indonesia’s Economic Crisis: Contagion And Fundamentals. The Developing Economies Volume 40 Issue 2, Pages 135 – 151 March 6, 2007 by Reiny Iriana And Fredrik Sjöholm
^ Russia and Brazil: Two defenseless giants, January 19, 1999 by Sergei Blagov
^ Contagion as a Wealth Effect by Kyle, Albert S. and Wei Xiong, 2001. Journal of Finance, Vol 56, Iss. 4, pages 1401-1440
^ Brazil crisis underlines the need for new solutions by Martin Khor
^ The Russian Default And The Contagion To Brazil, 2000 by Taimur Baig And Ilan Goldfajn. Page 8, Figure 1
^ Chapter 1 Current State of the World Economy, Section 1: Overview of the World Economy, Table 1-1-1
^ Speech at Credit Suisse First Boston Asian Investment Conference, March 26, 1999. International Capital Flows and Free Markets by Joseph Yam, JP Chief Executive Hong Kong Monetary Authority. Conclusion
^ The Economics of Developing Nations and the Global Financial Crisis, Thought Economics – Business & Strategy for “Economy 2.0” 15 December 2008 by Vikas Shah. Paragraph 1
^ A recession of global dimensions? – Globalization is a wonderful thing for the U.S. economy. It’s also driving the dramatic slowdown that’s underway. January 22, 2008 by Geoff Colvin

Good but not yet Gold

February 15, 2010 – 4:15 am ET

What a fun week! The bulls saved themselves (for now), the Winter Olympics got underway, the Canadians got their first Gold at home and unless you forgot Sunday was Valentines day.

Action from the market this last week while good was not good enough to call it a return to the bullish trend. We said it was do or die for the bulls and they held their ground. However key resistance levels remain intact.

ETF % Change Comparison

ETF % Change Comparison

It was an undeniably impressive week from all of the economically sensitive ETFs while the more stable SPY and DIA lagged behind which is a very positive sign. Notice how SMH is now the top performer over the 1 week, 2 week and 4 week time periods but has still declined the most from its peak 35 days ago? This points to the possibility that SMH has bounced the hardest because it was the most oversold. Fortunately the charts hold the answer.

What the % Comparison Table Tells Us:

A Look at the Charts

SPY

When assessing SPY on its own things looks good; the volume trend from the bottom of the market remains intact and the RSI has just turned bullish. If SPY is to break through resistance however it will require the likes of QQQQ and SMH to to lead the way.

QQQQ

QQQQ is also looking good but SMH and IWM offer a clearer picture.

SMH

I love the semis, not just because they tend to lead the market revealing its true direction but because they so often provide a clearer technical picture. After a solid week SMH has found resistance as expected from the 100 day SMA, if this level is broken and confirmed by a trend change in volume this would be very bullish.

IWM

IWM has already broken through resistance but needs volume to confirm the trend change. If both SMH and IWM can do this then a return to the bull market is likely.

IYT

IYT still has strong resistance to break through but is not currently offering much information of value.

OM3 Weekly Indicator

OM3 Indicator

IWM turned to a ‘Strong Buy’ on Friday but rather strangely is still showing a bear alert which is most likely due to internal weakness. Other than that all the ETFs remain on ‘Sell’ signals.

How to read the OM3 indicator

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

Transdow and Nasdow

The Dow remains dominant over both the Transports and the NASDAQ. Statistically this indicates a hightened level of risk in the market.

What the TransDow Readings tell us:

Historically the DJTI has been dominant over the Dow 45% of the time. The annualized rate of return from the DJTI during this period was 18.47% with the biggest loss for one trade sitting at -13.27%. The annualized rate on the DJIA during the periods it was dominant over the DJTI was just 4.06% and the biggest loss for one trade was -16.13%. A 4% stop-loss is applied to all trades adjusting positions only at the end of the week.

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically NASDAQ should be dominant over the DJIA.

LTMF 80 & Liquid Q

LTMF 80 & Liquid Q

Both the LTMF 80 and Liquid Q remain on a buy signal. Both systems look to take advantage of long term trends.

Historical Stats:

ltmf-80-liquid-q-stats

Summary

Really not a lot has changed over the last week; support held and resistance is yet to be broken. Key things to look for this coming week to indicate a return to the bull market are:

New high from OBV on QQQQ
Close by QQQQ above $44
Close by SMH above its 90 day SMA
OBV Bullish trend change on SMH
OBV Bullish trend change on IWM

Until all of these key things have happened, the risk remains to the downside.

Any disputes, questions, queries… comments or theories are most welcome below.

Best Regards

Derry

And the Team @ ETF HQ

P.S I love the Olympics and think this video captures the spirit of the games brilliantly:

Quote Of The Day

“To succeed as a trader, it is absolutely necessary to have an edge. You can’t win without an edge, even with the world’s greatest discipline and money management skills. If you don’t have an edge, all that money management and discipline will do for you is to guarantee that you will gradually bleed to death. Incidentally, if you don’t know what your edge is, you don’t have one.”

– Jack Schwager

What is Fundamental Analysis and does it work?

Fundamental Analysis is one of two processes commonly used to select a stock market investment or trade, the other is Technical Analysis (although throwing a dart at the Wall St Journal is also gaining popularity). In this article I will briefly cover:

What is Fundamental Analysis
Criticisms
Does it work?
Top 12 Fundamental Analysts of all time
and… Why I don’t use it

What is Fundamental Analysis? (FA)

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FA is the process of assessing the factors that affect a company in order to identify the future prospects of its share price. The majority of the necessary data to do this can be found in a company’s annual report. This includes its financial statement, management details, business concept and competition. Here are some of the most commonly used fundamental indicators for a company:

Market Capitalization	Book Value
Revenue	Revenue Per Share
Quarterly Revenue Growth	Earnings
Earnings Per Share	Quarterly Earnings Growth
Debt	Cash
Debt / Equity Ratio	Assets / Liabilities (Current Ratio)
Return on Assets (ROA)	Return on Equity (ROE)
Profit Margin	Operating Margin
Price / Earnings Ratio (P/E Ratio)	Price / Book Ratio
Price / Earnings To Growth (PEG)	Price / Sales Ratio
Dividend Yield	Dividend Payout Ratio

In addition to this, fundamental analysis can involve assessing the factors affecting the general economy. The aim is to identify whether the future is likely to bring expansion or contraction to the economy and how this will impact the different sectors and industries that you are thinking of investing in. Some of the most commonly used fundamental indicators for the economy are:

Interest Rates	Consumer Price Index (CPI)
Earnings Growth Rates	Gross Domestic Product (GDP)
Jobless Claims Report	Job Growth (Nonfarm Payrolls)
Employee Situation Report	Employee Cost Index (ECI)
Consumer Credit Report	Personal Income and Outlays
Money Supply	Consumer Confidence Index (CCI)
Producer Price Index (PPI)	Purchasing Managers Index (PMI)
Non-Manufacturing Report	Durable Goods Report
Retail Sales Report	Factory Orders Report
Productivity Report	Trade Balance Report
Industrial Production	Institute for Supply Management (ISM)
Existing Home Sales	Housing Starts
Business Outlook Survey	Tea Leaves

A Fundamental Analyst believes that the true value of a stock is based on its stability, earnings potential and ability to grow. The price that a stock is currently selling for could be above or below its true value when taking into account for its future potential. The fundamental analyst looks to profit by exploiting this mispricing and generally attempts to do so by utilizing one of two main schools of thought on the subject:

Growth Investing
Value Investing

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Criticisms of Fundamental Analysis

There are two common arguments against fundamental analysis. The first comes from those who follow the efficient market hypothesis and believe that stock prices already reflect all that is know. As a result they believe it is impossible to outsmart the market and identify mispriced stocks using publicly available information. This would be true if human emotions were not a factor in market fluctuations and group intelligence was allowed to take effect.

The second argument against fundamental analysis is simply a matter of practically. The following is a quote from a fundamental analyst who I have a lot of respect for. It is a prime example of the vague conclusions that even the best in the business often arrive at:

“How that will play out exactly, how long it will take and what the road map along the way might look like is difficult to say, due to the many permutations of how events might interact.” – Bill Flekenstein

There are so many different variables with regard to how a stock or the economy is going to perform in the future: there are economic factors, environmental factors, completion, currency fluctuations, changes in technology, the possibility that the information you have is not true or accurate etc. For this reason many people say that it is (almost) impossible to use fundamental analysis to forecast the impact of all these different factors and make money as a result. This begs the question:

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Does fundamental analysis work?

After doing much research into the subject I have come to the undeniable conclusion that fundamental analysis does work. In fact most of the world’s top investors with a long track record of market beating performance were/are fundamental analysts. Rather than try to quantify why it works I have put together a list of the Top 13 Fundamental Analysts of all time, along with a quick summary of each persons investing style:

Top 12 Fundamental Analysts of all time

Warren Buffett – The most famous and successful investor in the world, Buffett is a value investor who looks for exceptional companies at reasonable prices.

David Dreman – Looks for stocks that are battered with good price / earnings ratios, low price / book ratios and a higher than average dividend yield.

Philip Fisher – Was an advocate of investing for the long term in high quality, high growth companies. He looked to the strength of the management and the characteristics of the business.

Benjamin Graham – One of the founders of value investing he looked for companies with strong balance sheets, little debt, above average profit margins and good cash flow.

Jesse L. Livermore – Thought that the main difference between successful and unsuccessful investors was the amount of effort that they put into studying the fundamentals of a company and the economy.

Peter Lynch – Only invests for the long term and undergoes a depth of due diligence into the fundamentals of a company before investing that few can match.

Bill Miller – A value investor but not in the typical sense. Miller thinks that any company can be a value stock simply by trading below its intrinsic value. He attributes his success to extensive fundamental analysis.

John Neff – Uses fundamental analysis to identify good companies, in good industries, with low price / earnings ratios.

William J. O’Neil – A growth investor who looks for stocks with the greatest potential for large price increases within a short period if purchase.

Thomas Rowe Price, Jr. – A pioneer of growth investing he focused on identifying companies with strong management in fields that were likely to see earnings and dividend growth that would outstrip inflation and the overall economy.

Sir John Templeton – Was a value contrarian investor and searched for neglected companies around the world with low prices and an exceptional long term outlook.

Ralph Wanger – Looks for strong small companies with entrepreneurial managers running businesses that are easy to understand and will benefit from a macroeconomic trend.

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Why I don’t use Fundamental Analysis

We have established that fundamental analysis works and that most of the top investors of all time have used it to make their fortunes. Why then do I not use it and why do I think fundamental analysis is not suitable for the average investor?

One thing that became clear while I was researching the really successful fundamental analysts is that most underwent a depth of analysis that was beyond the capabilities of the average investor. They often meet with company management and got ‘inside’ a business before investing in it. They had the resources to check that a company’s balance sheet was in-line with reality. When asked how he became so successful in investing, Warren Buffett answered:

We read hundreds and hundreds of annual reports every year.

Personally I don’t have the intelligence or the motivation to go to such lengths before making an investment. Reading annual reports and balance sheets all day long is not something that I can get excited about. What about you?

However while observing the daily action of the market and looking for a way to draw a profit from it I came to a realization. Yes, the fundamentals dictate what a stock price will be… eventually. But over the short and medium term it isn’t the fundamentals that matter. It is the markets interpretation of the fundamentals. As a result I came to a new definition for what the market is:

The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

So we are dealing with human emotion and its effect on supply and demand; not human logic! Is it positive for the market when the Fed increases interest rates? That depends on the markets interpretation of the reasons for such action at the time. If a rate hike is expected and it doesn’t come then does that mean that the economy is too weak to handle higher rates or that inflation is under control and everything is great?

If the rate hike is expected and does come then does that mean that the economy is growing rapidly and just needs to be slowed down slightly or that inflation is a problem and the Fed is behind the curve? (Interest rates can be used to stimulate or slow the economy and to battle inflation.) When the same news can be good one day and bad the next it is extremely difficult to assess the implications of the fundamentals.

In addition to this, even if you have an amazing ability to bring all of the fundamental information together to make sound investment decisions, you have to assume that the fundamentals you are working with are true. Unfortunately Wall St has a long and growing history of lies, fraud and manipulation.

Buying stocks with low P/E ratios can make sense only if the earnings – the “E” – are real. The E was much worse than anyone thought… the banks themselves had no idea of how bad the E was – David Dreman, legendary fund manager laments purchases of financial companies made before the credit crunch.

What are your thoughts?

Do you think that Fundamental Analysis is a realistic path to stock market success for the average investor who works a 9-5? Share your thoughts on Fundamental Analysis in the comments section below.

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Key Support, Do or Die For The Bulls

February 08, 2010 – 6:47 am ET

This past week we saw some impressive declines and along with some impressive bounces off major support levels. The most bullish thing we have seen in a while was how violently SMH bounced off its 200 day moving average. This level will become pivotal in ensuring the continued health of the broad market.

ETF % Change Comparison

ETF % Change Comparison

SMH ended up as the top performer for the week followed by QQQQ while IYT and IWM were the biggest laggards. To see the economically sensitive stocks in SMH and QQQQ rebound on Friday was a positive development however this could just be a bounce caused my a combination of support and becoming oversold.

What the % Comparison Table Tells Us:

A Look at the Charts

Volume flows are maintaining their bullish trend which is a positive sign. Although it is concerning to see so little support between the current levels and the 200 day MA. If SPY can move higher then there are still solid resistance levels above. Look to SMH for a clearer picture.

Suddenly volume flows for QQQQ don’t look so bad. A few more good days and OBV will be moving to new highs and that would be a very good sign. If that were to occur in conjunction with a move above $44 then the bulls would have the upper hand again.

Here we have reached a critical point. Can SMH hold onto support from the 200 day MA? If it can then this will be the fuel that the market needs to take on overhead resistance. If not and $24 is also broken then things could really get nasty. Volume flows indicate that support is unlikely to hold so if you were to watch only one ETF this coming week then SMH would be it.

Volume flows on the small caps are in a firm down trend. There is strong support around $57 and from the 200 day MA. With OBV sitting below the November low there is a good chance that support will fail. The only thing that is likely to stop a test of support is strength from SMH.

Volume flows from the Dow Transportation ETF continue to move in a sideways trend. With the RSI approaching oversold territory this could indicate that a bounce is due however a move in either direction will be meaningless until there is a breach of resistance around $72 or support around $66.

OM3 Weekly Indicator

The OM3 indicator is showing a ‘Strong Sell’ for all of the ETFs we track and several of them for the 3rd week. In addition to this they have all had several weeks of ‘Bear Alert’ warnings.

How to read the OM3 indicator

This is an indicator not a mechanical trading model. It is useful to assist in analyzing the market but for the best results should be combined with commonsense and support/resistance levels etc.

TransDow & NasDow

The Dow remains dominant over the DJ Transportation Index and the NASDAQ. This indicates that there is a high level of risk in the market.

What the TransDow Readings tell us:

Historically the DJTI has been dominant over the Dow 45% of the time. The annualized rate of return from the DJTI during this period was 18.47% with the biggest loss for one trade sitting at -13.27%. The annualized rate on the DJIA during the periods it was dominant over the DJTI was just 4.06% and the biggest loss for one trade was -16.13%. A 4% stop-loss is applied to all trades adjusting positions only at the end of the week.

What the NasDow Readings tell us:

The NasDow measures dominance between the NASDAQ and the DJIA. Using the same theory behind the Trans Dow; in a strong market the more economically NASDAQ should be dominant over the DJIA.

LTMF 80 & Liquid Q

Both LTMF 80 and Liquid Q are on buy signals and showing small profits from the current trades. It is bullish to see these signals are active especially as Liquid Q is only in the market 27% of the time. Both systems aim to capture big moves over a timeframe that usually stretches into months.

Historical Stats:

Summary

For the bullish argument there was some impressive upside leadership from SMH and QQQQ on Friday as they found buyers at major support levels. Volume flows on SPY remain bullish and QQQQ’s OBV is not far from a new high. If resistance overhead were to be broken such as QQQQ closing above $44 then this would be very bullish.

The key thing to watch for this week is whether SMH can maintain support from its 200 day MA, if this fails then support at $24 is also likely to fail. Should this happen then expect support levels to start crumbling across market. The next most important support is the 200 day moving average from the Russell 2000 ETF – IWM.

For the bearish argument, nearly every major stock and ETF is below its 50 day MA and has strong resistance overhead most commonly in the form of the 100 day MA. Volume flows for SMH and IWM are clearly bearish and below their November lows indicating that support levels are unlikely to hold.

By looking at the major holdings of an index or ETF you can often reveal a lot about its internal strength. Some funds have 25% or more of their holdings in just a few stocks. SMH for instance has 57.88% of is holdings in only three stocks; INTC @ 23.47%, TXN @ 21.18% and AMAT @ 13.23%.

If you have a look you will see volume flows for INTC are moving sideways along with the stock price and there is staunch support around $19. Volume flows on TXN are clearly bearish while the volume flows on AMAT are actually looking quite healthy and are significantly outperforming the price action. I would expect AMAT to be the top performer of the three if there were a rebound this week. INTC is still above its 200 day MA while TXN and AMAT have already broken through this support level. For the market to recover this week it will be important for INTC to maintain support @ $19 so keep an eye on this as well.

The bulls are going to need to fight hard this week to maintain these key support levels or there is little chance that the bull market can continue.

Any disputes, questions, queries… comments or theories are most welcome below.

Best Regards

Derry

And the Team @ ETF HQ

Quote Of The Day

"Everything’s tested in historical markets. The past is a pretty good predictor of the future. It’s not perfect. But human beings drive markets, and human beings don’t change their stripes overnight. So to the extent that one can understand the past, there’s a good likelihood you’ll have some insight into the future."

– James Simons