QID - Boosting My Short Position

By midday today, the Dow had made an impressive run over 13,100, up over 1%, whereas the NASDAQ lagged behind, struggling to maintain 0.5% or 0.6% gains.

I entered a limit order near the day's lows for QID. Soon, my order filled at $36.89, and the market dropped, taking QID up to $38.50 intra-day before settling at the close at $37.76.

It looks as though I read the market action correctly today. Very satisfying.

This purchase lowered the cost basis of my now two-month-old QID position to $41.49.

So how did I make this decision to stare down this tech rally?

First off, Trader's Narrative started off a recent post with this bit of insight:

NASDAQ:NYSE Volume - I touched on the relative lack of volume and how this has historically marked tops, rather than spurred on rallies. Another troubling volume development is the ratio of volume on the Nasdaq compared to the NYSE. We are seeing a spike in this ratio, meaning that Nasdaq volume is significantly more than NYSE volume. Since the Nasdaq represents the riskier side of the market, this has usually meant that there is too much froth in the market.

Second, $NDXA50 closed last week at 84, meaning 84 out of 100 NASDAQ-100 stocks were trading above their 50-day moving averages. I wrote that I wouldn't use a high reading as an automatic trigger to short the market. That doesn't mean it's not a useful contributor to the NASDAQ-is-overbought argument.

Third, the RSI(2) reading for the NASDAQ at midday moved up to about 95; the RSI(14) approached 70. The NASDAQ was looking overbought in the short-term and in the longer-term.

Furthermore, Aaron Task and Henry Blodget at Yahoo!'s Tech-Ticker summed up the conventional market wisdom on the bear side quite nicely:

From a contrarian perspective, too much optimism -- as reflected by the falling VIX and other sentiment gauges -- is a negative sign because it means most people have already placed their bullish bets.

Furthermore, the fundamentals of oil, inflation and how the slowdown in housing is affecting consumers -- see Lowe's results and guidance -- provide formidable headwinds to a sustainable rally.

In addition, second-half earning estimates remain extremely rosy, meaning the market is not as attractive on a forward P/E basis as the bulls would have you believe.

Put all of these factors together, and that's why I boosted my QID position.

Data Mining with $NDXA50 Charts

My recent post looked at market extremes and charts depicting the percentage of stocks of the S&P 500 above their 50-day moving average.

We're approaching some market extremes, especially with the NASDAQ's recent tear.

Then, on Monday, the following post from Barry Ritholtz lodged itself in my head:

Peter Boockvar notes:
Today's consolidated volume for NYSE names was a
low for the year to date.

Helene Meisler notes:
It's a bear market -- and these low volume rallies
are typical of short covering. (unless you believe all those dark pools are
swallowing all the volume!).
As long as there are shorts in the market we
will get rallies; Once the shorts cover we get a decline like last week.

Doug Kass goes even further:
I am starting to scale into shorts
now. My favorite? PowerShares QQQ (QQQQ). My catalysts? The VIX and
volume.

That's our surprising data point of the day.

Kass was looking at shorting the NASDAQ 100 back on Monday. It's moved up almost 2%-3% since then. 83 components of the NASDAQ 100 are now trading above their 50-day moving averages. When that number hits 85 (or 15) on the $NDXA50 chart, is that a timely trading opportunity?

I didn't have an immediate answer, apart from Trader's Narrative's opinion that a low number of stocks trading above their 50-day moving average is a superior signal to its converse. So I put on my virtual spelunking hat, turned on that light on the front, and mined some data.

Here are the $NDXA50 charts from stockcharts.com:

How one defines extreme levels in these charts is somewhat arbitrary. At first, readings at or above 80, or at or below 20, seem like a good place to start. For me, that's where these charts begin to grab my attention, but if you look over the six-and-one-half years of information, you'll see that the 80/20 levels offer up too many data points. 80/20 is just not extreme enough.

85/15 are better extreme levels.

Here were my rules for this bit of mining:

I poured through daily $NDXA50 charts (not shown above) and noted the first trading day that the chart produced a value of 15 or below, or 85 or above. I recorded the price range for QQQQ shares for the following trading day, and then looked at the QQQQ trading range five, ten, 20, and 40 trading days into the future. Once the index was at an extreme level, I would not record a new trading day with a value of 15 or below, or 85 or above until the chart value returned to the normal range (16-84) for at least one trading day.

I also arbitrarily decided to start at 1/1/2004 until today.

Using these criteria, I found seven dates when $NDXA50 fell to 15 or below:

3/22/04
8/6/04
6/8/06
7/14/06
1/4/08
2/6/08
3/10/08

Six out of seven turned out to be profitable trades generally between five and ten trading days later. Three became significantly more profitable 20 and 40 trading days out. Only one trade required more than 40 trading days to turn a respectable profit (1/4/08).

Yes, this is a small data set, but the downside is quite limited if you take advantage of this trade by buying QQQQ shares. Buying QLD shares adds some leveraged juice to this trade, but also increases the downside risk. QQQQ call options are another interesting alternative, too, but as this data set implies that you need five to ten trading days for the trade to work, make sure that the options decay over that time doesn't cancel out the gains.

On the flip side, I found 14 discrete events when the $NDXA50 touched 85:

10/4/04
10/6/04
11/4/04
12/1/04
12/9/04
12/14/04
12/29/04
5/20/05
5/26/05
12/15/05
9/13/06
10/12/06
10/8/07

Here, the trading signal to go short on QQQQ was far from compelling. Six trades would have been successful, four would have failed, and four offered insignificant to small gains.

That's disappointing, as the NASDAQ is almost there, at 83. I agree with Kass, and may follow him in shorting the QQQQ's (I'll do it via adding to my QID position), but I'm not using the $NDXA50 data as a trigger. The data doesn't compel a trade.

Feeding the Bear - More Arguments for the Bear Rally

Here are some excerpts from a Bloomberg piece by Michael Tsang and Nick Baker, calling the recent market surge a "suckers' rally" and questioning whether the market has priced in the turmoil from the credit crunch, housing market, recession, etc.

The biggest rally in the Standard & Poor's 500 Index in more than four years is luring investors to equities from cash, just as options traders are betting the advance will evaporate.

The benchmark index for American shares rose 4.8 percent in April, the steepest jump since December 2003, and has climbed 11 percent from a 19-month low in March. The rebound came as Federal Reserve Chairman Ben S. Bernanke arranged the bailout of Bear Stearns Cos., took subprime-tainted mortgages as collateral from investment banks and cut borrowing costs to a three-year low.

Jean-Marie Eveillard, who runs the $22 billion First Eagle Global Fund, is skeptical the gains can last because the worst housing slump since the Great Depression will reduce earnings. S&P 500 companies were valued at 22.7 times profit last week, the most in four years. Options traders are paying 63 percent more to protect against a drop in the S&P 500 than to bet on a gain, the widest difference since at least 2005.

``It may be a suckers' rally,'' said Eveillard, who is based in New York. ``Investors want to believe. But if I'm right, then there's truth to the argument that this is the worst financial crisis since the end of World War II. The same kind of reflex is the wrong reflex.''

...

``There are pockets in the marketplace that believe this is a sucker rally, and they're willing to pay a substantial premium for downside protection,'' said Robert Arnott, whose Pasadena, California-based Research Affiliates LLC oversees $26 billion. He said in December 2006 that a bear market was probable.

Nouriel Roubini, professor of economics and international business at New York University's Stern School of Business, says the Fed's seven rate cuts since September -- which lowered the benchmark lending rate to 2 percent from 5.25 percent -- aren't enough to stave off a contraction and that earnings expectations are unrealistic.

Investors are currently paying the highest prices relative to earnings since March 2004 and 15 percent more than when the S&P 500 reached its all-time high in October.

...

Gerard Minack, chief market strategist at Morgan Stanley's unit in Australia, says that's a mistake. The global economy will probably worsen, Fed rate cuts will be less effective than in previous periods and profit growth will disappoint, he wrote in a note today.

``We are in the midst of a bear market rally,'' Sydney-based Minack said.

NYU's Roubini also expects additional pain.

There is ``complacency among investors thinking that the worst is behind us for credit markets and for financial markets and for the real economy,'' the New York-based Roubini said. ``This is not the year to be in risky assets like equities.''

Year of the Bear

Mark Hulbert commented yesterday in MarketWatch on John Dessauer's outlook on China. Hulbert covers investor newsletters, and John Dessauer is the editor of the straightforwardly titled Investor's World. Dessauer believes it's the year of the bear:

Does Dessauer consider Chinese stocks to represent a good value today, with the Shanghai Composite index trading at barely more than half its high set last fall?

In a word, no.

For starters, Dessauer is concerned about the speculative motivation of most individual Chinese investors in Chinese stocks, and what it would do to the prices of those stocks if and when they decide to pull out en masse. "The sixfold rise in Shanghai stocks happened at the same time that millions of new Chinese investors flooded into stocks," he pointed out. "At times, Shanghai stockbrokers were opening a million new individual accounts a week. Does anyone really believe these individuals are long-term investors?"

Answering his own question, Dessauer continues: "It will be interesting to see how all those millions of individual Chinese who rushed to buy stocks on the way up will react now that the market has fallen sharply. My guess is that many will lose interest in stocks and go back to work to earn back their losses."

In addition to being concerned about the speculative nature of the Chinese stock market, Dessauer also worries about the "lack of managerial talent in China. Mao killed or severely punished most intellectuals, or any talented people. An entire generation of managerial talent is missing in China. It takes a long time to create managerial talent. China has been making progress with education and training but the problem is still far from solved."

A third source of concern for Dessauer is "the difficult issue of guanxi, the intertwining of personal and business relationships, which leads to what we would call corruption or nepotism. In China, it has become ingrained that you combine personal and business relationships... I have visited many companies in China -- public, private and state-owned. The business culture is slowly changing, but it is still common to find high-level managers who do not know what 'profit' means, never mind shareholders. There is still a question about who owns what ... If you are still tempted to buy Chinese stocks, take a look at one or two prospectuses for Chinese companies. That is a sobering exercise that should curb your enthusiasm."

Let's quickly pick through Dessauer's concerns.

First, the Shanghai market does seem to still be Bubblicious TM, even with the 50% pullback. It's a fair assessment that the influx of new money from unsophisticated investors that followed the stellar Chinese market's performance could flee the market in a similarly spectacular fashion if Shanghai starts to look like the NASDAQ of the early aughts.

Second, I suspect the lack of management talent is more of a concern for investors looking at smaller Chinese companies. Since I'm focused on FXP, and the 25 largest Chinese concerns, I'm not sure the shallow management pool is as relevant for my bearish case.

Third, the nepotism issue probably concerns me as much as the management talent issue. Which means, not so much.

My main concern should be the Chinese government's attempts to put on its best showing in the run-up to the Olympic games on 8 August 2008. (The Chinese and their lucky number 8.)

Orwellian Inspiration

I found the following irresistable passage on Socialism in Jeff Greenfield's Slate piece on Obama:

One key to the movement's lack of popularity, Orwell argues, is its supporters. "As with the Christian religion," he writes, "the worst advertisement for Socialism is its adherents." Then he wheels out the heavy rhetorical artillery. The typical socialist, according to Orwell, "is either a youthful snob-Bolshevik who in five years time will quite probably have made a wealthy marriage and been converted to Roman Catholicism, or, still more typically, a prim little man with a white-collar job, usually a secret teetotaler, and often with vegetarian leanings … with a social position he has no intention of forfeiting. … One sometimes gets the impression that the mere words 'Socialism' and 'Communism' draw towards them with magnetic force every fruit-juice drinker, nudist,sandal-wearer, sex-maniac, Quaker, 'Nature Cure' quack, pacifist and feminist in England." (Think "organic food lover," "militant nonsmoker," and "environmentalist with a private jet" for a more contemporary list.)

Perhaps Andrew Sullivan should replace his blog's Orwell quote, "To see what is in front of one's nose needs a constant struggle." with some of the above. I suggest the portion I put in bold. Or perhaps I should replace my own introductory spiel with it.

Overbought Danger Signs for the Market

Trader's Narrative offers up some graphical evidence that the market is getting a bit overextended:

Here's yet another metric showing that the market may be approaching overbought conditions:

For those unfamiliar with this indicator, it is the percentage of stocks within the S&P 500 Index (SPX) which are trading above their simple 50 day moving average. So for example, if we had 100 trading above and 400 trading below, that would give us 20%.

...

Getting back to current market conditions, we are now slowly approaching the other extreme: overbought. We aren't there yet. Usually the market tops out when this percentage gets between 80% and 90%. When the market topped out in October 2007, this indicator reached 85%. But right now we are only at 74%.

So its just something to watch out for. Especially when compounded by other sentiment and technical indicators which similarly argue for a pause or retreat.

Trader's Narrative also believes that recent low volume offers up a caution sign for this rally.

The above chart is quite thought-provoking. I agree that it's another tool in the mental arsenal. But if you look back to August of '06, the market was at a similar overbought level. The market continued moving higher, to more overbought levels for most of the rest of '06 until the breakdown in late February '07. If the current market paralleled the market of August '06, we could conceivably see another six months of bullish market behavior.

On a similar note, Bespoke Investment Group offers up charts of the S&P 500 and individual sectors showing the current market's overbought condition. I've excerpted the first two charts from Bespoke, but click the link for the rest of their informative charts.

Below we highlight the percentage of stocks in the S&P 500 and its ten sectors that are currently trading above their 50-day moving averages. As shown, 77% of stocks in the S&P 500 are currently above their 50-days, the highest level seen since last October. While it's good to see markets doing well again, things have gotten overbought over the last week or so.

Currently, 85% of Financials, 80% of Industrials and 80% of Technology stocks are above their 50-days. The only sectors with a downward trending breadth line are Energy and Materials. After hitting a rough patch in recent days, the percentage of Material stocks above their 50-day moving averages has dropped to 54%.

Then I found this piece from Investment Executive, a magazine for Canadian financial advisors. Here's the back bacon:

A majority of financial analysts in believe North American markets will continue to fall, according to a poll released today.

When asked if the North American markets have hit rock bottom, 61% of Canadian Chartered Financial Analysts (CFA) respondents said no and only 17% replied yes. "There is lack of confidence in the financial system," said one respondent. "Both Canadian and American economies are in good general shape except for problems in the financial sectors. The bottom is much deeper than most of us could imagine."

...

The poll was conducted between April 15 and 17 and CFAs from all 12 Canadian CFA societies across the country participated.

Finally, I've loaded up my current RSI (2)/(14) chart below. The RSI (2) for the Dow on Friday closed at a 94, which is short-term overbought. The RSI (14) of 66 is approaching the longer-term overbought value of 70. 18 out of 30 Dow components are in the red.

What I Learned Losing a Million Dollars - Lessons from Failure, Part 2

In chapter 6, entitled "The Psychological Dynamics of Loss," Jim Paul reviews the process where a market participant experiences a loss, and instead of remaining objective and clearheaded in dealing with the losing position, becomes subjective, ego-driven, and exacerbates the negative outcome.

Market losses are external, objective losses. It's only when you internalize the loss that is becomes subjective. This involves your ego and causes you to view it in a negative way, as a failure, something that is wrong or bad. Since psychology deals with your ego, if you can eliminate ego from the decision making process, you can begin to control the losses caused by psychological factors. The trick to preventing market losses from becoming internal losses is to understand how it happens and then avoiding those processes.

Paul believes a successful investor/speculator/trader must strive to separate ego from their decision making processes. It's an easy lesson to take on its face, but an altogether more difficult lesson to consistently maintain in practice.

[I]t is easy to equate losing money in the market with being wrong. In doing so, you take what had been a decision about money (external) and make it a matter of reputation and pride (internal). You begin to take the market personally, which takes the loss from being objective to being subjective.

An example of personalizing market positions is people's tendency to exit profitable positions and keep unprofitable positions. It's as if profits and losses were a reflection of their intelligence or self-worth; if they take the loss it will make them feel stupid or wrong.

I know that I often feel that a profitable trade proves my market savvy. And likewise, I equate a loss with being wrong, bad, incorrect--a failure. I'm not sure that I agree with Paul when he writes that experiencing these emotions is inherently negative for the market participant. However, I tend to agree that allowing these emotions to linger and influence your investing methods is problematic.

Paul then explains the Kubler-Ross model (Five Stages of Grief) - Denial, Anger, Bargaining, Depression, Acceptance. I first learned of this model from Dennis Miller, back when he had a five-night-a-week talk show in 1992. Upon cancellation, Miller applied each Kubler-Ross stage of grief as the theme of his final five shows. I would guess that the Tuesday show was the most entertaining.

When a market participant experiences a loss (say my current FXP position), it's easy to understand that someone could go through many of the stages of the Kubler-Ross model. But it can happen to a trader who has a profitable position that is not at its peak profitability.

When that happens, he becomes married to the price at which it was the most profitable. He denies that the move is over, gets angry when the market starts to sell off, makes a bargain that he'll get out if the market moves back to that arbitrary point, gets depressed that he didn't get out and maybe even lets the profit turn into a loss, thus slipping again into denial, then anger, etc.

I went through denial when I built up a position in FXP starting at the high $90s and continued through the mid $60s. And I've been pretty depressed about the price action for the last month. But I am also not convinced that all is well in the Chinese market, nor am I convinced that this bear market rally is anything but that. Perhaps in a few months, if the market continues to flourish, then these opinions will make me look like I'm deep in denial. I think I have some objective evidence (in the next post) that shows the market to be overbought and due for a downturn. I will be better served by using objective information, and suppressing emotional inputs in my trading decisions.

Wrapping up Chapter 6, Paul differentiates continuous processes versus discrete processes:

In a continuous process, the participant gets to continuously make and re-make decisions that can affect how much money he makes or loses. On the other hand, a discrete event (e.g., a football game roulette, blackjack or other casino game) has a defined ending point, which is characteristic of external losses. A loss resulting from a discrete event is definitive and not open to interpretation.

Relating back to the process involved in creating my FXP position, the RSI and chart readings, along with the tenor of news stories from China validated each of my purchases all the way down from approximately $100 to $60 per share. The continuous process allowed me to make (currently wrong) decision after decision. The psychological impact of continuous, drawn out losing is quite distinct from the psychological impact of a winning or losing outcome of a discrete event. It's quite a challenge to work through the psychological effects of loss and prevent them from affecting one's objective trading plan. Guess that explains the value of this book.

Soon I'll examine Chapter 7, "The Psychological Fallacies of Risk."