Monthly Archives: April 2009

1000 Point Rally Coming

SPX

SPX

CBOE Volatility Index

CBOE Volatility Index

 Even though the DJIA has rallied just over 1400 points off of the March lows, the markets are setting up for another 1000 point run. The rally off the bottom was just under 22% in 30 trading days. Bears that are building short positions, are doing so under the false assumptions 1) the market is overbought 2) it cannot go any higher. These two delusions couldn’t be further from reality. Markets are never overbought or oversold. Maybe relatively overbought or oversold, but you show me a time period we are overbought, and I’ll show you a different time frame where we are oversold. For example, many bears argue the markets are severely overbought. I might agree that they are relatively overbought, but in the last year, they are most definitely still oversold. Saying the markets cannot go any higher is the same mistake many people made on the way down from 14,000. At 10,000 I heard many people saying, no way we can go any lower. Wrong. This time is no different.

The SPX chart above illustrates the markets are in the middle of the channel, and currently neither too “overbought” or “oversold.” This chart illustrates why the markets are headed much higher: higher lows and higher highs. The pattern of higher lows and higher highs is extremely bullish. In keeping with this pattern, the next time the SPX touches the top of the channel, it will happen above 875, I expect this to happen around 900.

The CBOE Volatility Index chart above supports the uptrend. The CBOE Volatility Index is commonly referred to as the fear index as it reflects the implied volatility of the S&P 500 index options. The down trending channel suggests fear and uncertainty are leaving the markets. It should also be noted that the index typically trades within a channel, usually a horizontal channel. The fact that the index did not breach 40 today is extremely bullish. Previously 40 had been support. Now 40 is resistance. The translates into further extensions of this rally. Today’s market movement was healthy and very indicative of bull markets. Bull markets see many smaller up days and few larger down days. Until early March, the scenario was reversed. Before March, up days were large and there were many more down days. The Fibonacci retracements show 33.22 as the next support level. On Friday, the index traded very close to this without closing below it. Based on the retracement pattern, if the index closes below 33.22, it will trade towards 17. If the index touches 17, I will guarantee the DJIA is at least 1000 points higher.

Lastly, for those who do not believe in technicals, I can show fundamental support of this prediction. Dating back to 1959, the 7 recessions that have occurred have lasted on average just over 1 year. The current recession is in its 17th month. Of the 7 recessions that have occurred since 1959, only 5 are technically recessions. Economists will generally agree that recessions are defined by two consecutive quarters of negative growth. Only 1 of the last 7 recessions had three consecutive quarters of negative growth. The current recession has had two. The economic data is showing empirical support that the economy is improving, or at the very least, that housing has bottomed. Considering the level of government spending coupled with quantitative easing and the significantly increasing money supply, once growth begins, it will explode. Although most of this growth can be attributed to inflation, it is growth nonetheless. Once the all clear signal is given, the unprecedented level of cash on the sidelines will pour into the equity markets causing a huge rally.

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This is extremely bullish

SPX

SPX

The uptrend is not over! The markets are adjusting perfectly for the next move higher. In the chart, the SPX is trading in an upward trending channel. The downside resistance in the channel is SPX 820 in a worse case scenario today.  It is very likely we will close much above this as closing at 820 would be almost a 6% slide. The horizontal line on this chart illustrates former resistance becoming support. If the SPX retests 820, it will make a double bottom. Not on this chart, Fibonacci retracement levels for 3 month time frame are: 875 and the March lows of 667. It’s no coincidence the SPX retraced after touching 875, this is very healthy. If Fibonacci retracement lines are drawn on this chart, in this time frame, the next support level is at SPX 832. As a result, I am not surprised that currently we are trading at 836. I do not expect the day to get much worse. In the recent uptrend, down days have been violent and on low volume, and today is no different. There has not been more than two consecutive down days since the March lows. Although it is possible for us to be down again tomorrow, I do not expect this, unless there is a negative earnings surprise.

Unfortunately, people forget quickly and have unreasonable expectations. Many bears are coming out of the woodwork, saying “I told you the markets were due.” They proceed to suggest that now the bulls are “bottom fishing.” I find this very ironic since most of the bears have been top fishing for the last six weeks. This time, the bears who went short on Friday, got lucky. There is no real catalyst for today’s downward price pressure other than the fact that markets do not move in a straight line. It is terribly wrong to try to short this rally. Eight months ago I traded by the saying “don’t be caught wrong long.” All this simply means is that if I’m going to be wrong, I might as well be wrong short. Since I was fairly certain the economy was getting worse, this was a safer bet. Now the economy is improving, and the saying has switched. Being wrong short is a recipe for disaster. It’s clear the government will do whatever it has to for the banks to succeed. Do not try to get cute and attempt to time this perfectly. If you are uncomfortable with today’s down move, close your long positions, but do not try to short this. I will almost guarantee, all else equal, the market closes on Friday higher than it closes today.

Pre-Market Buzz

Futures showing the markets to open lower by about 1.5%. Foreign markets rallied overnight while commodities were hit hard. Crude opened lower in New York by about 6%. This morning Goldman Sachs has come out with a sell recommendation on Citigroup (C) saying its overpriced and gave a target price of $1.50. The government has shown some inconsistency by telling the 9 banks ready to pay back TARP that the government would like to convert to shares of the companies instead of receiving a cash payments. Bank of America (BAC), the largest bank by assets, reported first-quarter profits that more than tripled on gains from mortgage refinancing and trading.

My gut is that this gap down is very healthy for the markets. We needed a small pull back to continue to the push higher. Markets can only consolidate sideways so long before they must retrace. I feel like this will be a capitulation of sorts. Not the traditional capitulation, but I think we could see the markets trade higher the rest of the week following this huge gap down. I remain very bullish on crude and equities, particularly small cap, tech and the banking sector. I’m building positions in these on pull backs.

Bullish on Oil

U.S. Oil Fund ETF (USO)

U.S. Oeil Fund ETF (USO)

The U.S. Oil Fund ETF attempts to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. I was unable to find a chart that I could annotate and post of the commodity itself, so this will act as a proxy. Addressing the downside risk first, the longer term triangle bearish pattern suggests the possibility of a 50% retracement in the spot price of crude. The realization of this scenario would price crude around $25 a barrel. Technical analysis confirms that my previous downside target of crude under $30 is in fact possible. However, when I made this prediction, crude had not bottomed and the economy was not improving. Commodity prices are more supply and demand sensitive than equities in regards to the physical assets. The pricing of equities is done on a supply and demand basis, but here I’m referring to the availability or use of the physical commodity. This downside price target was plausible, and even likely if the economy would have stagnated in March. The economic improvements have greatly reduced this possibility, but to respect technical analysis, we should not completely eliminate the chance of this downside price target being realized.

The upside potential, on the other hand, looks very promising. Technically, the shorter term pennant bullish pattern suggests the possibility of a 10% increase in the spot price of crude. The realization of this scenario would price crude around $60 a barrel. This short term price target seems very probably as we head into the summer driving season and approach the start of hurricane season. Another pattern found on this chart is the cup with a handle pattern. This pattern is known as a bullish continuation pattern. The cup is not as clear in this chart because it appears a little more “V” shaped than the actual spot price of crude does. The handle is the consolidation that has occurred after crude reached upside resistance around $55 a barrel. The handle typically represents the final consolidation/ pullback before the breakout. The smaller the retracement is, the more bullish the formation and significant the breakout. Based on this pattern, the longer term upside potential is an approximate 40% increase in the spot price of crude oil. This translates to about $75 a barrel, which has been my end of the year price target on crude for about a month now. The volume on the breakout should increase substantially as crude trades above the handle’s resistance. A dramatic increase in volume will be the final confirmation the breakout is underway.
This Bloomberg article supports my assessment on crude.

Dow 10K

SPX

SPX

 I know the title says Dow 10K and this is a picture of the SPX, synonymous with the S&P 500, but they track each other close enough to make the point. In addition, the price weighted nature of the Dow, versus the market capitalization weighted nature of the SPX causes some problems in forecasting. Nevertheless, the market bias is higher.

Chart Interpretation:
I have use Fibonacci retracements to show target levels as well as trend lines that suggest a head and shoulder reversal patter, also known as a Kilroy Bottom. According to the retracement levels, closing above 849.32 on the SPX is bullish and suggests the index will trade higher, more specifically to its next resistance level: 962.25. In my newsletters on www.marketfallacy.com, I called the possibility of a bottom on March 10th just shortly after the intraday lows of 667 on the SPX occurred on March 6th. This link is to the March 10th newsletter http://marketfallacy.com/newsletter/files/Market_Fallacy_%7C_3-10-09_2009-03-11.html. In the same newsletter I also suggested it was very likely the SPX would trade at or near 815 and the DJIAat or near 7900. In the weekend edition on March 15th, http://marketfallacy.com/newsletter/files/Market_Fallacy_%7C_3-15-09_2009-03-15.html, I called the bottom. With the SPX closing at 806.12 on March 24th, I increased my target  on the SPX to 875, http://marketfallacy.com/newsletter/files/Market_Fallacy_%7C_3-24-09_%7C_Dont_Fight_the_Fed_2009-03-24.html. On the 2nd of April, http://marketfallacy.com/newsletter/files/Market_Fallacy_%7C_4-2-09_%7C_Cramer_Calls_Bottom_2009-04-02.html, I increased my targets once again. On the 2nd, the SPX closed at 834.38 and the DJIA7978.08. Please do not misunderstand me, I by no means am patting myself on the back for these calls, I simply wanted to post reference points to support why I changed my targets.

In addition, the purpose of bringing up the forecast is to explain what I was seeing when I made these predictions. In another article I’ll explain how I predicted that the DJIA would trade in the 6000’s all the way back in August of 2008 (DJIAwas trading in the mid 11000’s). In early March, I saw the current Kilroy Bottom forming. After drawing a neckline at almost 875, I realized if the trend holds, the SPXwould have to trade above 1000. I know the chart shows a neckline at around 950, but the interpretation of the charts are subjective. On a side note, I believe that if you are truly gifted at the stock market, you should be able to take the same information, the same charts, and tell one person why they should buy, then walk into the next room and tell another person why they should sell. The difference is probability or likelihood that the current trends or information will be realized.

Most bears are calling for a significant retracement. Some bulls are even secretly hoping for a slight pullback in fear that the markets cannot sustain the current up-trend. Let me first begin by saying, I was one of the more bearish traders in the Fall of 2008. Until recently, I thought I was watching the collapse of the greatest empire ever, the United States. However, the last month has given me much hope. America is the land of opportunity, and the current market environment is a huge opportunity. Because of these opportunities Americans have always overcome adversity, whether it’s the bombing of Pearl Harbor, September 11, 2001 World Trade terrorist attack, natural disasters such as fires in California or Hurricanes hitting the coasts of Texas and Louisiana, Americans have always shown perseverance. Unfortunately, in order for there to be good opportunities there have to be bad ones. During the past 8 months talking to different investors, I have continually reminded them that if the want the coin they have to be willing to have both sides, heads and tails. This translates to: If you want economic boom, you have to have economic recession. It’s completely natural, and in fact a very good thing. Through economic recessions, the economy gets rid of the companies that should not be, in order to prepare itself for the ensuing expansion.

I made this reference to the show that I have not always been as bullish as I am currently for two reasons. The first reason is hopefully to establish some credibility and the second, very similar to the first, is so that I could show that I change as the facts change. Until recently, there has been a lot of uncertainty in the market. Generally, markets do not like uncertainty, and as a result volatility increased. During the increased period of volatility, negative news compounded this uncertainty and exacerbated it. This resulted in psychology driving the markets rather than facts. Fear and lack of trust produced the bankruptcy at Lehman Brothers. Yes they were probably insolvent as well, but once there is a run on a bank, it almost always goes under. The bears that are left are hoping for results of the stress test or a bankruptcy announcement from General Motors to reverse this market. I seriously see these events as very positive. It’s about expectations. We all know that GM is struggling, it won’t surprise anyone if  they file for bankruptcy. I think the market might actually rally on this information as there will be less uncertainty. Additionally, results of the stress test will reveal which banks can survive andwhich will fail. Again, uncertainty will exit the markets because the bad banks will fail while the good banks have the backing of the United States Government. I know that this post is under the technical analysis tab, I’m getting to its technical relevance. But first I need to say one more thing about the banks. Some people have suggested that banks raising additional capital is bearish. While I’d agree that this without a doubt means the need more capital, obviously because they wouldn’t raise capital if they didn’t need it, but do not agree that it is bearish. The fact that Goldman Sachs was able to raise $5 billion this week without the backing of the government is huge. It means that once again people are trusting the banks to do what they do.

Now for the technical relevance of all this fundamental information. I think the markets will continue higher to approximately SPX 1000 before any significant retracement occurs. At that time I am going to reduce the size of all my long positions, but I am not going to short the market. My reference earlier to changing when the facts change will be reiterated here. Unfortunately, economists such as Nouriel Roubini are going to all the credibility they have established over the last year quickly. Nouriel Roubini, also known as Dr. Doom, is a professor of economic at Stern school of business at New York University. He predicted the real estate bubble in September of 2006, and the ensuing sub-prime crisis in September 2008. Many people viewed him as very pessimistic, just as they did to me when I told people the DJIA was headed to the mid 6000’s. Nevertheless, he received much credibility and respect for his predictions. Sadly, he thinks the economy has not bottomed, and is on the verge of losing all the credibility he gained in the last two years.

Having said this, as the SPX approaches 1000, I expect a significant retracement in the range of 20-25%. This would move the SPX back down to around 800, still approximately 20% off the March 6th lows. Remember if the SPX does get to 1000, it will have rallied approximately 50% off the bottom with virtually no down movement. Markets do not move in straight lines, although this might suggest otherwise. According to Elliot Wave Theory (EWT), we have ended the down-wave and are now in an up-wave. This change in trend is due to the violation of rule one of the three consistent rules of EWT: 1) wave 4 cannot enter wave 1’s territory 2) wave 3 is never the shortest impulse wave 3) wave 2 never exceeds the start of wave 1.

If the markets continue to follow technical analysis, a continuation of the up-trend to approximately SPX 1000 followed by a 20-25% retracement are supported by the forming of the Kilroy Bottom, Fibonacci retracements, EWT and even fundamental analysis. All of the technical analysis just covered have very similar targets, with a small margin for error. Regardless, it has been very accurate and profitable for me since suggesting the possibility of a bottom in early March.

Mendoza Ranked #2 Undergraduate School

The University of Notre Dame received the number 2 undergraduate business school ranking for the Spring of 2009. Mendoza, the Notre Dame business school, was ranked 3rd in 2008 and jumped the University of Pennsylvania’s business school Wharton. The University of Virginia’s business school McIntire, ranked 2nd last year also jumped Wharton, and is currently ranked 1st.

Business Week sites Notre Dame’s focus on ethis and strong alumni network as key factors in setting Mendoza apart from other undergraduate business schools.

http://www.businessweek.com/bschools/rankings/
http://www.businessweek.com/magazine/content/09_10/b4122048934051.htm

Academia and the Random Walk

With the exception of a few, I think most would agree that academia could not translate theory into practice, nor could many fund managers translate their practical knowledge into academic theory. This unfortunately is due to the widely accepted concept known as Random Walk Theory. Many academics do not feel it is possible to add value, in terms of risk-adjusted returns, to investing. The Random Walk Theory asserts that it is impossible to outperform the market on a consistent basis. It views managers who empirically challenge this theory with skepticism suggesting chance correlation is more likely than proof that managers can outperform the market. They will generally agree that exceptional stock picking or market timing skills are not widely held among the many financial managers on Wall Street. I tend to agree that probably only a small percentage of Wall Street managers can actually beat the market, on a risk-adjusted basis consistently. But please do not misunderstand what I’m saying, I do believe it’s very possible to beat the market consistently. The only reason we do not see this more commonly is because the managers that can beat the market get over run by greed, causing them to lose sight of the basics. An example of this is Bill Miller. Bill Miller beat the S&P 500 index for 15 consecutive years from 1991 through 2005, but the current economic downturn has ended his streak. What happened? He lost sight of his basics which overexposed him to the financial downturn.

Academia generally holds the view that opportunities do not exist to add value to investing. If they believe in mispricings at all, they typically argue that one could not profit off of these mispricings successfullyenough to demonstrate, statistically speaking, that they have either stock picking or market timing abilities. This view holds relatively well considering it stems from the Efficient Market Hypothesis (EMH). I believe in the EMH, and this is why I believe it is possible to consistently beat the market on a risk-adjusted basis.

The Efficient Market Hypothesis suggests that stock market efficiency causes existing share prices to always reflect the most relevant information. As a result, stocks always trade at their fair value which in turn makes it impossible for investors to purchase undervalued or sell overvalued stocks. These assumptions imply exceptional stock picking or market timing impossible and the only way to obtain higher returns is by purchasing riskier investments. This is why the reference to risk-adjusted returns is so important. However, the three forms of market efficiency attempt to explain why such returns do happen.

Weak-Form Efficiency suggests that future stock prices cannot be predicted by analyzing historical stock prices. More specifically, this form implies that past returns are not indicative of future returns and that technical analysis cannot be used to exploit the markets. Weak-Form does believe certain fundamental analysis could provide excess returns to fund managers. Semi-Strong Form Efficiency suggests that share prices reflect all publicly available information and adjust to new information very quickly and in an unbiased manor. As a result, neither fundamental nor technical analysis techniques can be used to produce excess returns. Strong-Form Efficiency suggests that share prices reflect all information, public and private, and no one can earn excess returns.

Now that the three forms of efficiency have addressed, I will explain why I feel it is possible for us to have an efficient market and have people beat the very same market. First it should be noted that because people do earn excess returns, Strong-Form Efficiency does not hold. If Strong-Form is rejected, the possibility of having both an efficientmarket and people beating the same market very possible. I believe that markets are not efficient, but that they work towards efficiency as a result of the market participants. I believe that they never really achieve true efficiency because as they begin to converge to the truth, the truth changes. The truth can change for 2 reasons: 1) the facts have changed, that is new information enters the market or 2) enough market participants hold a contrarian view.

The purpose of the stock market side of this blogis to attempt to reveal that market fallacies exist. More specifically, the market fallacy that suggests consistent risk-adjusted returns are impossible.