The song remains the same

Hope, despair, hope, despair. Big gap up, big gap down, big gap up, big gap down. That's been the pattern in the market for the past few months. This has been a very frustrating, annoying and dangerous market.

Let's forget about indicators, sentiment, opinions about the bailouts, Merkel and what-not and just try to look at this market using objectivity and common sense. I've said before that bull markets don't have the type of volatility we are seeing. What we are seeing reminds me a lot of  the months that followed the Lehman crash. About a month ago I saw this chart posted on tickersense.com which proves what I'm talking about. This is a very important chart.



The red areas highlight prior instances when the market had the type of volatility we are seeing now. These signals all previously occurred in bear markets. That's the bad news, but there's good news too as you will see.  Whenever we saw such instances of  "high volatility" as per the above chart, it signaled the start of the puke stage of the bear market. Significant and immediate damage lied ahead in the weeks that followed but that ended up marking close to where the bear market had finally bottomed - that's the good news. However, the bottoming process took about half a year to complete the previous 2 times we got the signal. Even last summer's flash crash (arguably a mini-bear) which didn't trigger a high volatility signal, took about about 4 months to complete.

So, let's consider the current situation. Just like with the two previous high volatility triggers, we saw significant and immediate damage occur. The signal was triggered on July 27th.  The good news is that if history repeats, there's a good chance the worst of damage has already taken place. The bad news is that the bottoming process is quite likely not be complete and some sort of retest of the lows, whether it's a higher low or lower low is in the cards. We made the first significant low on August 9th. Therefore, it's quite likely that the bottoming process won't be complete for another 1-4 months - if we are indeed in a bottoming process. But let's be careful not to be dogmatic about this....there's no law that says the market can't bottom sooner.  It's been just under 4 months now since the bottom in August and so I suppose that might be considered long enough time to have completed the bottoming process.  I'm doubtful about that but I'll keep and open mind and be on the lookout for the return of bull market behavior (which is characterized by a upward grinding market with low volatility)..

There's also the possibility for a grim resolution this time around. Bears will argue that massive policy intervention stymied the last 2 bears and if not for that the damage would have been a lot worse. As a result, the heightened volatility could have been an indication of the beginning of the "end game". According to the bears, all the authorities did was delay the end game creating even more imbalances. This time around authorities have largely exhausted their "bullets" to thwart the end game and so that leaves us much more likely to experience it this time around than ever before. It's still an unlikely outcome but IMO, the odds are higher than anytime since about 1996  when many of today's permabears first started calling for it. If this ends up happening I can guarantee you most bears will not even come close to fully capitalizing on it since the market would likely go down in an almost straight line down fashion for months.

A few words on today's rally. The market was quite oversold heading into this week and so it's not surprising to see it go up like this on rumors about the IMF helping Italy or whatever. Anything could serve as a excuse because most shorts by nature are weak and fickle and focus on the ST and they have been clown raped so many times during the past couple of years that they are now conditioned to cover when the market gets oversold. There's room for the market to go higher still even after today's run up but if you bet on it just remember you're likely playing the game of chicken. This seems like yet another hope rally doomed to fail if you ask me.

Bear market strategy

During times like this to keep me focused, I tend to review the principles I believe in....principles that have been forged out of years of experience. Doing so helps me to resist the temptations to do something impulsive instead of patiently waiting for the right opportunities. Let's talk about bear markets because that's what were are in right now. The main "tell" that distinguishes a bear market from a bull market aside from an overall downtrend vs an uptrend is that bear markets have much higher volatility on all time frames: intraday, weekly, monthly. This is how you can tell a bear market rally from a bull market rally. While the initial rally from a bottom in both bear and bull markets often appear the same, (fast and furious) what happens afterwards gives you a better sense of determining if the rally is "real" or not. In bull markets you will see small but relentless upward progress almost daily. If you want in you have to chase because pullbacks are few and are quite shallow. In bear market rallies you tend to see the type of volatility like we've been seeing for the past several weeks - huge up days and down days.

My main philosophy regarding bear market is this. Don' lose money. Making money is secondary and if you want to do so you need to take a trading approach both on the short and long side (emphasis on the short side) as opposed to a long only, buy and hold approach that is optimal in bull market. By trading I'm referring to the intermediate term 1-4 month swings not ST trading and especially not daytrading..... I don't believe in those types of trading.  As a speculator you should be looking to make money in any type of market but I find that with bear market because of the heightened and erratic volatility it is easier said than done. Bear markets tend to destroy bulls AND bears alike.

As a result of the heightened and erratic volatility in bear markets, you need to be able to withstand a lot of noise. If you are convinced that the market is headed a lot lower in the months ahead (and not because you're biased or bitter but because you actually have objective reasons) and want to profit from it,  you need to make yourself a strong holder and ensure that your holding period in line with your beliefs. I chuckle when I visit some of these bear blogs and I read commentary from them about how they believe the economy/market is doomed due some macro argument/facts. Then they go out and make a trade like "Short QQQ at 55 with a  stop at $55.20".  Lol! That's fucking retarded. They are using ST trading tactics to profit from a macro conviction. In bear markets because volatility is so high and erratic, making trades like this will almost certainly result in failure.Your trade has to be aligned with market conditions and your conviction. If you can't comfortably make such a  trade then don't make it!

In my opinion, it's only worth trying to profit on the short side during bear markets when the market is overbought and there is strong evidence of complacency with weak bears throwing in the towel. This is characterized by a VIX in the low 20's, a string of low put/call ratios and AAII sentiment 2:1 bulls vs bears. In such instances, the risk/reward is favorable to make a bearish bet.  In the bear market of 2000-2002 we saw this happen in May of 2001 and March 2002. In the bear market of 2007-2009 we saw this happen in May of 2008. At the peak of this latest rally the above conditions were not met...some were almost met but not quite. As a result I didn't pull the bear trigger. That's fine. Again, protecting capital is the primary objective. The fact that we rolled over so soon also suggests that there's a decent chance we are in a situation similar to December 2008 or August 2010 whereby the roll over in the market was part of the LT bottoming process.

To play the intermediate term swings in the market allowing yourself to be a strong holder able to withstand the day to day noise, I believe that the best strategy is to purchase long dated deep in the money options with an amount of capital that you can afford to lose should you end up being wrong. No stops. By risking only a limited amount of capital, that in effect is your stop. This strategy is especially advantageous when betting on the downside. By using puts as opposed to shorting you will never be forced to cover your position if the price goes against you by a significant amount nor will the fear of "unlimited losses" make you unable to sleep at night and tempt you to make an emotional decision.  By using long dated deep in the money puts, you also don't suffer from the time decay that one would experience holding bear ETFs and short dated OTM puts which is the preferred choice of the  retail  schmucks who try to profit on the downside. When playing the bigger swing it's important to stick with your plan. Don't get tempted by ST market action taking profits too soon in the hopes of getting back in on a counter trend reaction...more often then not you will find yourself on the sidelines missing out.

It's a jungle out there. I'm hearing a lot of market veterans who have trade for over 30 years say that this is the toughest market they have ever seen. It doesn't have to be tough. You can simply not play and wait for things to settle down or wait for those really fat pitches.

Word on the street

There's two things I'm hearing a lot about. The first is the triangle formation in the chart and the second is the notion that the ECB will be end up having to print money to end the crisis once and for all. Let's focus on the second issue first because that's far more important.  I've been saying for a while that ultimately we need to see the entire restructuring of PIIGs debt before all is said and done. The cancer needs to be cut out from the system. For a while, European authorities were in denial about the crisis thinking the problem was one of a lack of confidence as opposed to the grim structural reality which is that these countries have dug themselves in a hole too deep. They figured if they took care of Greece confidence would be restored and all would be well. They tried to pay for the solution as cheaply as possible ...and they got what they payed for. As this crisis has been unfolding the market has been dragging Merkel and others by the collar kicking and screaming forcing them to take further action. It wasn't too long ago whereby a Greek default was considered out of the question and now we've esssentially seen it happen via the 50% haircut. Now the Germans are saying that money printing is out of the question. In fact, a few minutes ago on BNN I saw a quote from Merkel that said she believes the ECB acting as a last resort won't solve the crisis. If she was such as expert as to what will and what won't  solve the crisis why the fuck has she not solved it yet and why does it appear to be getting worse? Merkel has her head up her ass just like she did with Greece a couple months ago.  It's seems to me that it's either print or see messy defaults and a break up of the Euro zone.

As far as the market goes, we are finally starting to see a breakdown from the widely watched triangle which according to textbook t/a should have resulted in an upside breakout. Since everyone is a technician now a days, you can toss the textbook out the window. And who knows, maybe this is a downside head fake to foil the technicians. I wouldn't play that game of chicken though given that we are seeing bond yields blow out in Spain and France. One thing the bulls have in their favor is that the put/call ratio continues to be high day in and day out and the VIX is well above 30. This suggests that if we see the market roll over and make a run for the October lows, there's a good chance it will end up being part of the bottoming process as opposed to a new down leg. It could also mean that the short side is still too crowded and this dip we are seeing today is going to end up being a massive head fake. Either way, I'm still stepping aside. I didn't see enough sentiment indicators give me the green light to make a short bet and so if the market tanks I won't be on board. I don't have a problem with that unlike in early October when there was in fact enough sentiment indicators lining up to give the green light for a trading buy but I never pulled the trigger.

What I haven't liked about this rally since the recent bottom in October has been the high volatility and now the oil spike to $100. The last thing the global economy needs is oil back to $100. I couldn't give a fuck about seasonality and Santa Claus rallies, fundamentals and market action trump and neither suggest this rally from the October lows is the start of new bull run and so if you play the long side you're playing a game of chicken with the bears hoping to that they'll blink before you do. The problem with this game is that once the bears are shaken out the market will likely drop abruptly leaving you the risk of being trapped holding the bag. There's two ways bears tend to get shaken out 1)by a strong rally or 2) covering way too early on the first dip of a major downside move.  

It's been frustrating being on the sidelines for so long. I am however starting to see some emerging bottoming formations on a few small cap stocks I have my eye on that have attractive fundamentals. I'm in the process of making a short list of such stocks.

In these types of volatile, headline driven markets, protecting your capital is paramount. While it may seem likely that this rally from the October lows will fail, there's no telling if it will fail now or a few months from now and so if your betting on the downside you could easily see yourself get stopped out for losses because too many people were in the same trade. After all, the bear case regarding Europe is no a secret and because of that, I believe the bears have been their own worst enemy and the cause of their own frustration these past several weeks and not the "PPT".

Silvio che cazzo fai?

This translates to "Silvio what the fuck are you doing?" In today's National Post it showed a picture of 2 protesters from a Ukranian women's rights group in Rome holding up signs. One of them said this and the other said "Silvio stai scopandi L'Italia" which translates to "Silvio you're screwing Italy". I couldn't help but chuckle when I saw this but at the same time feel a bit sad. Being of Italian decent, I can't help but recognize the decline in the country of my ancestors. Italy's economy has been pretty crumby to say the least for the past several years even during times when the global economy was in expansion. Now it seems like they might be next in line at the barber shop to get a debt haircut. Oh dio.

My previous post did indeed help put things into perspective. I believe it's likely there will be a retest of the October lows in the coming months whether it's due to Europe or other reasons. But I also believe that until the chronic hedging stops (i.e the high put/call ratio), it's not worth making a bet on that outcome. Today's action doesn't change my opinion on this. High put/call ratios like we've been seeing doesn't guarantee there will be no major downside by any means.... nothing in this game is guaranteed....it's all about probabilities and risk/reward. It's just that in my experience, when you're in an uptrend as strong as the one we've been in since October, bear market rally or not, it usually doesn't end untill you see complacency in the options data i.e.  low put/call ratios and a VIX in the low 20s. If that doesn't turn out the be case this time, fair enough. I'll have no regrets if I miss out profiting from the downside because I didn't see what I needed to see to pull the trigger. Nor will I have been burned playing the game of chicken long side. Despite the severity of today's decline it doesn't really look too bad when you look at the chart now does it? The uptrend is still in tact and we could simply be consolidating before another push higher. But what today's decline does tell you is that the market is still headline driven and it's still broken. Bull markets don't behave like this. 

Look people, this market is dangerous for all players on either side of the market and I've been saying that for quite some time now. The only way to have captured today's downside was if you made a bearish bet before yesterday's close gambling that the after hours headlines would be negative. It could have just as well went the other way. The same thing goes for the upside. Most of the upside has been done via gap ups due to favorable headlines. The market is therefore forcing you to gamble at the end of the trading day to capture the big moves the following day. You typically either get instantly rewarded or your nuts chopped off the next morning via the gap. That's not much different that going to a roulette table and betting on red or black. I know not everyday has been like that but a lot of them have been and that's not my kind of market. I know I said I need to be more flexible but I'm not going to play a game that forces me to gamble in a casino-like way....sorry. I'll just remain in cash until things settle down or I see a really good ST edge. You know what? When I first started trading full time in December 2008  it was the same. The market was crazy volatile and I although I was somewhat sure there would be a retest of the November 2008 lows, I couldn't bring myself to bet on it because the market was too nuts and there was too many cross currents and not enough edges. I ended up making very few trades until the summer of 2009. 

Don't force it. Wait for your pitch. You don't have to trade every day, week or even month for that matter. The market is not going away. 

Remember Lester? Here's what he posted last night....no wonder the market is tanking lol!

I fucking give up.  I closed my two remaining IWM Puts near the close today.  They were Dec 66s and sold for 0.98 after paying 1.35 last week.  So this leaves me $200 from the $4000 that I started with in mid-August.  I have taken that $200 and bought a SPY Dec quarterly 133 Call for 1.84.  This will give me the whole month of Dec to catch the Santa rally. 

This guy is gold I tell you!

Who should you believe?

As you know, I've been dazed and confused about where the market and economy is going longer term because there's a strong case to be made for either a bullish or bearish resolution. We're at a major cross road here and if you take the wrong path you're either going to get hurt in a big way or miss out in a big way. It all hinges down to the reccession debate. In this post I'm going to flesh out all of the things running through my mind that is causing me such conflict. Hopefully this catharsis will help me get a better feel for what probably lies ahead. Some of this will sound repetitive given my recent posts.

Last weekend Hussman made a convincing case to support the case for a recession. Here's a crucial except from his lengthy commentary...

Since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.

If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.

That simple set of conditions (WLI < -5, PMI < 52, SPX < 6 months earlier) has been seen in every postwar recession for which the data is available. Though we've seen recessions without a drop in the WLI much below -5, when a WLI below -7 has been coupled with a PMI below 52 and an S&P 500 below its level of 6 months earlier, the economy has been in recession within 13 weeks, 100% of the time. This is the combination, incidentally, that we observe today.

Now, here's some convincing points from James Stack that totally refute the reccession call

the four-week moving average of weekly jobless claims had hit a six-month low. How often has the economy fallen into recession after such a development? Trick question. It has never happened in 44 years of claims data, he said. The Index of Leading Economic Indicators just hit an all-time high. When has that occurred in the six months prior to or in the early stages of a recession? Never in the 52-year history of the LEI data.

So, you have Hussman arguing that there's a 100% chance of a reccesion according to historical data and Stack who says there's a 100% chance of no reccession according to a different set of historical data! lol! WTF!!!! Well, somebody is going to be wrong....obviously.

Do you see folks why I am so fucking frazzled? Ok, let's get back to the the ECRI recession call. I mentioned how I don't like the fact that they are so popular amongst the masses which in my experience makes it more likely that the guru in question will soon be wrong in a big way.  It's interesting to note that the previous 2 times the ECRI made official recession calls were in March 2001 and March 2008. In both those cases, leading indicators, coincident indicators and reported earnings had all already decidedly turned down from their peaks. That has not happened this time around with their call. Also, when ECRI made the previous 2 recession calls, the stock market had made its peak several months prior and was in a well established downtrend - undeniably in a bear market. Therefore, the ECRI was a little "late" in making their official recession calls from a market timing perspective in 2001 and 2008 (but in their defense, in the months leading to official recession call, ECRI was strongly warning about the negative things brewing in the economy).  This time around, with earnings still elevated, leading indicators still making new highs and the stock market not off it's highs as much relative to when the last 2 recession calls were made, could it be that ECRI is jumping the gun with their recession call?  And isn't it funny how bears love the ECRI now but didn't mention jack shit about ECRI's bullish calls in March of 2009 and November of 2010? In fact, the media mentioned fuck all when ECRI turned bullish. And where was Hussman when ECRI was bullish?  Did he make mention of this? Of course not. He was wallowing in his dogma. That's permabears for you folks and that's why you need to have a balanced approach when reading commentaries from these guys. It's still worth reading what smart guys like Hussman have to say though because they can provide facts and studies that can help you form objective opinions.

Aside from issues with ECRI's latest call, a couple of other things are making me suspicious of a recession and a big bear is forthcoming. I mentioned a couple weeks ago how dumb money thinks one is coming, in particular, a few of  my friends on facebook and the late night talk show hosts making jokes about the economy. You have consumer confidence plunging to early 2009 levels where historically it's a great time to buy LT  and again, all of this is happening in the face of still strong earnings that are poised to make all time highs this year which makes the gloom appear unjustified. If you look at the crash of 1987 and 1998 earnings were still strong and hadn't rolled over thus the crash was simply a severe correction in a bull market (or a short and sweet mini-bear market....whatever tickles your fancy) while many believed it was indeed the start of a big bear market.

The media both mainstreet and financial are quite sour and that bodes well for an eventual bullish resolution to this crisis and we never did see any signs of giddiness from them near the peak either. Sure, you had Wall street strategists bullish and equity inflows were coming in, but that's to be expected in a bull market and those inflows were just a drop in the bucket compared to the outflows that occurred from 2007-2009. And now, those inflows have been completely reversed and then some and so any kind of budding optimism has been completely undone. Bull market tops are usually characterized by giddiness and corporate greed and it's the unwinding of this greed that fuels the bear market that follows. We did not see such greed at the latest peak. The only case where a big bear market occurred under the above circumstance was in 1937 and admittedly, as I pointed out in a recent post, there some important similarities with today's conditions vs. those in 1937.

Lastly, if you look at how severely oversold the market got after the crash in August, the statistics matched what you see towards the end of bear market not the beginning of them and I mentioned  back in early August how we were as oversold as we were in October of 2008. That to me again gives me reason to believe this is just a severe correction and not a new big daddy bear.

Now, let's exam the bear case.  I have concerns aside from Hussman's work that concludes a recession is pretty much guaranteed. My instincts tell me that untill we see a complete restructing of all troubled PIIGs debt this market ain't out of the woods. This situation reminds of me of late 2007 and early 2008 when toxic MBS was really starting to wreck havok. I remember telling my co-worker at the time that in the end the government is going to end up buying all this toxic shit from banks before this is over and that's what ended up happening but not before the markets went down a lot more.  MBS was a cancer to the system just like PIIGs debt is and until this cancer is removed once and for all, at the very least I don't think this market is out of the woods and a major retracement of this latest rally at the least, is inevitable.  Bond markets for PIIGS are saying loud and clear that it does not end with Greece. The potential fallout from this European debt debacle could be just as serious if not worse than  the MBS meltdown. And this time around government authorities have their hands tied a lot more to intervene given already low interest rates and pressure to embrace austerity.

Next you have yield curves in the BRICs - the number one driver of the bull market still flat overall suggesting a serious slow down lies ahead for them. It's likely that they will end up having to cut rates but with oil back to the mid 90's, they may have their hands tied as inflation concerns will remain given that food and energy account for a lager portion of overall inflation compared to developed nations. It seems that the only way for easy monetary conditions to be possible for them  is  if there's a global downturn sharp enough to take the air out of commodities and that translates to lower stock prices.

A rather obscure but historically quite effective indicator that I keep tabs on is OEX option data. Unlike the traditional put/call ratio, the OEX put/call ratio is a smart money indicator, therefore a high put/call  ratios is bearish for the market and low ones are bullish. It doesn't always pinpoint major tops and bottoms to the exact day....it can be early upto a few months, but's effective in signaling an immanent change in  IT/LT market trends in the weeks ahead. It's worth paying attention to only when where there's a bullish or bearish extreme. Look at the chart below and you will see that when the market was close to making it's bear market bottom in March 2009 and during the aftermath of the flash crash, OEX option traders were aggressivly buying calls pushing the 10 DMA below 0.75. OEX traders then became quite bearish during the spring and early summer of 2011. The bearishness unwound only modestly after the crash in August and it's now deep into bear territory again.

Unlike what happened in the months following the flash crash of 2010, wherby OEX traders became aggressivly bullish, they only got so far as being less bearish for a while before going back to deep bearish territory which is where we stand now. This supports the thesis that the market isn't through with this deep correction/bear market. Would I bet the farm on this one indicator? No! There have been some false signals over the years (not evident on this chart) but this indicator clearly favors the bears and suggests at the very least a major retracement, if not a full retest or worse in going the occur in the months ahead.

Next, I want to mention Lester - the worst trader in the world.  I discovered this guy posting on blogs 3 years ago and I kept tabs on him because he is bar none, the worst trader I have ever seen. His major achievements include switching his 401K from equities to cash in November of 2008 and then blowing his entire $300,000+ IRA using option trades in about 18 months wherby practically every single trade he made was the wrong trade! He trades purely on impulse and emotion. Do you know what Lester did this year? He switched half of his 401K back into an SPX equity mutual fund in March when the SPX first hit 1300. Usually he panicks during sell-offs but this time around he actually doubled down on his bet by averaging down into equities about 2 months ago (at around 1200).  He then later went even more aggressive by switching half from the SPX fund to his company stock! This is not a good for the bulls medium/longer term! Bulls need him to flip flop and go back to cash but that's not going to happen until the market goes down in a big way and given Lester's track record that's likely going to happen! I realize you shouldn't base your investment thesis on just one man's behavior but I gotta tell you if I was forced to, I would pick this guy hands down. He is the absolute worst!

Finally, there's the action of the market itself. Although the market rally has been impressive with what still appears to be plenty of doubters via the frequently  high put/call ratio and only modest equity inflows, the rally has been done primarily via gap up behavior. Also, volatility is still high which is not the characteristic of a new sustainable advance coming out of a correction that's going to last several months and make new highs. Take a look at how the market behaved off the July 2009 bottom and the September 2010 bottom. It grinded higher with small but frequent up days temporarily interrupted with sharp but short dips which were few and far in between. That's classic bull market behavior. The upside we've seen so far has been erratic characterized by large gap up and gap down days because most of the movements in the market as of late has been happening after hours or before the bell driven by headlines. That tells me the market is still broken without a solid foundation of true buyers.  It's the chronic shorting/hedging that has been keeping it afloat but that can only go so far. Once the shorts eventually give up (as the always end up doing) the market will  be very vulnerable to an abrupt drop. Admittedly, this short squeezing could potentially last for several more weeks but it can just as well last for a few more days so you better be careful if you try to go long playing the game of chicken with these bagholders.  Look for the VIX to drop to the low 20's to signal  potential true bear capitulation.

So there you have it....a complete info dump from my brain as to my thoughts and observations about this market. I'm going to take some time to review what I just wrote and let it sink in. Hopefully this will help provide me a better understanding as to were this market is headed and what actions I need to take with my account which is still primarily in cash.