Market at Crossroad & Potential Catalysts

Over the past few weeks, we are seeing several consolidation patterns popping-up in different markets. Consolidation usually signals in-decision or brief pause before resumption of the underlying trend. However, markets also consolidate in a sequence of 1s and 2s before a significant move in a new direction.

It appears like we are experiencing both the cases in different areas, where market is tracing out a sequence of 1s and 2s, and is waiting for a catalyst to break out of this consolidation. Following charts show this pattern:

Bonds: Since July Bond prices have been increasing but in an overlapping manner. This suggests that either this is a corrective move and we will see a move down soon, or we will soon see above June highs.

Gold: Over the past 4 days, Gold has placed in 4 inside days above the downtrend line and near the resistance. Inside days show indecision - a point where buyers and sellers are not comfortable making the move. Although most of sideways consolidations result in a move in the direction of the trends, next few days will be telling in terms of the move.

Stocks: SP500 is stair stepping down. Like other instruments, this stair-step pattern would either give way to a substantial decline in the near future or would turn out to be a correction in the broader up trend.

Even though stock market sentiment has come down recently, it remains elevated. On the other hand sentiment for Bonds and Gold is rising but not very optimistic yet. Proprietary timing indicators suggest that next turn date is few weeks away in the stock market. Therefore, if the market declines, other assets could rally but they need a catalyst to move away from current sideways indecision.

Need for Catalyst
Today's Jackson Hole speeches by Janet Yellen (Fed Chair) and Mario Draghi (Chair ECB) could be the catalyst that the market is waiting for.

If it is the trigger and if the markets start moving in 3rd wave out of this consolidation, logical move would be a rally in Gold and Bonds, while decline in Stock Market. Stock market is over-valued and has been rising for over a year, so this move is very possible. A decline in the stocks will be attributed to debt-ceiling debate and numerous other distractions from Washington by fundamental analysis but essentially it will be a natural part of the market rhythm.

We have underscored this observation multiple times that financial news media distracts investors. It can lead to early exit and pre-mature entry into investment positions. As a result, one of the lessons that we learned through 2016 is (Investing Lessons)

Lesson 1: There are no guarantees but being persistent is the key to long-term success

Long-term investing is regarded as the secret ingredient for many successful investors. Time is a very powerful commodity. If you give time to a successful business model or investing strategy, and combine it with dedicated and passionate management team, it will give you amazing long-term results.

Another reason why long-term returns are much more important than short-term returns is because when a portfolio achieve critical mass, one’s personal savings will not have that big an impact on the growth of portfolio. For example: $100K invested today will grow to 1M @ 20% return in ~13 years. At that point 100K will not have as much value because @20% / year an investor will experience a $200K increase without adding any more funds.

Thirdly, investing is a game of nerves and patience, whether in the stock market or any other endeavor like small business, start-ups through Angel/Venture investing, or Private Equity. The only difference with stock market based investing is that you have the opportunity to exit early because the market provides excessive liquidity, which provides peace of mind for many investors.

Long-term investment positioning and persistence provides investor with the focus needed to successfully withstand periods of draw-down because major moves take place after big draw-down periods. We will discuss additional lessons in the next post.

How to Position? 

Most of the readers would agree that the markets are at a critical juncture. However, knowing this is one thing and acting on this information is totally different. So far in 2017, we have mentioned several big moves on this blog and on twitter but doubt if effective trading was performed around this analysis by the readers.

Effective, long-term and consistent trading requires discipline and an edge in the market to adjust findings as market situations change. At this critical time, we are using proprietary models to expose clients to positions that have the highest success probability.  Performance - H1 2017 

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Bond Market Buy Signals

After experiencing a sharp decline in the last ~2 months, bond markets is now consolidating. In fact, today it managed to rally above a critical level. If bonds can hold near this level for the next few days, intermediate trend would turn up.

This decline has resulted in multiple bond indicators turning bullish i.e. sentiment turning so pessimistic that it is now bullish. Three widely followed sentiment indicator readings are given below:

1- Hulbert Sentiment Index:
The blue line below represents bond yields. Bond yields move in the opposite direction to the bond prices. Red line indicates the sentiment towards bonds. At this point, it appears that the sentiment is as negative as we have seen in ~2 years. Therefore, there is a good wall of worry to support a bond rally.

2- Bund Sentiment
Bunds are German bonds. Bunds were among the bonds that went into negative yield territory. While they were negative, everyone was bullish on the future of Bunds. However, very few realized that it was more close to the end of the Bunds rise. On the contrary, right now investors are very bearish on Bunds. This suggests that this a good time to increase exposure to bonds

3- Bond Sentiment NDR indicator
According to NDR services, bond sentiment is now extremely pessimistic, which supports the argument that the Bond decline is over-extended and we should anticipate a rise in Bond prices:

Bond Market Trend
While we are seeing some very pessimistic sentiment readings, these are coming at a time when the Bond market remains in a bull market according to our proprietary Market Classification Model. Therefore, the prudent trade right now would be to add or maintain longs in the bond market.

Keep in mind that bond market has been rallying for over 30 years, and yields have been declining for the same period. This trend will eventually come to an end. The question is whether it has already ended or will end with one for decline.

In either case, bond yields will not go up right away. They will go up if the economy continues to improve and Federal Reserves raises interest rates couple of times. Fed's changes to short-term interest rates does not directly impact the longer-term interest rates because those rates are driven by market expectation.

In the next blog post, we will discuss the bond market structure and both Bull and Bear scenarios. Poor bond market is in no one's favor and the central banks will try their utmost to ensure interest rate rise remains in control. From an investment perspective, we might see 1 or 2 more opportunities to fund big capital purchases at a lower interest rate.

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Bonds Market Analysis and Impact

After a dynamic and super-charged start of 2016, the long-term bond prices, as measured by TLT, are at the same level where they started the year - 120.6 vs 120.7 (shown below).

 
Above chart shows the amazing ascent and first six months and the sharp decline over past 4 months. Today's news is full of negative articles about the bond market rout, and potential consequences.

Bond market is the life blood of modern economies. There is hardly any developed country in the world that is debt free. Countries issue debt/bonds to implement development projects and repay any interest/payments that are due on existing obligations.

United States is a unique case where the government cannot just keep issuing bonds to raise money without any checks and balances. These checks and balances help keep the government debt in control, which supports the dollar and increases confidence among the lenders that they will get their money back.

This check/balance process is known as the debt-ceiling. Without confidence in the system, creditors might start hesitating in purchasing government treasuries, which could lead to higher bond yields, making it more difficult for US to finance future needs.

Orderly, rise and fall of treasury yield is very normal because it is governed by economic realities and Fed's actions. But sudden sharp rise, can be catastrophic for the overall economy. That being said, we are in a long-term downtrend in the bond yields, which will reverse one day in the near future.

Long-term view
In early 1980s, long-term treasuries were yielding 14%. They went as low as 2% in July 2016 - amazing time to refinance or make a big purchase at next to no interest rate.

However, this kind of decline will not last for ever. Typically, there is a ~30 year bond market cycle and right now we are near the bottom of the yield cycle. Following chart shows the yield decline structure.

Now the question is whether this trend has ended or does it have one last decline left in it? 

From a fundamental perspective, it is difficult to rationalize how the inflation can pick-up with oil, gold and other commodities being hit with higher dollar. If dollar rallies, it will pressure inflation and as a result, yields would come down.

Short-term View
From a short-term perspective, bond market has become extremely oversold. The sentiment is conducive to a sharp rally, as investors start to rationalize higher yields through new post-election economic realities. DSI sentiment is also extremely subdued.

Note - Election or no-election, economic realities don't change randomly. Rather, their interpretation changes but in the end everything cancels out in the direction of the primary trend

Following chart shows the near-term structure of the bond market. There are two ways to decipher this structure, but both ways suggest that this is a corrective structure. Below chart shows both the wave counts.

We will continue to monitor the bond market as we approach next month's Fed FOMC meeting. Fed might not raise the rates after an election surprise, which could give a boost to bond market.

Last Word
A collapse of the bond market will be a very bad scenario for investors and the economy. Abrupt rise in interest rates can destroy US abilities to pay existing obligations and could lead to a significant market impact. This impact might start from the US but could quickly spread through out the world. And once such a spiral starts, it is almost impossible to halt it in the middle.

If you are an investor with a substantial portfolio in bonds, you need to carefully watch for trend change in the bond market. Our proprietary Market Classification Model remains in a bull market for Bonds.

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Stock Market Consolidation & Break-out Levels

Since July, market has been going sideways to down. This downdraft has been persistent, boring and choppy. While markets are still within 1-2% of all-time highs, this choppy action has brought forward a lot of bears and helped improve the valuation measures like P/E ratios. 

In fact, the true purpose of these kind of market declines/sideways corrections is to reduce optimism and lay the foundation for the next rally phase because investors get tired of the market performance.

Sentiment - Fear/Greed Indicator

CNN's fear greed indicator is suggesting that the frothy sentiment that we saw in mid July has now been replaced by lack of enthusiasm towards the market. 

In fact, the sentiment is as negative right now, as it was at the time of Brexit. Therefore, we can see another sharper rally from these levels.

Signs of a Break-out

While market's decline has been choppy in nature, it is along the top downtrend trend line. One key indication of a market trend reversal would be a break of the trend line to the upside. For DJIA, this trend line is currently at 18,300.  

A similar situation is present in case of SP500, where the downtrend line is crossing at 2166.

Therefore, a sustained rally of 100 points in DJIA and ~20 points in SP500 would confirm a break-out.

Overall, the markets remain in an uptrend. Market Classification Model remains in an uptrend. Therefore, there is a very high probability that we will soon experience a market break-out. Long lasting sideways action is preparing for a break-out after resetting optimistic sentiment, market valuations and technical indicators

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The Next Big Opportunity - Emerging Markets

US Markets rallied impressively today. More importantly, they maintained the gains that were achieved at the start of the session. Hallmark of a sustained rally is that it continues and does not fail.

While US stocks are coming out of a consolidation phase (detailed analysis), and have many catalysts that could propel them to higher levels, the next big move might come from the emerging markets.

Long-term Emerging Market structure
Emerging markets have been in a sideways mode since 2011. For the past 5 years, emerging market have consolidated while US markets were making new highs. Following chart shows the performance of EEM (emerging markets ETF) over last 13 years.

Since 2003, emerging markets have gone through 4 phases:

1. Major rally (impulsive move) lasting for several years and culminating in 2007
2. Major correction of 2008, which was caused by global financial crisis
3. Sharp rally out of the financial crisis lows of 2009
4. Correction from 2011 highs that has brought EEM down to levels not seen 2006

Interestingly, both corrections (2 and 4) have a corrective formation i.e. 3-wave structure and both rallies (1 and 3) are impulsive in nature Therefore, it means that the trend remains up. And if the recent correction has ended, we should expect a very sharp and long-lasting rally in the emerging markets.

Short-term Structure

From a shorter term perspective, emerging markets are consolidating in a sideways formation. Once this sideways action ends and the market breaks out to the upside, it will have a lot of momentum. In fact, it could lead emerging markets to reach 2011 highs in the next burst higher.

Emerging market components
Although the EEM components will be adjusted next month, currently Chinese stocks determine the performance of the emerging market ETF. If Chinese markets are break-out, the entire emerging market complex will follow suite.

Market Classification Model
We have developed MCM for emerging markets. We will share the latest finding with subscribers. However, the bottom line is that the trend is approaching a reversal in the emerging markets to the upside. Once the trend reverses, we should expect a long-lasting rally in the emerging markets index.

Persistent investment behavior is critical for longer-term capital gains because that's the best way of gaining preferred tax treatment, which can significantly help your portfolio.

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Market Timing (IPM Model) & Structure

Just re-ran the Inflection Point Model and it seems like the next turn window is approaching fast. It is scheduled for October 21, 2016 (shown in chart below)

As you can see from the above chart, last turn window was on Sept 26, 2016. And the market topped on Sept 22, 2016, followed by ~3 weeks of sideways action. Following chart shows the best market structure representation with latest timing information

Market is still in a sideways correction. In fact, the 2nd portion of this correction took the shape of a triangle (X). Now it is in the final leg of this decline. So far, this last leg of the decline has been tracing out 3 waves, which means that this might turn into an ending diagonal.

Last wave will be sub-divided into 5 parts. 2 of 5 have been completed. The market could bottom in the area of 2090-2065 (SP500).

A signal of bottom will be generated by a buy signal generated within the IPM turn window. Confirmation will be received by a rally above critical proprietary levels.

Overall market trend remains up and this correction should give way to a sharper rally. Seems like market is setting-up for a wash-out to scare enough people out of the market, so that a big year end rally can start.

If your already long, stay long. If you want to go long, wait for another few days and then start adding longs.

Market Classification Model
Market Classification Model (MCM) remains bullish on the US stock market. It turned bullish in July 2016 and has remained bullish through last 3 months. Even though many market pundits have been advocating a sharp decline.

Persistent investment behavior is critical for longer-term capital gains because that's the best way of gaining preferred tax treatment, which can significantly help your portfolio.

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Stock Market Bottom & Next Rally

Market's correction appears to be complete. It was a long drawn out process. After topping in early August, market went sideways with certain phases of sharp declines.

Market Correction
Recent market action has been one of the most choppy phases over last 6 years. Interesting, this choppy behavior did not result in a triangle. As you can see below, latest decline that ended yesterday, made a lower low below 2120 level. As a result, we can mark it a zig-zag correction.

Many market participants were expecting a break of  2120 to mark the start of selling. However, at this point it could turn out to be a bear trap, where market participants are caught off-guard with the rally. Furthermore, since recent correction was not a triangle, it can be regarded as a 2nd wave decline.

Approaching Rally
Investors who follow Elliott Wave theory know that after 2nd wave comes one of the strongest parts of the rally, knows as wave 3. Following chart shows that the market might be setting-up for a sharper rally in wave 3, which will easily take the market to all time highs and will take Nasdaq into the Vacuum zone, where it might get sucked up (details).

This rally phase will be continuation of the rally that started after Brexit vote!


Rally Support

Consolidation
Every rally needs fuel and if you look back at SP500 chart over last 2 years, latest decline brought SP500 back in the area where it was in Jan/Feb 2015 (shown below).

In other words, market has gone sideways for almost 2 years. This kind of consolidation suggests that there is a lot of energy available in the market if it wants to rally hard. Now that the earnings season is upon us, there will be enough catalysts to propel the market out of current range.

Buy Signal
Yesterday, market also generated a buy signal. This signal is another reason to be on the look out for a sharp rally.

Market Classification Model
Market Classification Model (MCM) is a long-term trend identification model. It went long at the end of June and since then it is bullish. Before that it went out of the market in Sept'15 and kept us away from the volatility during China/Oil scare of Jan/Feb'16 decline, then interest rate scare of Apr/May'16 and during Brexit volatility in June'16. All the while allowing us to be invested in assets that were yielding much higher returns.

However, since turning bullish at the end of June'16, it has remained bullish even during the recent decline when all of the financial media outlets started talking about a new bear market or severe correction. MCM allows us to stay on the right side of the market and add to long positions in case of corrections in bull-market. Otherwise, one might be scared to go long in a sideways market, not knowing whether it will turn into a bear market

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Inverted Head and Shoulders pattern abound

Even though the market declined in the beginning of this week and scared away many market participants, who had just recently entered the markets, market is now again near all-time highs. But this time, markets are sporting inverted head and shoulders patterns.

Inverted Head and Shoulder patterns are bullish patterns. They either suggest trend reversal or trend continuation after consolidation. Once this pattern is complete, we can assume that the sideways action of the past 2 months has been completed and we are not on the verge of a substantial rally.

Following chart shows the inverted head and shoulders pattern in SP500:

A rally above 2200 level and holding that price will suggest that the market has broken out. Target of this pattern is at least 2275. However, this pattern could result in significantly higher prices because we will enter a very bullish part of the market rally i.e. 3rd wave ascent.

We have been discussing this potential Head and Shoulders pattern for the past few weeks. Following chart was shared on September 20th, highlighting Nasdaq 100 performance and potential Head and Shoulder formation:

Since then the Nasdaq 100 index broke above the neck line and has now completed a successful test of the neck line. Following chart shows the performance of Nasdaq with recent market data filled in:

Overall market trend remain up, as per Market Classification Model. We use MCM to identify the trend and it has kept us on the right side of the market for a very long time now.

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Federal Reserves and Market Action

The Fed announced holding the rates and provided guidance for potential increases in future. It wasn't anything out of the ordinary. It was highly unlikely for the fed to raise rates at such time before the elections. However, the more interesting reading came from the dot-plot.

Fed uses this plot to provide guidance regarding future interest rate path. Median of the dots show a curve where Fed officials believe interest rates should be over the next few years.

Following chart shows the plot:

Along with the dot plot, above chart also shows the median projections for the next few years as taken in June and September. As one can see these estimates have come down a lot. As a result, the expectation of interest rise have also decline.

Once this expectation declines, it gives was to higher bond prices and lower yield. At this time, higher bond prices would mean more liquidity, thus being favorable for the overall asset class complex. This situation will surely change one day. For now, we are in an uptrend. In yesterday's analysis on Pre Fed and Bank of Japan announcement, we shared same outcomes

Market Classification Model has been bullish on Bonds for years now. And it seems like there is no reason to bail-out on bonds just yet. Even though many financial gurus have been predicting an inevitable bond demise, which will happen one day, current situation is supportive for a bond rally. As long as trend remains up, forecasts for bond collapse will not come to fruition. Therefore, it's imperative that one remains with the trend.

At Understand, Survive and Thrive, we use Market Classification Model to stay aligned with the trend. MCM is an algorithm based on some of the most time-tested market indicators and their inter-relations to determine when the trend changes, so that we don't stay on the wrong side of the trend for long.

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Strategy Performance

Our proprietary model has been performing very well so far this year. Even with recent 2.5 month sideways consolidation, model is up 22.1% vs 6.3% rise in SP500. We will continue to monitor the performance of this model and share updates. This model will be available for investors to replicate or invest in towards the end of the year.

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Pre-Federal Reserves and BoJ Analysis

Sideways Action Continues

This week, so far, has been as uneventful as prior week. Yesterday, markets opened higher but then sold-off towards the end to close slightly negative. Today, markets closed slightly positive. Since last Monday, market has gone net sideways without any major directional move.

Following chart shows that today we closed at the level where we close on Sept 9th, when the world was coming to an end and DJIA had just declined ~4%

Markets are like a coiled spring. And it seems like the entire world is waiting for the Central Banks. Bank of Japan is going to announce its policy statement early in the morning, while Fed announcement will come at 2 PM.


Bank of Japan and Yen

From Bank of Japan perspective, they would like Yen to decline because that was the catalyst to push Nikkei higher couple of years ago. Right now, Commitment Of Trader data (shown below) shows that the market is ripe for another decline in Yen, which means that its likely Japan will reduce interest rates further or introduce some sort of monetary stimulus.

If BoJ stimulates the market and forces a decline in Yen, we can expect a rally in the indices.


Technology getting ready for a Break-Out

While the US markets have been going sideways, Nasdaq has traced out an inverted head and shoulders near all time highs (shown below):

These highs are 16 years old and there is vacuum above this level. If this pattern holds, we can expect a sharp rally in the near future. This rally can start in parallel with central banks announcements or it can start after a decline following Federal Reserves announcement. In any case, this is a very positive development for the market.

If Nasdaq can lead the market, we can be sure that the overall market will follow and that the recession talk will substantially subside. According to Market Classification Model, we remain in an uptrend. Uptrend typically results in rallies and market participants find reasons to be bullish even in front of negative news.


Strategy Performance

Our proprietary model has been performing very well so far this year. Even with recent 2.5 month sideways consolidation, model is up 22.1% vs 6.3% rise in SP500. We will continue to monitor the performance of this model and share updates. This model will be available for investors to replicate or invest in towards the end of the year.

If interested in free e-mail list or in paid services, please fill-out the form below.

Stock Market Structure

Stock Market and Bond market action suggests that both markets are consolidating. Once this consolidation is complete in the stock market, we should see a rally. 

We discussed about the potential of sideways market action and formation of a head and shoulders pattern on Aug 8th. As of Aug 21, market has traced out the right shoulder. 

Aug 8, 2016

Aug 21, 2016

Now that the right shoulder is almost complete, next step is to analyze the market structure to identify next steps. 

From an Elliott Wave perspective, market is currently in the last wave of the up-move. When we say last wave, it by no means mean that this will end the bull market. Instead, it just means that the current rally phase will give way to relatively large decline.

Recent market consolidation has helped in reducing market participants' optimism over the past few weeks, as evident from recent surveys. This will help in the next short-term rally phase. However, since the market is nearing the end of the larger rally phase which started with Brexit vote, we will see a resurgence of optimism and sharper decline.

In the above chart, a box is placed to show potential price and time range of market top based on Fibonacci relationship and IPM market timing analysis.

Overall market trend remains up. Even if the market declines, it will lead to higher prices till the time Market Classification Model is in Bull territory for the stock market.

                                                                                                                                              

MARKET CLASSIFICATION MODEL
A proprietary algorithm that classifies market conditions i.e. Bull market or Bear market. Currently, this model is suggesting a longer-term up-trend for the US Stock Market. In fact, this model is close to triggering another new Bull trigger.

Inflection Point Model - August Turn Date

Market's decline over the past few days probably culminated at today's Fed meetings minutes. Although there was nothing significant in the minutes, underlying uptrend of the stock market is taking the lead. 

There are several ways, technical and non-technical, in which one can justify either direction of the market i.e. up or down. But in any case, according to our proprietary market timing model, the next turn window is scheduled for Aug 30, 2016 (+/- 4 days).

Although the turn date signifies a major market inflection point with the direction, different market indicators suggest that current rally will continue till the end of August. End of August turn window will most likely be a short-term market top. 

This also means that next week's Federal Reserves Jackson Hole meeting would also propel the stock market. We will will discuss other indicators in the next posts. But the key thing to keep in mind is that no matter what anybody says about the market, the path of least resistance is always with the trend.

Currently, according to proprietary Market Classification Model, the stock market is in an uptrend. This model took us out of the stock market in September 2015 and kept us out of the stocks till June 2016. As a result, we avoided the sharp market gyrations, while investing in better performing areas. 

Market Update and Portfolio Performance

As markets wrap-up another quite week, there is a lot of discussion regarding the next steps of the market. Over the weekend, I have read several articles on the next steps of the market. There is an apparent disconnect between market observers. Some are calling for market to continue its rally, while others regard this market as being extremely over-valued. Few good articles in this regard have been pointed out by the following article (link): 

Main theme are related:

1. Bollinger Bands tightening
2. Financial sector break-out
3. Strength of the overall rally.

According to our proprietary model, stock market entered a new bull phase in July 2016. That was a time when the world was focused on the impact of Brexit. Brexit was supposed to bring the world economy to a halt, and would have shaved several percentage points from the global economy. Many people not only abstained from the market, they even totally exited the markets. Fast forward to today, and the markets are doing very well. SP500 total return index is up 4.32% since June 30th 2016. 

Prior to this correct call, our proprietary Market Classification Model rightly identified change in trend in September 2016. It kept us away from the treacherous markets of H1 2016, which allowed us to invest in other more prolific asset classes.

So far in 2016 (by the grace of God), our proprietary portfolio is performed extremely well with half the volatility risk and amazing Sharp Ratio. Furthermore, this portfolio is constructed in such a way that it minimize the Beta correlation with SP500. Current weighted asset Beta value is 0.35, which means that our model portfolio is nearly completely uncorrelated with the market. Therefore, one should not worry about market/economy risks.

Above chart shows the real-time performance of the model portfolio with real $. This performance is tracked at OpenFolio. The YTD performance values from the brokerage account is +27.6%

As we have mentioned before that we have also been testing an aggressive version of the investment model. We are humbled to share the YTD (7.5 months) results of this model - +57%.

Both of these results, by the grace of Almighty, are amazing and are achieved with minimal risk. In next couple of months, we will share original monthly statements from the brokerage account to share these results. Above all, we continue to enhance our strategies - Our motto is:

"Never Ending Search For Even Better Returns"

Although at this time we are not expecting any investments for these models (we are trying to make that a possibility at some time in future), if your interested, you can subscribe for "Market Classification Model" for now.

MARKET CLASSIFICATION MODEL
A proprietary algorithm that classifies market conditions i.e. Bull market or Bear market. Currently, this model is suggesting a longer-term up-trend for the US Stock Market.

Downtrend Continues

Market resumed its decline in a major way today. More interesting than the decline was the muted reaction from the traders, as VIX did not spike. If fear doesn't spike with declines, it means that we have further decline ahead.

Market rallied last week but got way over-bought in just few days. In fact, a sell signal was generated on Friday. That sell signal resulted in decline yesterday from which the market initially recovered. However, it was too much weight for the market to carry. As a result, it gave way to serious selling today.

We have been maintaining that the stock market's inherent structure changed last year in August, and suggested a move to cash. Proprietary portfolio allocation model allowed us to diversify between bonds and short stocks. This portfolio has been performing very well so far this year (link). It is up +6.7% this year, while SP500 is down 6.7% this year. We will talk about latest results in the next post. Right mow, let's look at the structure of the market.

Nasdaq along with many other indices, is tracing out another head and shoulders pattern. This pattern is larger in magnitude than the prior pattern, and could result in substantial decline.

Over the next few days, market will fill the right shoulder of this pattern. Once right shoulder is filled and market breaks below the neck-line, significant decline can be in the offering.

Head and Shoulders are reversal patterns, and when you see a cluster of these patterns, as shown above, they become even more important. Overall, it means that the trend of the last 7 years has ended and we have entered a bear market. This would mean that the economy will slow down and we might see additional bad news coming from different market segments. Oil was the initial catalyst but now we could see other areas hurting.

However, many people are just realizing this new development and others are still oblivious to a market decline. But we prepared for this potential scenario and now are waiting for the downtrend to unfold over the next few months. Bonds remain in a bull market, as yields continue to decline.

New Year and the Stock Market

Happy New Year. Although today is the first trading day of the year, markets opened at negative 300. From a such a negative opening its very hard to make a come back and close in the positive territory. And market declines on the first day of the year, odds of a losing year are at 50% based on historical data (link).  

At Understand, Survive and Thrive, we suggested that the market has undergone a trend change back in September (link).  However, we suggested that shorting opportunity is not here, and we should wait for a market rally. Experience shows that markets rally after a sharp decline for two reasons:

1. To entice weak hands into the market as buying opportunity
2. To shake shorts who were early to the game

Once the mood changes, markets start their decline phase, which is persistent. At this point, the possibility of a prolonged decline has increased sharply. In fact, several of the high fliers like MSFT, NetFlix and others are down big today, which shows that the leadership is now leaving the market.

This is also evident from the structural integrity of the market. Stock market patterns can provide very valuable insights into the performance of a particular stock or the over all market. We discussed in December (link) that the market is tracing out a Head and Shoulders pattern, which symbolizes potential trend changes. That pattern is still in plan. But now another Head and Shoulders pattern is visible in Nasdaq (shown below).

Once this pattern is completed, which is almost complete, we can see a sharp sell-off to the downside. This could take the prices down to prior base level i.e. potential 6%+ decline from current levels.

One might ask what can cause such a decline. Although there are many reasons that we will read in the news for today's decline, earnings will be the primary driver, which start in 2 weeks. As economy weakens, earnings will dwindle and stock market will follow. So in the situation what an investor must do?

Following are some of the strategies that we are applying to navigate through this situations:

1. Invest in assets that are in bull markets (Bonds)
2. Exit longs from stocks
3. Short indexed ETFs with predefined mix of diversified assets and risk mitigation startegies
4. Keep powder dry for upcoming bull markets in other asset classes

 

Fed Decision and its Impacts

After 6 years, Federal Reserves raised the Fed benchmark rate. While on one hand it signifies the fact that the underlying economy is doing well because of which Fed increased the rates, it also suggests that the market should embrace the new normal i.e. upcoming higher interest rates. Higher rates can impact many different walks of life ranging from savers to home owners.

Higher rates mean lower bond prices and could impact:

1. Home buyers
2. Credit Borrowers
3. Real estate investors
4. Savers
5. Equity investors
6. Bond investors

Although one can write separate blog posts for every individual class, the major theme will revolve around increased cost of credit. With increased borrowing cost, it will get difficult to buy homes, borrow for credit card purchases, borrow for investments in real estate or other venture, thus reducing the flow of money in the economy.

It will also encourage corporations and individuals to save and at some point make equities less appealing, as they will be able to get higher rates without added risk. Please don't get me wrong - savings are the engine of long-term economic development, while spending helps in the short-term.

Since the rates and prices move in opposite direction, rate increase by Feds means that bond prices will decline. However, contrary to this simplistic idea, UST's proprietary bond market analysis suggests that longer term bonds are still in a bull market. It is one of the 3 primary asset classes that is in a bull market.

Therefore, bond investors should not be scared by this Fed hike. Bonds will continue to do better for some time. This also flows well with our discussion on objective trend following, in the last blog post. Objective investing requires one to analyze asset classes holistically rather than event based analysis. And at this point, holistic picture based on proprietary indicators is suggesting that the bond market will do better. This could mean:

1. Stocks are going to perform poorly to push interest rates down even with fed hikes
2. Fed fund rate hikes will be in contrast to economic reality, and could result in yield curve inversion

Both of the above scenarios are bad for economy and investors. In the next few posts, we will discuss:

Detailed discussion on potential causes of bond yield decline even with Fed's increased rates

Alternative investments, according to their state - Part 2

Elliott Wave analysis of current stock market

Asset allocation options

Tax implications 

Revisiting Objectivity and market trend

Let me know if you think the best time to buy homes is about to come or has already passed?



 

Markets Overview and Further Decline Possible

Yesterday's sideways action flows very nicely with the wave 4 argument. Wave 4s give way to wave 5. Therefore, we should expect another down draft in the very near future. Following chart shows the updated market structure.

In order for this structure to remain valid, market should stay below 1770. Once we break below recent lows and enter the 1730 area, we will near the end of Wave 3 of a higher degree. SP500 target levels is between 1722 and 1730.

This 5-wave completion could have two possibilities:

1. Immediate sharp rally
2. Immediate rally but more of a sideways market action, followed by another low

• Scenario 1 would mean that markets will likely rally to new all-time highs.
• Scenario 2 would mean that markets have entered a downtrend and one should be careful of rallies. 

From a Market Matrix perspective, it seems like market wants to decline to lower levels and this decline is not over yet. Sentiment is also not showing pessimistic extremes. Above all, one should wait for the IPM Turn Window to pick the bottom. Therefore, we will keep on analyzing the market for further clues and see how things evolve. This analysis will help us in next IPM Trade Matrix trade.

Please note that latest IPM Trade Matrix trades have been updated on the blog at: 

IPM Trade Matrix - Trade 4 (Part 3)

IPM Trade Matrix - Trade 4 (Part 3)

IPM Trade Matrix Trades

TRADE - 1: (Long) = +2.6%

TRADE - 2: (Short) = +9.3%

TRADE - 3: (Long) - Non IPM Trade Matrix trade = -0.2%

TRADE - 4: Short - Still holding short since 1/31/14
Long TZA (short ETF) at 18.23 ==> 18.57 (shorts added) 
Short positions were added on 1/31/14, 2/3/14 and 2/4/14 based on Elliott Wave structure and break below critical levels. 

TRADE CONDITIONS
Condition: Outside IPM Turn Window (Re-entry)
Trigger: Test of ~1785 (SP500) and decline below 1769 (SP500). Decline trigger was based on EW analysis and other proprietary levels. 
Supporting Indicators:  Initial decline was impulsive (5-wave). Next IPM window is a Bottom and is 1-2 weeks away. Details of IPM turn window e-mailed to subscribers. 

PROFIT TARGETS
Profit Target 1: 1725 - 1730
Profit Target 2: 1670 

RISK
Stop: Above 1770
Trailing Stops: 1770 - Based on Elliott Wave analysis (will be updated on a regular basis)
Typical IPM Trade Matrix Risk: 1.5%
Actual IPM Trade Matrix Risk: 0% (Entry = 1785, Exit = 1770, Risk = No Risk)
Risk Reason: No significant risk because upcoming turn date is a bottom.

Applicable Rule: Do not go long or short without trigger to prevent losses by market moving against you.  

Note: IPM Trade Matrix Trades will be posted in the first half of 2014. This is an experiment to understand and enhance the capabilities of this Matrix.

IPM Trade Matrix - Trade 1 (Part 6)

Market Overview:
Market has been going sideways. This kind of market action suggests that the market is getting ready for a blast higher. There is no significant hindrance which can stop the market from rallying. Although market driving news typically comes from the left field, market structure is suggesting smooth sailings for the next 2-3 weeks. Details about the next market turn date has been e-mailed to subscribers. Overall, it seems like market wants to give Chairman Bernanke a standing ovation before his departure from the Fed towards the end of this month.

As per Elliott Wave structural analysis, market is setting up for a sharp rally (wave 3 of a minor degree) - possibly into the early February.

As far as the IPM Trade Matrix trading is concerned, we are still tracking this trade below and will continue to do so till we exit the trade.

First Trade of 2014 is in process:

SP500 (1/16/14) = 1844
DJIA (1/16/14) = 16414

TRADE
Long TNA at 76.25 (original) ==> 76.6 (new)
Long FAS at 92.30 (original) ==> 91.6 (new)
Long TSLA at 171.2
Long positions were added on 1/14/14 & 1/16/14 based on IPM Bottom window expiration and low risk scenario

Condition: Next IPM Window is Top or Bottom
No. of Trades between turn windows: 1
Triggered (Updated at End of Day on 1/9/14): Rally above 1837 (SP500) and above 16450 (DJIA)
Profit Target: 1885-1890 (Will be evaluated as Elliott Wave structure matures)

RISK
Stop: Below SP500 = 1816, DJIA = 16217, Comp = 4090, Rut = 1141 (3 of 4)
Trailing Stops (updated on 1/15): Close Below SP500 = 1835, DJIA = 16442, Comp = 4170, Rut = 1160 (3 of 4) 
Typical IPM Trade Matrix Risk: 1.5%
Actual IPM Trade Matrix Risk (1/15/14): 0% (Entry = 1837, Exit = 1835, Risk = 0%)
Risk Reason: IPM Top is approaching. Market needs to hold during this top window, otherwise we can see a serious correction. Rise above 1850 will neutralize this risk

Applicable Rule: If next minor IPM turn window is within 2 weeks then wait for a confirmation break before exiting longs. 

Note: IPM Trade Matrix Trades will be posted in the first half of 2014. This is an experiment to understand and enhance the capabilities of this Matrix.