Stock Market - Risk Definition

SP500 finally reached the target of 1340 stated on this blog in early January 2011. At that time, the market was still around 1260. Moreover, the final down-up sequence as discussed in Sunday's stock market analysis,  is also almostcomplete - please see Detailed Market Analysis (Mid 02/11) - Part 4. Therefore, it is time for the market to show its future direction. 

At this point in time, the trend is clearly up, but optimism is also extremely elevated, Elliott Wave structure is nearly complete, technical divergences are evident, and cycles have topped. In other words, this is a classic opportunity to short the market. However, major trend can stay up for a very long time. As John Maynard Keynes once said, "Markets can remain irrational a lot longer than you and I can remain solvent."   

Therefore, one should always have a clear, well-defined and appropriate risk-management strategy for successful and sustainable financial investments.

Risk Definition:

Based on analysis SP500 should not exceed 1345 in the near term. If it does break above this level then the risk-reward ratio, which is currently very low for shorting the market will turn higher. At that point it would be reasonable to go long again on partial positions.

Charles Nenner - February 2011

Why the Australian dollar is coming down | Karen Maley | Commentary | Business Spectator

Long term interest rates are heading inexorably higher and the Australian dollar is coming down, according to one of the world’s leading market analysts, Charles Nenner, head of research at the Charles Nenner Research Centre in Amsterdam.

Nenner, dubbed the "cycle guru" because he uses technical analysis to predict future market moves, has a huge following among hedge funds, investment bankers and brokers.

His reputation was enhanced after he correctly predicted the peak of the US share market in 2007. Now, in an interview with Business Spectator, he warns that US bonds have now entered a bear market.

Although Nenner says we might see small bounce in bond prices from this point, the low point for bond yields has already passed. (Bond prices move inversely to yields.)

“Rates will go higher”, he tells Business Spectator, “we’ve already seen the low in rates."

His first target is for the 10-year bond yield to climb to 4.3 per cent (from 3.7 per cent at present) while the yield on 30-year bonds will move to around 5.2 per cent (from its current level of 4.77 per cent).

At that point, he predicts the bond market will rally, with bond prices rising while yields drop back, because of fears over weakness in the US economy. After this rally, he predicts bond prices will fall, and bond yields will again push higher.

Bond yields have been rising recently, over concerns that the US Federal Reserve might scale back its bond buying in coming months.

But in making his forecasts, Nenner does not try to second guess the actions of the US central bank.

Instead, he argues that if you look at a graph of bond prices over the past 300 years, you see a perfect cycle – with exactly the same distance between the tops.

click the image to enlarge

Detailed Market Analysis (Mid 02/11) - Part 4

Stock Market Analysis - February 13, 2011

Stock Market Recap

Last time - January 30, 2011, I said that "it seems like market can still continue higher for the next couple of weeks." Well, we are now at the end of the two week period and we should re-evaluate the situation 

Stock Market Analysis

Based on current sentiment readings, historical perspective, indicator's analysis and Elliott Wave structure, it seems that we are approaching an inflection point. Therefore, one should be very careful. This observation is in agreement with the new inflection point model. Market Matrix is given below. 

Conclusion

There are many flashing cautionary signals. It appears that we are nearing a top. However, we are still in an uptrend and the top will not be confirmed until a break below 1310 (closing). With cycles topping, technicals deteriorating, sentiment elevated and waves complete, the risk-reward ratio is very high. In any case, until unless the trading model is not violated, I will not short the market. If market closes below 1275 then market could see further selling into 1100s.

I have already discussed various supporting wave structures in the last few updates on this blog. These supporting wave structures include: Treasuries, US Dollar, SP500, Nasdaq and Financials. At the same time, there has been a continuous discussion of the Inflection Point Model on this blog: Mid February 2011 - Be Careful

One important development to keep in mind is that we are seeing elevated optimism along with a very mature wave structure. This high-level of optimism means that there are very few short-sellers in the market. Under these circumstances, if the market tops it can result in a sharp decline. For a detailed overview of the sentiment data please visit: Trader's Narrative

Even with all of this analysis, one should always remember that price pays. Therefore, one should always trade in the direction of the primary trend and have a comprehensive risk-management strategy. I will discuss risk-management scenarios next week.

Detailed Market Analysis (Mid 02/11) - Part 3

Finally, in order to get a comprehensive picture of the Market's Wave structure, one should understand the behavior of the US Dollar Index and the Treasury bonds. For the past few months, the market has been going up in the face of declining bonds and the US Dollar. If these two assets classes are near a low, then their rise might result in market weakness. 

Treasury (20+ years):

TLT is close proxy of the long term bond market. 10 Year Treasury Bonds started their decline in the week of QE2 was announcement. This turn was discussed on this blog, in "Quantitative Easing and Recent Market Behavior.... Perplexing!!!," on November 13, 2010. Since then 10 Year bonds have declined 8%.

At that point everyone was extremely bullish i.e. there were more than 90% Bond bulls, especially due to the initiation of Quantitative Easing program. However, now we are witnessing a totally opposite picture with only 8% Bond bulls left. Recently, we have also witnessed significant bond market outflows.  

On the other hand, the chart clearly shows that we are nearing the end of this decline, with a clear 5-waves decline pattern. Therefore, one should be very wary of a potential upcoming upturn in the bond market. This turn will provide significant headwinds for future stock market rally.  

Treasury Bonds (20+ years)

US Dollar:

There are two potential for the US Dollar

1- US Dollar Index is carving out a long-term triangle

2- US Dollar Index is about to embark on an impulsive rise.

Both scenarios, in conjunction with extreme pessimism towards US Dollar support a significant rise potential over the next few months. If this scenario does plays out then one should be careful with commodity prices and the stock market. Since rising dollar usually brings about deflationary pressures, it is highly probable that markets will experience some set back.

A situation similar to today's high flying commodity markets prevailed was seen in the Summer of 2008. However, as soon as the US Dollar started rallying in July 2008 the entire financial system came to a complete halt. Within months stocks and commodities fell anywhere from 40%  to 70 %, from top to bottom. 

Conclusion:

One should vigilantly watch the developments in these two markets to get a cue for the upcoming move in the equity market. Since both treasury bonds and the US Dollar are considered to be a safety play against economic and socio-political uncertainty, there completed decline patterns and possible upward reversals might suggest that we are in for a rough ride in the equity markets. 

"Value of each man depends on the art and skills that he has attained." Hazrat Ali A.S. 

Detailed Market Analysis (Mid 02/11) - Part 2

Lets look at some supportive Market Structures and Elliott Wave patterns in Nasdaq (Comp) and Financials (XLF), for better understanding of the current scenario.


Nasdaq (Comp):

This image shows Nasdaq Composite Index since 1999. Although market has almost recovered all its losses of 2007-2009 bear market, it is still far below its previous highs. In Stock Market Analysis - Nov 7, 2010, it was stated that there is a potential that Nasdaq can rise up to 3000. I still feel like that, but right now there is a potential double top forming in the Nasdaq index. This double top could lead to the much awaited intermediate term decline.

Like SP500's daily chart, Nasdaq's daily chart (shown on the left) shows a similar pattern. According to this charts, after a decent decline in May - June 2010 time frame,  market has been going up for the last 6 months. Interestingly, market has traced out a clear 5 wave structure, which normally should lead to a pull back.  

Finally, the third chart shows 15 min COMP data. This chart also clearly demarcates a 5 wave rise since late January 2011 low. 

Based on the above mentioned analysis, Nasdaq's structure is ripe for a pull back. There are varying opinions for the degree of the pull back, and we will discuss them with Sentiment and Cyclical analysis. 

Financials (XLF):

Similar to Nasdaq, Financials are also exhibiting a potential double top pattern on the daily time frame. Very recently, financials carved out a triangle pattern, like they did in October 2010. In October, break of the triangle lead to a sharp rally and then a sharp decline below the start of the rally. Following statement was written in the Stock Market Analysis - Nov 7, 2010, "Financials have recently rallied after consolidating for weeks in a triangular shape. Post triangle rallies are usually last spikes. Therefore, rally in the financial stocks might soon get exhausted." 

Recent triangle has also led to a sharp rally up to $17 level. But this rally has shown overlapping waves. Overlapping waves are indication of an ending diagonal. Since post triangle moves are typically terminating moves, this ending diagonal in conjunction with a potential double top is pointing to a potential upcoming correction.

Conclusion:

Market is potentially approaching a risky area, where risk-reward ratio is too high. Therefore, one should clearly define his risk, if he want to play this game.

"Contentment is the capital which will never diminish" Hazrat Ali A.S.

Detailed Market Analysis (Mid 02/11) - Part 1

We are finally around mid February 2011. Market continued to march higher over the last 1.5 months, since we went long. At this point in time, I would like to analyze the market in detail from Elliott Wave, Sentiment, Cycle, Models and Technical Indicator perspective. This study will be culminated with a detailed trading plan in conjunction with the Market Matrix.

Elliott Wave Analysis of SP500:

The first chart on the left is a daily SP500 chart since early the start of 2010. According to this charts, after a decent decline in May - June 2010 time frame,  market has been going up for the last 6 months. Interestingly, market has traced out a clear 5 wave structure, which normally should lead to a pull back to around 1170-1190 area. 

Second chart is the horly chart from the November 2010 low of SP500. This chart also sports a clear 5-wave structure, which mean that the market's rally is nearing a termination point.

Finally, the third chart shows 15 min SP500 data. This chart also clearly demarcates a 5 wave rise since late January 2011 low. According to this count, market should not rise above 1341.

Conclusion: 

Cumulatively this analysis suggests that market is approaching a turning point or at least the current wave structure fits the definition of a completed Elliott Wave structure for a rise. However, a completed wave structure does not guarantee price decline. Therefore, over the next few days, we will discuss the Elliott Wave structure of Financial, Nasdaq and Treasury bonds to further understand the current market situation. 

Mid February 2011 - Be Careful

On January 12, 2011, I stated that the inflection point models were suggesting a top around mid February 2011 in the financial markets. Interestingly, SP500 has continued to rise since that time. Even during the brief decline due to Egypt fears, my model (Inflection Point Model + Market Matrix) did not generate a sell signal. In order to refine the turn dates based on the most recent market data, I re-ran the two inflection point models. 

Conclusions

Model 1 and model 2, both are suggesting that the next market turn date will be around February 14, 2011. Since both models are in agreement, we might witness a significant decline i.e. 5-10 %. Furthermore, week of February 14 is the options expirations week and normally market turns during options expiration. This date is also confirmed by several other market measures like:

1- Sentiment: Extreme Optimism (expectations of higher inflation and higher stock prices)

2- Almost complete Elliott Wave structure of Indices, US Dollar and Commodities 

3- Cycles 

4- Indicators

I will discuss these four components in forthcoming upcoming Market Matrix posts. In short, we might be nearing a significant top in the financial markets but nearing does not necessarily means topped and does not generate a signal to exit longs.  Therefore, even if the market does decline in the vicinity of the upcoming turn-date, I will wait for a confirmation from the second model before exiting longs and going short. This confirmation has prevented me from prematurely exiting the market on the recent insignificant declines. 

One question that I have been asking myself, is that how to use this data for trading purposes. In this regard, there are typically three scenarios in which this turn date can play out:

1- Market tops and Declines till the next turn date - Highest Probability
This is the highest probability scenario because of optimistic extremes evident from different surveys, almost complete EW structure and a faltering rally. Since this rally has been going on for the last 7 months, correction should at least last a few weeks. 

2- Market pauses (shallow decline/sideways), Resumes uptrend and Top at the next turn date - Medium Probability 
Although this is a lower probability option, if the market manages to rise above the high set around the vicinity of the forthcoming turn date then it would suggest that market will continue to rise. In that case market will most probably rise till March 2011.

3- Market rises, and then Falls into the next turn date - Lowest Probability

This situation is possible if market makes a top in late February 2011. The best technique to counter this scenario is to have a tight stop. Therefore, if the market falls below a particular level then one should exit. In this way, he will be sure of the new direction i.e. lower. As of today, the trend reversal level (on a closing basis) is 1280 for SP500. This scenario is low probability because over the course of last 2 years this scenario has played out very rarely.

Note: 

1- If the market does not declines significantly or rises sharply after a trend reversal date, it would go sideways for some time: This kind of behavior is normally exhibited by strongly up or down trending markets.

2- Always trade in the direction of the trend. Even if there is a trend reversal date, wait for confirmation by other signals because "Markets can remain irrational, more than you can remain solvent."