Trading Algorithm Update - September 30, 2011

SP500 Closing Level - 1160

Market: Bear	Defining Level: 1210
Trend: Down	Defining Level: 1242
4/8 Trend Change Confirmation (Up to Down): Yes
Current Trade: Short from 1186 (Shorted market on break below 1187) Profit Objective 1:  1150 (achieved - half @ 1143         Trailing Stop (closing): 1173 Profit Objective 2:  1114 (stops will be lowered)            EW Stop: 1173 Status: This short trade can be a 1-2 week swing trade. We are now at break even in terms of stops.
Next Trade / Model Based Approach: N/A Stop:                                                                              Risk:  Risk Associated with trade: N/A
Turn Window: September 28 (+/- 4 days) Market is in the turn window. Market might have put in a double top.	Scenarios 1-   Market bottoms in turn window 2-   Market tops in turn window 3-   Market double bottoms and breaks out 4-   Market double tops and breaks down
Observations:  Last Trading Algorithm update suggested that the market might have turned during the Inflection Point Model's turn window, as the market structure had completed. This shows the importance of analyzing the market structure in conjunction with the turn date.   Proprietary indicators have been indicating for the past several weeks that we are in a well defined bear market. In a bear market, one should expect surprises to the down side. Following figure shows that over the past several days, market has been stair stepping down with a series of lower highs and lower lows. This kind of market behavior is a classic downtrend example. Alongside being a persistent decline, the decline has been very orderly. This kind of behavior suggests that the market is not yet ready to put in a bottom because bottoms are formed with a spike in pessimism. Hence, we can see the market declining for several days. Furthermore, above chart shows a series of overlapping waves. Some (including me) might argue that this behavior is represents a corrective pattern and that we will soon rally from here. But interestingly, all of the wave-1 declines have been 5-wave affairs. In other words, the market is tracing out a series of 1s and 2s, and once the market enters the 3rd wave down it will be a sharp decline (might be a mini-crash). Therefore, one should not be long in a down trending market with a possible series of 1s and 2s. In fact, since there is a very high potential of new lows, one can short the market with tight stops. Finally, if this pattern plays out we will be able to dramatically reduce the risk from this trade, once the next down phase starts. As far as the Trading Algorithm is concerned, it has been short for few days now. Unlike recent shorts, current trade might last for another week, so one needs to be patient in order to reap gigantic profits. We will keep reducing the stop locations along with the market, thus, eliminating risk from our trade. In order to manage risk in the current trade, stop has been reduced to 1175, and will be further reduced after another lower leg. We will update this sheet with market updates and potential dates to cover the short-positions as time goes on.

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Characteristics of Bear Markets

Written by: Elliott Wave International's Vadim Pokhlebkin


When I read the following piece, I thought that it truly represented current market behavior. I hope that you will get a better market perspective through this article.




Bear markets are cunning beasts.

Don't get me wrong -- we are not in the bear market territory yet. At least, not officially.

 

An "official" bear market begins when the stocks indexes decline 20%. The DJIA's decline from the May 2, 2011 high to the September 21 low is about 17%. Close, but no cigar.

 

Add to that the strong rallies we've seen over the past few weeks (Sept. 12-20: +685 points in the Dow, for example) -- and lots of people conclude that despite the volatility, things aren't so bad.

 

But let's get some perspective. The stock market has been around a while. Only when you look at its history do you realize just how cunning -- and fast, and strong -- bear markets can be.

 

Here's a chart we've shown readers before. It's worth printing out and keeping on the wall above the desk where you open your brokerage statements.

 

This is the DJIA between 1930 and 1932, one of the worst bear markets in history. Robert Prechter, EWI's president, took the time to measure the percentage gain of each bear market rally during the 2-year period -- you can see them in this chart.

 

 

 

When you routinely see double-digit rallies (11 percent, 18 percent, even 39%) over the course of two or three years, it's easy to be lulled into thinking that maybe things aren't so bad.

 

The reality, of course, is that the bear market's chokehold grows tighter around your neck with every drop-rally sequence. (Think back to the 2007-2009 collapse, and you'll remember the same behavior.)

 

Which brings us to here and now. Rallies and declines of 300-400+ points have been so common since August that we're kinda getting used to them.

 

The question is: Are we in a bear market, or is it that "maybe things aren't so bad"?

Trading Algorithm Update - September 28, 2011

Market: Bear	Defining Level: 1210
Trend: Down	Defining Level: 1245
4/8 Trend Change Confirmation (Up to Down): Yes
Current Trade: Short from 1186 (Shorted market on break below 1187 in the afternoon) Profit Objective 1:  1150                                                Trailing Stop (closing): 1211 Profit Objective 2:  1114                                                EW Stop: 1220 Status: This short trade can be a 1-2 week swing trade. Risk is moderate b/c stops are a little wide.
Next Trade / Model Based Approach: N/A Stop:                                                                              Risk:  Risk Associated with trade: N/A
Turn Window: September 28 (+/- 4 days) Market is in the turn window. Market might have put in a double top.	Scenarios 1-   Market bottoms in turn window 2-   Market tops in turn window 3-   Market double bottoms and breaks out 4-   Market double tops and breaks down
Observations:  On Tuesday US markets staged an impressive rally in the morning. However, this rally evaporated by the end of the day with SP500 losing almost 30 point in the last trading hour. Monday also witnessed a strong market rally. Although recent market action seems to be bullish and there is pessimism in the market to support this rally, overall market structure gives a different picture. In the context of the overall market structure it seems like recent rally was only a partial retracement of the previous impulsive decline. As seen below, market has risen in a three wave fashion since last week's lows. 3-waves suggest a corrective market pattern. Once this pattern is complete, we will most likely see new lows. As shown above, yesterday's market rise reached the 78.6% (Fibonacci relationship) retracement level of the previous 5-wave decline (1220-1114). This is a common retracement for a corrective wave.    Moreover, recent rally had following disturbing attributes: Rally was accompanied by lighter volume, showing lack of market conviction Rally was accompanied by very low TRIN value, depicting buying exhaustion Rally resulted in lower Put/Call rations, exhibiting a pacified attitude of market participants All of these developments symbolize a corrective wave, rather than an impulsive advance. Alongside these indicators, we are in the Inflection Point Model's turn window. One should be vigilant during the turn window because market can turn at any time. Primary turn date is scheduled for September 28, 2011. Keeping in mind this date, it is possible that market might have topped yesterday afternoon. Furthermore, market reversal towards the end of the day also supports this observation.  Since the broader trend is down, market has been rallying recently and we are in the turn window, the Trading Algorithm went short yesterday on break below 1187. In order for the short trade to materialize, markets need to stop their assent below 1211 (SP500). We will update this sheet with Risk Management levels.

IPM - Something Big is Coming!!!

As stated yesterday, the stock market was setting up for a strong rally. This prediction was made when the DJIA futures were down more than 100 points. Thereafter, markets turned on a dime and rose more than 350 points. This kind of analysis not only proves the reliability and ability of Understand, Survive and Thrive's market analysis techniques, but also forces us to thank God as such accuracy is only possible through God's guidance.

INFLECTION POINT MODEL

For the last two months, UST has been asserting that markets are in a downtrend and that one should pick the tops to short the market rather than picking the bottoms. Based on this hypothesis, it was mentioned that an Inflection Point Model turn window is fast approaching. This turn date is very critical because financial markets, which are already badly bruised by the debt crises, could turn for the worse. In order to further refine the turn date, we re-ran the Inflection Point Model. The program output is given below:

  

ANALYSIS

According to the two models, the next turn date is scheduled for September 28, 2011 (+/- 4 days). This means that markets are already in the turn window, and can turn on any day. 

Therefore, one should be very careful and be on the lookout for a trend reversal before going short. 

At the next turn date, both models are showing a potential turn, thus amplifying turn possibility. To our amazement, there are two turn dates very close to one another. First turn occurred on September 22, 2011 giving way to 7.7% market decline in less than 3 days. Now the second turn date and recent market action suggests that we might see a double top, or a sharp rally to complete 2nd wave, before starting the 3rd (strongest) down leg.

Interestingly, this time frame also coincides with elections in the European Union to support or negate the European Bailout package. Hence, this week can prove to be a very significant week in terms of global macro-economic events. At this point one should keep in mind that 2008 crash actually started when the U.S. Congress finally passed the bailout package in September 2008 (shown on right). A similar announcement from the EU nations could mark the top of current upward correction (If the uptrend remains intact for the next couple of days). 

Note: Whenever I see such fundamental developments in conjunction with the Inflection Point Model turn dates, I ask myself: How does IPM know about an impending fundamental event? 

Since we are in a bear market, the primary goal of investors should be to preserve capital as sharp rallies can result in significant losses. Hence, we will intently and safely wait on the sidelines for the turn window and the Trading Algorithm signal. In the next few days, Trading Algorithm might generate a Short Sell Signal - we will trade the signal when it is generated and not our hypothesis.  

MARKET PROBABILISTIC ANALYSIS

Since trading is a probabilistic endeavor, one should always assign each potential scenario a probability based on historical data and then calculate expected profitability of any trade before committing capital. Right now, there are three possible scenarios with regards to the upcoming turn date: 

1- Market tops during the turn window - Highest Probability (0.7)
This is the highest probability scenario because of EW structure, bear market, historical precedence.  

2- Market pauses (sideways movement), Resumes uptrend - Low Probability (0.3)
This is a less likely scenario because we are in a downtrend, and if the market continues to rise through the turn window then it would most likely suggest that the bear market has ended. In order for this scenario to materialize, market (SP500) should break above 1220 level. Since this is a low probability scenario, we will deal with it if current market structure changes. 

In any case, Trading Algorithm will continuously evaluate the market structure and will undertake the trade with highest success probability and highest expected profitability.

VERY INTERESTING OBSERVATION

When running the IPM, we extended the data array to get an idea of potential future market turns. What we found was really fascinating! Current Inflection Point Model behavior is similar to the July/August time frame i.e. the next turn date is far away from September 28, 2011 turn date. This kind of behavior demands closer scrutiny through Market Structure, Market Matrix and other proprietary market analysis techniques. 

UST team will continuously evaluate the market behavior to decipher the future market direction and to pick a potentially significant Market bottom in October/November time frame. As we enter October, UST team will re-run the Inflection Point Model to further narrow down the next turn window. 

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Market Overview - September 26, 2011

There is a lot of news out of Europe suggesting that no agreement has been reached on the Greece issue. As a result, Dow futures are down more than 100 points.

Today, I noticed that various financial websites are publishing articles comparing current situation to the 1930s and 2008. Although it might be true, these type of articles on prominent financial websites might be a contrary buy, and could result in a short-term but sharp market bounce. A similar message is being conveyed by the evolving Market Structure (shown below).

After completing a triangular correction pattern, market sharply broke to the downside on Tuesday - September 20, 2011 (predicted by IPM on September 4, 2011). After Tuesday's highs, market declined more than 7% in 3 days in a clear 5 wave impulsive fashion. This impulsive decline highlights the fact that the primary trend is down, and after a partial retracement markets should resume their decline.

Since August lows were not broken by the recent decline, some analysts are regarding this as a positive test of the lows and that one should take advantage of this opportunity to buy stocks. However, one should keep in mind that we are in a bear market and in bear markets these kind of tests typically fail until unless these tests are accompanied by excessive pessimism and despair. That is why, capital preservation is regarded as the most important task in a bear market

On the sentiment front we are starting to see significant pessimism from Individual Investors, as shown by two prominent market surveys. Furthermore, VIX generated a buy signal on Friday. VIX based buy/sell signals are generated every 2/3 months and have been very good over past several years. Both of these developments - Sentiment and VIX signal, can result in a short term but sharp rally to work-off oversold market condition.

Greek default or a significant bailout package might be the event which could result in widespread capitulation. This package might be announced around October 15, 2011 - date by which Greek could default if new loans are not secured. At the same time, in mid October corporate earnings will be released. It is often seen that if the market declines into the earnings season, it rises when the earnings actually start. Although both of these observations are interesting and coincide with the mid October 2011 time frame, UST team will continuously analyze the market structure for potential bottom, in conjunction with various technical and sentiment indicators through the lens of the Market Matrix. Trading Algorithm will then utilize the Market Matrix data to generate a buy/sell signal in conjunction with the Inflection Point Model turn window.

Note: As mentioned previously there is a turn window right around the corner. This IPM turn window might be the market top and could provide a good shorting opportunity. It would be very interesting to see how the market behaves when entering this turn window. Detailed IPM model analysis will be presented in the coming days.

Trading Algorithm Update - September 23, 2011

Update 7:00 PM

SP500 (Closing as of September 22, 2011) = 1129

Market: Bear	Defining Level: 1209
Trend: Down	Defining Level: 1248
4/8 Trend Change Confirmation (Up to Down): Yes on July 27, 2011
Current Trade:  Short from 1197 Profit Objective 1: 1160 (achieved, sold at 1140 (market open))     Trailing Stop (closing): 1129 Profit Objective 2: 1124 (achieved - trailing stop hit at 1131)          EW Stop: 1131 Status: Stop was hit at 1131. Short trade closed for a total profit of 4.3%.
Next Trade / Model Based Approach: Short on a partial retracement Stop:                                                                                       Risk: Low Risk Associated with trade: Low because Shorting in a downtrend is a low risk trade.
Turn Window: September 20 (+/- 4 days) Market has entered the turn window. Market's behavior over the last few days suggest that we will see a top	Scenarios 1-   Market bottoms in turn window 2-   Market tops in turn window 3-   Market double bottoms and breaks out 4-   Market double tops and breaks down
Observations: As mentioned yesterday (in the note section), there was a possibility of a short-term market bottom either on Thursday or Friday. As a result, we decided to tighten our stops to lock in gains. Stop was hit in the morning and we are now out of our Short trade for a 4.3% profit.       This same approach (tightening of stops) helped us in our last Short trade (early-mid September). In fact, after we got out of our short positions, the market (SP500) rose from 1145 to 1220 within a week. If we had held the short positions, a profitable trade would have turned into a losing trade.       Note: It is very important to note that stops should be placed at places which demarcate a key wave structure level - a level which if broken would mean that there is a high probability of stronger move in the opposite direction.      Over the next few days, we might experience a market bounce. This bounce can reach anywhere from 1160 to 1210, depending on the market internals. However, we are approaching an IPM turn window. We will discuss this turn window and its implications in greater detail in the Market Overview.       Overall, recent decline has exhibited clear downtrend characteristics. This behavior in conjunction with time symmetry analysis leads us to conclude that we will soon see further downside. On the other hand, we are seeing pretty pessimistic readings from some sentiment surveys. This kind of pessimism can result in a sustainable rally. Therefore, at this point in time one should patiently analyze the market and make the trade with highest expected profitability (typically highest probability trades in a bear market are on the short side), with an open mind for a trend reversal.

The Most Valuable Tool - Inflection Point Model!!!

In the name of God, the most gracious, most merciful

Wow!!! Market declined 7.7% in 3 days (top to bottom). Did we really see the top on September 20, 2011, the exact date which was predicted by the Inflection Point Model several weeks ago. This kind of market timing accuracy is scary and is a blessing from the Almighty God.

Tuesday's market action was a grand head-fake, and I expressed this concern when I stated my displeasure with the market action at 11:00AM. There was something missing from the market and it seemed like we were going to see something significant. As anticipated, by the close of Tuesday the market finally resolved to the downside again respecting the 1210 Bull/Bear demarcation line. Thus, the closing stop loss was never hit.

Furthermore, Tuesday's clear downside reversal was the kind of market action we were looking for to strengthen the conviction in short positions. At the same time, since over the past 9 months the Inflection Point Model has an accuracy rating of 95%, there was a .95 probability of seeing a reversal. Such a high probability demands respect from any statistically minded individual. Finally, as stated in earlier market updates the market structure over the past few weeks had been overlapping and triangular - overlapping structures symbolize market correction. Market Matrix also allowed us to objectively analyze the market and showed us that except for the sentiment, all other indicators were suggesting a continued slide. Overall, we might be on the verge of completing the H&S pattern discussed previously. Thus confirming the H&S hypothesis.

Cumulatively, these reasons prompted us to believe that a significant move was coming in the primary direction i.e. downside.

On Tuesday a reader asked me about the market rally and my reaction. I am attaching my reply for your understanding:

By being a part of the recent market action and staying steadfast, our belief in the Inflection Point Model's accuracy and the importance of one's decision making ability has been amplified. It seems like decision making ability is a God gifted attributed and it is tough to assume that we do everything on our own (we do not deserve 100% credit).

Anyways, at today's opening market hit both 1st and 2nd profit objectives as mentioned in the Trading Algorithm update. Hitting both of these objectives in such a small trading window i.e. just 3 days, speaks volumes about the intensity of the decline. By looking at the market structure, it is evident that we have started the final wave down to new lows. As discussed previously in the comments section, it might be interesting to see if the market declines into the earnings reports next.

In the event, it should be mentioned that yesterday we saw a sharp increase in Pessimism among individual investors. This kind of increase will at some point lead to a sharp rally. However, as mentioned several times before that one should trade with the trend. When we are in a bear market, market conditions can become even more oversold before a significant bounce can materialize.

Note: Trading Algorithm's profit objectives were hit. However, we are staying partially short with a tight stop. TA will posted tomorrow. It seems like we might bottom today/tomorrow and then rally for next few days. There is a turn window coming up soon. We will discuss it in the next post.


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Trading Algorithm Update - September 20, 2011

Update: 11:00 AM

Why do I have the feeling that there is something wrong with this market? I know that pessimism is high but also the market itself is not trading very well. Why are the Small caps and Financials lagging both SP500 and Nasdaq? Small caps are supposed to be the leaders of a new rally!!! I do not know, but there is something wrong... Are we going to see another QE tomorrow? Are we going to experience "Sell the News" event with QE3? These are all the questions that are confusing me.

Original Post

Market: Bear	Defining Level: 1210 (closing)
Trend: Down	Defining Level: 1255
4/8 Trend Change Confirmation (Up to Down): Yes on July 27, 2011
Current Trade: Short from 1197 with tight stop above 1213 (CLOSING - 1210) Profit Objective 1: 1160                                                            Trailing Stop (closing): Profit Objective 2: 1124                                                            EW Stop: 1213 Status: Short from 1196. Risk associated with this trade: 1.4%
Next Trade / Model Based Approach: Long Stop:  Above highs                                                                    Risk:  Risk Associated with trade: Market conditions will be continuously evaluated for better entry
Turn Window: September 20 (+/- 4 days) Market has entered the turn window. Market's behavior over the last few days suggest that we will see a top	Scenarios 1-   Market bottoms in turn window 2-   Market tops in turn window 3-   Market double bottoms and breaks out 4-   Market double tops and breaks down
Observations:  US Markets declined sharply yesterday morning. However, by the end of the day they had regained most of the losses. If the market continues its decline and falls below 1188 then the down trend will be confirmed. On the other hand, if the market rises above 1215 and close above 1212 then we will be stopped out. The reason why I am not suggesting long is because it is never prudent to trade against the broader trend, especially within the Inflection Point Model turn window. Sharp decline from near current levels, will confirm the potential H&S pattern presented in the last Trading Algorithm Update. On the other hand, we should appreciate the fact that Market has risen more than 75 SP500 points (600 Dow points), and even with such significant rise we have not seen a significant increase in the overall optimism. In fact, investors are very pessimistic. This is bullish for the market and can lead to a sharp rally. Note: Downside decline structure has not been constructive (more of a corrective pattern rather than primary pattern) Interesting Scenario: Market bottoms tomorrow on the exact turn date and starts rallying sharply. We observed this kind of behavior during the February 2010 turn window. At that time, we also had very elevated pessimism. Although this is a low probability scenario, it is still possible because of market participants' pessimism. Pessimism: This emotion leads to extra defensive stock trades, with excessive hedging. Under such circumstances, whenever there is slightly better news market rallies because shorts cover and money on the sidelines come to buy.    As mentioned earlier, Trading Algorithm does not participate in counter trend trades until unless there is ample conviction through Inflection Point Model. We might be near one of those high conviction points. In the broader scheme of things, market is still struggling with the 1210 level (SP500). It will be prudent to stay on the sidelines if you are not in, and if you are in the keep your stops in place because we are about to see an explosive move in either direction.