Tuesday, January 31, 2012

Zen and the Art of Trading

Came across this "lost" interview excerpt with an unnamed trader from Jack Schwager's New Market Wizards and I'd like to share it with you here. 

As Schwager explains in the intro to his "Zen and the Art of Trading" chapter, this wide-ranging, and rather philosophical, interview with a top trader had to be scrapped on fears it would alter the trader's image with his firm's corporate clients. 

Schwager asked this trader for permission to anonymously publish one interview excerpt, which he found particularly insightful. Here's a sample:  

"...I still don't understand your trading method. How could you make these huge sums of money by just watching the screen?

There was no system to it. It was nothing more than, "I think the market is going up, so I'm going to buy." "It's gone up enough, so I'm going to sell." It was completely impulsive. I didn't sit down and formulate any trading plan. I don't know where the intuition comes from, and there are times when it goes away.

How do you recognize when it goes away? 

When I'm wrong three times in a row, I call time out. Then I paper trade for a while.

For how long do you paper trade? 

Until I think I'm in sync with the market again. Every market has a rhythm, and our job as traders is to get in sync with that rhythm. I'm not really trading when I'm doing those trades. There's trading being done, but I'm not doing it.

What do you mean you're not doing it? 

There's buying and selling going on, but it's just going through me. It's like my personality and ego are not there. I don't even get a sense of satisfaction on these trades. It's absolutely that objective. Did you ever read Zen and the Art of Archery?..."

Let's note that the unnamed trader's view of zen in trading was partially informed by his reading of Herrigel's Zen in the Art of Archery. This leads me to the following thoughts & questions.

Some reviewers on Amazon have noted that Herrigel's understanding of zen and his tutelage in archery were rather muddled (for a variety of reasons). They went on to recommend reading Yamada Shoji's critique, "The Myth of Zen in the Art of Archery", along with Kyudo: The Essence and Practice of Japanese Archery for greater understanding of these topics. 

Kyudo: The Essence and Practice of Japanese Archery

If Herrigel's pursuit of zen was fraught with misunderstanding, does this mean that some of the lessons drawn from his book are false? 

Was our mystery trader still able to connect with a Westerner's explanation of these topics, thereby fueling his own understanding? 

Can one really achieve a zen state of trading or being, and if so, did the unnamed trader somehow begin to approach this state, as described by his experience in the interview?

As a total (Western-born) outsider, I'll leave these questions open for you to ponder. 

Still, as this interview chapter is now 20 years old, I'd be interested to know more about the unnamed trader and the lessons he has learned in the intervening years. If nothing else, this brief and unique chapter of Schwager's book has certainly proven to be a catalyst for further reflection on the ideas of a "flow state" and trading/being. 

If you're enjoying these posts and would like to see more, please subscribe to our free RSS updates and follow Finance Trends in real-time on Twitter and StockTwits. You can also check out our related posts below for more market wisdom and trading insights.

Related articles and posts

1. What makes a great trader? Managing risk.

2. "Know Thyself" - Richard Russell on identity

3. Inner Voice of Trading: Lesson on ego and risk.

Nightly Report. January 31, 2012.

 Today’s market action can be summed up as “WTF”?  But that is the nature of the topping process after a long bull run. Like an accelerating car, it has to slow down, stop and reverse. And if it is running till the gas runs out, may be one final push before stalling.

There is no reason for the equities or risk currencies to go higher except liquidity induced push. And for various reasons, that is not forthcoming from the Fed. I am very sure that the Fed will create a wealth affect right before the Presidential election.  But that is far away. For now we have to get past this week before we can see some decent pull-back in the equities.

Situation in Europe is as confusing as ever. Now the hair-cut figure has grown to 70% and even that does not guarantee any deal. Other PIIGS are closely watching and will demand the same relief. So far as Germany is concerned, it just wants to be prepared for the eventual split of Euro. Sarko is going to have the tough time.

Although I said that there is no reason for the equities to go higher, if the SPX comes close to 1300 level or breaches it, I plan to go long for a day or two. Someone out there is trying very hard for the last many trading sessions not to let SPX fall through 1300. Today was another bearish reversal day and that makes it two in four days. And yet we are holding on! 

I would like to show you a chart from Chris Kimble which is self explanatory.

Sooner rather than later, all the negative divergences will catch up with the market. NYMO is giving a sell signal with daily MACD turning over. But NASI is still on buy signal.
Thus there are conflicting TA signals and it will not be resolved unless and until the market moved decisively one way or other. I am expecting that we will get decent pull-back starting from next week. 

Consumer financial protection, 1984

The Financial Times reports an amazing interview with Martin Wheatley, the "head of the UK's new consumer protection watchdog."
Investors cannot be counted on to make rational choices so regulators need to “step into their footprints” and limit or ban the sale of potentially harmful products,

“You have to assume that you don’t have rational consumers. Faced with complex decisions or too much information, they default ... They hide behind credit rating agencies or behind the promises that are given to them by the salesperson,” said Mr Wheatley..

The new approach rests on research in behavioural economics that shows investors often make decisions contrary to their own interests because of their aversion to losses or unwillingness to ditch a losing strategy. It represents a profound shift in regulatory stance.

Rather than simply ensuring that consumers are provided with complete and accurate information, the FCA will be monitoring firms to make sure that the right kinds of products get sold to the right kinds of people.

I can't wait to see the Nanny State plan to help day traders to ditch those losing stocks faster. 

Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook.

Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?

Sure, the market will get it wrong. But behavioral economics, if you take it seriously,  predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions.

More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong. 

Serious behaviorists know this. Thaler and Sunstein's "Nudge" is pretty careful not to jump from "people make mistakes" to "a benevolent bureacracy must take care of the charming moronic pesantry." Alas, fans of 19th century aristocratic paternalism, who call themselves "liberals" today, make the jump with alacrity. They love to (mis-) cite behavioral economics as cover for their interventions. As, apparaently,  Mr. Wheatley and the UK "protection" scheme he will now lead.

If he were to take behavioralism seriously, the interview would reveal a deep reflection on how he was going to keep his new agency from displaying all those biases likely to lead to bad decisions.

For example, his new power to tell bank A that its products are "mis-sold" will quickly and predictably lead to bank B taking his employees out to lunch to explain how terrible bank A's products are and how it must be stopped. "Consumer protection" has quickly morphed into "protection from competitors" the world over, and the behavioral biases of regulators (salience, social networks, etc.) are part of the story. "Watchdogs" become lap-dogs.

Where are the behavioral Stigler and Buchanan? It seems high time for a thoroughgoing behavioral analysis of the functioning of government bureacracy, legislation, and regulation.

Here's some real "financial protection" advice: Look at the elephants in the room.

The first thing the average American should do is get out of a highly leveraged, very illiquid investment that poses huge idiosyncratic risk. That's called an "owner-occupied home." Rent, and put the money in the stock market.  Or buy a smaller home, that you can afford. Our government is still nudging us in exactly the wrong direction

The seond thing the average American should do is save a whole lot more. Our government is pushing more subsidies for student, homeowner, and business loans, and dramatically raising the already high taxes on saving and investment. When the American consumer tried to start saving a bit more in 2008, our Government responded with massive "stimulus" whose explicit purpose was to undo this bout of national thriftiness and get us to consume more, now.

Who's behavioral here?

Update: (response to some comments).

There is a huge difference between the justifications for regulation.  1) Protecting people from fraud. This is enforcing contracts and property rights, which is an obvious function of government. 2) Protecting people from definable and remediable market failures. That's more tenuous, but still a justifiable form of regulation. Though it's dangerous, see the capture exmaples, and often backfires. 3) "Protecting" people because the beuracracy just thinks it knows how to run people's lives better than they do. This used to be called aristocratic paternalism. Now it's defended by a misreading of behavioral economics. That's what the post is about. I hope that helps. I see it's an issue worth revisiting.

So, Who Is the Free Market Candidate?

Who among the various candidates, Democratic or Republican, truly believes that economic scarcity is best solved by free markets? Indeed!

It is not clear that any of the candidates now running for the Republican nomination, other than Ron Paul, have any real faith in free market solutions to the problems of economic scarcity. No one is really proposing returning to free market principles. The battle ground seems much narrower -- personal and business tax rates, minor amendations to Obamacare, support for the Keystone project -- but not much else really.

The most likely outcome is a Romney candidacy. As much as that will be presented as the free market alternative to President Obama, in truth there is not much daylight between Romney and Obama. Neither seem to understand the fundamental economic malaise of modern America, nor to understand the root cause. One way you can tell that neither "get it" is the constant China-bashing that comes from the White House and the campaign trail.

Anybody that thinks China is at the heart of our economic stagnation believes in a fantasy. China is not the culprit. China is doing the right thing for its people by creating the largest expansion in free markets in the history of the world. The result -- economic prosperity for hundreds of millions of people who lived in subjection and poverty a mere generation ago.

What has the West accomplished in the last couple of generations? Growth of government mainly and a declining status of the middle class whose savings rate has collapsed to zero in the US and whose work ethic has slipped into the mud. Absent a savings rate and a work ethic, no amount of government waste will pull the US out of its malaise.

So, who speaks up for free markets. Sadly, no one except Ron Paul and he's not on a path to the White House, given his isolationist outlook on foreign policy.

Monday, January 30, 2012

Interesting Monday.

I wrote on Friday that it was the calm before the storm. But given the size and nature of the overextended / overbought market, the sell-off has not been that severe, at least not yet.

Greece will default no matter what. Question is when. One report is saying that it will happen in the early March. (http://www.examiner.com/international-trade-in-national/greece-plans-orderly-exit-of-the-eurozone ) But I think early April is more likely. Germany is tired of handing out money to Greece and they are only buying time. Question remains of contagion. Have LTRO been able to provide a cushion to the European banks from the coming shock? Next in line is Portugal and Spain. But short term trading in Wall St. is devoid of fundamentals. It is all about set up. So today SPX gaped down in the open but reduced the gap at the close. It was all about squeeze the short and keeping the bulls interested. If you look at the variances between Euro/USD, AUD/USD and GBP/USD, you will see that it is more of short squeeze than a rally.
SPX touched the Fib.23.6 level and reversed. Let us see how it behaves tomorrow and day after.

The US Dollar rebounded of key support area at the 38.2% Fib. extension. If this level holds we will see more weakness in equity in the next few days.

The general consensus is that we have a top in SPX at intraday high of 1333. But I think we have not seen the end of the Bull Run yet. This high may be tested very soon and rejected before we can call a short term top and before we see some sustained weakness.  As I always ask myself, where we are in terms of the sentiment?

Yesterday Mr. Gábor Jandó shared an interesting chart in Cobra’s forum which is as follows:

According to him, we may have a final blowout before meaningful reversal.  It is very likely that we will have this situation. So for now, we have to trade like day traders. Take each day and adjust our trading strategy.  The market will do the most unexpected thing to hurt maximum number of traders and so lets be prepared for the worst.

Thank you for reading http://bbfinance.blogspot.com/  and following me on Twitter. (@BBFinanceblog).

Consumer financial protection, 1840

I recently read again a very nice paper by Toby Moskowitz and Effi Benmelech, "The Political Economy of Financial Regulation" which studies 19th century usury laws. Usury laws limit interest rates that can be charged for loans, supposedly to protect borrowers.

It doesn't always work out that way.

Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit.  And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses. Toby and Effi present a powerful case that this is what happened in 19th century America.

I like this paper also for a deeper methodological reason. Cause and effect are devilishly hard to distinguish in economics. We have many fewer good instruments or "natural experiments" than we would like. Toby and Effi build a strong case for cause and effect with patient and exhaustive circumstantial evidence. I can't cover all that in a blog post, but it's good to look for it in the paper.

Here are just a few of the fun facts.
  • Tighter usury laws led to less credit. People didn't easily get around them.
  • Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade. 
  • Usury laws only affect the growth of small firms. Big firms do fine. 
Unlike many analyses, Toby and Effi spend a lot of effort understanding why the right hand variable moves. Why do states put in usury laws?
  • Usury laws relax in financial crises, when all interest rates spke and even well-connected borrowers are starting to be affected. 
  • Usury laws are stronger in states where voting is restricted to wealthy people. It's also stronger in states with other restrictions on competition such as restricted incorporation laws
  • Usury laws are relaxed when there are more newspapers, and when those newspapers are more active an challenging politics and corruption. 
In sum, "Our evidence suggests that incumbents with political power prefer stringent usury laws because they impede competition from potential new entrants who are credit rationed."

Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...

Sunday, January 29, 2012

Obama Is Right on Tuition Levels

In his State of the Union address last week, the President put forth an idea that is a long time in coming. Federal government aid should be curtailed to schools whose tuition is going through the roof and redirected toward schools who are running a tight ship. Amen.

In the past, the answer to the surging costs of higher education was to throw more money at higher education through more federal dollars and increasing loan availability to students. All this did was feed the beast and have universities searching for ways to toss money down ratholes. Meanwhile, millions of our college graduates are now saddled with debts that they have no hope of ever coming out from under. All of this to fatten the ever bloated monstrosity that is known as higher education.

Higher education is one of the few areas of American life, where there has been no serious change in technology implementation. Most schools still run their classroom in the same old way -- blackboard, chalk and someone droning on in the front of a mostly empty classroom. While there is technology available in abundance, it lies mostly unused at the modern American university. Facebook gets more action from University students than any websites that provide serious educational offerings.

Obama is on the right track on this one. Higher education costs are completely out of control. The priorities in the modern American university are less about educating students and improving skills and more about advancing the narrow political agenda of university faculty and administrations. The losers are taxpayers and students.

Three cheers for the President.

Saturday, January 28, 2012

The New Normal in the Obama Economy

Peter Whoriskey's article in today's Washington Post gives a brief summary of the "Obama Recovery" and it's not pretty. The slowest economic recovery in post World War II history has left the economy, even at this late date, with 6 million fewer jobs than it had before Obama took office. This after the most incredible expansion in federal spending and the national debt in American history. Quite a record!

The article shows who are the winners and who are the losers. The winners are businesses, who no longer intend to carry the albatross of the American worker. Loaded up with government mandates, rights, privileges, benefits, and lawyers, the American worker is a luxury that American businesses are determined to wean themselves away from.

"Businesses are swiftly investing in equipment and software. Those investments were up 5 percent in the last quarter of 2011 and 16 percent the quarter before that...."

As for the middle class that Obama claims to be defending: " disposable personal income is slightly lower, in inflation-adjusted dollars, than it was a year earlier."

That's the report card for big government. The rich and powerful do fine in the Obama economy. But, everyone else is in big trouble.

Friday, January 27, 2012

Calm Before The Storm.

GDP report came weaker than expected. Fitch downgrades five European countries. And SPX barely moved! You still think news drives the market and there is no market manipulation! Which rational investor will buy equities when countries are downgraded? All the power to the believers.

Today was a kind of consolidation day where the purpose of the day was to kill the short and bring in the wavering bulls. The problem as I see it, the capitulation is not complete yet. The SSI (Speculative Sentiment Index) is still negative for the Euro and AUD.  The SSI has to turn positive before we can see any meaningful pull back.
AUD completed the week at the top of the range and I think there is not much room to go higher from here. But I have been proven wrong in the past. Even now I think the cycle for AUD has topped and it should go down. But so far it is not listening. From 9 AM Eastern, AUD started the upward journey and followed the trendline. The trendline was broken only after 4 PM Eastern after the close of NYSE. Let us see how it behaves next week.
NYMO is also hanging on and refusing to break down below the trend line. So the change of trend is not confirmed yet.
From a TA point of view, it is possible for SPX to move towards 1200 level in the next seven to ten trading days.  But that is based on the assumption that TA is allowed to work independently.
The correction, when it comes may not comply with the TA parameters. What makes me worried about the correction is the huge long position that the commercials have in Euro for last so many months. At some point of time, they will take profit from their long position. When that happens, indexes will go through the roof. Take a look at the latest COT report.
The million dollar question is, when? I wish I knew.

For now however, US $ is testing the support at 9871-9823 region and in near term, may see a bounce which is consistent with the reversal in equities and other risk assets.
Thank you for reading http://bbfinance.blogspot.com/  and following me on Twitter. (@BBFinanceblog). Have a relaxing weekend folks.

Thursday, January 26, 2012

Netflix chart update

Netflix chart update (see: "Netflix melt-up and Google breakdown"). This earnings period was kinder to $NFLX and the market reacted positively. The gap-fill play to $115 is now complete.

"Da-doo-ron-ron-ron,  Da-doo-ron-ron".

The Evil Plan.

In a regular bull market the rise in share prices is backed by general growth in economy, wage growth, falling unemployment and all good things. In a bear market, it is the opposite. There is recession or fear of recession, credit is unavailable, unemployment is high and mood is gloomy. That is what fundamental analysis tells us.

If that is correct, where do you think the world is today? Is it in a growth phase or declining phase? There is no Nobel Prize for guessing the correct answer. But the question is if the world economy is in a declining stage, why the stock prices keep getting higher. The answer to that riddle is found in the continuous flow of liquidity injected by the CBs of the world. They are trying to solve the problem of solvency with more liquidity. In the process, they are buying time, hoping somehow, miracle will happen, growth will return and we will return to the goldilocks economy.

What do the small investors do in such a situation? If we short the market now, we will see that for the next one year or so, stock prices zooming higher and at some point we will be forced to cover our short position. So the best course of action may be to run with the hare and hunt with the hound.

Many do not believe that the stock market can be manipulated. They argue that it is so big, how can anyone manipulate it. But the fact is the big Ponzi scheme that is stock market is utterly rigged by the fifty TBTFBs of the world who control 90% of the trading and most of it through black pool trading which we never know. These are the same powerful bunch who borrow money from the FED or ECB at zero % rate of interest and then give back the same money to the FED at 3% ( buying treasuries). Thus, the Fed monetizes the debt at back door and banksters make risk free money from the tax payers.

As there is no immediate trend, they set up the market and create volatility. For the last two weeks they have created an expectation of a bull market where prices just keep going up.  Slowly all the bears are throwing in the towel and joining the buy program. Equity mutual funds are again seeing inflow of money. Retail is now afraid that they might miss the bus and are too eager to join. The free cash levels of the equity mutual funds are at all time low. Rydex money market funds have only $669 million now vs. $1.5 billion at October 2011 market bottom. The game plan is working. While retail is buying at the top, someone is selling these shares to them. You can again guess who are that someone. Today the believers of the rally are saying that one day sale does not derail such a strong bullish move.  While they would be correct in a normal market, this market is anything but normal.

When almost everyone is in, then the Boyz will take out the carpet under our feet. For the next two/ three week, we will see that a bearish environment will be created. ZH, CNBC will be filled with stories how Europe is falling apart. The retail will again sell cheap.
This pattern will be repeated many times in 2012 and if we can remember this game plan and play accordingly, we can come out alive in this market. Timing will be the key. As an individual trader we are pitted against these behemoths that have the best brains, best technologies and almost unlimited resources at their disposal. Our only chance is to find a quantifiable edge. That may be cycle analysis, TA, COT report, Liquidity analysis, market sentiment analysis or whatever works. Sometimes nothing seems to work, like now. But even in such situation two eternal drivers of the stock market work. Greed and Fear.

Today morning when the markets opened higher and kept going higher, those who were on the sideline, joined the buy express. Those who were short, closed their short to cut down further losses.  And now the almost entire Fed rally has been wiped off. Will they buy the dips tomorrow? May be we will see some buying in the morning just to convince the doubters.

But the evil plan is: wash, rinse, repeat.

A brief parable of over-differencing

The Grumpy Economist has sat through one too many seminars with triple differenced data, 5 fixed effects and 30 willy-nilly controls. I wrote up a little note (7 pages, but too long for a blog post), relating the experience (from a Bob Lucas paper) that made me skeptical of highly processed empirical work.

The graph here shows velocity and interest rates.  You can see the nice sensible relationship.

(The graph has an important lesson for policy debates. There is a lot of puzzling why people and companies are sitting on so much cash. Well, at zero interest rates, the opportunity cost of holding cash is zero, so it's a wonder they don't hold more. This measure of velocity is tracking interest rates with exactly the historical pattern.) 

But when you run the regression, the econometrics books tell you to use first differences, and then the whole relationship falls apart. The estimated coefficient falls by a factor of 10, and a scatterplot shows no reliable relationship.  See the the note for details, but you can see in the second graph  how differencing throws out the important variation in the data. 

The perils of over differencing, too many fixed effects, too many controls, and that GLS or maximum likelihood will jump on silly implications of necessarily simplified theories are well known in principle. But a few clear parables might make people more wary in practice.  Needed: a similarly clear panel-data example.

The Obama Plan to Lower Tax Revenues

The so-called "Buffett-Rule," which would impose a minimum tax on incomes above $ 1 million, would guarantee lower tax revenues for the US Treasury. Folks with high income would simply choose to lower their taxable income. That is a fairly simple thing to do and always happens when you raise tax rates on wealthy citizens. Short of confiscating folk's wealth, something Obama may get around to eventually, raising tax rates just encourages tax lawyers and leverage (the wealthy borrow more to live and let their assets grow unrealized...that solves the problem of lowering your taxable income without affecting your lifestyle).

Meanwhile, as tax revenues collapse, the Obama folks will find a way to tack on a tax increase for the middle class to offset the revenue loss from rich folks. This is always the route that tax rate increase advocates end up taking. The result: the middle class gets soaked with more taxation, while the no-nothings revel in the irrelevant higher rate structure that wealthy folks face, but do not pay. This is the kind of absurdity that Obama's class warfare will lead to. No wonderrich people support higher tax rates. Buffett knows he will pay less under Obama's soak-the-rich tax than he does now, so why worry? (Once the new rates are passed, Buffett will lob a call into his high priced tax attorney and get the advice he needs to pay less taxes under the Obama plan than he pays now. Don't think he won't make that call. He will).

Meanwhile, higher marginal rates will mean that money that would have flowed into the capital markets to create new businesses and new jobs will lie dormant in frozen assets. High levels of unemployment, economic stagnation and increasing misery for the poor, minorities and old folks will be the Obama legacy. This is what happens when economic policy is an outgrowth of coffee-house conversations at Harvard by people who have never held a real job.

Wednesday, January 25, 2012

New Bull Market or Irrational Exuberance?

Are we in a new bull market? Surely the Boyz would like us to believe that. Remember that time in not so distant April 2011 when the famous perma bear David Rosenberg capitulated and accepted that may be a new bull market has started.  Ironically that was the top of the market.

What we see today is pure and simple irrational exuberance. Nothing Uncle Ben said today was new, except that they will maintain the ZIRP till 2013 or infinity. There was no talk of QE3. On the other hand, everything that we know in TA is way out of sync and over extended. But we have been in such set up many times before and yet our collective memory is no better than a goldfish. As much as we talk of being a contrarian investor, we still fall victim of collective emotion and greed.

If the purpose of this set up was to lure in investors, they have been quite successful.  Investors have take out money out of the equity mutual funds in the last eight months of 2011, selling into the stock market decline. Now as per the ICI data for the week of January 11, 2012,: “Equity funds had estimated inflows of $1.43 billion for the week, compared to estimated outflows of $9.37 billion in the previous week.” Investors have now bought in the hype that the new bull market is here and now and they do not want to miss the bus.
The fact is none of the reasons that are being given for the rally are true. Neither fundamental nor technical. 

Last year, when everyone was sure that the market collapse is imminent, I was possibly only one saying that the world is not going to end. Now when everyone and his uncle are convinced of a new bull market, I dare to say that we are being set up and a bigger correction is around the corner.

Today it may sound like a broken record but one week is not a long time in the life time. We will see.

547 pages

As reported by the Wall Street Journal, Mitt Romney's tax return was 547 pages long. If you want to know what's completely sick with our tax code, this is it.

Demographics and stock prices

Zheng Liu and Mark Spiegel at the San Francisco Fed wrote a very nice letter  on demographics and asset prices, summarizing a lot of good academic work on the question.

See the graph to the left, taken from the letter: M/O is the ratio of middle aged to old, and P/E is the stock market price-earnings ratio. 

It seems like a natural story: In the 1970s, there were relatively few prime-age savers around to buy stocks, and the prices fell. Starting in the 1980s to late 1990s, boomers entered their prime saving years, bought stocks and drove the prices up. And now that the boomers are retiring, they start selling, and watch out for prices! Zheng and Mark make a pretty discouraging forecast.

These facts dovetail with research (my summary here, but lots of people have made this point) that high price/earnings ratios correspond to lower subsequent returns, and low price/earnings ratios correrpond to higher subsequent returns. One alternative story is that low prices come when people expect low growth in cashflows, and high prices come when people expect better future cashflows. That story does not turn out to be true on average. So the buying and selling pressure view is consistent with those facts.

I'm still not convinced, however, for a few reasons (all completely acknowledged by Zheng and Mark -- no fight here, we're just dissecting the evidence). First, empirically, movements in stock prices are about the equity premium, how much more you expect to earn on stocks rather than bonds, not the overall level of returns. Stock prices are about the willingness to bear risk, not about saving or dissaving. If it's all about saving and dissaving, we should see bond prices and yields (adjusted for expected inflation) move right along with stock prices and expected returns. To construct a demographic theory of stock prices and returns we have to argue not that people want to save more in middle age, but that they become less risk averse in middle age. Maybe, but it's a different story.

Second, markets are internationally linked. There may not be any American savers  to sell your stocks to when you retire (especially if the taxation of investment returns rises sharply). But there will still be a billion Chinese! 

Empirically, you can see there are about three data points, and Zheng and Mark acknowledge playing a bit with the demographic data. Lots of other things generate the same correlation with P/E ratios. In my research, I've been emphasizing the link to economic conditions that you can also see in the P/E plot -- good prices in good times, bad prices in times of recession or stagnation.

However, this is also a more important question than people think. Stocks earned about 8% real and about 6% or so more than bonds over the long histories of data we have, starting in either 1926 or post WWII. Many people bake in the idea that we will continue to get great returns like these in the future. Many pension funds discount there liabilities at these high rates of return.

Maybe, maybe not. There are lots of stories that the expected return on stocks for the next 20-30 years could be a lower. Wider participation via index funds and 401(k) -- wider risk sharing -- is one. Demographics, whether local or global, are another. The chance that we will enter a few decades of slow economic growth is another.

"Who will you sell your stocks to when you retire?" is an important question. With limited data, thinking through the various stories to see if they make sense is the only way to make much progress.

More Politics from Obama

The state of the union speech revealed a complete lack of interest in the absence of growth in the US economy on the part of the President. This means that lower income folks can expect their misery to continue as long as this President remains in office.

Instead the President launched a variety of attacks against his coffee-house enemies -- "the rich." As Buffett knows, apparently better than Obama, the tax rate is completely irrelevant to the truly wealthy. The truly wealthy can arrange things so that they have zero income for tax purposes, so who cares whether the tax rate is 30 percent or 100 percent. 30 percent of zero is zero. That's math that the President and his crew don't seem to understand.

But, it all sounds good I guess, to the uninformed. There is no question that this is class warfare and shows a President of the United States several shades to the left of the most socialist leaders in Europe. Whether Obama gets his way on all of this economic nonsense is yet to be seen.

The rich have nothing to fear from this President and they know it. That's why most of the truly wealthy support Obama now and will continue to support him throughout his political career. Those with modest incomes and those among the youth, the aged and the minorities, whose futures are blighted by the economic mess that the Administration has created, have little to look forward to.

America's economic stagnation will continue and it's dwindling world economic stature will continue with the kind of policies advocated by President Obama. Only free markets and capitalism can provide a rebirth to the American economy. Overbearing government will simply lead to more and more economic decline for what once was the most vibrant economy in the world.

Tuesday, January 24, 2012

Market Manipulation 101

ES closes the last four days as follows:
1310.50, 1310.75, 1311 and today 1310.50
Does anybody still think that there is no market manipulation? As usual, volume was almost non-existent and well below average.

Given that we are being set up nicely, where the retail is encouraged to buy buy buy by various talking heads of CNBC and other MSM, this itself should raise the red flag that there is cliff ahead.

Everything is screaming for a reversal but the money flowing in from Europe is keeping the US stock markets alive. Some of the reversal patterns are so rare that they happen once in a while and yet we are hanging on. Can the market defy gravity forever?  Unless there is more free money infused by the Fed, it cannot. So may be one more day we will have to bear the agony. In the mean time, gold down, silver down, oil down, copper down and equities barely moved!

Today we had a 3rd consecutive doji  or tri star pattern in SPX. It can be a good reversal pattern but given the fact that so many reversal patterns have not yet delivered, let us not be too excited about this one either.  When the reversal comes, it will be short and swift because I think there are unfinished businesses on the upside. 

AUD retraced back some of its earlier losses and is now testing the 1.05 level. Aussie economic data will be out tonight. The technical outlook suggests that AUD may have put an interim top. The ATR (Average True Range) suggests that the topside breach may be a head fake.

Another carry trade favourite pair AUD/JPY  also seems to hot the resistance.

Apple blew past the top line and bottom line projection. But there should be no surprise there.  After market it is trading at $ 452.50 after reaching a high of $460. This was the only thing left to convince the retail to join the buy express and buy the dip.  IFM on the other hand came out with their dire projection of the world growth and no deal has yet been reached on the Greece debt.  So neither technically nor fundamentally, I am able to convince myself that the bull market is here. May be after some 50-75 points correction, it will be nicer bait but at this moment, it is not that inviting.

But it seems to be working at some level. During the “buying stampede” which typically last between 17 to 25 trading sessions, even the weak stocks have been bid.  You can see for yourself where we are at this point of time. With the bullish sentiment at extreme high level, it is just a matter of time.
Tomorrow morning is going to be interesting. With the huge up from APPL and expectations of more free money, the markets may open higher. But when everyone is agreed that the market will move up, it has a tendency to do the opposite.  

Thank you for reading my not so cheerful thoughts at http://bbfinance.blogspot.com/ and following me at Twitter. (@BBFinanceblog). I am looking forward to write something more interesting in the coming days and weeks and not be stuck at the anticipation of correction.

Podesta Needs a Reality Check

The op-ed in today's Wall Street Journal co-authored by John Podesta, life long Democratic Party strategist, suggests that the "clean energy" industry is soon to reduce America's dependence on foreign oil. That is so absurd as to be laughable.

One supposes that this article was trotted out to defend the indefensible -- the Obama decision not to give the go-ahead to the Keystone pipeline project that would have permitted the US to tap Canada as an oil source instead of Syria.

There is no "clean energy" industry out there, either in the US or China, that has any potential to reduce America's or anyone else' dependence on fossil fuels. To pretend that there is, is irresponsible.

Whatever there may or may not be to a "clean energy" industry is far into the distant future and will only come into existence when the free market wills it so. Governments will just continue to waste taxpayer money. Does anyone really think wasting money on the Solyndras of the world will be a substitute for entrepreneurship and the free market?

Podesta should be ashamed of this article.

Monday, January 23, 2012

Republicans In the Mud

It is hard to see either Mitt Romney or Newt Gingrich emerging with much of a claim to lead a major political party campaign after the absurd performance in Tampa tonight. Instead of discussing the economy and the important campaign issues, the main spotlight was on who was the biggest devil in the room. The President must have enjoyed this debate.

AUD Reaches Measured Level.

Hat tip to Jamie Seattete, currency trader.

The AUDUSD has exceeded the trendline that extends off of the July and October highs and has reached the 100% extension of the rally from 9861 (2 equal legs). An extension of strength targets channel resistance at about 10650 on Tuesday. 10490 is short term support. While the rally looks tired at these levels (extremely low volatility for example), the upside demands respect above 10458.

Time To Wake-Up And Smell The Coffee.

We ended the day with a spinning top candle in SPX and red in DOW as well as Nasdaq. And the volume was non-existent. So far the much anticipate correction has not materialized in any meaningful way. But even when I am trying to become bullish, I am unable to find much upside in the market. 16 SPX points after 1300, SPX is sitting just below the long term falling trend line, with all parameters and indicators over stretched.
Many reasons have been given for the continued rise of the stock market. Seasonality, Greece deal, QE3 etc. Apart from seasonality, none of the other reasons are good enough. But seasonality also called for a correction in mid-January, which has not come. And without more free money from the Fed and ECB, this extended Santa rally cannot be sustained. This is a game we have seen many times over. I am not a bear per-se. So I am happy to participate in any rally and gain from it even when it is not supported by fundamentals and even when I do not believe in it. But I would rather not join in any such rally at a late stage.

Or if you would like, we are close to the “Oh Sh*t” moment as highlighted by Doug Short.

The market manipulators are doing their best to make people believe in tooth fairy. So far all their efforts have resulted in paltry 16 SPX points and have taken the market to the edge of the cliff.  GS advised its client to short 10 year treasury. In other words, they want client’s money to come out of bonds and go into equities, equities which are now at the top of the range and are at serious risk of gut-check.  Is it because they want to get out of equities at the top? Normally, it is a good practice to do opposite of what GS says. I think 10 year Treasury has reached its downside price target for now and there is not much room to go down any further.  A look at TLT will show that it is sitting on a long term support and is oversold.
Today VIX BB sell set up was triggered.  Yesterday, VIX closed outside the BB and today it closed inside BB and in green.  Such a set up signifies reversal in the market.  Whether the reversal starts tomorrow or few days after does not matter. It is not a question of if; it is a matter of when and how far. Longer we will have to wait for the correction, more significant it will be.

I think tomorrow morning we will see SPX will re-test the high of today and in all likelihood fail and roll over.  If markets were going up either on the hope of the Greek debt deal, that hope has now been dashed, per ZH.  Also it seems S&P has started downgrading the European banks. How far it is true, we will have to wait and see.  There is a lot of tail risk coming out of Europe and while technical rally has taken us this far, the next six months are going to be painful. Also I do not think QE3 is coming anytime soon. Whether we get one last up move in US stock markets will depend on how quickly we resolve this current overbought condition.

That leaves us with the situation that there is no more free money, at least for now. Will the market now wake up and smell the coffee?

Romer on Regulation

I ran in to a lovely little paper on regulation, thinking about financial regulation, from Paul Romer.

In my thinking about financial regulation, I've been heading toward the idea that we should regulate assets, not institutions; that regulations should be few and simple; that regulations should be rules, not licenses for regulators to do whatever they want; that rights and recourse for the regulated are important limits on the abuse of even well-intentioned power; and that pre-commitment, limiting the power of regulators ex-ante to bail out ex-post is important.  That view is in an earlier blog post, and in an article in Regulation. More to come of course.

Paul comes to about the opposite conclusion, in a very thought-provoking way.

Paul cites Myron Scholes' law, "Asymptotically, any finite tax code collects zero revenue," to suggest that simple clear rules will never work. He cites the FAA's regulation of flight safety and the Army's  integration as successful examples in which regulators, given wide latitude but rewarded on results achieved. And he cites the OSHA as an example of the hopelessness of a rules-based approach. For example,
The height of stair rails shall be as follows:
Stair rails installed after March 15, 1991, shall be not less than 36 inches (91.5 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Stair rails installed before March 15, 1991, shall be not less than 30 inches (76 cm) nor more than 34 inches (86 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Paul comments:
 It is tempting to ridicule regulations like these, [you bet! -JC] but it is more informative to adopt the default assumption that the people who wrote them are as smart and dedicated as the people who work at the FAA. From this it follows that differences in what the two types of government employees actually do must be traced back to structural differences in the meta-rules that specify how their rules are established and enforced. The employees at the FAA have responsibility for flight safety. They do not have to adhere to our usual notions of legalistic process and are not subject to judicial review. In  contrast, employees of OSHA have to follow a precise process specified by law to establish or enforce a regulation. The judicial checks built into the process mean that employees at OSHA do not have any real responsibility for worker safety. All they can do is follow the process.
I'm not totally convinced. In part, I'm a pilot, aircraft owner, and flight instructor, so I have a slightly different view of the FAA than the average air traveler. Yes, commercial jet travel is remarkably safe. But it's not at all obvious how much of this comes from the FAA regulation, especially at the margin, and how much from technical progress in aircraft and pilot training.

The surest way to ensure flight safety is to make sure nobody takes off in the first place. That often seems to be the FAA's attitude towards the light aircraft that I fly.

For in fact the social optimum balances flight safety against the economic and personal advantages of flying. For commercial aircraft, the airline companies and the flying public are loud enough to be heard. For light aircraft, we are not. No FAA employee was ever fired for the number of flights that didn't happen, the number of pilots who gave up flying, the technical innovations that didn't happen under his watch.

And the Federal Aviation Regulations, plus the FAA's love of paperwork, can make the OSHA stair railings look positively simple. In fact, there are rules, there is right of appeal, and by and large the FAA does not have the authority to come out to your airport and shut you down if it doesn't like what you're doing. (It can, and does, dig in to the paperwork to find inevitable flaws.)  And these are good things!
Some of the FAA's "safety" regulation has the opposite effect. For example, automobile engines are now more reliable than light aircraft engines. But they and their parts are not "certified," a long and expensive process. So we use what's certified. Airplane-to-airplane collision avoidance systems have been on the market for several years that cost $1000, yet the FAA's system ("ADS-B") which will be much more expensive is taking years to come out.

I'll say this for the FAA: it's all much worse in Europe. And the FAA is not  corrupt. Wide latitude to make decisions as you see fit, and to selectively enforce a forest of rules, is usually a surefire recipe for corruption.

Looking forward to financial regulation, it seems inevitable that regulators, given wide latitude, and  charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety. The Fed's proposals to implement Dodd-Frank (comments here) seem already very clear in that direction

Scholes' rule is fun too, but the corollary is that any society will arbitrarily expand the complexity of its regulation and the deviousness of lawyers and accountants to avoid it, until nobody actually does anything anymore and the society grinds to a halt.

So, it's a great and thought provoking read, and it's making me think a lot harder, though I'm not totally convinced.

Sunday, January 22, 2012

State and Local Pension Reform

As everyone by now must know, state and local defined benefit pension funds are broke and are not sustainable in their present form. So, what should be done?

Most states are creating Rube Goldberg machines to "reform" their state pension systems. Virginia is a good example. The proposals by the McDonnell Administration recently unveiled have the potential to make a bad system even worse.

What should state pension funds look like?

If you lump defined benefit pension funds in with social security, it is easy to see the overall problem -- the absence of saving. Social security is a net dis-saver (that's really the meaning of the "social security trust fund") and defined benefit systems have the effect of encouraging state workers to dramatically reduce their personal savings because of the expectation of future benefits. The result is that the national savings rate plummets effectively to zero (except for the savings done by the wealthy and by the corporate sector).

If savings are negligible, then there are no assets to support retirees (or to support young folks either). That's the problem in the US. Our assets are declining (Mostly by being purchased by non-US entities). It is as if the squirrels quit gathering acorns to prepare for the winter. When the winter comes, there are no acorns. For a while, you might be able to borrow acorns from the squirrels down the road, but that will only postpone the inevitable disaster.

Retirement plans should be about accumulating savings. The rationale behind defined benefit plans was that states would do the accumulating (ditto with social security), but we know that didn't work. States, all of them, use various accounting tricks and political excuses to avoid providing the necessary accumulation of assets to support future retirees. Early retirees win, but later retirees have no hope of winning.

Here is what a state retirement system for employees should look like: Employees should be required to put away five percent of compensation. The state can kick in another 2 1/2 percent. The total 7 1/2 percent should be exempt from current taxation so that it would essentially be structured like an IRA. Individuals should not be permitted to withdraw anything until age 65. Period. Individuals should be permitted to invest the money however they choose.

On top of the 7 1/2 percent the state could provide a 1 for 3 match up to some maximum. For example, if the employee chooses they could save another three percent of income and the state would match that with an addition one percent contribution. Imagine that you capped this at 9 percent (with a 3 percent kick-in by the state). Adding it all up, an employee could potentially end up saving 7 1/2 plus 9 plus 3 for nearly 20 percent annual, tax-deferred saving.

Notice that system would cost the state, at most 5 1/2% (or a mere 2 1/2 % if no one opts to go for the match) of total payroll. The employee would end up with annual savings of between 7 1/2 percent and 19 1/2 percent depending upon how much they choose to take advantage of the "free-money" match).

People could then choose the lifestyle they want in retirement: minimal or maximal. The state could lock in its liability to current contributions. Unfunded liability would be impossible in this system.

Best of all, aggregate savings would increase without question. Thus, the acorns would be available when winter comes as opposed to the almost complete absence of acorns that the current system promises.

The only objection to this is the old and tired excuse that employees cannot competently invest their own money. TIAA-CREF is the largest pension fund in
America and the most successful. The employees choose their own investments in TIAA-CREF and I doubt that any participant has ever voiced any real complaint about this system. So, individual investing works, contrary to popular myth. People do learn.

A similar structure could be used for social security. Together these reforms would create adequate savings for comfortable retirements for all Americans and get government out of the "unfunded liability" business.

These are the reforms needed, not the half-baked measures that are currently under review.

Saturday, January 21, 2012

New Keynesian Stimulus

One piece of interesting economics did come up while I was looking through the stimulus blogwars.

Paul Krugman pointed to New Keynesian stimulus models in a recent post, When Some Rigor Helps.
But take an NK [New-Keynesian] model like Mike Woodford’s (pdf) — a model in which everyone maximizes given a budget constraint, in which by construction all the accounting identities are honored, and in which it is assumed that everyone perfectly anticipates future taxes and all that— and you find immediately that a temporary rise in G produces a rise in Y"...

So I guess I’d urge all the people now engaging in contorted debates about what S=I does and does not imply to read Mike first, and see whether you have any point left. 
As it happens, I've spent a lot of time reading and teaching New Keynesian models.

I  wrote a paper about New Keynesian models, published in the Journal of Political Economy (appendix, html on JSTOR).  I haven't totally digested the NK stimulus literature --  In addition to Mike's paper, Christiano, Eichenbaum and Rebelo; Gauti Eggertsson; Leeper Traum and Walker; Cogan, Cwik, Taylor, and Wieland are on my reading list -- but I've gotten far enough to have some sharp questions worth passing on in a blog post.

Krugman continues,
That doesn’t mean that you have to use Mike’s model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment

One thing I know for sure: This is wrong. (It's an understandable mistake, and many people make it.) The New Keynesian models are radically different from Old-Keynesian ISLM models. They are not a magic wand that lets you silence Lucas and Sargent and go back to the good old days.

New-Keynesian models have multiple equilibria. The model's responses -- such as the response of output to government spending or to monetary policy shocks -- are not controlled by demand and  supply.  They occur by cajoling the economy to jump to a different one of many possible equilibria. If you're going to write an honest op-ed about New Keynesian models, you really have to say "government spending will make the economy jump from one equilibrium to another."  Good luck! 

New Keynesian models offer a fundamentally different mechanism from the IS-LM or standard stories that Krugman -- and Bernanke, and lots of sensible people who think about policy -- find "actually more useful."

For example, the common-sense story for inflation control via the Taylor rule is this:  Inflation rises 1%, the Fed raises rates 1.5% so real rates rise 0.5%, "demand" falls, and inflation subsides.  In a new-Keynesian model, by contrast, if inflation rises 1%, the Fed engineers a hyperinflation where inflation will rise more and more! Not liking this threat, the private sector jumps to an alternative equilibrium in which inflation doesn't rise in the first place. New Keynesian models try to attain "determinacy" -- choose one of many equilibria -- by supposing that the Fed deliberately introduces "instability" (eigenvalues greater than one in system dynamics). Good luck explaining that honestly!

In the context of the zero bound and multipliers, not even this mechanism can work, because the interest rate is stuck at zero. There are "multiple locally-bounded equilibria."  Some stimulus models select equilbria by supposing that for any but the chosen one, people expect that the Fed will l hyperinflate many years in the future once the zero bound is lifted. Hmmm.

These problems can be fixed, and my paper shows how. Alas, the fix completely changes the model dynamics and predictions for the economy's reaction to shocks. 

Or maybe not. I know the simple New Keynesian models suffer these problems. (That's what the JPE paper is about.)  Do they apply to the stimulus models? I don't know yet. I certainly have some sharp questions to ask, and I don't see anything in the models I've looked at with a hope of solving these problems.

Moreover, even taken at face value, the predictions of New Keynesian models are a lot different from Krugman's advertisement that more G gives more Y.

Every NK stimulus model that I have read is "Ricardian." Government spending has very large effects, even if it is financed by current taxes. Good luck writing an op-ed that says, "The government should grab a trillion of new taxes this year and spend it. We'll all be a trillion and a half better off by Christmas."  The popular appeal of stimulus comes from the idea that borrowed money doesn't transparently reduce demand as much as taxed money.  But that's the iron discipline of models -- you can't take one prediction without the other. If you don't believe in taxed stimulus, you can't use a Ricardian New Keynesian model to defend borrowed stimulus. (Or you have to construct one in which there is a big difference, which I have not found so far.)

More weird stuff, from Gauti Eggertsson's introduction
Cutting taxes on labor or capital is contractionary under the special circumstances the United States is experiencing today. Meanwhile, the effect of temporarily increasing government spending is large, much larger than under normal circumstances. Similarly, some other forms of tax cuts, such as a reduction in sales taxes and investment tax credits, as suggested, for example, by Feldstein (2002) in the context of Japan’s “Great Recession,” are extremely effective....

At positive interest rates, a labor tax cut is expansionary, as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts become contractionary. Similarly while capital tax cuts are almost irrelevant in the model at a positive interest rate (up to the second decimal point) they become strongly negative at zero. Meanwhile, the multiplier of government spending not only stays positive at zero interest rates but becomes almost five times larger.
Tax cuts are contractionary? The stimulus failed because the large tax cut component dragged output down? That's new, and I didn't hear Krugman complaining! Maybe it's right, but you can see we're a long long way from simple ISLM logic. Also, it's clear that these models make a sharp distinction between zero and nonzero rates, that stimulus advocates certainly do not make.

I also notice that "deflationary spirals" are a big part of the analysis. For example, in Christiano et al.,
But, in contrast to the textbook scenario, the zero-bound scenario studied in the modern literature involves a deflationary spiral which contributes to and accompanies the large fall in output.
OK, but we have near zero short-term government rates, a 3% positive rate of inflation and far from zero corporate and long term rates. Does the analysis apply?

Back to reading. I'll post again if I get more NK stimulus insights. It may take a while. I still think it's yesterday's news. Sovereign default seems more important for the future.

The Week Ahead.

After the surreal week when equities defied all logic and reasoning only to gain 15 SPX points, the hangover from the party may be due next week. In the process, all trading parameters have been trashed to the extreme and if there is anything called super overbought, it is here and now. But we all know that markets can remain irrational longer than we can remain solvent or sane. So we see die-hard bears throwing in towels. When such a thing happens, you know that the reversal is round the corner.

The situation is not a cut and dry one. I expect a higher high in February before weakness returns with a vengeance. By May of 2012, the bulls will forget that they were ever so ecstatic. The mood will swing from euphoria to eternal gloom. But we have some unfinished business before that.  For now let us take a short term view of only the next week and see what is possibly in store.

Given that indexes are due for a decent pull back, question is when is that going to happen. For answer let us look at AUD which has the highest correlation with SPX. AUD has reached 100% of FIB extension on Friday, January 20th, and the coming week we may see a sell off. The following is from David Song, currency analyst.

“The Australian dollar advanced to a fresh monthly high of 1.0480 following the rise in risk-taking behavior, but the high-yielding currency may come under pressure next week as the fundamental outlook for the region deteriorates. Indeed, the 4Q Consumer Price report highlights the biggest event risk for the Aussie, and the development may trigger a selloff in the AUD/USD as the headline reading for inflation is expected to expand at a slower pace during the last three-months of 2011.
In turn, the Reserve Bank of Australia is widely expected to further reduce borrowing costs this year, and we will maintain a bearish outlook for the high-yielding currency as interest rate expectations remain weak. According to Credit Suisse overnight index swaps, market participants see the RBA lowering the cash rate by another 100bp over the next 12-months, and the weakening outlook for growth and inflation is likely to heighten speculation for additional monetary support as the central bank tries to balance the risks surrounding the economy. At the same time, the slowing recovery in China – Australia’s largest trading partner – fosters a bearish outlook for the AUD/USD as the world’s second largest economy faces an increased risk for a ‘hard-landing,’ and we may see the RBA aggressively scale back the slew of rate hikes from 2009 as the region faces a protracted recovery.
As the rally in the AUD/USD tapers off ahead of 1.0500, the weakening outlook for growth and inflation is expected to drag on the exchange rate, and we expect to see a short-term reversal next week as long as the relative strength index holds below 70.”

Yesterday I posted about the RSI divergence in AUD, (http://bbfinance.blogspot.com/2012/01/aud-trend_20.html ) and the before that I have posted that AUD has reached the top of the triangle (http://bbfinance.blogspot.com/2012/01/bend-in-road.html ) . It seems that AUD is running out of steam short term and may now test the lower trendline of the triangle. And the AUD cycle tops early next week.

 The following chart shows the daily correlation between AUD and SPX. You will note that from time to time, SPX diverges from AUD but eventually comes back closer. 
If now is the time for correction for both AUD and SPX, we may see some violent movement in SPX in the next week. Of course nobody knows what will be the extent of the correction because many other factors are in play and given that a high is due in February, the correction this time may not be for long either. It will be an opportunity for trapped short holders to get out of the position with the skin intact. A bigger and better opportunity to short is coming by Mid-February.  

The year 2012 is going to be more like 2011. No one can afford to be perma- bull or perma-bear and investors will find it hard as ever. While we may see SPX 1000 being tested by May 2012, we may also see SPX 1500 being probed in October 2012. So let us not get carried over by end of the world stories. Nor let us believe the buy hype because fundamentals do not justify. It will be a liquidity driven market, run by the TBTF banks, for the TBTF banks.  That is the only way they will be able to make profit and write off the toxic assets in their balance sheet. Otherwise they are all dead men walking. The Fed, ECB, Governments and TPTB (the powers that be) know this and encourage this with their printing press.

So let us ride the BS when we can. Let us run with the hare and hunt with the hound and keep the holding period short.  

Thank you for visiting http://bbfinance.blogspot.com/ and following me in Twitter (@BBFinanceblog). Please share it with your friends and circle. And enjoy the weekend.

Friday, January 20, 2012

End Of A Surreal Week.

What a week! Let me accept the fact that I have not expected the last fifteen SPX points this week. I was ready for it in the 1st week of January but not now. Each and every indicator we can think of is stretched beyond imagination and if this logic defying situation continues longer, the retracement will be that much harder.

Throughout the day, I have been following the moves of AUD and at the end of the day, it tagged 100% of fib. extension. (http://bbfinance.blogspot.com/2012/01/aud-tags-100-fib.html )

It also developed a RSI divergence at the 240 minute chart which needs to be resolved. (http://bbfinance.blogspot.com/2012/01/aud-trend_20.html )

The late gain in SPX is correlated with the gain on AUD.

When everything else fails, we have to look at what is working and at this point only thing that seems to be working is the following analogy which I showed yesterday.

Let us see if we get the long awaited correction on Monday/ Tuesday of next week. A short panic would be nice. The original plan was to go long by the last week of January following a correction and go short in the 1st week of February following the top.  Depending on the price action in the early part of next week, I may close my short position, go long for a while and flip to short again.

Trading is not about being right all the time. It is about being right more often and quickly adjusting and minimizing the loss. While the retail has been absent in the current rally, the mutual funds have totally committed themselves and the available cash with the institutional investors is at record low.

The big sell off is round the corner but a higher high is going to come before that. I would love to take part in both. But will have to wait till next week for that.

Thank you for all your support and comments. Please share this blog in your Facebook / retweet to your friends. Have a nice and relaxing weekend folks. 

AUD Tags 100% Fib.

While AUD broke above the trend line, the RSI divergence shown earlier in the 240 minute chart remain valid for the next week as well.
It has reached 100% of Fib. extension and risk remains for a sharp correction.

AUD Faces Trend line Resistance.

AUD action will define SPX move in the coming days. 

AUD Trend

Hat Tip to CVecchioFX

Thursday, January 19, 2012

A Bend In The Road?

The last two days were really hectic with no internet connection and fifteen hour flight etc. As such I could not post anything and my apologies for the absence.

In the mean time, the stock market in USA has been a one way street. It has so far defied all logic and divergences. It has gone from extreme to further extreme. But such extremes are not backed by any fundamentals. We all know that seasonality pushes the stock prices higher at this time of the year but usually there is a correction during mid-January which has not happened yet.

I was looking for SPX 1300+ during the 1st week of January but it did not come then. I was also expecting a mild correction and continuation of the rally in the 1st week of February. So far the correction has been elusive. The problem with such situation is that without a correction not much upside can be expected in February.

I wanted to check if my models are totally wrong or are they just ahead of time. (Just like Prechter!) One of the best ways to check is to find out what other Gurus are saying. These are the people who have track record little better than Prechter and while nobody is correct all the time, it is better when success rates are higher than failure rate.

So I first turned to Charles Nenner. According to Mr. Nenner the short term upside price target for Emini is 1312. And today ES reached a high of 1311.5. We will see if Mr. Nenner is right this time.

Next I turned to Tom Demark. He gave an interview in Bloomberg on December 22nd. You can view it here; http://www.bloomberg.com/video/83290816/ . His upside price projection for SPX is 1313-1340.But he also expected to reach this target by the 1st week of January. One interesting point made by him is if SPX takes out the high of October 27, then it will create three successive high and that will be the top. We have now satisfied his two conditions for a top. We have reached the upside price target and SPX has created three successive highs as seen in the following chart.
Another person who makes a very good use of analog is Eric Swarts. The following chart is from him.
According to his analogy, the top was in today with pull back imminent before a final push in February. That fits well with my original model.

I also wanted to see what FX is doing. AUD has been my favourite indicator for SPX with a very high (almost 99% in 2012) correlation.
From the daily bar it seems that an AUD/USD top is either in place today or will be with one more try. It is at the falling resistance level and at the top of the triangle.
On the other hand USD has been falling from the start of the year and has now created an inverse HS pattern. The DJ-USD index support is at 9900 level and it seems that support is going to hold. While I do not expect DJ-USD index to run away over 10200 levels immediately, I think it will test the neck line as early as next week.

Bottom line, I am continuing with my short position. There are times when the model gets extended and I think now is one of those times. So instead of looking for the bottom by 20th January, I will now look for a short term bottom by around 24th – 26th January and then go for final pop in a long while by the 1st week of February.

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