Is the recent market rally sustainable

The recent market rally has let many people wondering if the economy is recovering? 

According to an article I read online , it mentioned  two out of four conditions need to be met for an economic recover to begin and for the moment , only the fourth condition is partly fulfilled, with timid signs of recovery in China emerging.

i) House prices need to stabilize
ii) Banks must start lending again
iii) Consumers must start spending again
iv) Rest of the world must pick up

Reasons why I think economy has not bottomed out yet.

1) Inventories of house for sale remain high and house prices continue to tumble. The Case-Shiller Home Price Index dropped in January by 19% from a year ago, following an 18.6% year-to-year decline in December.

2) Job losses have been accelerating in recent months

3) Unexpected drop in retail sales as reported on 14 April 2009

4) GM/Crysler bankruptcy repercussions have not even hit yet

5) Standard & Poor’s reports there was a record high in the first quarter for the number of companies cutting dividends (367) and a record low for the number raising them (83)

6) Lot of speculation about which corner of the economy is likely to implode next and start to write the next chapter in the current financial crisis. Credit card debt and commercial real estate are two of the most frequently cited potential culprits

Based on the above, I will still play the momentum game by trading short term and also take more precautions in risk management (i.e not taking excessively large positions and profit take when opportunity arises) or cut loss when my stop loss is hit.

The above info are consolidated from the website http://seekingalpha.com 

2 indicators to measure investor sentiment

There are 2 indicators which are often used to gauge the market sentiment . They are put/call ratios and VIX. Both are calculated based on US equities and Index options.

In most cases these indicators are used as contrarian tools: when market participants are most bullish, the likelihood of a downside reversal is greatest; when investors become overly bearish, a market rally may
be on the horizon.

PCR Ratio
Put/call ratios provide us with an excellent window into what investors are doing. When speculation in calls gets too excessive, the put/call ratio will be low. When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high.

It might be more accurate to use equity-only put/call ratio as professional money mangers might use index options to hedge portfolio of stocks.

VIX
VIX is a measure of the level of implied volatility - not historical or statistical volatility - of a wide range of options based on the S&P 500

When the VIX (which is related to the S&P500) is under 20, there is excessive complacency, and over 30 is excessive fear.  But just as the Nasdaq is more volatile than the S&P500, the VXN is also more volatile, so anything under 25 is excessive complacency, and over 35 is excessive fear which usually happens when we are close to a bottom.

The importance of these 2 indicators cant be discounted as non economic factors are increasingly becoming important elements and they are best used in conjunction with other indicators. I might consider to use this as one of the factor to determine my entry/exit point (i.e wont buy if its overly bullish) but this might contradict with momentum style so I guess an optimal balance in mixing the strategy can only be achieved through real time experiment.

Free tools to gauge the sentiment can be found at schaeffersresearch.com .

8 habits to adopt be a good trader

If you need 8 habits to have in order to be a good trader. They are:

1. Be Proactive

2. Begin with the end in mind

3. Passion and Commitment

4. Patience

5. Discipline

6. Confidence

7. Control Risk

8. Continue to Improve

If you need to see the article detailing the above, here it is at Phileo’s.

Stock Pick (Google) Summary

This will be a page where i will be modifying weekly to update several values like stop trail, relative ratios, ATR as discussed in previous post.

Google as of  10/04/2009
Stock Price  : US$372.5

Quantity bought: 17 shares
Price Paid : US$370.69
Total Cost  (inclusive brokerage) : ?
Brokerage Fee : ?
1R(Downside) = US$762(? of equity)

Highest Price since I entered the trade : US$374.35
ATR(50 day) : 14.956
Stop Trail : 374.35 - (3*14.956) = 329.482

Fundamental relative valuation as of 10/04/2009

	Stock	Industry	Stock's 5Yr Average*
Price/Earnings	28.0	24.6	67.1
Price/Book	4.2	5.5	10.5
Price/Sales	6.7	5.0	13.6
Price/Cash Flow	18.7	22.0	21.7
Dividend Yield %	---	---	---

Stock Pick - Google

Fundamentals
- I will sell Google when its fundamentals has deteriorated like decline in cash flow and also when, I am no longer optimistic on its growth. I will compare the quarterly result against the previous quarters and also the annual result too .. Will probably come up with a list similar to the one I did for entry to decide again. (This will be an exception whereby I will sell off the stock without adhering to my below stop trail set),

- I will also sell Google if its relative valuation like (P/E , P/S) has ballooned excessively.

Momentum

1. Relative Strength
Weaker 3, 6 and 12 month relative strength.. Anything below 50 will be considered weak

2. On Balance Volume
OBV is downward sloping

3. ADX
Anything between 13 and 14 will indicate a weak trend

4. Moving Averages
When Occurrences of fast moving averages go below the slow moving average.

5. Trend
- Parabolic move is fully developed (three or more success trend lines)
- Stock price is near vertical

I will asses the above factors weekly and if there's a need, I  will consider to sell  the stock even when the current price is higher than my pre defined stop loss trail.





Reproduced with permission from http://melynn-lynch.blogspot.com

3 factor model (Momentum)

I don't really know much on this area yet so if anyone happened to come across this blog, please feel free to comment on it or contribute.

As of now, following are the indicators which I used to check the stock's momentum .

1. Relative Strength 
Relative strength, or RS, measures how a stock has performed compared to the overall market over a specified time frame. This info is only easily accessible for US markets.

Six-month relative strength >= 75.
Three-month relative strength >= 65.

For example, a 6 -month relative strength of 75 means that a stock has outperformed 75% of all stocks, in terms of price performance, over the past 6 months.

2. On Balance Volume
OBV attempts to detect when a financial instrument (stock, bond, etc.) is being accumulated by a large number of buyers or sold by many sellers. Traders will use an upward sloping OBV to confirm an uptrend, while a downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of an asset is trending upward can be used to suggest that the "smart" traders are starting to exit their positions and that a shift in trend may be coming. (Byinvestopedia)

If the OBV is moving in the same direction as the existing trend, it is a signal that the strength of the trend remains. When the OBV starts to move against the trend, it is a signal that the existing trend is weakening and may reverse. 

3. ADX
Analysis of ADX is a method of evaluating trend and can help traders to choose the strongest trends and also how to let profits run when the trend is strong.  (By investopedia)

 A low ADX value (generally less than 20) can indicate a non-trending market with low volumes; a cross above 20, on the other hand, may indicate the start of a trend (either up or down). If the ADX is over 40 and begins to fall, it can indicate the slowdown of a current trend. This indicator can also be used to identify non-trending markets or a deterioration of an ongoing trend. Although market direction is important in its calculation, the ADX is not a directional indicator.

4. Moving Averages
Occurrences of fast moving averages crossing over the slow moving average is a bullish signal while the vice versa is a bearish.Current moving average I'm using is 14,25 and 200

Pitfalls of Momentum Trading 
Here they are: 

Jumping into a position too soon, before a momentum move is confirmed. Closing the position too late, after saturation has been reached. Failing to keep eyes on the screen, missing changing trends, reversals or signs of news that take the market by surprise. Keeping a position open overnight. Stocks are particularly susceptible to external factors occurring after the close of that day's trading - these factors could cause radically different prices and patterns the next day. Failing to act quickly to close a bad position, thereby riding the momentum train the wrong way down the tracks. Based on the above, i personally think momentum has to be done in moderation cos I never want to be the last one holding on to it therefore for my future trades, I will try not hold on to it based on greed (Not willing to profit early) or fear (Not willing to cut loss).

3 factor model (Fundamentals)

My entry/sell point is currently based on the following 3 factors Fundamental, Momentum and Volatility. I will be doing trial and error to adjust the weightage of each factors but for a start, I will allocate more weight to fundamentals.

For fundamentals, it will be categorized into 2 section, valuation and operating history.  For operating history, I will use both quantitative and qualititave analysis to assess the company's management, financial health, profitability and cash flow.

For valuation, I will use p/cf , p/b, p/e, p/s and compared them against other similar industry competitors or the company's own 5 year historical average. One thing to take note is that companies with low ratios might be value traps and it may take years for the market to find this value and the stock can stay priced at these undervalued levels for extended periods, resulting in opportunity cost incurred as capital will be tied up on the stock.

Therefore to mitigate the risk of value investing, I will add a momentum filter to improve returns by avoiding the problem of waiting for the market to recognize the undervaluation. This will be discussed in the next section.

Not too sure if the above has already been mentioned before in my previous posts but the most significant change which I am making to my current system is to use relative valuation instead of absolute.