The Van Tharp Institute

August 03, 2005 — Issue #231

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In this Issue:

Feature Article

Monthly Market Update. By Van K. Tharp

Coming Workshops Coming This Fall: Five Premium Workshops for Traders and Investors.
Trading Tip

What Is A Primary Bear Market And Are We In One? By Van K. Tharp

Listening In Stops
Special Report Eight Page Report by Van Tharp, Does Your System Still Work in Changing Markets? 

View this newsletter on-line, or read back issues

 

Feature

Tharp’s Thoughts

Market Update for Period Ending July 29, 2005

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Look for these monthly updates on the first issue of each month. This allows us to get the closing month data.  In these updates, we’ll be covering each of the major models mentioned in the Safe Strategies book:  1) the 1-2-3 stock market model; 2) the five week status on each of the major stock U.S. stock market indices; 3) our new four star inflation-deflation model; and we’ll be 4) tracking the dollar.

Part I:  Market Commentary.

The market seems to be continuing its trend of the last 18 months of doing nothing by going sideways.  In fact, I’ve included another article in this issue of Tharp’s Thoughts just to explain why I believe that doing these updates each month is so important.

Sideways is always a possibility in an inflationary bear market.  For example, from 1962-1982 we had a market (i.e., DOW 30) bouncing between 500 and 1000.  Perhaps in this climate it will bounce between 7000 and 11000 over the next 15 years.

The 1-2-3 Stock Market Model IS IN RED LIGHT MODE.  BE CAREFUL.

What the market is doing.  Currently, all three major averages are still 1) down for the year and 2) but they are up over the last five weeks.  Furthermore, the Russell 2000 (which tracks small cap stocks) has made a new, all-time high, which makes people think we’re really in a bull market.  However, I generally don’t like this market at all.  It’s just being a very subtle bear, making it hard for anyone to take much money out of the market.  It’s probably nibbling most of you to financial ruin – but just a few percent each month. 

So let’s look at what the market has done over the last five weeks and compare that with where the averages were December 31st last year.  This is given in the next table. Incidentally, this data is calculated by hand based upon last Friday’s close (i.e., July 29, 2005), so there is always a possibility of human error in our numbers.

Weekly Changes in the Major Stock Market Indices

Date

Week Ending

DOW 30

Change

SP500

Change

NAS 100

(NDX)

Change

12/31/04

10,783.01

-0.4%

1211.12

+0.1%

1621.12

+0.5%

6/24/05

10,297.78

-3.1%

1191.57

-2.1%

1500.18

-2.5%

7/1/05

10,303.44

-0.1%

1194.44

+0.2%

1490.53

-0.6%

7/8/05

10,449.14

+1.4%

1211.86

+1.4%

1503.78

+0.2%

7/15/05

10,640.83

+1.8%

1227.92

+1.3%

1577.82

+4.9%

7/22/05

10,651.18

+0.1%

1233.68

+0.5%

1600.76

+1.5%

7/29/05

10,640.91

-0.1%

1234.18

-0.0%

1605.14

+0..3%

What’s a good strategy for the month?  Homebuilding and energy stocks continue to lead the market, so a position is some of those stocks is not a bad strategy.  Consider homebuilders like TOL, MTH, KBH, and SPF.  While some areas of the country have experienced huge run-ups in prices, the overall country has not.  And even though the Federal Reserve continues to raise short-term rates, mortgages have stayed steady and even fallen a little since the Fed increases started.  Furthermore homebuilders are relatively cheap.

Land holder JOE is also interesting and an interesting stock in terms of efficiency is NTRI.  However, remember that this newsletter is not about giving you recommendations, please do your own do diligence and invest based upon a sound trading plan that has stops, profit taking exits, and sound position sizing.

One positive force for the stock market is that the dollar again looking very powerful.  At the close of the month the dollar index at 89.9 was higher than it was in June 2003 when it was 88.68.  That means that the U.S. stock market is looking good to international investors.  

However, there are a number of serious factors on the down side.  First, this is typically not a strong time of the year for the stock market.  Second, oil has gone over $60 per barrel and that is not good for the economy as a whole – it certain is a major inflationary force.  And, lastly, as I mentioned last month many people seem to be putting their money into real estate.  Again, I don’t think that there is a real estate bubble yet – let’s wait until long-term interest rates start to rise significantly before we talk about a problem with real estate.

Part III: Our Four Star Inflation-Deflation Model.

So what’s our new indicator telling us about inflation?

1)      The CRB index

2)      The price of Gold

3)      The CPI and

4)      The trend in interest rates.

Since the description of the model we’re now using is not in any of my books, I’ll continue to give it here. 

1)  The CRB Index.  I believe that the CRB index is the one we have currently that is the least manipulated by the government.  But what’s the best way to measure it?  For consistency, I plan to give two measurements. 

·        Is the CRB index higher than it was six months ago?  

·       If it is, we are on track for inflation.

·        Is the CRB index higher than it was two months ago?

Now there are several ways to monitor these two indices.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then will only count ½ star for inflation. 

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

2) The Basic Materials Sector ETF (XLB).  In an inflationary environment, basic materials will definitely go up and this sector, to the best of my knowledge, is not manipulated by the government.  Thus, will use this sector to monitor inflation and we’ll use the same measurements use for the CRB.  (1) Is the XLB higher than it was six months ago; and (2) Is the XLB higher than it was two months ago.  These two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then will only count ½ star for inflation. 

·        And if both the two and six month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

3) The London PM Gold price at the end of each month.  Although the government can manipulate Gold, I still like to look at monthly gold prices.  However, to be consistent, we’ll use the same two measurements that we’ve used for the other indices that we are monitoring.  1) Is the price higher than it was six months ago and 2) is the price higher than it was two months ago.  Again, these two measurements give us four possible results.

·        If both differences are higher, we’ll count one star for inflation. 

·        If the six-month change is higher, but the two-month change is not, then will only count ½ star for inflation. 

·        And if both the two and six-month changes are lower, then we’ll be minus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be minus ½ star for inflation.  Obviously, the two minus scores will point to deflation.

4) The Fourth Measurement we’ll use is related to the Financial Sector of the S&P 500.

The financial sector (XLF) tends to do well when we have deflation and poorly when we have inflation.  Martin Pring, in fact, has used an index in which he divides the XLB by the XLF.  Since we already use the XLB, we’ll use the XLF by itself as well.  Again, we’ll use the change over six months and over two months.  However, the four possible outcomes with give us a different interpretation.

·        If both differences are higher, we’ll count one star for deflation. 

·        If the six-month change is higher, but the two-month change is not, then will only count ½ star for deflation. 

·        And if both the two and six month changes are lower, then we’ll be plus one for inflation.

·        However, if the six-month change is lower, while the two-month change is higher, then we’ll be plus ½ star for inflation.  Obviously, the two minus scores will point to strong inflation.

Okay, so now let’s look at the results for the year.  

Date

CRB

XLB

Gold

XLF

September 30

285.1

27.30

415.65

28.13

October 31st

283.70

27.04

425.55

28.38

November 30th

291.10

29.24

453.40

29.16

December 31st

283.90

29.63

435.60

30.37

January 31st

284.75

28.72

422.15

29.71

February 28th

305.00

30.98

435.45

29.51

March 31st

311.02

30.16

427.15

28.39

April 30th

303.75

28.01

435.70

28.44

May 27th

300.09

28.03

418.25

29.33

June 30th

306.91

27.12

437.10

29.50

July 29th

317.78

28.64

429.00

29.93

We’ll now look at the two-month and six-month changes during 2005, to see what our readings have been.

Date

CRB2

CRB6

XLB2

XLB6

Gold2

Gold6

XLF2

XLF6

Total Score

Jan 05

Lower

Higher

Lower

Higher

Lower

Higher

Higher

Higher

 

 

 

-+/2

 

+1/2

 

+1/2

 

-1

+0.5

Feb 05

Higher

Higher

Higher

Higher

Lower

Higher

Lower

Higher

 

 

 

+1

 

+1

 

+1/2

 

-1/2

+2

Mar 05

Higher

Higher

Higher

Higher

Higher

Higher

Lower

Lower

 

 

 

+1

 

+1

 

+1

 

+1

+4

Apr 05

Lower

Higher

Lower

Higher

Higher

Higher

Lower

Higher

 

 

 

+1/2

 

+1/2

 

+1

 

-1/2

+1.5

May 05

Lower

Higher

Lower

Lower

Lower

Lower

Higher

Higher

 

 

 

+1/2

 

-1

 

-1

 

-1

-2.5

Jun 05

Higher

Higher

Lower

Lower

Higher

Higher

Higher

Lower

 

 

 

+1

 

-1

 

+1

 

+1/2

+1.5

Jul 05

Higher

Higher

Higher

Lower

Higher

Higher

Higher

Higher

 

 

 

+1

 

-1/2

 

+1

 

-1

+0.5

The results of this model are much more sensitive (I believe) than the model I presented in Safe Strategies for Financial Freedom.  The model seems to be signaling a struggle between inflation and deflation with inflation winning slightly.

Part IV: Tracking the Dollar.

Look at the next table, showing the dollar index over the last five months and comparing in with its price at the close of the last three years.

The Dollar Index

Month

Dollar Index

December 02

98.62

December 03

86.27

December 04

80.19

January 05

81.10

February 05

83.50

March 05

84.20

April 05

84.92

May 05

86.42

June 05

89.10

July 05

89.91

The dollar is now much higher than it was at the start of the year and its gone up every month of the year – with the biggest jump in June.  It’s now higher than it was in mid 2003.  The dollar has probably bottomed out against the Euro.  And the index is highly weighted toward the Euro.  However, my guess is that it will continue to be weak compared with commodity currencies such as the Canadian Dollar, the New Zealand dollar, or the Australian dollar.  Fundamentals (i.e., with the main factor being the US debt) suggest that the dollar has a long ways to go on the downside.  However, we could have made that argument for much of the last ten years. 

 What this all means.

Our big picture still suggests a long-term BEAR market.  And it looks like a flat, inflationary type market for equities.  For example, all three major averages are down slightly for the year, while the CRB suggests that prices have gone up 4.5% during the same period.  This is not good for the economic well being of most Americans.  However, let’s continue to watch the market for more signs.  Until the end of August update on the market…..this is Van Tharp.  

Now be sure to read the article below on why this information is important to you.

 

WORKSHOP LINE UP

 

Van Tharp's Workshops Are Known For High Quality And Value Received 

Workshop Date Location Information and Discount offers
Systems Development  September 9-11
2005
Raleigh/Durham N.C.  Click for More
 
Peak Performance 101 September 26-28
 2005
Raleigh/Durham N.C. Click for More
Peak Performance 202 September 30-October 2
 2005
Raleigh/Durham N.C. Click for More
 
Exchange Traded Funds (ETF) (New) October 7-9
 2005
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Trading Tip: 

What Is A Primary Bear Market And Are We In One?

By

Van K. Tharp

On  the first Wednesday of the each new month I write the Market Update as I have done above.  However, they are usually fairly similar, stating that we’re in a primary bear market and that it’s probably an inflationary bear market.

Recently on the Van Tharp Mastermind Forum, someone asked the question, “Are we really in a bear market?”  Most people responded, “No, we were not.”  Or some gave a better response, “It depends upon your perspective.”  I personally don’t like either of those responses, because in my opinion, we are definitely in a Primary Bear Market.

Some people might be saying, “Come on, Tharp, the Russell 2000 just hit an all time high and the Dow Jones Industrials is not that far away.  How can you say we’re in a primary bear market?  

First, it’s not that important for me to be right about my opinions.  However, it is important for me to help you understand where I’m coming from on this topic. So I wrote this supplemental article to help put things into perspective. 

So where am I coming from?

First, I believe that you must have a macro-economic perspective from which to build your tactical trading plans.  You must know the big picture.  And that big picture consists of some fundamental truths plus a technical overview.

Why am I saying this?  Most people are blind to the big picture.  And when things suddenly change dramatically, they just keep doing what they have been doing – only the results get much worse.  That’s why I’d like you to all have business plans that have some clear perspective on the big picture right up front.

Yes, you can use your own data to determine the big picture.  You don’t have to use my perspective.  But if you do, you should continually monitor that data to keep up with the big picture.  And that means update your charts and spreadsheets at least monthly.

However, that big picture scenario that you come up with should incorporate most, if not all, of the following data.

1) If you look at the stock market since 1982, there are clear stock market cycles that last 15 to 20 years.  These tend to alternate between bull cycles when it is easy to make money and bear cycles when it is much more difficult to make money in the stock market.  The last bull cycle ran from 1982 through 2000 (18 years).  And during that time, the market was mostly up and it was quite easy to make money.

Now contrast that with the period from 1966 through 1982.  Here the market was in an inflationary bear market scenario.  The Dow Jones Industrials approached 1000 three times during that period – so you could have argued bull, bull, bull!  And it also had severe crashes when it actually dropped below 500.  And during the entire period, the dollar was eroding its value rapidly so that even if you made money in the stock market, it was still hard to keep ahead in real dollar terms.

In my opinion, we’re probably in a similar type of bear market now.  From 2000 to 2002 we had a major downturn.  This was followed by a nice rally in 2003, while 2004 through now has been a relatively flat market.

A primary bear market is a period in which it is much harder to make money in the stock market.  The overall trend tends to be down, but it doesn’t mean that there cannot be exceptional up periods.  For example in the great bear deflationary bear market that lasted from 1929 through 1949, there were clear up years.  1932 and 1935 were great up years for the stock market.  But during the entire period from 1929 through 1949, it was generally hard to make money in the stock market.

There are also some huge fundamentals that are at play behind this primary bear market.

2)  The U.S. government has accumulated a huge debt.  I remember when it first reached a trillion dollars and people said, “Something has to happen, it cannot go any higher.”  Well, nothing happened and the current debt is now 7 trillion dollars and our government now spends more than a half trillion dollars more each year than it takes in.  DOESN’T IT MAKE SENSE TO YOU THAT SOMETHING HAS TO HAPPEN HERE?  Do you think it will go up forever?

To make matters worse, that 7 trillion dollars doesn’t even cover the future promises of the U.S. government.  The baby boomers are going to start retiring in about six years.  If you look at what the government has promised them in terms of retirement, it has basically made promises that it cannot keep.  The debt to the baby boomers is about 53 trillion dollars and there is no way the government can pay that – although it has promised to do so.  What do you think will happen if 1) the government tries to keep it’s promise and 2) worse yet, the government says, “Too bad, we promised you this but we cannot keep the promise.”  People will lose faith in the U.S. government and it is only the faith of the people that keeps our economy going.

Incidentally, the 53 trillion dollars amounts to a personal debt for each household in the U.S. of about $500,000.  This debt must unravel itself and that is one of the primary factors behind the primary bear market of the next 10-15 years.

3) The U.S. government gets 47.8% of its revenue from personal income taxes and another 34.2% of its revenue from social security.  There are two disturbing parts of this.  First, the social security revenue should be accumulated for our retirees, not spent, but we’ve already covered that above in the 53 trillion in future debt.  But in addition, a great deal of the income tax comes from the baby boomers who are about to retire.  Then what?

4) The U.S. buys more from overseas than it sells – to the tune of over a half trillion dollars each year.  This means that foreigners are accumulating a half trillion U.S. dollars each year.  And most of them are keeping it and supporting our debt.  What happens when they want to cash it in?  It’s no longer redeemable for gold.  It’s actually just supported by our debt.  Each year the Federal Reserve prints more money (out of nothing) and our debt goes up.

The Asian countries in particular have accumulated much of this debt.  And they are afraid to give it up because if they do so the U.S. dollar will totally collapse and their dollars will be worth nothing.  But at the same time, they realize that they are accumulating “paper dollars” to the tune of a half trillion dollars each year and that those dollars are really just paper.  This trend will not continue forever.  When will it stop?  Nobody knows for sure, but it is certainly something to consider as a basis for a primary bear market.  Eventually, the U.S. dollar will collapse.

5) There are two huge former third world countries that are growing and their  growth depends upon the U.S. and will be at the expense of the U.S.  They grow by accumulating U.S. assets cheaply and U.S. jobs cheaply.  Those two countries are India and China.  Much of our current debt is now going to China.  And they are doing such things as attempting to buy out major U.S. companies at rock bottom prices.  Currently, they  just failed on their bid to buy UNOCAL from the U.S , but in 2004 Chinese companies (now flush with cash) acquired 649 U.S. companies.  Expect this to continue and watch and see what happens.  They are also accumulating huge reserves of gold and could soon have a gold- backed currency that could become the world standard, replacing the dollar.  China, incidentally, is turning out 2 million high tech graduates every year and that will probably go up.

The other such country is India.  Only India is operating a little differently.  For example, they’ve recently convinced IBM to layoff 13,000 American hi-tech workers in favor of 14,000 cheaper and more efficient Indian workers half a world away.  Want high tech support for your computer?  Chances are you’ll be talking to someone on the phone who lives in India. 

Ten years ago General Electric made a global decision to lay off American executives in favor of better trained and cheaper Indian executives.  Go to the American Club in Singapore today.  Do you find American executives there?  No, most of the executives are now Indian, which suggests that General Electric is not the only big corporation to make such decisions.

Most Americans think of a company like General Electric as being a great American company.  But GE is interested in profits and they don’t care who pays the price.  The results is that former American jobs are going international.  Again, this is another fundamental behind the primary bear market.

6)  My friend Gary Scott recently brought up another fact that makes all of these statistics even worse, and that’s the health of the average American. 

First, the average American now spends more on health care than the average citizen from any other major country in the world – almost 50% more according to U.S.A Today.  We currently spend about 14.6% of our GDP on health care compared with 10.9% for Germany (the next highest spender).  All other countries spend far less.

But what has this gotten us?  Americans have the shortest longevity of all.  The U.S male will live an average of 74.7 years which is shorter than males from Australia, Austria, Canada, France, Germany, Ireland, Italy, Japan, Norway, the United Kingdom, Sweden and Spain.

The major new killer for Americans is the food we eat (and the quantity of food).  In 1991, four of the 50 states had obesity rates above 15%.  By 1999, 61% of all U.S. adults were considered overweight.  By 2003, all 50 states had obesity rates above 15% and four states had obesity rates above 25%.  In fact, today 13% of all U.S. children 6-11 years of age are obese and 14% of those in the 12-19 year range are obese.  This means that they rank in the 95th percentile or higher on their BMI readings.  And today obesity accounts for 300,000 deaths annually (compared with 400,000 for smoking).  But the child statistics suggests that many of our children will not outlive us.

I’ve already written three articles on Peak Performance Health (obtainable as back issues of Market Mastery), which I recommend that you read.  But Gary Scott is quick to point out the dire economic potential of this major problem.  Our very way of life could easily fall apart.  And Bruce DuVe has been quick to point out the strong correlation between health and performance.  Those with unhealthy bodies cannot begin to imagine what they’ve given up in terms of mental performance and productivity.

I have not written all of this to scare you.  Sometimes newsletter writers will do that to get you to buy their stock predictions.  We don’t sell stock predictions.  Instead, I’ve written this to get you to think – about your own life and about how you plan for the future.

Furthermore, just because we’re in a primary bear market doesn’t mean that there will not be huge opportunities for profit.

Here are some of the huge trends we’re seen since 2000.

  • A three-year downturn in the NASDAQ which was a huge opportunity on the short side.
  • A major fall in the dollar (which was a major profit opportunity).
  • A major rise in oil prices and many other commodities as China has become a new major consumer of commodity products.  (A boom in the futures market).
  • A major boom in housing – both in housing stocks and in real estate.  This has been so great that many people are now calling for a huge bubble to burst.  (I’m not one of them – at least not yet.)
  • A major rise in short term interest rates (we’ve had nine Federal Reserve rate increases, while long term rates have generally gone down).  This is why the 1-2-3 model has not been too good this time around in  predicting a major downturn in the market.

And there will be many more such trends.

Please keep all of this in perspective as you trade.

For More About Van Tharp, Click Here

Listening In... 


Stops 
Author: Francis
Date: 08-01-05 14:43

Hi,

I am currently trying out doing trades on stocks that break out at high volume. I am wondering if it is good to place a tight stop or a wide stop in such a situation? Should I employ a trailing stop after the stock increases by a certain degree while holding on to the initial stop before that happens?

I know there is no correct or one way to employ stops but I would appreciate any suggestion or anyone having any experience on such issues as I have little experience on it...

Currently, I am using the ATR trailing stop based on the close to trail the stop which I think is a rather tight stop.

Thanks.

Reply To This Message 

Re: Stops 
Author: PMK
Date: 08-01-05 15:30

Francis,

There are two concepts in your question. The first is 'where should my initial stop be' and the second one is 'how should I manage the trade once I am in it with regard to reducing risk and protecting profits'.

The first part relates to how you classify a successful breakout versus a failed one. You want your initial stop to be placed at a point that says to you 'this is a failed breakout, the original premise for entering the trade has been invalidated and it is very unlikely to turn around and become a winner'.

This initial stop point is totally dependent on how you classify a breakout, but I would suggest it should at least be out of the 'normal' noise of the day-to-day fluctuations of the instrument you are trading. If you have a very strict definition for failure e.g. any price below the trendline or moving average you used to signal the breakout, then you will get stopped out a lot with smaller losses. If you have a looser definition e.g. 5 times the average true range over the last 10 days below the moving average, then you will get stopped out much less often, but with much bigger losses. You need to decide which trading profile suits you better (many small losses, or few big ones) and set your stop accordingly. Note that this is determined by your personal trading psychology, not 'what is the correct answer'. Both tight and loose stops can be valid, but just produce a different distribution of winners/losers and average win/loss size.

The second part is about how you move your initial stop after entry to either reduce open risk or protect open profit. A trailing stop outside the normal noise of the market is a satisfactory approach. Again, this depends on whether you want many small profits, or fewer large ones as your trading profile. As a general guide, I would suggest stops that are harsh on losers and generous to winners would be the way to go (which is probably opposite to 'what feels good' for most people since we all want to 'give a loser the chance to change direction, and 'not let a winner slip away').

In my experience telling the difference between winners and losers is one of the easiest of all things to do with trading, and I am amazed by the number of people who seem to look at a losing trade and see a 'potential winner disguised as a loser' and so set a wide stop so it doesn't get hit and become a 'real' loss. Don't let your trades fool you - a losing trade is one with a negative open profit, so set your stops accordingly.

Hope this helps

Paul

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