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August 2, 2006 — Issue #282

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Takeover Arbitrage, Spreads and Pairs Continued, by D. R. Barton, Jr.

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SmartTraderBlog: Slipping Through Your Stops

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Feature

Tharp's Thoughts

Market Update for August 2, 2006

1-2-3 Model Still in Red Light Mode

By
Van K. Tharp

Look for these monthly updates in 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

Some of the pundits were right because there was a slight turnaround in the market in June.  It was actually one of the larger monthly gains in some time, but in my opinion, the results were not impressive.  Between June 30th and July 31st, the DOW Jones Industrial average was up 35 points, the S&P 500 was up 8 points, and the NASDAQ 100 was down 65 points.  To me that’s not impressive.  But it was a typical up month for a secular bear market.  Long gone are the months of 1999 where we could see the market up 10% or more in a month.  Part of the rally was attributed to the prospect that perhaps the Federal Reserve would ease up on their tightening.  And now the market is getting weak because the pundits say the Fed will probably continue to tighten.  And to me it doesn’t make any difference what the pundits say; we’re simply in a secular bear market.

Part II: The 1-2-3 Stock Market Model IS IN RED LIGHT MODE

Let’s look at what the market has done over the last five weeks and compare that with where the averages were December 31st 2005.  This is given in the next table. Incidentally, this data is calculated by hand based upon last Friday’s close (i.e., July 28th , 2006), 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

 

1211.12

 

1621.12

 

12/30/05

10,717.50

-0.6

1248.29

+3.1

1645.20

+1.5%

6/30/06

11,150.22

+1.4%

1270.30

+2.1%

1575.23

+1.5%

7/7/06

11,090.67

-0.5%

1265.48

-0.4%

1533.71

-2.6%

7/14/06

10,739.35

+5.8%

1236.20

-2.3%

1462.17

-4.7%

7/21/06

10,868.38

+1.2%

1240.29

+0.3%

1451.88

-0.7%

7/28/06

11,185.68

+0.1%

1278.55  

+3.1%

1510.30  

+4.0%

Efficient stocks.  What is the market telling me in terms of efficiency?  Here, the data is very interesting.  I now have a proprietary indicator of the entire market— its efficiency.  What percentage of the stocks that I screen show positive efficiency?  What percentage of the stocks that I screen show negative efficiency?  I’ve only been doing this for about six months so I don’t have much historical data.  Last month I mentioned that the stock market had shown a dramatic turn, moving from 80% efficiency in February to 55% efficiency in July.  When I started our model portfolio in the middle of the month, the index had moved down to 37.4% positive.  And with the little rally we had (naturally I started the portfolio with seven shorts), it’s moved back to 50.2% positive efficiency.  Thus, the efficiency rating is actually down over the entire month.  At the close on July 28th, only two stocks showed positive efficiencies above 15 while ten showed ratings below minus 15. 

Mid-month Portfolio Update

I only plan to track the efficiency portfolio once each month. The overall portfolio is up about $50 (1/4%), despite being stopped out of two of our shorts,  DLX and BSX, and I exited SCT because there were better short candidates.  I also exited one long (FAL) at a slight profit because it was a buyout candidate and one of the bidders dropped out, leaving it just about at the buyout price.  Because there were 61 stocks with efficiencies below minus ten and 47 stocks with efficiencies above plus ten, I elected to go with four longs and six shorts.

On the short side we added EBAY and HOV at the open yesterday.  On the long side, we added AYE and CG.  I’ll do another update on the portfolio in two weeks.

Part III: Our Four Star Inflation-Deflation Model

I believe that we are in an inflationary bear market and that our inflation rate is simply masked by government statistics. 

So far our models have been telling us that inflation/deflation is pretty steady, with a slight inflationary bias and that’s where secular bear markets tend to start. 

So what’s our indicator telling us about inflation?

1) The CRB Index

2) The Basic Materials Sector (XLB)

3) The  London Price of Gold and

4) The Financial Sector (XLF)

1)  The CRB Index.  I believe that the CRB index is the least manipulated by the government.  But what’s the best way to measure it?  For consistency, I use 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?

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 we 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, we will use this sector to monitor inflation and we’ll use the same measurements used for the CRB.  (1) Is the XLB higher than it was six months ago?  (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 we 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?  (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 we 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 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 will give us a different interpretation.

  • If both differences are higher, we’ll count one star for deflation (i.e., minus one for inflation). 

  • If the six-month change is higher, but the two-month change is not, then we will only count ½ star for deflation (i.e., minus ½ for inflation). 

  • 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 last six months. 

Date

CRB

XLB

Gold

XLF

November 30th

332.49

29.67

495.85

31.87

December 30th

347.89

30.28

513.00

31.67

January 31st

363.30

31.74

568.25

31.95

February 28th

353.27

31.06

556.00

32.63

March 30th

364.70

32.35

582.00

32.55

April 28th

379.53

33.50

644.00

33.96

May 31st

385.65 (6/2)

31.95

653.00

32.56

June 30th

385.63

32.10

613.50

32.34

July 31st

391.49

30.90

632.50

33.08

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

Date

CRB2

CRB6

XLB2

XLB6

Gold2

Gold6

XLF2

XLF6

Total Score

June

Higher

Higher

Lower

Lower

Lower

Higher

Higher

Higher

 

 

 

+1

 

-1

 

+0.5

 

-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 is suggesting a pause in inflation with a slight deflationary pressure right now.  However, this is only the second monthly deflationary signal in over a year following this model.

Part IV: Tracking the Dollar

The U.S. dollar is still looking weak, which is another reason that the Federal Reserve needs to continue to raise rates. It seemed to pick the low point of the year when I was in Europe and has retraced slightly.

The Dollar Index

Month

Dollar Index

Jan 05

81.06

Jan 06

84.45

Feb 06

85.26

Mar 06

85.17

Apr 06

84.05

May 06

80.78

June 06

81.66

July 06

81.32

Aug 06

82.09

Something rather amazing happened in June.  The Federal Reserve commissioned and published a study by Professor Laurence Kotlikoff.  It was published in the July/August issue of the Federal Reserve Bank of St. Louis Review.  The study basically concluded as follows:  Countries can go broke. The  United States is going broke and a radical reform of  U.S. fiscal institutions is essential to secure the nation’s economic future.

The study was published by our own government, but did the media bother to report it?  I didn’t hear anything.  Possibly, the media got destracted by Israel invading Lebanon.  However, I’d think that the study at least warrants a front page headline in the Wall Street Journal and the New York Times.  Did you see it?  I actually heard about it from an Australian newsletter.  With all the financial emails and newsletters I see regularly, this study was largely ignored.

Kotlikoff cites a study by Gokhale and Smetters in 2005 that states the present value of the projected differences between all future government expenditures and all future receipts is a staggering $65.9 trillion dollars.  I had estimated it at about 40 trillion.  This figure is almost twice the size of the nation’s total wealth and it is five times the size of the U.S. GDP.  The three immediate solutions are

*       Double personal and corporate income taxes

*       Cut Social Security and Medicare benefits by 67%

*       Cut Federal discretionary spending by 143%.

None of these are acceptable solutions, of course.  Kotlikoff concludes that a solution is still possible, but it requires all of the following be implemented:  1) An immediate national sales tax of 33%; 2) privatize social security in which only accrued benefits are paid, not the projected benefits, plus putting an immediate lid on medical costs; and 3) reduce discretionary federal spending by 20%.

The latter solutions seem much less drastic, but even so would certainly throw the United States into a major recession.  And if you’d like to read the study for yourself, you can find it at: www.research.stlouisfed.org/publications/review/06/07/Kotlikoff.pdf.

What’s the impact of all of this?  I don’t really know except that its part of the secular bear market that we are in and it’s part of the debt crisis that I’ve been talking about.  For a country to accumulate very large debts as we have, that country must have the world’s reserve currency.  And one implication is that fairly shortly, the U.S. dollar will no longer have that status.  At that point, we’ll have a lot more problems selling our debt, which means T-bill and T-bond rates will probably go much higher.  And that could have an imploding effect on those who have a lot of debt.

The overall impact might not hit us for years.  It could be a lot like global warming.  My belief is that over the next 50 to 100 years, global warming will transform the planet in a major way.  It will be Mother Earth’s way of telling some of her misbehaving children to stop what they are doing and making sure they do stop.  But 50 to 100 years is probably beyond my lifetime, so I don’t talk about it much in these newsletters.  However, I think the effects of the impending  U.S. bankruptcy will be felt during the current secular bear market.

In the meantime, I’d suggest you take a look at the St. Louis Federal reserve study for yourself.  Until the end of August update on the market…this is Van Tharp. 

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

Techniques

Day Trading Workshop

September 16-18, 2006 - Raleigh, NC

Presented by: D.R. Barton and Brad Martin

         Spend Three Days with Master Trader Brad Martin. Learn His Trading Beliefs And The Intimate Details of His Trading Systems.

         Top system designer D. R. Barton will reveal the powerful yet simple system that provided a 100% return on  equity in difficult markets. (How many systems do you know that did that?)

         Insight on the special psychological tools that supercharge the performance of short-term traders.

         Dig into the fine points of winning day trading strategies in this fast-paced course.

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Trading Tip 

Trading Tip

A Review of Market Models: Spreads & Pairs Continued

by D. R. Barton, Jr.

We’ve spent a couple of weeks looking at spread or pairs trading.  Last week we reviewed the pros and cons of spread and pairs trading in general.  This week we’ll look at a couple of specific styles of spread trading using market model questions:

Takeover Arbitrage:  The “Almost” Sure Thing

Stock takeover arbitrage pairs:  As review - When one company announces the purchase of another, a purchase price is set.  However, the takeover stock still trades under its own name and stock symbol until all of the legal wrangling is completed.  During this time, between the announcement and the legal closing of the transaction, the ratio or spread between the two companies’ stock prices should theoretically be fixed.  However, market and psychological factors push the spread to narrow and widen, and people then play the spread to revert to the logical norm.

This style of trading was all the rage back in 1999 and 2000 when takeovers and other merger and acquisition (M&A) activity was occurring at a fevered pitch.  During that time, this trading was so lucrative that whole trading desks were being formed to do nothing but takeover arbitrage.  This trading style tracks the prevalence of M&A activity.  It was all but dead in 2002 & 2003 and is now being practiced at a moderate pace as M&A activity has picked up slightly.

Let’s look at our market model questions for takeover arbitrage pairs trading:

Is it theoretically credible?  Absolutely.  Prices set by legal documents are pretty darn credible.

Who’s it most useful for?  People who enjoy fundamental analysis, are patient, and adept at picking up nickels in front of steam rollers.  When things are going according to plan, this is a very high percentage, low volatility game.  But that “once in a blue moon” occurrence, when a deal falls apart, can cause monstrous moves against your position. 

How Fanatic are the fans?  Not very vocal.  Takeover arbitragers are more likely quiet plodders, pounding out profits under the radar screen.

Is it being used by real-life traders?  Yes, and will it always be more popular at the height of M&A cycles and less so when deals are few and far between.

Highly Correlated Stock Pairs – Reduced Risk When Done Right

Highly correlated stock pairs:  As review —  highly correlated stock pairs are identified.  This means that two stocks move in a very similar manner and are usually in the same sector.  Historical norms are developed (long and short-term) and when the spread between the stocks gets to the outer limit of its historical norm, one side of the pair is bought and one side is sold short in expectation of a return to normalcy.  Typical pairs are SPY vs. QQQQ (though this has had a poor correlation lately) and semiconductor stocks like ALTR vs. XLNX.

This trading style received some bad press early in this decade because it was exploited by a few brokers looking to generate excess commissions.  However, the strategy is actually quite reliable and is used by some very sophisticated traders.

Here’s a look at our market model questions for highly correlated stock pairs:

Is it theoretically credible?  Yes.  There are many pairs that have stuck to their historical norms for years.

Who’s it most useful for?  Patient traders who can trade counter-trend entries.  Remember that you have to act when the spread is widening and looks to be heading into trend.  You often have to take some heat against your position before the spread starts reverting to the mean.

How Fanatic are the fans?  Back in its heyday, there were some brokerages that were overly enthusiastic about this style of trading.  Today’s spread traders tend to be a relatively reserved crowd.

Is it being used by real-life traders?  Yes.  Some very good traders are using this style including my good friend and fellow course instructor Brad Martin.

Great Trading!

D. R. Barton, Jr. is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching, and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

D.R. presents the IITM Swing Trading Workshop and Professional Tactics for Day Traders Workshop. Each workshop is only held once each year. 

 

Special Reports By Van Tharp

Market Mastery Reports - Downloadable 


$39.95 each 
[Regularly $59.95]

BUY ALL 4 Reports for $129.00!

Click on any title below to read an excerpt

1. Doing a Spring Cleaning on Yourself as a Trader
2. Understanding Expectancy and the Golden Rule of Trading
3. Are You Doomed to Failure? Yes, but Only if You Avoid Working on Yourself!
4. How Academia Leads Wall Street Astray

More Info...

Listening in...  

VAN THARP HAS A NEW BLOG

July 27, 2006

Slipping Through Stops

Comment: Your July 4 entry is instructive, but does not hold together. You mention risking $1000 on each trade, yet you have two examples of losses of $2,000 and $1,500. Per the "rules" of your example this could not happen, you would have been stopped out at $1000 loss.

Van's reply:  Just because you have stops that should get you out at a particular levels doesn't mean that you will get out at that level. First, the market will definitely gap against you from time to time. A stop order is generally
designed to get you out at the market once the stop price is given. However, anyone who uses stops on a regular basis will soon learn that you will quite often have losses that are much bigger than your stop.

I usually estimate that such happenings should not be bigger than 2R -- although they could be. If you were in silver when the government changed the rules because the Hunt Brothers had cornered the markets, the markets basically were in a free fall to the downside with no way to get out. This can easily happen in the futures market with limit down days in which no orders get filled because there is such a demand to sell with no buying demand. 

Lastly, psychological errors and mistakes will always creep into people's trading. I usually consider losses of 5R or greater to be psychological losses. Yes, the examples are accurate because you can easily have losses bigger than your stop.

Visit Van's Blog at: www.SmartTraderBlog.com

and

Participate on our Trading Forum,  a place for traders and investors to share ideas and learn from each other. 

 

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Workshop Schedule

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