Tharp's Thoughts Weekly Newsletter (View On-Line)
Another Structural Change in the Market? by D.R. Barton, Jr.
Trading Tip Gold Analysis and Strategy June 26, 2010
by Florian Grummes
Expiration Months in Futures Trading
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Another Structural Change in the Markets?
In times of peak uncertainty, market participants tend to look at the bigger picture for answers. I’m not talking about the big philosophical “whys” of life (e.g., Why do I exist?), but the more market oriented questions: What is causing this market behavior? Why is it happening? Can it continue?
Certainly, this discussion is taking place now that the markets are reaching nine month lows. Pundits lament that corporate earnings are projected to be very strong when second quarter numbers are rolled out. The bears point out that state and local governments will have trouble balancing budgets with current revenue shortfalls and bailout money fading. This will lead to payroll cuts that directly affect consumption patterns and will have trickle down effects on the economy.
As with most macroeconomic analysis, it’s almost impossible to tell which point of view will win in the intermediate term. We do know, however, that this market downturn has added a significant element of fear back into the market. Multiple media outlets report that Google searches for phrases like “double dip recession” have increased in the last ten days. And, as reported in Barron's, many professional money managers are moving more toward cash.
Some of the most intriguing work that I’ve been looking at points to a structural change taking place in market activity. Let me explain what I mean by structural change and then we’ll look at what might be brewing.
The Nature of Structural Changes
Some would argue that we have just entered another bear market phase in equities. That is a change in market category or type. When I talk about structural changes, I’m referring to fundamental changes in the way markets operate over time. Any number of causes can produce this level of change, but I’ll mention three of them today: technology, regulation, and financial innovation.
New technology, like the telephone in Jesse Livermore’s day or in the Internet in ours, has certainly caused changes in how the markets behave (among other effects, both of these technologies shortened the news cycle).
Regulatory changes definitely have affected the way markets behave. When margin requirements were raised from 10% to 50% after the 1929 crash, fewer dollars were chasing the same amount of shares. The data reporting and execution changes made in 1997 that made intraday trading possible for retail traders ushered in a new order of magnitude of volume into the market. Decimalization further reduced transaction costs and almost completely killed one type of trading (retail market making became virtually unprofitable).
Financial instrument innovations have also led to structural market changes. Mutual Funds allowed retail investors to participate in equities markets on a scale never before seen. Derivatives allowed institutions to hedge risk and/or take on huge leverage in ways that were not possible previously.
A New Structure: The Same Investor Psychology but Bigger and Faster
All of these changes led to different trading and investing dynamics. At their core, however, market movements remain driven as always by the cumulative effects of the market participants' fear and greed. We can display the classic investor psychology market cycle of bottom, rise, peak, fall on a chart as a sine wave.
Even though the forces that drive the markets remain the same, it fascinates me that their expression is evolving. If you think about the cycle of a sine curve, it moves up and down a certain amount and it repeats within a certain time frame. Structural changes in the markets are altering the characteristics of that cycle. It seems that the amplitude (the level of highs and lows) is increasing while the frequency (time between successive highs or lows) is getting shorter.
I saw the chart below in a blog recently. This intriguing graphical display depicts the expanding amplitude of the moves of the Dow over the past 12+ years.
We’ve crossed below the “12 year breakeven” line since this graphic was made in May 2010 with the Dow closing at 9774 on Wednesday. But the reality of the chart is stunning: bigger and faster climbs followed by bigger and faster drops. And for the past 12 years or so, this led long term investors on a road to nowhere.
This visual is perhaps the best that I’ve seen that truly shows how buy and hold is dead. Imagine the work involved holding onto investments for 12 years that included an Internet boom and a real estate boom and having no gains to show for the effort in the end.
In the coming weeks, we’ll look at some additional evidence that structural changes are underway in the markets.
Until then, I’d love to hear your thoughts and feedback at drbarton “at” iitm.com.
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Gold Analysis and Strategy June 26, 2010
1. Gold Spot price Analysis
1.1 Gold in USD (one ounce = US$1,255.70)
Current Action and Short Term Picture
Last Monday gold reached a new all-time high around US$1,265. Just a couple of hours later on that same day, the price plunged US$35 and then reached a short term bottom around US$1,225 on Wednesday June 23rd. From here it went straight up again to close at US$1,255 on Friday June 25th. Finally, we’ve had a week without change. Gold did not break out of the rising triangle and successfully tested the lower trend line for support. (Editor's note: At the time of publishing mid-day July 1, gold appeared to have broken out of this pattern to the downside.)
These recent volatile trading days created a doji candlestick pattern on the weekly chart where the opening and closing price are very close. A doji represents a market in which bulls and bears are balanced momentarily. In an uptrend it can be a sign of a trend reversal because the bulls have lost control of the market, although it doesn´t mean that the bears are already in charge. A doji is a sign of indecision, uncertainty and a change in mood.
Technically, a doji is a clear warning sign for a continuation of the uptrend. Another warning sign is the sideways Bollinger Bands (upper band at US$1,257.50), which are also moving closer together. Combine these factors with the rising wedge on the weekly chart and the market is hinting at a big move to come.
On the positive side for the continued upward trend, we can find three factors. First, there’s a distinct uptrend since the lows in mid-May of around US$ 1,165. Second, the 50-day Moving Average (US$1,204.75) and the 200-day Moving Average (US$1,125.25) are parallel and moving up. Finally, the RSI on the daily chart is not overbought and generally has much more room to go up.
Medium to Long Term Picture
Even though gold presents a mixed short-term picture, the intermediate term favors a big correction soon. If gold does not manage to break out above US$1,265 quickly, it should see a retracement to at least US$1,170 to US$1,190.
Longer term, the picture for gold is still very bullish. My longer term price target is the Fibonacci extension (261.8% of the last big correction) at US$1,600. This might be possible towards the end of this year or in the spring of 2011.
The Dow Jones/Gold Ratio is currently 8.08 and seems to be on the way back to the low from Spring 2009 of around 6.86. Long term, I expect the price of gold to move towards parity to the Dow Jones (=1:1). Because the next primary cyclical change is years away, we are still in a long term bull market in gold (commodities, also) and in a secular bear market in stocks.
This chart gives you a good idea about the big picture and shows the huge potential for precious metals in the future.
1.2. Gold in EUR (one ounce = 1015€)
€-Gold did not move at all last week. But we can find lots of negative divergences in various indicators as well as the huge gap with the 50d-MA (959€) and especially the 200d-MA (817€). The new all-time high in early June was not confirmed by RSI and MACD. Normally these kinds of parabolic moves (200€ in less than 2 months) will be corrected via time and price.
Even though the current worldwide currency crisis makes everything possible, I still would not buy gold at its current lofty price levels. Instead, wait for lower prices during the summer.
1.3. Gold bugs Index USD (492.93 points)
The Gold mining index (HUI) did not change last week and is still moving in a big sideways pattern between 375 and 500 points. In contrast to the general market, the HUI held quite well during last week´s sell-off in Dow, S&P, etc. Now we have to see if the gold miners manage to breakout to the upside or if the strong resistance around 500 points forces another sell-off.
The upper Bollinger Band (493.89) clearly limits higher prices at the moment. A move to below 480 points could trigger a fast correction.
There is no reason to buy gold stocks at current levels or add to your positions. Instead, wait to buy more and make sure that you have tight stops in place for any current positions. This sector is quite famous for its nasty and heavy sell-offs.
1.4. Gold COT Data
The commercials increased their short position for another 10,000 contracts and are approaching levels last seen in December 2009 before gold reacted heavily. This is a clear warning signal.
- 04/18/2009 = -153,419 ( PoG Low of the day = US$885 )
- 12/01/2009 = -308,231 ( PoG Low of the day = US$1,190 )
- 05/11/2010 = -282,644 ( PoG Low of the day = US$1,201 )
- 06/15/2010 = -278,944 ( PoG Low of the day = US$1,220 )
- 06/22/2010 = -288,916 ( PoG Low of the day = US$1,232 )
1.5. Gold Seasonality
Gold has a strong seasonality factor in its price. During June, July and August the price normally moves down or sideways while September is one of the strongest months. Therefore, we should not be surprised by a typical shakeout of the weak hands during summer.
1.6. Gold Sentiment
Gold is not a contrarian investment anymore, which makes analyzing sentiment more complex and difficult. Last week a very big German newspaper Die Süddeutsche dedicated its famous page 3 entirely to gold. This reflects a high level of optimism about gold and is usually a contrarian signal.
In the medium term gold should be on the way to my next price target around US$1,600. Before this kind of big move, however, there has typically been a nasty seasonal setback in July/August to shake out the weak hands. Watch out for such a move down in the short term.
I am expecting a decision in favor of the bears as soon as this week or next and the start of a typical summer correction. This will be confirmed with a daily close below US$1,240.
© 2010 all rights at Florian Grummes
Hohenzollerstrasse 36, 80802 Munich, Germany
English Translation by Florian Grummes
Expiration Months in Futures Trading
Q: I just read Trade Your Way to Financial Freedom. It's a great book. It demystified the systems behind successful trading, explaining entry and exit strategies in straightforward language.
After reading the book, I have a question I’d like to ask about futures trading: If I’m following several different commodities, and planning to enter on a breakout to potentially catch a trend-move as described in the book, how do I decide between the different expiration months? Do I follow just the front-month contract for a break out? Or do I need to separately follow the various contract months of each commodity? What happens if the front-month contract, which has the most liquidity, hasn’t existed long enough to be tested for, say, a 20-day break-out?
Stock trading avoids this problem since stocks don’t expire. But futures seem to trend better, and it’s easier to go short, which is why I’m interested in futures trading.
A: We don’t have anyone on staff here that trades futures to answer your question with authority. Even if we did, however, we don’t usually answer them straight out—that would be a disservice to you in the end. We usually reply back to questions like yours with the following type of response:
What are the objectives for your trading system? How will you identify a trend? When will you enter a trade and what portion of the trend are you trying to capture? How will you know when the trend is over? Have you gone back and checked historical charts to help you answer these kinds of questions? I expect with answers to these questions you will have a good idea on how to find the best way to profit from the best way from front month or back month contracts.
Finally, you point to some often cited beliefs in your last paragraph (i.e., futures seem to trend better and they are easier to short). If those are strong beliefs of yours and the market yields evidence for them, then the requisite work to take advantage of futures trading will pay off for you. Do you know and understand your other beliefs about futures versus stocks? You might find some value in writing out all of your beliefs about the two.
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