Tharp's Thoughts Weekly Newsletter (View On-Line)
Last Week's News Flash Update by Van K. Tharp, Ph.D.
Market Mania: Sorting the Historical from the Hysterical by D.R. Barton, Jr.
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Last Week's News Flash Update
Last Friday I issued a flash update that the market condition changed to Strong Bear Volatile due to the action on August 4th.
However, a miscommunication between me and my staff led to the addition of a suggestion at the end of my comments that our readers should tighten their stops. I don’t agree with that. Your system either works in bear volatile markets or it doesn’t. Tightening your stops would amount to changing your system, and I’m totally against that.
Several people responded that the update disturbed them. For example, one person said:
Anyone selling now is a fool to sell as issues bottom. This happened so fast; the best approach would be to anticipate, not react. Good luck to the little guy on doing that. On long term investments (5+ years) I am ignoring stops and buying quality stocks that will rebound nicely when this storm passes. I am struggling in being a believer in your methods with markets like this.
I would like to respond to this reader for the benefit of everyone who responded similarly and for those who didn't contact us, but who had similar thoughts.
First, everyone trades their beliefs. And you are right about whatever you believe. If you want to trade long term (i.e., five years or more) with no stops or exit point, go ahead.
Second, we are in a secular bear market. Secular bear markets end after the major indices hit single digit PE ratios and dividends on major stocks reach around 6%. We are a long way from that. This is just pure observation. Depending on the estimates for earning, the PE ratio of the S&P 500 currently varies between 15.4 to 22.3. That is a long way from single digits and PEs could bottom out at the end of the cycle as low as 5-7. Could you withstand the S&P 500 going down to between 400 to 600 from its current level at about 1150? Holding on through such a drop means you would have to make well over 100% just to get back to today’s level. Are you willing to take that chance?
Most secular bear markets are not necessarily supported by weak fundamentals in the economic picture. However, the current conditions are the worst fundamentals for the economy that we have seen in a long time. Finally, Standard and Poor’s just downgraded the United State Government debt to AA+. This is the first downgrade in the history of the United States and it has serious implications. Unless the US government totally finances the debt with more debt, it will probably be impossible for short term interest rates to stay near zero after a such a downgrade.
Third, for people who believe in holding positions long term, please take a look at the charts by Crestmont Research. You will see that long-term investors may have to wait 20+ years to get positive returns out of a buy and hold approach.
Fourth, I told people in December of 2007 that market conditions were bearish and the stock market was for trading only (not investing). The S&P 500 dropped from 1468 to the low 700s. It recovered somewhat to the mid-1300s recently, but it is clearly heading down again. If you ignored my warning in 2007 and held on to your positions since then, you have yet to make your money back in nearly four years. Plus, if your holdings were in US dollars, you've had a larger loss relatively to the value of other currencies and gold. The US dollar has fallen dramatically, and we’ve had (according to Shadowstats.com) 10%+ inflation during that time. Is that smart investing?
What are your alternatives? Ken Long teaches several systems in his Core Systems Workshop that trade on a monthly basis and have consistently outperformed the S&P 500 (a proxy for a buy and hold strategy). His primary systems from that course either went to cash before the big drop or better yet, held select positions that rose for the last two weeks as the broad market fell. In additional, many of the short-term trading systems he teaches in his Mechanical Swing and Day Trading Systems Workshop also work very well even in these market conditions (i.e., you could easily make 5R per week if you are a good trader).
So please, if you are a firm believer in buy and hold, at least look at the chart from Crestmont Research. It is just my belief that buy and hold during a secular bear market is dangerous to your wealth, but I think it is a useful belief.
And just to keep you updated, the current market type charts are shown below. They show us in Strong Bear Volatile market conditions.
2011 Fall Workshop Schedule
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Market Mania: Sorting the Historical from the Hysterical
“The market crawls up the stairs, then leaps out the window.”
— Chuck Le Beau quoting classic market wisdom
I first heard that quote from my friend Chuck Le Beau when we taught a System Development Workshop many years ago. Chuck has done so many interesting things in life and in the markets. He seems to have an anecdote for almost every situation. While his observation that markets crawl up the stairs only to jump out the window was made years ago, he might as well have been looking at the chart below of the current S&P 500 Index.
Far beyond the financial press, the consensus among talking heads on TV, mainstream newspapers and even local papers is that the plummeting market is a proposal for the end of the world. And by some sentiment indicators, buyers and sellers are acting like this is financial Armageddon, Part 2. This is the hysterical part of what’s going on today.
But rather than getting caught up in the hype, let's look at some historical context for our situation to provide us with a little bit of perspective. Then, we'll go through a bit of analysis to see where the markets might go from here.
Some Historical Perspective
On Monday and Tuesday, the market had huge moves. After the dubious announcement on Friday evening by Standard & Poors about downgrading US debt, Monday started with a big gap down and the selling continued for most of the day. Though the bears have decisively won the battle over the last 2+ weeks, both the bears and the bulls have won various offensives during the period:
- On Friday, there were 12 moves in the S&P futures contract of 12 points or more (either up or down).
- On Monday, in the last two hours of the regular trading session, there were 3 moves of 30 points or more.
- The real topper was Tuesday afternoon: after the Fed statement, the S&P initially dropped 47 points in 30 minutes only to be followed by a violent snap-back rally of a stunning 78.5 points in the last 75 minutes of trading.
For perspective, the S&P futures spent 60% of the time from mid-December through mid-February with its average daily range below 12 points.
So the past couple of weeks truly have been a traders’ market.
Long term investors and antiquated buy-and-holders have taken it on the chin. From the July 21st intermediate top to Tuesday’s low (August 8th), the S&P 500 cash market lost 18.2% of its value. The number climbs to a 19.6% drop if marked from the 2011 high made on May 2nd.
Add this to yesterday’s (August 9th) massive drop then rise and you have evidence of hysteria. The Dow Jones Industrial Average (which is still the most widely reported index by the media) had a 622 point range yesterday. And while that is huge, it is hardly unprecedented.
Using historical data from the Yahoo! database, I looked back to October 1, 1928 to compare present day to prior monster moves. Out of 20,808 days, Tuesday’s range was the 26th biggest in terms of absolute number of points. But less than three short years ago, in October 2008, there was a run of 10 straight days with a daily range greater than we saw yesterday.
Really though, absolute values mean little when comparing historic data. If we look at yesterday’s range on a percent basis, it was 6.13% of the previous day’s closing price. Again, that is huge, but this move places it only 160th overall for daily range as a percent of price.
So Where Do We Go From Here?
You may recall that in mid-June, we looked at some analysis that showed the oversold markets were due for a rally. We got that rally and the markets then stalled twice right at a “market memory” target that I suggested in a subsequent article. I also said in June that the rally from the 200 SMA support was likely to be weaker than the rally that led to the May highs. Indeed it was. Here are the same levels shown from the earlier chart with up-to-date market data.
For the downside, there are really no good support levels from market memory points until we get down to 1039 on the S&P 500 cash chart. This was the area of the August 2010 lows that formed a take-off point for the big rally into November. However, getting down to those levels is not likely without significant new financial problems arising.
During the last five trading days, the market hit such extreme oversold readings that Tuesday’s end of the trading day spike up was growing more inevitable by the minute. Since that relieved some of the ultra-extreme oversold readings, our most likely scenario for the short term is a consolidation period for at least a couple of days. Volatility will wane, perhaps in a big way if the news stream quiets down and traders both in the US and abroad can finally go on vacation. In the absence of big financial news out of Europe or the US, the market should rally from here to truly relieve the oversold condition that still exists. But beware: the launching pad for this type of rally is often a retest of the lows to suck in a few more short sellers.
Be careful out there and reduce your trading and investing size until the volatility quiets down again.
Futures and Fixed Ratio
Q: I would like to take your Introduction to Position Sizing™ Strategies E-learning course, but I don't see how it would apply to futures day trading on the ES. Since the ES is a derivative, the idea of risking only 1% of my equity cannot work with a small account day trader.
Please clarify if Dr. Tharp specifically addresses derivative traders like futures day trading and whether this course will help me. I currently use the fixed ratio method.
A: If you are using fixed ratio and understand that strategy well, the Introduction to Position Sizing E-learning Course may be too basic for you.
If you are interested in exploring the topic of position sizing strategies, you might consider the Definitive Guide to Position Sizing book. There’s a whole chapter devoted to the fixed ratio strategy and an exploration of multiple other position sizing strategies well suited to futures traders.
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