From technical point of view, 50 dma of major indices are still below their 200 dma, trending downward. Although the volume was good in last Wednesday, it was not so in last Thursday and Friday. Any given rally needs strong volume to prove its legitimacy. Further, my fellow SeekingAlpha contributor, Richard Shaw, provides an excellent article talking about entry points for major indices. Unless these indices reach the right level and stay there for at least 3 consecutive days, the real bull trend is not well established. It is better to put one’s money at the sideline, instead of losing money in a direction-less, range traded market. We had a 6-day rally at the beginning of August, ended with the worst month in the year. This rally needs to prove itself beyond the first week.

Then, let’s look at the job report. Dave Rosenberg, one of the Mr. Dooms, dug into the “good” report, and found “softness beneath the surface” (Source: Barrons.com):

• Flat aggregate hours worked.
• All of the employment gains were part-time—full-time employment, according to the Household Survey, plunged 254,000.
• Those working part-time did so pretty much because they had no choice, and their numbers surged by 331,000—the biggest increase in six months.
• Of the 67,000 rise in private-sector jobs, 10,000 reflected returning construction workers who had been on strike.
• The 27,000 shrinkage in manufacturing slots and flat total goods-producing employment are hardly evidence of a vibrant economy.
• That contraction in the diffusion index is consistent with an economy slowing down to stall-speed.
• The aforementioned rise in U6 is reason enough to suspect that we’re not about to see a sustained acceleration in wages.

On top of that, this article from ZeroHedge provides one good point on how accurate the job report is:

(This administration) naively expect(s) people to believe that the labor force in August 2010 (154,110) was lower than that in August 2009 (154,426). That in the meantime the US population grew by 2.5 million seems to make no difference to the administration.

Last but not least, it was the good PMI number coming out of China at 51.7% in August from 51.2% in July. The number is not good at all. First, seasonally, August number is better than July. Second, that same number stood at 52% in this February, meaning that a month at the end of shopping season has a better number than a month heading into shopping season. According to this article (in Chinese), China will face severe debt issue as early as 2011 as local governments’ debt bloated to officially more than $1 trillion. The real number could be higher. China banks are holding land as the collateral for the debt. As the central government is forced to rein the real estate market, land could become illiquid. Strong head winds are awaiting China’s financial system.

Markets could go higher or build a base from the current level. Bulls need to be careful with stop orders.

Disclosure: long TZA

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Here are seven reasons that I believe we will see a repeat of 2008 crash unless the government steps in and saves our investors again.

1. Markets have been performed poorly in the last week by gapping down key support levels. S&P 500 gapped down from its 10-day and 200-day moving average in one day, dropped below its 50-day moving average the next day, and have stayed below the line for 3 days in a row. Nasdaq composite performed the worst with Dow still above its 50-day moving average.
2. According to Wikipedia, there have been two unconfirmed Hindenburg Omens occurred since the market lows of 2009: one in last Thursday and another yesterday. The Omen has repeated twice within a week. Zeroheadge.net believes that all bets are off. A big crash will happen within 120 days as what has happened in 2008.
3. U.S. economy is facing the second dip. Alan Albeson from Barron’s sharply pointed out that
   

   No sooner did the less-than inspiring trade data come out than estimates for second-quarter gross domestic product fell like dry leaves in autumn. The preliinary seasonally adjusted annual growth rate of 2.4% was shaved by pencil-wielding Street savants to as low as 1.3%. And the redoubtable John Williams, chief cook and bottle washer at Shadow government Statistics, reckons there’s fair chance the GDP in the current quarter could be negative.




4. Economy slow-down is further re-affirmed by the Fed last week’s decision of purchasing Treasury bonds. On the other hand, the largest bond fund, Total Return fund of PIMC has reduced its U.S. government-related holdings in July from 63% to a still-high 54% by taking in $1 billion a week form bond-craving investors. In the same time, China, the largest owners of U.S. government debt, has reduced its holdings for a second straight month in June by $24 billion.
5. A good observation from Michael Santoli at Barron’s:
   

   …… the dividend yield of the Dow Jones Industrial Average components, at 2.65%, is essentially equal to the 10-year Treasury yield. The folks at Morgan Stanley note that over the past 50 years the Down’s yield has exceeded that of the 10-year Treasury yield. The only one period — the end of 2008 into early 2009, as the financial crisis climaxed.

6. Unemployment rate will stay high for years to come as population growth requires U.S. to add about 125,000 jobs a month to just stay even while the government seems to talk the talk, instead of walking the walk:
   

   The best year, 2006, averaged 232,000 jobs added per month — that was the top of the Housing Bubble. The best decade, 1991-2000, averaged 150,000 jobs added per month. And yet the official forecast from the White House & the Treasury asserts we will add an average of 200,000 jobs per month in 2011, and 250,000 jobs per month in 2012.

7. Last but not least, U.S. mood cycles, based on the research from Dr. Cari Bourette from A New Story Foundation, lead the stock markets. Currently, collective mood now places markets 33% below current levels. For details of her research, please check out the following video from Youtube:
   

Disclosure: TZA

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Modern quantitative techniques are based on modern portfolio theory, introduced by Harry Markowitz in 1952,

in which he suggested that investors should decide the allocation of their investment funds on the basis of the trade-off between portfolio risk, as measured by the standard deviation of investment returns, and portfolio return, as measured by the expected value of the investment return. …… Developing the necessary inputs for constructing portfolios based on modern portfolio theory has been facilitated by the development of Bayesian statistics, shrinkage techniques, factor models, and robust portfolio optimization(, with the help of powerful computers).

All these techniques have been skillfully depicted by the export authors, who have all worked closely with hedge fund and quantitative asset management firms, who are famous university professors with series of books focusing on related financial topics.

The book starts with the role and use of mathematical techniques in finance. The authors’ argument is very powerful:

As there are unpredictable events with a potentially major impact on the economy, it is claimed that financial economics cannot be formalized as a mathematical methodology with predictive power. In a nutshell, the answer is that black swans exit not only in financial markets but also in the physical sciences. But no one questions the use of mathematics in the physical sciences because there are major events that we cannot predict.

The book continues with financial model building, which covers modern regression theory, applications of Random Matrix Theory, dynamic time series model, vector autoregressive models, cointegration analysis. Then, it moves on to include financial engineering, static and dynamic factor models, asset allocation, portfolio models, transaction costs, trading strategies, etc.

Overall, the book is math-heavy except the first chapter. It is an excellent textbook for students majored in finance. It is also a good guide book for traders who focus on quantitative trading techniques in a daily basis. It is also a recommendation for power investors who start to leverage brokerages’ open trading APIs. It is not recommended for these who don’t have math background and who don’t understand any mathematical terms mentioned in the earlier paragraphs of this review.

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After dropping 9 out of 10 trading days, finally, major indices turned green last week for the past 5 trading sessions. Note that we are near the position where markets started to correct 15 days ago as Dow ($INDU) came inches away from its 50 dma. Another weakness is that the recent rally was not led by Russell 200 ($RUT) and Nadaq ($COMPQ), but by Dow ($INDU). Given the fact that both Dow ($INDU) and S&P 500 ($SPX) have experienced their Death Cross earlier, it is more like a bear rally to suck people in than anything else. Even though the sentiment is very bearish, there are strong reasons. Consumer de-leveraging is ongoing, as Alan Abelson from Barron’s has pointed out:

…… the consumer, who accounts for two-thirds of the economy, isn’t playing his customary role of sparkplug. Just the opposite: He cut back his borrowing in May by a formidable $9.1 billion, making it the fourth straight month of contraction (April’s reported increase of $954.8 million, it turns out, was slightly exaggerated and duly revised to a drop of $14.9 billion).
Credit-card use (so-called revolving credit) shrank by $7.4 billion, or 10.5%, extending its string of monthly declines to 20. ……
……
With three million folks slated to lose unemployment benefits by the end of this month, and something like five times as many job seekers out there as there are job openings, the mood of the consumer, less than ecstatic in any case, is likely to remain somber and his eagerness to spend constrained.

Economic Cycle Research Institute weekly leading indicator continued to drop like a stone, falling to minus 8.3% from a positive 12.9% in April 30th. My fellow SeekingAlpha contributor, Doug Short, has a nice article, charting the correlation between GDP growth and NCRI WLI, way back to 1965. At the current rate, it would be a surprise if we don’t observe a second dip in the economy.

As we are heading into the earning season, it is important to check out the earning estimates. Jacqueline Doherty from Barron’s has a good summary:

…… On April 1, analysts thought earnings would grow 22.7% in the second quarter, and those estimates rose to 27.7% near the end of May. Analysts have trimmed their numbers only slightly since then, to the aforementioned 27%.
The good times should continue to roll for the next four quarters, based on analysts’ estimates. The Street is targeting growth of 25% in the third quarter, 33% in the fourth and 13% and 20% thereafter. In all, that would mean the S&P 500 would produce $82 of earnings this year and $96 the following year. That would catapult earnings above the previous record of $88, hit three years ago.

It is hardly imagine that after so many damages have been done, S&P 500 is coming back to bypass the peak of November 2007. More ironically, last week, Bank of America became the latest big financial firm to cop to manipulating end-of-the-quarter earnings. It admits that it masked debt levels between 2007 and 2009 by making six trades designed to shine up the numbers on earnings day. What so called “dollar rolls” has helped the bank hide as much as $10.7 billion in debt, which was in September 30, 2008. It could force banks to revise their earnings of the second quarter downward, adding pressure to their stocks.

As Russell 2000 ($RUT) and Nasdaq ($COMPQ) facing their Death Cross, markets might experience more days of dead cat bounces to fool people. Further, the second quarter earnings look likely to be mixed with the fading influence of government stimulus. Bulls still have the time to trim their positions while bears need to prepare for the prime time. One more thing is clear now that government stimulus are for the Wall Street, not for the Main Street.

Disclosure: none

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The first two days of last week demonstrated the typical daily pattern when institutions are dumping stocks, as the markets gaped high at open and dropped much lower at the end of the day. Barely missing the 50 day moving average, all three major indices (Dow, Nasdaq composite, and S&P 500) trended down, and all closed below their 200 day moving average at the end of the week near their two-week low. Note that it is the third time for Nasdaq to close below the 200 day moving average. The cross formed on these three major indices last Friday gave a slight of hope of market reversal. More importantly, Michael Santoli from Barron’s has observed that

The fact that the market didn’t blink upon Friday’s downward revision of first-quarter GDP hints that a softer outlook is largely discounted. Another thin reed is the fact that a Barclays Capital slashing of Goldman Sachs’ (GS) second-quarter profits to $1.95 from $5.35 Wednesday didn’t faze the bellwether stock.

What could push the markets higher in the next couple of days? G20 might have provided the necessary push on Sunday. There are two major pieces of good news from the G20 meeting:

1. As Obama put it, the G20’s endorsement of cutting deficits by 2013 mirrors U.S. targets and takes into account the fiscal and economic needs of each nation. A slower paced austerity measure is good news to the economic recovery generally.
2. World leaders said the new capital requirements against banks would be so high that banks would be able to ensure financial crisis without “extraordinary government support.” Though there is no mentioning of bank levy, capital requirements will be phased in different paces among G20 countries.

Another piece of news is from Bloomberg:

The Standard & Poor’s 500 Index and 10-year Treasury rates posted a correlation coefficient of 0.8412 in the 60 trading days through June 16, showing stock prices and bond yields were the most linked in Bloomberg data going back to 1962. The last time the relationship was almost this strong during an economic expansion was the beginning of the 2002 to 2007 bull market, when the benchmark gauge for U.S. equities doubled.

Simply put, the correlation between the S&P 500 and 10-year treasury rates signals a continued economic recovery.

On the flip side, all major indices are forming their right shoulder in a head-shoulder pattern for a major landslide. The trading range is between their previous low early this month to their 50 day moving average. As $VIX stays slightly below 30, the risk of stock trading is pretty high as the markets are range bound, with a wide range. Both shorts and longs could be slaughtered by institutions. Particularly, we need to watch out for Friday’s non-farm payrolls report for June. A drop-off in census workers is seen reducing the headline number by 150,000, but private payrolls are expected to rise to 100,000. A quarter-end window dressing could quickly fade into a continued hammering. Last but not least, corporate bond distress rises as yields have jumped sharply among speculative-grade companies. The ratio of companies with bond yields at least 10% points more than government bonds climbed to 16.7% of the total, compared to 9.2% on April 30, which was the lowest since November 2007. It is a sign that debt investors expect the economy to slow and defaults to rise.

Disclousre: none.

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So far, the markets have been following my script as going down first and going up. $VIX is a very good gauge. The recent uptrend has been consistent with $VIX below 30, which signals the higher risk on the short side. The markets did go down further to whipsaw investors before turning back. At the current level, the markets can continue going up either to form the right shoulder for major indices or to form a double peak. Or, the market could go down to complete the triple-bottom pattern before going into a bear market again. The next 1.5 weeks are super critical as the period of quarterly window dressing. If the markets fail to break upward and to stay at the new-higher level(s) back-to-back, most likely, the markets will break down.The downward pressure still out-weighs the upward momentum as there have been too many negative news on the surface, casting an overshadow on the fate of the economic recovery for the second half of this year. Let’s start with Obama.

Obama warned against a too hasty stimulus withdrawal, albeit of G20 finance ministers calling for faster deficit reduction (based on the article from Financial Times):

We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past when stimulus was too quickly withdrawn and resulted in renewed economic hardships in renewed economic hardships and recession.
Should confidence in the strength of our recoveries diminish, we should be prepared to respond again as quickly and as forcefully as needed to avert a slowdown in economic activity.

It seems to be obvious that if his $787-billion stimulus package had been working as expected, he wouldn’t worry about “renewed economic hardships and recession” and call for anticipation of “a slowdown in economic activity.” Note that “the president has not made the case for a continued need for public stimulus amid a weakening recovery” in front of congress.

According to Randall Forsyth in the latest issue of Barron’s:

… investors appear willing to hold cash earning 0% or 10-year Treasuries yielding 3.25% “and yet remain unwilling to buy large-cap growth stocks with fortress balance sheets and decent dividend yields trading at low double-digit earnings multiples,”

He continues to offer the main reason behind the risk averse behavior of investors:

Nomura chief U.S. economist Davidd Resler says that, even after households paid down debt for the seventh straight quarter in the first quarter, the process still has a long way to go. That, even with a $374 billion reduction in household borrowing from its peak of $13.9 trillion in the second quarter of 2008, with most of the drop coming in mortgage debt.
In fact, financial deleveraging has just begun, …

Now, it might help us understand a bit why the stimulus package has failed, other than offering Wall Street executives tons of bonus, as “the real problem is that the economy remains mired in a debt-deflationary cycle from which the only way out is through paying down the debt.”

In order to figure out the potential forces to push the markets lower, I have stumble upon an article from BusinessWeek.com:

FedEx slid 6 percent after saying rising health-care and pension costs will constrain earnings. Fannie Mae and Freddie Mac sank more than 38 percent as regulators ordered them to delist their stock from exchanges.

Based on the FedEx case, Michael Santoli from Barron’s has offered a most likely scenario:

If this plays out market-wide, perhaps a staccato beat of downward earnings revisions is on the way, and will drag lower what appears a too-high consensus expectation for S&P 500 companies’ 2011 earnings, of $95. Indeed, if the market “believed in” that $95, indexes would probably be a fair distance higher.

Fannie and Freddie’s delisting is not a sign of economy recovery since housing is one of the two biggest consumer spending areas.

All these actually sound awfully similar, compared to November 2007. From then, trillion dollars have been poured into the economic system by major governments in the world, the mark-to-market rule have been abandoned by regulators, and SEC has set up “circuit breaks” on S&P 500. Still, Soros might be right that we are now in ACT II of the second Great Depression.

Disclosure: long AAPL and TNA

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… this is not a liquidity crisis but a solvency one and the fiscal and political resources of the capital providers of last resort – the governments – are virtually exhausted given rising public debt levels, unstable capital markets and a strong aversion by the domestic electorates to further bail-outs. So the current crisis looks less disorderly, but it is potentially more long-lasting and far-reaching.

As the outcome, according to Mohamed El-Erian, CEO of Pimco, the latest G-20 communiqué

recognizes that “significant challenges remain.” Some of these are behind an important change in the overall G-20 policy approach. As I read the communiqué, the Group has gone from strongly supporting growth stimulus to recognizing two critical issues: The approach has not succeeded in delivering sufficient economic escape velocity (confirming recent sluggish indicators of self-sustaining recoveries in the industrial world, including yesterday’s disappointing U.S. jobs report); and that collateral damage is being strongly felt in the form of increasingly unsustainable deficits and debts (consistent with growing core/peripheral tensions in Europe and the failure of the massive ECB/EU/IMF response to deliver any durable improvement to date).

This time is different from all the previous recessions after the World War II in the sense that it is a solvency crisis, starting from the banking system, extending to the governments as sovereign debt is mounting and quantitative easing becomes unsustainable. The crisis is far from over. Sovereign solvency issues can only be resolved by a package of solutions:

1. Restructure the debt
2. Largely deflate the currency
3. Dramatically cut spending and raise taxes
4. Export out of the debt

It has been the perfect recipe. Use Turkey as an example. In 2001, Turkey’s debt was approaching 80% of its GDP and failed to collect enough taxes to cover interest payments on its national debt. Now, its debt-to-GDP ratio is 46%. To achieve this, Turkey’s lira fell 54% against the dollar in 2001. Unfortunately, PIIGS countries cannot take the same recipe as far as they are within the euro-zone. Even if they did, today’s global economy weakness makes it hard for a swift bounce-back. As the crisis drags on, investors will eventually reach a real panicking point sometime down the road. If it happened, it would bust the whole bond market, triggering the second Great Depression.

People might not believe such kind of doom’s day talk. Surprisingly, not so many people have noticed the almost failed German debt auction in May 26th:

Germany’s issue of five-year bonds attracted bids of just 1.1 times the amount on offer, compared with 1.5 times at the previous auction last month. This was only achieved after the Bundesbank retained £1.55bn, or 22%, of the €7bn (£5.45bn) issue of 2.25% bonds on offer. Had this chunk of the debt remained on the table, Germany would probably have failed to find buyers for all of it.

If countries like Germany starts to have issues to sell its treasury bonds, how long will it take before it impacts the global bond market? It shouldn’t take long. That’s why Europe cannot afford the same quantitative easing as U.S. has done in the last year. Thus, the Greece Crisis is not well contained yet. As U.S. public debt reaching $13 trillion this year, how long could U.S. enjoy the good time? Finally, is the Great Depression Avoidable?

Disclosure: long vxx and energy, and short finance and real estate

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Let me start with the downside. This book is the author’s favorite as he wrote the book for the general public with little or no charting experience when he was the technical analyst for CNBC. It is the answer to all of those viewer requests against his charts in the TV program. Thus, market professionals, and investors with some degree of charting experiences might not find the book very usual. This group of people should check out his other two books, or dig into books like Technical Analysis: The Complete Resource for Financial Market Technicians, which have more depth and breadth. Compared to the first edition, the second edition doesn’t have any CD attached. The major upgrade is updated charts. Previous owners might find limited value from this edition. Last but not least, the author has spent quite amount of pages to promote StockCharts.com, which could piss off couple of folks.

Now, let’s look at the upside. John really knows how to explain technical analysis with simple and straightforward illustrations. Technical analysis should be tedious and complicated. This book is able to take readers step by step on how to start and continue into the more complex versions of technical analysis. The new charts that the author has picked well depict the up and down of the last economic cycle under Bush era, which are very persuasive.

The book is well organized into four sections. The first section deals with trendlines, peak, trough, chart patterns and the importance of looking at daily, weekly, and monthly charts, etc. The second section explains indicators: moving averages, oscillators, RSI, MACD and, briefly, ADX. The third section is for linkage, market breath and relative strength, covering the relationships among three major asset classes – commodities, bonds and stocks. The final section could be skipped as full of promotional materials.

Overall the book is educational and filled with useful information to make proper decisions of investment(s). I would highly recommend it for beginners and people not familiar with technical analysis. Before concluding the review, I would like to share where we are in the current market by applying what I have learned from the book:

• A close below a 200-day moving average is considered very bearish and hints of a major trend change. All the three major indices ($indu, $compq, $spx) are below their 200-day moving average. Though, many times prices will drop back to their moving average lines before resuming their uptrend.
• By comparing daily, weekly and monthly charts against moving average, MACD, and RSI, all the three major indices shows short-term (daily) struggling, near-term (weekly) down or testing (for Nasdaq), and long-term (monthly) up. It seems that the markets hasn’t finished the correction, while the economic recovery is still on its course.
• A bearish divergence occurred in last week’s rally between Cumulative Nasdaq Advance-Decline and Nasdaq Composite, signaling the downfall of last Friday.

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This May has been brutal to the stock markets, as Kopin Tan of Barron’s has put it:

By the end of May, they (investors) had yanked nearly $30 billion from stock mutual funds — a one-month flight from risk that surpassed the $25 billion withdrawn in February 2009, or the $26 billion pulled in March 2009. That was just before this bull run began and when the economic outlook was far grimmer.

It is true that the economic outlook has been improved dramatically. The last earning season has been the best since the trough of March, 2009. European sovereign crisis has been contained, so far. Even Friday’s job report doesn’t necessarily emphasize an economic second-dip as the same thing happened before in July, 2004 during the previous economic recovery. More importantly, when markets closed at Friday, major indices stood at a major support line. If people carefully analyze the stock chart of S&P 500, the support line near 1060 hasn’t been fully breached. We believe that more downward attempts will follow, given the fact that S&P 500 has been below its 200-day moving average on its daily chart with its RSI below 50 for the past 11 days, and European sovereign default crisis further extended to Hungary. What could happen next week is for S&P 500 to re-try 1060 during intra-day lows. Besides, VXX is consolidating above 20-day moving average, signaling incoming market volatility. On the upside, as the ratio of number of S&P 500 stocks above 50-day moving average drops below 10%, the markets become more and more oversold. Further, a strong support line requires multiple attempts before it gets penetrated, and major market drops typically happen after the forming of strong downward patterns, such as double-peak, header-and-shoudler, or triple-bottom. The triple-bottom pattern is more likely under the current situation. We believe that S&P 500 will go up and re-test its 200-day moving average after couple of tanking days next week, which gives swing traders good opportunities to make some easy money. We believe that when markets go up, oil and natural gas ETFs (UNG, USO, DBO) will do well. Here are the reasons:

• We are in the hurricane season.
• There is a 6-month moratorium on exploratory drilling in the Gulf’s deep waters.
• Pension funds are shifting towards raw materials.

The triple-bottom pattern will finish when Dow breaks 9000 the third time.

Disclosure: long vxx and energy, and short finance and real estate

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June is the last month of the quarter, a perfect month for fund managers to do window dressing. So far, there are two up days, discounting the first down day. As the panic ebbs, the markets have been mysteriously quiet, which includes the corporate bond market. Is the bond market still liquid? Markets have experienced the first back-to-back up days after the recent correction started in April with lower than average volumes. Particularly, both Dow and S&P500 experienced lower volumes today than yesterday and both have stayed below 200 day moving average since May 20th. Among all the three major indices, Nasdaq has been the strongest, having its right shoulder forming, touching upper Parabolic SAR from the low end, again, with low volumes. Unless both S&P 500 and Dow jump above 200 day moving average with higher volumes and stay there for three days to confirm, the downside still overwhelms the upside.

Here are the charts of the three major indices with annotation notes. (Chart Courtesy of StockCharts.com)

Disclosure: long vxx and energy, and short finance and real estate

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After so much negative news lately, I decide to give the markets a positive spin, not surprisingly, by looking backward. Some have called this rally from the low of March, 2009 as the mother of all the bear market rallies, expecting an incoming depression. Others believe that U.S. markets are set for another decade of bull run. If history repeats, we will anticipate strong rallies regardless of which side is correct. Yes, there were strong dead cat bounces in the Great Depression era. Thus, there is an urgent need to understand how markets have behaved in a broader picture.

Look at the past 20 years of S&P 500. It has been consistent that a big correction follows the first leg of recovery, normally around a year from the trough. It has been in that way for the past recovery as well as this one, as the following chart reveals. Currently, $SPX has broken the 50% Fibonacci line, trending towards 61.8% line from the November 2007 peak. It might be normal as markets dropped deeper in March 2009, bounced higher in this April as the first leg of recovery, and corrected steeper since then. (Chart courtesy of StockCharts.com).

Now, let’s look at the comparison charts of major U.S. indices. The next two charts illustrate that Russell 2000 leads the recovery, followed by Nasdaq, NYSE, S&P 500, Dow and Amex.




A Morningstar research, analyzing stock markets back to 1931, draws the conclusion that small and mid caps lead the stock markets out of the recessions. It was the case for the recovery out of 2001-2003. It is still the case in this recovery. Though, at the beginning, some people did fret that this time is different (see the article from Forbes).

Could we do better than the 100% return given by Russell 2000? Yes, a lot of people would mention leveraged ETFs. The following charts compare the performance among triple long ETFs.


Small and mid caps Bull 3X ETFs provide more than 550% return. Further, when the economy is derailed, the single dominant factor of the economy is government policy, or government stimulus policy. Finance happens to be the industry benefiting the most with 750% return. On top of that, industrial leaders benefit even more. A return of 650% by investing in Ford is a good proof.

Even as markets are going up, stocks would fluctuate and could fall because of various reasons. Let’s make some easy money by following major indices and leveraged ETFs when the trend is obvious!

Disclosure: long vxx and energy, short finance and real estate

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1. In the past 20 years, Nasdaq advance-decline spread doesn’t reach the level of -2000 during normal market corrections. Every time it touches that level in a short period, a sharp market drop follows. That was the case in Sept. 2008 when Lehman went belly up.
   
2. There hasn’t been a positive divergence between full stochastic oscillator and $SPX as the February correction did. The upward angle of full stochastic oscillator is even lower than the the hike happened around May 10 while $SPX has been below its 200 day moving average for 7 days in a row, which shows remarkable weakness.




3. RSI has dropped to 49.54 on the monthly chart of $SPX, which was not the case in the previous two economic recoveries happened in 1992 and 2004, respectively. It is an alarming signal. From the pattern of the candlestick chart, we were at November 2007 again and we might head into June for a cross candle as happened in December 2007.
4. The markets normally go down at the 3rd year of a president’s first term if the economy is ramping up since the first year. Besides, years ended with 0 have the worst track record in the history for the stock markets. The following chart shows that the new high new low spread of U.S. stock markets reached -3045 in 1994 in the 3rd year of Clinton’s first term, and touched the level of -2984 in 2004 as the first correction out of the dot-com debris. Now, the value reads as -351 for more corrections.
5. Greece, Spain and Portugal are sinking as Mohammed El-Erian mentioned to Barron’s that PIMCO has no holdings of bonds from these three countries. The situation is so dire that Jamie Dimon of JPMorgan has warned: “If they (European countries) don’t fix the problem now, they’re … Going to fix it later by bailing out their banks. A lot of that sovereign debt is owned by banks.”
6. Germany, the biggest and the healthiest economy in Europe, is encountering troubles on its treasury bond sales. As the Financial Times reported that its latest 5-year auction only attracted bids from investors of 6.1 billion euros when officials said they had wanted to raise 7 billion. The contagion of Greece has affected Germany. It is not good news as the situation continues.
7. The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index, a measure of future U.S. economic growth, fell to 125.6 in the week ended May 21, down from a revised 127.2 the previous week, originally reported as 127.3. That is a 39-week low. As PIMCO’s CEO Mohamed El-Erian put it: “We will remain vulnerable.”
8. A sign of China real estate bubble bursts has appeared in bond market as yields of dollar bonds sold by China real estate companies widened by an average 2.26% points relative to Treasuries as of last week. That’s more than 2.05% -point increase in spreads for bonds sold by other companies in Asia outside Japan
9. Based on the data from ICI, there has been a outflow of $16 billion dollar from domestic mutual funds at the end of the third week of May. The last time that we saw such kind of panic withdraw happening was in March, 2009. According to Wall Street Journal, after the forgotten “flash crash” in 1962, individual investors shunned the markets for couple of years. We are just starting to see the negative impact of the “flash crash” of May 6th. Investors’ confidence have been deeply damaged.

We are facing couple of active economic volcanoes right now. We don’t know which month exactly the bad thing would happen but the time frame is pretty clear as in either 2010 or 2011. As markets going down, there are always bull traps and dead cat bounces. For these who are on the long side, it is important to start to hedge positions as Dow drops below 10,000 and stays there, which is a good advice from Zacks.com.

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• The 3-month Libor (London InterBank Offered Rate) has hiked up to 0.54%, the highest since last August. If the situation continues worsening, banks will stop lending to each other again, which could easily force couple of them to go under.
• VIX has been above 40 for 3 times in the past 20 years. One was around the Black Monday in 1987 and another was the 2008-2009 Great Recession. Last time when it jumped, it stayed high for 4 months. The chart is very similar this time as of now.
• The flash crash in May 6th is eerily strange. When Lehman Brother went bankrupt, the first day, Dow dropped about 780 points. We didn’t have any liquidity then. How could 300 points drop trigger the issue? Either market makers were playing the game or it illustrates the potential liquidity issue in the markets as the sell side is way too big so that its pace has to be slowed down systematically. The ban on the naked shorts by German government is just another footnote.
• Three major indices, Dow, S&P 500, and Nasdaq Composite, have stayed below their 200 day moving average for 4 days, except last Friday for Nasdaq Composite, which simply confirms the downward trend.
• Currently, Nasdaq Composite Bullish Percent Index stays at 51.39%, and its new-high-new-low stands at -157. Compared to the first big correction happened in 2004 since the Internet bubble burst, the numbers are 33.77%, and -264.75, respectively. Further, Nasdaq Composite Advance-Decline Issues is at -917 and the CBOE Option Equity Put/Call Ratio is 69%, leaving more room of further hammering.
• Austerity measures in the government level, compound with the ending of stimulus program world wide, simply suppress the consumer spending down the road. As the markets look 6 month ahead, it is the right time for the markets to re-valuate all the stocks.

By saying all these, Dow has formed a hammer candlestick pattern today. Let’s see what will happen tomorrow.

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Dow Jones Industrial Average Intraday Chart - 20100517

If we look at the candlestick version of the near-term chart (chart courtesy of StockCharts.com), it seems that the markets are set for a bounce tomorrow. It is hard to see whether it would be a strong one as the one appeared around February 8th since the pattern didn’t happen at the bottom of a correction this time. Still, it shows the strength of the markets as today’s low is above the blue trend line from the February 8th’s low.

Dow Jones Industrial Average - 20100517

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Here is the chart of Dow Jones Industrial Average Index from Feb, 2009 to May 7th, 2009 (chart courtesy of StockCharts.com).

As we can see, the timing has been perfect. After the bull smashed to the ground in March 9th, 2009, the market took off big time. As the bear hit by a bus driven by the bull, the market started the recent correction. When the bull was threatened by the bear claw, the market closed the recent week with a 2% gain after a 400-point jump in Monday.

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The author breaks the book into 4 parts. Part I starts with the investment fallibility of Long-Term Capital Management, Sir Isaac Newton, and Samuel Clemens (Mark Twain) to reveal the intersection of mind and mind and money. Most of the readers might know the story of LTCM while not necessarily the ones of Newton and Mark Twain. Newton experienced the crash of August 1720 in South Sea Company while Mark Twain became Mark Twain, the famous author in the American history, thanks to the silver fever in late 19^th century. Part II describe how various emotions impact judgement, including excitement, greed, overconfidence, anxiety, stress, and love of risk. Part III is a review of the cognitive (thinking and perception) biases, such as loss aversion, time discounting, herding, etc. Part IV presents techniques for managing biases. The author includes practical trading and investing cases to demonstrate points, which makes the reading interesting and fun. The author shares pragmatic insights that can help readers in the financial markets. By understanding and controlling emotions, readers can invest more wisely and successfully.

Last but not least, the author is very good to select the right quotations to make his points. Here are couple for entertainment:

• Warren Buffett: I’d be a bum on the street with a tin cup if the markets were always efficient.
• Mark Twain: What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.
• Nathan Mayer Rothschild: Buy to the sound of cannons, sell to the sound of trumpets.
• Peter Lynch: If you spend more than 14 minutes a year worrying about the market, you’ve wasted 12 minutes.
• Peter Bernstein: The fundamental law of investing is the uncertainty of the future.
• George Soros: I’m not better than the next trader, just quicker at admitting my mistakes and moving on to the next opportunity.
• Warren Buffett: We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.
• Upton Sinclair: It is difficult to get a man to understand something when his salary depends upon his not understanding it.

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The touchstone of the quants, as the book reveals, surprisingly, is the efficient-market hypothesis. The idea that the stock market is generally an efficient, randomly churning price-processing machine has pushed money making traders to gobble up juicy fleeting inefficiencies, which in turn, make the market more efficient, gravitating towards equilibrium. Leveraging their sophisticated algorithms and super computing powers, the quants have all the advantages of capturing any moments of market inefficiencies and make tons of money out of them. Substantial and lasting inefficiencies could occur as the market showed in the Internet bubble in 2000, which are regarded as black swans to quants’ money making models, causing the market collapse catastrophically. The Black Monday in October 1987 and the downfall of LTCM were merely the prefaces of the history book of the quants that was completely opened in fall 2008, following the bankruptcy of Lehman Brother.

When the model is working, the quant’s way does bring in a lot of money. Among all the stories, Peter Muller’s has caught my attention. As the founder and the head of PDT (Process-Driven Trading) of Morgan Stanley, Peter is an excellent poker player, which provides the necessary skill set for Peter to handle black swans. “For the ten years through 2006, PDT churned out an estimated $4 billion in profits, after shaving 20% off the top, which the company paid to member of PDT. … During the late 1990s and early 200s, PDT accounted for one-quarter of Morgan Stanley’s net income.” In the end of October 2008, “Muller decided to reduce a large portion of PDT’s positions, putting a hoard of its assets into cash before everyone else did” after huge losses. With the strategies successfully lined out by Muller, PDT posted “a gain of about 25 percent for the year”, giving Muller “north of $20 million”.

I bet that one day, this book will be turned into a fantastic movie for future generations to remember the Great Recession as one of the major episodes in the financial history as well as the major roles that the quants have played. With tons of insights piled up by Scott Patterson into the book, there are a lot more gems left for readers to chew on by themselves.

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Dow (April 8th Chart)

S&P 500 (April 8th)

Nasdaq (April 8th)

NYSE composite (April 8th)

It doesn’t mean that the stock market would tank. It is simple something to watch. There is one more incoming event worth watching. That’s the 30-year treasury auction happening 1PM tomorrow. Higher long-term interest rate hurts real estate market as extra 1% hike on mortgage rate lowers loan affordability by 10%. New home construction has been the source of job creation behind every economy recovery as one newly constructed home generates 1.7 jobs.

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ProShares Ultra Financials Chart (March 31, 2010)

JP Morgan Chart (March 31, 2010)

Bank of America Chart (March 31, 2010)

Wells Fargo Chart (March 31, 2010)

Citigroup Chart (March 31, 2010)

Goldman Sachs Chart (March 31, 2010)

Berkshire Hathaway Inc. Chart (March 31, 2010)

With central bank wiring down the cushion created for the credit crunch, it is hard to image how banks could achieve high profit margins as last year. As 50% real estate mortgage assets on their balance sheet, banks will earn much less down the road. Reduction of mortgage loan principals, pioneered by Bank of America recently, simply signals another run of mortgage write-downs (or bank profit contraction) near the horizon. Note that it is a downward spiral as loan principal reduction pushing potential home buyers away to the sideline and further depressing the house prices.

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Dow in March 30th, 2010

Nasdaq in March 30th, 2010

S&P 500 in March 30th, 2010

Among all the three major indexes, Dow is the strongest. Bear in mind that near the end of quarter, there are a lot of window dressing activities in the market.

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