$SPY - Head & Shoulders Pattern Forming?

As indicated in the chart below, the put-call ratio is overly bearish which sets up nicely for a rally in the S&P.  In addition, several other indicators show that we might be due for a rally.

If we get a rally over the next several weeks, I'll be watching how the S&P interacts with the 1150-1170 levels of former support and resistance, as well as the 50-day moving average (currently at 1163).  Should the S&P fail to break through these levels and start to retreat, it will form the right shoulder of a head and shoulders topping pattern, which would be immensely bearish.

If it forms, this right shoulder should complete well ahead of Terry Laundry's August 26 projected top date.

$$ Huge Spike in the Put/Call Ratio

The combined equity-index put/call ratio spiked to over 4:1 at the open.  Readings over 1:1 are considered extreme fear.  Looking at long-only day trading set ups today.

$SLV Put-Call Ratio Update

Last Wednesday, I wrote about about the Put-Call ratio in SLV reaching a one-year low.  I mentioned you might want to start planning your exit strategy if you were long.  The next day, silver hit a yearly high of $19.80 an ounce on Thursday, May 13. 

This morning, silver is now trading at less than $18.80 an ounce, a fall of more than $1.00 an ounce since last Thursday:

Why does this happen?  Once you get full participation on the bull side, there's a ton of sell stop orders sitting beneath the market price.  Many of them are market orders.  Once they start to get triggered, it can become a cascade of selling action.

$$ Fed Funds Target Rate & AAII Stock Screens

Every few years, the Federal Reserve changes direction on its Fed Funds target rate.  I classify a change of direction as a 50 basis point move.  It usually happens over two 25 basis point moves, but occasionally the Fed will move 50 basis points all at once.  Here's the history over the last ~15 years:

December 19, 1995:  Target rate coming down. 
August 24, 1999:  Target rate going up. 
January 31, 2001:  Target rate coming down. 
August 10, 2004:  Target rate going up. 
September 18, 2007:  Target rate coming down. 

The American Association of Individual Investors (AAII) has tracked the performance of a variety of stock screens since 1998.  Theorizing that some companies and therefore AAII screens do better in times of cheap money, while other companies/AAII screens outperform in times of money tightening, I wondered whether the change of direction in the Fed Funds target rate could be a useful signal in choosing between the AAII stock screens over the last 13 years.  

AAII member Todd (screen name "tschoepflin") came to the rescue.  What he found was quite remarkable:  using the Piotroski 9 screen during periods when the Fed Funds target rate was coming down, and switching to the Kirkpatrick Value screen once the Fed Funds target rate started to climb produced annualized compound returns in excess of 48% from 1998-2009!  And you'd be up another 158% from January 1, 2010 through April 30 2010! 

Switching between Piotroski 9 and Kirkpatrick Value significantly outperformed sticking to one screen or the other exclusively.  From 1998-2009, Piotroski 9 returned ~28% a year (one of the top 4 performing screens), while Kirkpatrick Value returned ~19% per annum.  Further, during periods of money tightening, Piotroski 9 returned only 15.7% cumulative from September 1, 1999 - January 31, 2001, and lost money between September 1, 2004 and September 30, 2007.  During periods of money easing, Kirkpatrick Value essentially broke even between February 1, 2001 and August 31, 2004, and has lost money since October 1, 2007.

This performance was measured using AAII's methodology, which is a monthly re-balancing model with 100% re-invested in all passing companies each month.  If only one company passed the screen, you'd be 100% allocated in that one stock for the month.  If no companies passed the screen, you'd sit the month out.  No stop loss orders are used.   

To use the Fed Funds target rate change of direction as a signal, you would simply switch screens the month after a Fed Funds target rate change of direction.  Here's the yearly performance breakdown, with the S&P cited for comparison:

1998

Piotroski 9:  17.9%

S&P:   26.7%

1999

Piotroski 9/KV:  26.6%

S&P:  19.5%

2000

Kirkpatrick Value:  63.9%

S&P:  (10.1%)

2001

KV/Piotroski 9:  48.3%

S&P:  (13.0%)

2002

Piotroski 9:  (15.9%)

S&P:  (23.4%)

2003

Piotroski 9:  154.6%

S&P:  26.4%

2004

Piotroski 9/KV:  91.3%

S&P:  9.0%

2005

Kirkpatrick Value:  88.2%

S&P:  3.0%

2006

Kirkpatrick Value:  18.5%

S&P:  13.6%

2007

KV/Piotroski 9:  44.2%

S&P:  3.5%

2008

Piotroski 9:  32.6%

S&P:  (38.5%)

2009

Piotroski 9:  78.3%

S&P:  23.5%

2010 ending 4/30/10

Piotroski 9:  158.3%

S&P:  6.4%

Switching between Piotroski 9 and Kirkpatrick Value using the Fed Fund target rate change of direction as a signal beat the S&P every year except 1998, and most years it crushed the S&P by a net of at least 40%.  The S&P returned a compounded ~1% from 1998-2009.  Also, Piotroksi 9/KV only had one losing year  in thirteen (2002). 

With taxes, slippage and transaction costs, it's impossible to duplicate these results in the real world.  Especially in some of the thinly traded stocks that pass through these screens.  But thanks to Todd for giving us something the chew on if the Fed ever decides to raise the target rate again.

$$ IOUs? We don't need no stinking IOUs!

Unlike California, Illinois is not issuing IOUs.  They're simply refusing to pay their bills:

Right now, $4.4 billion worth of bills, some dating back to October, are sitting in the Illinois comptroller's office waiting to be paid someday. . . . Illinois is on track to end the current fiscal year with about $6 billion in unpaid bills. Budget proposals for the coming year — when the state faces a $13 billion deficit — assume the same thing will happen again.

As you might imagine, this is wreaking havoc on companies that do business with Illinois.  For more details on this sorry "state" of affairs, see IllinoisIsBroke.com. 

$$ More Put/Call Ratio

Expanding our view from individual stocks/ETFs discussed earlier, the CBOE tracks three broad-based put/call ratios throughout the day which are best applied to the action in the Dow and S&P:  

1.  The Equity PC ratio;

2.  The Index PC ratio, and 

3.  The Combined PC ratio.  

The Equity PC ratio is generally much lower than the Index PC ratio, as the Equity reflects a retail investor crowd with a tendency to favor longs (more calls), while the Index PC ratio reflects the institutional investor crowd with a greater interest in hedging (more puts). 

The Combined PC ratio gives the trader the best gauge of what the overall market is thinking.  Of the three, this is the ratio I watch.

In his excellent book Mastering the Trade, John Carter writes that if the Combined PC ratio falls below 0.6 intraday, he will ignore all long set ups and start looking at short set ups.  He explains that below 0.6 represents extreme bullishness with near full participation from the long side.  In other words, there's:

1.  Very few left to buy, and

2.  Lots of sell stops sitting beneath the current price, just waiting to be hit.

Conversely, if the Combined PC ratio rises above 1.0 intraday, Carter will ignore all short set ups and start looking at long set ups.  He explains that above 1.0 represents extreme bearishness with near full participation from the bear side.  There are many buy stops sitting above the current price, just waiting to be taken out.

On Stockcharts.com, the symbol for the Combined PC ratio is $CPC.  Via subscription, it can be tracked real-time intraday.  Let's take a look at a 30-minute chart over the last month, with the S&P charted below it by comparison:

As you can see, tracking the Combined PC ratio would have alerted you to the extreme greed at  the yearly market highs in late April, extreme fear after the May 6 correction, as well as the gyrations between greed and fear late last week.  

We'll see if ~1130 turns out to be a swing low, or if the market continues to slide some more before turning around.  One thing is certain, the odds are against you trying to build a short position here with a Combined PC ratio of 1.11.  You should have been looking at long set ups on Friday.

$$ David Rosenberg Projects Gold to Peak at $3000+/ounce

David Rosenberg was Chief Economist at Merrill Lynch before moving back home to Canada a year ago.  He now works for Gluskin-Sheff and writes a near-daily economic report called "Breakfast with Dave."  I highly recommend it.  It's the best source of macro-economic news I have seen.  You can subscribe by e-mail for free.  Click on the link above to learn how.  

Mr. Rosenberg penned the following on May 12, 2010:

"GOLD GLITTERS

In the aftermath of the Lehman collapse, gold faltered as there was a huge margin call everywhere and investors seeking liquidity sold off their winners. The secular bull market for bullion did not end at the time, no long-term trendline was violated, and gold did rise in non-U.S. dollars and far outperformed other currencies.

But what happened during this recent round of intense European-led volatility and financial market weakness was that gold rallied even in U.S. dollar terms, which is significant seeing as there were large-scale safe-haven inflows into greenbacks. So this time, gold has managed to hit new highs in all currencies, and gold rallied even with the overall commodity complex slipping noticeably over the past few weeks.

This is a sign. Of what, you may ask? That gold is no longer trading just as part of the resource sector but is now taking on the characteristics of a currency. While the U.S. dollar has gained ground since late last year, there is no doubt that an Administration that has a stated policy of doubling exports in the next five years to “support” two million jobs absolutely craves a depreciating greenback.

Meanwhile, a new socialist government in Japan wants a weaker yen. Sterling has only one way to go in an environment of heightened political uncertainty and a balance sheet that is at least as extended as Greece. And the ECB just gave notice with its agreement to buy sovereign and corporate debt that it is willing to distort the pricing of risk in the bond market for the greater good of helping profligate countries to avoid either defaulting or certainly help them finance their obligations at a subsidized cost. The Bundesbank, this is not.

So gold is no government’s liability and the shape and shift in its supply curve is the shape would seem to be a little easier to make out than fiat currency. We may end up being overly conservative on our peak gold price forecast of $3,000 an ounce."

$SLV Put-Call Ratio at One Year Low

SLV will likely make a 2-year price high today.  As of yesterday, the put-call ratio made a 1-year low.  This is evidence of extreme greed:

If you are long SLV, a reading of extreme greed is usually a good indication that you need to start planning your exit strategy. Note:  I didn't say exit right away.  Nor did I say start building a short position.

Chart courtesy of Schaeffers.

$$ One in Eight Americans on Food Stamps

Nearly 40 million Americans were enrolled in the Supplemental Nutrition Assistance Program (SNAP) in February.  That's a rise of 8 million Americans since December 2008.  SNAP anticipates another 4 million Americans joining the rolls in fiscal 2011.

Hunger is basic.  While this is a lagging indicator, I won't feel good about any economic recovery until this number starts to come down.

$$ Parabolic Trendicator

Some trends go parabolic at the end - seemingly almost straight up or down.  Nearly all parabolic trends experience range expansion throughout the trend culminating in a blow off, high volatility climax.

As a trader, you don't want to miss out on a parabolic trend.  They rarely happen more than once a year in any security.  So I devised my "Parabolic Trendicator" to make sure I'm always aware of trends that have a high probability of going parabolic. Here are the basics:

1.  On a weekly chart, multiply the Friday weekly closing value of the ADX indicator by the Bollinger Band width.  If you don't know what these indicators measure, please read the links.  I use the standard settings for each indicator.  The product of multiplying the two values is the "Parabolic Trendicator Value" (PTV) for the week.

2.  Keep a database of the last 7 months of weekly PTVs on the securities you follow.  I track about 30 ETFs across the spectrum.  It takes me less than an hour each weekend to update the database. 

3.  You get the warning signal once the weekly PTV makes a 6-month high.

The Parabolic Trendicator is not designed to be an early detection system.  Often times, a trend will be in full force for awhile before you get the signal, so don't expect to be catching trends in their early stages.  The upside is that it's usually very easy to determine what direction you need to invest (long or short) by the time you get the signal.

One reason I devised the Parabolic Trendicator is because it's not my nature to chase prices.  If there's a trend in full force already, I'm reluctant to play the part of the "greater fool" for fear of getting left holding the bag.  However, with the promise of a parabolic ending, I'm much more eager to jump into a trend mid-stream.

$$ Other Sentiment Indicators

Besides the put-call ratio, I look at a couple of other sentiment indicators.  The American Association of Individual Investors (AAII) polls its members once a week and asks whether they are bullish, bearish or neutral on the stock market for the next six months.  

Like the put-call ratio, the AAII survey is useful for identifying extreme greed at tops and fear at bottoms.  Consider that on August 21, 1987, 66% of AAII members were bullish while only 6% were bearish.   Or January 6, 2000 when 75% were bullish to 13% bearish.  Contrast March 5, 2009 when 70% were bearish and 19% were bullish.

I also subscribe to Market Vane.  They publish the "Bullish Consensus" which is compiled daily by tracking the buy and sell recommendations of leading market advisers and commodity trading advisers.  As such, the Bullish Consensus tracks "market sentiment" as opposed to public sentiment.  Market Vane covers 36 futures markets, including:

Gold

Silver

Platinum

Copper

S&P 500

Nasdaq 100

Light Crude Oil

Natural Gas

Treasury Bonds

10-Year Treasury Notes

US Dollar Index

The markets are ranked from 1% to 100% in terms of bullishness.  Like AAII and the put-call ratio, I look at extreme bullishness and bearishness on Market Vane.  For example, on April 29 the NASDAQ was rated just 3% less bullish than its two-year high Bullish Consensus.  QID (the double inverse NASDAQ ETF) closed on April 29 at $15.35.  By May 6, QID traded over $20 a share.

I also use traditional divergence analysis on the Market Vane Bullish Consensus charts.  For example, if price is trending higher but Bullish Consensus cannot make higher highs, this is an indication that a correction is due.   

$$ Various Put-Call Ratios

Schaeffer's Investment Research provides lots of free sentiment information and charts. One of my favorites is their chart showing the 21-day average of the put-call ratio.

On any given day, the put-call ratio is simply the number of put options traded that day divided by the number of call options traded that day. The ratio falls when call trading dominates put trading. The ratio rises when put trading dominates call trading. Calls are by nature bullish, and puts are bearish.

So, when the 21-day put-call ratio average spikes to a multi-month low, it's a sign of euphoria and greed. When the the 21-day put-call ratio average spikes to a multi-month high, it's a sign of fear and pessimism.

Many traders use the put-call ratio as a contrarian indicator. When price rallies up as the put-call ratio spikes down, traders often look to sell or short the security. When price corrects down as the put-call ratio spikes up, traders often look to build a long position or cover their shorts.

Let's take a look at a couple of examples. The charts are courtesy of Schaeffer's. Here is SPY:

So we can see that the 21-day put-call ratio showed greed in early January as price rose to $114, fear in early February as price fell to $106, greed in mid-March to mid-April as price was rising to $120. Currently, we are at a 6-month high in the put-call ratio showing extreme fear during this latest price correction.

Here's the GLD chart:

Again, greed prevailed in early December as price spiked to $118. Note the fear spike in the put call ratio in early February and again in late March as price corrected to $104 and $106 respectively. These were excellent entry points to get long.

Currently, we are approaching early December greed levels in the put-call ratio as price rallies to near it's early December high. While this type of analysis is not infallible, it's probably not the best time to start building a position in gold. Better to wait for a price correction that results in a up spike in the put-call ratio.

$GLD Consolidates while the Dollar Strengthens

We've seen this before. Gold made a new multi-year high in early December 2004. From there, the dollar rallied for 11 months while gold consolidated. When the dollar topped in November 2005 and started down, gold blasted off from $460 to $730 by May of 2006. Click on the chart:

This time, gold made an all-time high in early December 2009. Since then, the dollar has rallied from 74 to 85 while gold has consolidated between $1226 and $1045. See:

At some point, the dollar rally will likely top out. If gold is still in a consolidation pattern, I would expect that a falling dollar would be the catalyst for a run at $1650 - $2000 an ounce.

$XVG and the Four Percent Model

In Martin Zweig's book Winning on Wall Street, he wrote about his friend Ned Davis' Four Percent Model. Davis used the Value Line Composite Index (symbol $XVG on Stockcharts). His model was simple:

1. Buy if the $XVG weekly close rallies 4%+ off the most recent weekly swing low close.

2. Sell if the $XVG weekly close corrects 4%+ from the most recent weekly swing high close.

Note: you can also use the sell signals to short, and the next buy signal to cover.

This model is designed to force you to stay with the market trend. When the market is choppy and not trending, it's prone to whipsaw.

Using this model, we got a buy signal on the February 19 weekly close at 312.80. The most recent $XVG swing high weekly close was 361.46 on Friday, April 23. We'll get a sell signal on a $XVG weekly close under 347.00. Today, $XVG closed at 340.37. We may get the sell signal Friday afternoon.

Zweig published historical results of the model from 1966 to 1995 assuming 100% invested at all times, switching from long to short. Short trades produced winners at 46% with payoff odds of 2.7:1 (9.5% winners to 3.5% losers). Long trades won 49% of the time with payoff odds of 3.6:1 (14.1% winners to 3.9% losers).

Looking at Zweig's charts, if we had just taken the short signals during the stock bear market from 1966 to 1982:

21 winners
17 losers
55%

9% avg. win
3.9% avg. loss
2.3:1 payoff odds

If we had just taken the long signals during the stock bull market from 1982 to 1995:

12 winners
12 losers
50%

15.5% avg. win
3.3% avg. loss
4.7:1 payoff odds

So, optimizing the strategy depending on the nature of the secular market produced a significantly better won-loss percentage on short trades at a cost of reduced payoff odds. Long trades saw the same win percentage, but much higher payoff odds when confined to bull markets.

The problem is you can't buy the Value Line Composite Index. Fortunately, SPY is very closely correlated with $XVG.

$$ Europe's Web of Debt

A house of cards. No wonder gold's been making new highs in the Euro. Click on the pic (from the New York Times):

$$ Fibonacci in the S&P

The S&P made an all-time high on October 11, 2007 at 1577. The October 2007 high close was 1565. On March 6, 2009, the S&P bottomed at 667 with a low close of 677 on March 9, 2009.

A 61.8% retracement of 1577 to 667 is 1229. 61.8% of 1565 to 677 is 1226.

We recently reached a high of 1220 in the S&P on April 26, 2010, and a high close of 1217 on April 23, both of which are spitting distance from completing the 61.8% retracement.

For several months, Terry Laundry has forecast a May 20, 2010 interim top in the stock market, followed by a decline into June, and a subsequent final rally to August 26 to conclude the upswing that began in March of 2009.

Today, the S&P closed down at 1174. With May 20th only 12 trading days away, it's looking like if Terry's May 20 forecast is accurate at all, the best we can probably hope for is double top (compared to the late April peak) or a token new high at the Fibonacci 1225-1230 level.

$$ First Trading Day of the Month Update

The Dow closed up 143.22 points today in May's first trading day, continuing a trend that started 13 years ago.

The Dow closed at 7622.42 on September 2, 1997. Since then, the Dow has gained a total of 3529.41 points. The first day of trading of the last 153 months have seen cumulative gains of 5173.23 points. Meaning all the other days of the month have combined to lose 1643.82 points.

First trading days of the month have averaged gains of 33.8 points per day over that span. 99 of 153 first trading days were winners (64.7%). The average winning first trading day returned 105.3 points. The average losing first trading day lost 97.2 points.

The first trading day of May is by far the best over the period, while the first trading day of August is by far the worst.

As you might expect, first trading days in bull markets perform much better. From September 1997 to September 2000, first trading days went 30-7 for 81% winners. The average win was 106.6 points, and the average loss was 87.7 points.

From November 2002 to October 2007, first trading days went 41-19 for 68% winners. The average win was 82.9 points, and the average loss was 42.5 points.

From April 2009 to present, first trading days are 12-2 for 86% winners. The average win is 113.3 points, while the average loss is 194.34 points (likely skewed by the small sample size).

In stock bear markets since 1997, first trading days are just 16-26 for 62% LOSERS. The average loss was 131.8 points while the average win was 153.4 points. Performance was particularly bad at the tail end of bear markets.

Tip of the hat to the Stock Traders Almanac for this bit of trivia.

$$ Greece? What about Puerto Rico???

The GDP of Puerto Rico is $76B, about 21% the size of Greece's GDP ($356B). On Friday, the FDIC shut down 3 banks in Puerto Rico with deposits of $14.8B, or nearly 20% of Puerto Rico's GDP. Combined, these 3 banks were $5.3B in the red.

This feels much closer to home, doesn't it? For more information on all of Friday's bank closures (which were quite serious), see Jim Sinclair's Mineset.

$$ Terry Laundry's Commentary on My Charts

Terry Laundry of T Theory Observations discusses his confidence indicator, how it compares to the Barron's confidence indicator, and my charts showing fundamental divergence between confidence and stock prices at tops and bottoms.

$$ Broad Money Supply Growth Turns Negative

Dartmouth man John Williams runs ShadowStats.com which seeks to clear the haze of biased and manipulated government financial reporting. In a recent interview, Williams stated that annual broad based money supply growth turned negative in December 2009. He says historically this means we'll soon see a downturn in economic activity:

"Whenever the broad money supply–adjusted for inflation–has turned negative year over year, the economy has gone into recession, or if it already was in a recession, the downturn intensified. It's happened four times before now, in modern reporting. You saw it in the terrible downturn of '73 to '75, the early '80s and again in the early '90s.

In December of 2009, annual growth in real M3 turned negative. It's now at a record low in terms of decline, down more than 6% year over year. What that suggests is that in the immediate future you're going to see renewed downturn in economic activity.

In all the prior instances that I mentioned, this event led recessions, except for '73 to '75. That's when you had the oil spike and a recession that came from that. When the money supply turned down in that recession, the economy accelerated in its decline. We're going to see something along those lines, now, with about a six-month lead time.

You're going to have negative economic growth this year. The implications for that are extraordinary, because the projections on the federal budget deficit, a number of the state deficits, and the solvency and stress tests for the banking system all were structured assuming positive economic growth in the 2% to 3% range for 2010. Instead it's going to be negative.

Many states are going to be in greater difficulty than they thought. Most likely, you're going to have federal bailouts there. The banks are going to have more troubles. All this means more government support, more government spending, greater deficits and greater funding needs for the U.S. Treasury."

***************

Note the government stopped tracking M3 money supply several years ago, but Williams tracks current M3 using the government's old methodology.