The Magic of Numbers

I was introduced to Austrian Economics through the works of Ayn Rand. From the first works that I read, I knew I had encountered a school of thought that would describe the real world. I have not been disappointed.

I tell you this to answer the question that was posed to me: on what do I base my belief that the FED’s actions, since the beginning of the sub-prime crisis, will lead  to an exacerbation of the recession in the US?

Here is a simplified explanation of my reasons. If you want to have full understanding read Rothbard’s book:

Austrian Economics teaches that recessions are caused by an increase of the money supply. As a result of such expansion there is a misallocation of investment . At some point, (especially where the money supply rises much faster than productivity) the misallocation causes crises (sub-prime, Bear Stearns, Indy Mac etc) or results in an inflation rate that forces the excess funds to be mopped up (e.g. raising rates). (See America’s Great Depression by Murray Rothbard). Recessions follow if the market is allowed to correct the malinvestment; depressions follow Government intervention.

The charts below are from ShadowStats. The site does a superlative job in providing a true picture of the US Economy.

Figure 1 shows an exponential rise in M3 since mid-2006. There is a lag between the time the money supply expands or declines of 9 to 12 months. However since the end of 2007, we have seen an ever rising CPI. This is true even on the ‘official’ figures. Officially, since end 2007, the CPI has risen from 2% to 5.5 % – an increase of 175% in less than 12-months. And given the rise in M3, there is more to come in terms of CPI increase.

Figure 2 shows the CPI increase.

What this means is after the elections when the excessive fiddling with the CPI numbers ceases (if historical patterns hold true), we’ll see a sharper rise in the CPI numbers. Bernanke will have to raise rates or be faced with hyperinflation.

But as Figure 3 (Unemployment) and Figure 4 show (GDP), the US economy is still far from robust. A rise in the interest rates will depress the economy and the recession will exacerbate. If Bernanke fails to act promptly, he’ll eventually have to raise rates anyway but the later he leaves it, the greater will be the increase needed and the greater the adverse effects on the US economy.

So folks, we can expect a deepening set of economic problems in the future. Bear Markets anyone?

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FIGURE 1 M3 (supplied by ShadowStats)

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FIGURE 2 CPI (supplied by ShadowStats)

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FIGURE 3 Unemployment (supplied by ShadowStats)

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FIGURE 4 US GDP (supplied by ShadowStats)

S&P 08-11-2008

I know I am supposed to comment on the S&P, Strait Times, All Ords and Sensex. But over the weekend, I received a number of requests to do an analysis clearly identifying Nature of Trends Material (NOT), Market Profile and Ray Wave.

I am happy to oblige. The link for the video is: http://www.tradingsuccess.com/download/811-blog/811-blog.html

There are a few points I want to make.

  1. There are no Ray Wave Counts. The RW is best used in directional markets; the Market Profile in rotational. The RW material lies in the ratios used to identify the possible resistance zone.
  2. My starting point is the theme that the massive increase in M3 will force the FED to raise rates, probably after the elections. This is a continuation of the theme that enabled me to identify the coming of the sub-prime crisis long before the crisis hit.
  3. I say in the video that the 12-m Upthrust was confirmed (by the June bar)…..This was a poor choice of words. The Upthrust will not be confirmed until we see lower lows and lower highs after acceptance below the October low at 768. What I should have said was: “The June bar increased the probability of a valid Upthrust Change In Trend pattern”.

A Review of Four Stock Indicies 07-27-2008

The numbers of visitors from Australia and India have increased dramatically in the past 2 weeks. The US and Singapore still lead but the others are catching up!

In view of this, each Monday I’ll post a chart/charts of the stock index from each of the four countries with a short commentary. The ideas behind the analysis are all contained in the Nature of Trends. Each chart contains my thoughts for the direction of the market for the next five to ten days.

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Figure 1 S&P 18-D

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Figure 2 S&P 18-D

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Figure 3 Strait Times 18-D

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Figure 4 Strait Times 18-D

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Figure 5 Australian All Ords 18-D

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Figure 6 India Sensex

30 Yr Bonds 07-22-2008

In yesterday’s blog, I laid the foundation for today’s analysis of the 30 Year Bonds. I am most comfortable with a trade when the price action for a secular (long-term) trend accords with the economic picture.

I have said this in earlier blogs, but it’s worth repeating: I subscribe to the Austrian School of Economics. Their basis is a simple but profound one: Humans Act; and because it is human action, we’re unlikely to be able to place economics in the same category as the physical sciences – i.e. we won’t be able to reduce economics to a set of formulae. It’s for this reason that I subscribe to the approach.

The assumptions I made in yesterday’s blog were:

  1. Because of massive increases in M3 since August 2007, we’ll see higher inflation numbers in 2009. I expect to see double digit inflation threaten as measured by the US CPI.
  2. Since the US economy is already weak, this turn of events can best be described as stagflation in the making.
  3. Under stagflation conditions, bond prices and stock prices can move in the same direction i.e. there is no flight to quality.

With that under our belt, let’s turn to the charts. Figure 1 shows the 12-Month (yearly trend), CSI Perpetual data.

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FIGURE 12-M 30-Year Bonds CSI Perpetual

The 30Yr bottomed in 1981; from 1981 to date, we have seen a 28-Yr bull market. But, the inability of the market to get to the top of the channel since May 2004 suggests that the turn down from January 2008 will mark the beginning of a bear phase. Note that this is an unproven statement. After all, the market could turn north and hit the top of the channel. But given the assumptions yesterday, and the position of the 13-Week (quarterly trend), I rate the move North as an unlikely event.

Figure 2 shows the 13-W position (quarterly trend).

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Figure 2 13-W US Bonds, CSI Perpetual

Figures 2 & 3 show a number of behavioural parameters:

In Figure 2, we have acceptance below the top of the Value Area, 118.90. The 80% Rule states we should see the market go to the bottom of value, 109.9 before we see re-acceptance above the top of value. If the down move is to stall, it will most likely stall at the Point of Control, 113.75. So, any shorts instituted above Value, will have exposure i.e. the worst that can happen is a scratch trade.

Figure 3 shows:

The Ray Wave Count on the 18-D (monthly trend). We see a Running Correction at Wave 2. One close above 117.52 would be a warning the move is aborting. So we can center exit strategies around this price.

There are two areas where the move may abort:

  1. The confluence of 100% of the H&S and one of the First Wave price zones, 108.34. Note that this is below the bottom of Value. Once we have acceptance below the bottom of value, Market Profile Theory suggests the market should move to the 13-W Primary Buy Zone, 105.82 to 103.36.
  2. The confluence of a First Wave Price Zone and the minimum target for Wave 3 where Wave 2 is a running correction, 104.63 to 105.06. Note that this price area is within the 13-W Primary Buy Zone.

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FIGURE 3 18-D Ray Wave Count 30-Year Bonds, CSI Perpetual
The statistical targets are not relevant at the moment. The normal 13-W impulse move runs for 26 to 52 weeks and for a move of 25.33% to 17.17%, I’d consider them after (and if) the 30-Year Bonds move to the 13-w Primary Buy Zone.

One last point. Last night’s price action shows that the majority of trades in the 30-Year still seem to be tied to the idea “S&P down, Bond Prices up”. We will need a number of high CPI to break the ‘flight to quality nexus’. So, it’s important to pick your spots to enter under these conditions.

Summarising this blog, I’d like you to notice:

  1. I explicitly set out my assumptions. This makes it easier to identify where a trade has gone right or wrong.
  2. I treat chart patterns as behavioural parameters i.e.they can fail. So, it’s important to identify the price zones and conditions under which I believe they are failing. These form my exit strategies.
  3. I identify my target areas for profitable exit. With the information, I’ll calculate my Risk: Reward. In addition, the targets play a part in my position sizing

From the questions I have been receiving, it’s clear you are using the blog as a trade advisory service. Not a great idea,folks. One of the reasons why 80% to 90% of newbies fail even though there are quite a few great services is because:

  • a ) The time frame may not suit the subscriber
  • b) The stop risk exposure (stop levels) may not suit
  • c) Most importantly in my case, I am not providing position sizing and trade management information – info that is critical to your success.

If this blog is to provide a public service, it is as a coaching tool. It’s best you treat this as that.

An Overview of Markets

First off, thanks, Ana, for helping out on Friday – I was trying to do too much too soon and paid the price.

I was going to examine the 30 Yr Bonds today – but I think a better approach is to lay the foundation for the comments.

In my trading, I look for an idea that places the secular trends in context. Markets have certain relationships that hold true but the relationships differ according to the context in which they occur. The current context is rare and I’d like to examine that next.

The current economic state has brought about bubbles in the stock and housing markets that led to the sub-prime crisis.

What would have been a reasonably short recession now has all the earmarks of a longer term down-term or hyperinflation ; hyperinflation will occur if the Fed fails to act once the results of its actions, since August 2007, filters into the inflation figures. If hyperinflation does not occur, the US, at the very least, will suffer a period of stagflation.

In the meantime, the other economic engine, China, is already suffering rampant inflation, and unless the Chinese authorities take more aggressive actions to cage and curb that tiger, it too will have to deal with hyperinflation.

If both the US and China suffer an economic downturn at the same time, then the rest of the world will catch more than a cold.

In this environment, what can we expect?

  • A strong secular uptrend in commodities – Soybeans, Gold, Wheat etc. This does not mean we won’t have corrections e.g. Crude and Soybeans are in the throes of one now. But it does mean that the commodity boom will continue until the threat of hyperinflation is negated.
  • The start of a new uptrend in interest rate yields (downtrend in price).
  • Global tensions that will add to a strong secular uptrend in Gold and Silver. Again I do not expect a straight line advance. Right now for example, I see Gold forming a sideways market between $1045 and $850.
  • A bear market in the stock indices. In the S&P, we are currently forming either a simple correction or a sideways market between 1256 to 1280 and 1200. We’ll have a better idea of the type of correction when we see a retest of the 1200 to 1210 area.
  • The bear market in the US$ to continue. We can expect a bear market rally once the CPI starts in earnest to rise; that rally will terminate once it becomes clear that hyperinflation is a real threat to the US economy.

These are rare conditions: a current stagflation with the overhanging threat of hype inflation. In addition, we can expect even greater volatility because of the actions of politicians, who failing to understand the cause of the crisis, will look for scapegoats. What better candidates than ‘greedy’ speculators? In their attempts to ‘fix’ the problem, their actions will further disrupt the markets and will cause even greater volatility in price action.

As traders we can expect:

  1. the secular trends in commodities to continue but need to be careful of political action: for example, some sort of bill to restrict the number of contracts we can hold in Crude Oil.
  2. the secular trend in gold to continue
  3. a particular strong secular trend to begin in 10-Yr Notes and 30-yr Bonds.
  4. the stock market bear to begin in earnest.

Correlations

I am flying to Singapore today so I am posting Thursday’s blog early morning Hong Kong time.

Yesterday I received two e-mails asking: “since you believe that Crude Oil is going to go down, won’t this mean the S&P will go up?”

The questions imply that there is a negative correlation between Crude and the US Stock Market i.e. if Crude goes down, the Stock Market will go up.

I ran some correlation studies; in fact the correlation between Crude Oil and the S&P is meaningful (90%) only in 2008. The farther back we go, the lower the correlation becomes. For correlations to be robust I like to see 90% over at least 15 years of data. Even in 2007, the correlation was less than robust.

Figure 1 is an example of what I mean.

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FIGURE 1 Correlation Crude Oil and S&P

We start at the 13-week (quarterly trend) S&P swing low. (Note I have not shown the Barros Swings for the sake of clarity). The Crude Oil 13-w swing low occurred earlier on January 18 2007.

Both markets went up until the S&P peak on July 16 2007. The S&P corrected down while Crude continued up until August 01 2007. The correction for the S&P ended on August 16 2007, while the correction for Crude ended on August 22. From August 22, both markets turned up until an S&P high occurred on October 11 2007.

The example is meant as an example to illustrate the correlation studies I did; it is not meant as evidence of a lack of correlation – the correlation studies do that.

The point is, be careful of “Wall Street Lore”. Sometimes the story has some merit; at other times, the story has no merit and at still other times, the current situation is an exception to the story. Speaking of exceptions, let’s turn to one.

“Bonds and stocks don’t move down together “.

The reason for this is when the stock market moves down, there is a flight to quality to Bonds that drives prices up (yields down).

Correlation studies show this is generally true. But, there is one exception: in periods of stagflation, Bond prices and the Stock Market can run in the same direction. For example, in 1972 to 1974, Bond prices went down (yields up from 5.73% to 8.70%) and the stock market also went down 38%. The critical question, therefore, is whether the US economy is set for a stagflation period.

I believe it is.

At the very best, the US economy can be said to be in slow-down mode. I say this to avoid getting embroiled in a discussion on whether or not the current state satisfies the technical definition of a recession. As Shadow Stats (http://www.shadowstats.com) points out:

“… real (inflation-adjusted) second quarter retail sales contracted for the fourth consecutive quarter, while the second-quarter industrial production showed a sharp quarterly contraction. In conjunction with consecutive quarterly contractions in payroll employments, these numbers should remove any doubt of the economy being in recession.”

Yesterday (CPI) and Tuesday (PPI), we saw the effects of the recent FED/Treasury bailouts seep into the inflation numbers. Shadow Stats tracks M3 growth and it shows a massive increase since August 2007; M3 peaked at a massive +17%. It currently stands at 16%.

Given what Bernanke said at his testimony on Tuesday and Wednesday, we can expect new liquidity moves – these will increase M3 even further. Based on this, Blind Freddy would see that the CPI will probably be reporting double-digit inflation in 2009.

I write this to lay the foundation for a possible long-term top in the 30-year Bonds. More on this tomorrow.

Soybeans July 16 2008

Before I get into today’s blog, a short detour to comment on Ana’s contribution:

The SEC has passed an emergency rule to limit short selling in certain types of institutions. Hmm, the thin edge of the wedge? Steve Briese recently placed a warning on his site that I posted on “S&P 06-30-2008“. Speculators are being blamed for the short-sighted policies of the Bernanke FED and the Bush administration. What’s frightening is this could be  the first step in this direction. The next targets could well be the evil-doers who have pushed up Crude Oil prices! It would not surprise me to see some move in that area. Be warned!

Off my soap box and onto the Soybeans. In this blog. the data  used for my charts is CSI’s Perpetual Contract. The ideas expressed here are contained in the Nature of Trends except for the references to Seasonal Patterns and COT data.

Figure 1 shows the 12-month swing (12-M; yearly trend).

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Figure 1 12-M Soybeans CSI Perpetual

Notice that the current increase of 225% is second only to that of the 1974 increase. In addition,the stats from Gann Global data confirm the view derived from Figure 1: we are at an extreme price (i.e. mean + 3 stdev) where theoretically, there is less than a 1% chance of the 12-M swing line continuing up.

Figure 2 shows the 13-week swing (13-W; quarterly trend).

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Figure 2 13-W Soybeans CSI Perpetual

Notice that we have a potential Upthrust Change in Trend pattern. We need to see a weekly close below 1486 that exhibits selling conviction to confirm the13-W Change in Trend.

The ancillary tools I use are also supportive of a short. Seasonal highs occur at this time and bottom end September. In addition the COT studies show  noticeably reduced trader interest than that shown at the March high, making a continuation of the up move unlikely. These indicators increase the probability of a short moving to at least Figure 2’s Primary Buy Zone (1086 to 1143, basis Perpetual Contract).

Figure 3 shows the bars that I entered the trade. I was happy to enter on the basis of a potential 3-d Head & Shoulders Pattern and more importantly because:

  1. A DOJI formed on Friday July 11 2008
  2. The market on July 14 formed an ‘Open-Gap’ down that was not filled on the 1st hour. (Bearish sign)
  3. The bear bar of July 14 prompted the entry on July 15 when the market accepted prices below the low of July 12.

Stops are above the July highs. My reward to risk ratio is 6:1. (Yes I did pre-empt the 13-W Change in Trend signal. I’ll do this where the short-term patterns support early entry, as in this case).

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Figure 3 18-d Soybeans CSI Perpetual

Crude Oil – Wither now?

I wanted to review Crude Oil (this blog) and Soybeans (next one), the two hot commodities.

In the case of Crude Oil, let me say I am indebted to Gann Global (http://www.gannglobal.com/gateway.php) . I have a reasonable data base but it is nothing compared to Gann Global’s. I subscribe to their services because of the raw information they provide.

If we look at a Crude Oil chart since inception, we go back to 1983. Let’s say I want to calculate a mean impulse move in the 12-Month swing (yearly trend), Figure 1 shows that a 5-year low took place in February 1999 and since that low we have had 2 measurable impulse swings – hardly an adequate sample.

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FIGURE 1 12-M Crude Oil

The reason I want to calculate the stats? The move since January 2007 looks like a blow-off wave. I want to know if it is still high risk to contemplate an entry at these levels. You will recall I had posted a blog explaining why I had exited all longs at around 137.00

Gann Global came to my rescue – they provided the information I required. The approach they took was to measure the equivalent of the 60-month swing for all commodities and came up with a sample size of 67. Based on Pete Steidlmayer’s method of calculating the stats, mean +1 standard deviation came in at ‘290% increase to 729%’; ‘mean +2 came in at 728% to 1020%’; ‘mean +3’ came in at 1021% and higher. Since the start of the 60-M swing, February 1999, the increase has been 1092%, in the mean +3 category.

Theoretically, therefore, Crude Oil has less than 1% chance of continuing its upward climb. On this alone, I would say that to enter now would be a high risk entry. In addition, since it made a high on June 6 2008 at about 139 (basis CSI’s Perpetual Contract), Crude has been struggling to move higher. Finally, we can’t get away from Crude in the news; it’s everywhere: TV, magazines, papers etc.

There is another point I’d like to mention, because this is a blow-off wave, I expect the market to break sharply once the high is hit. Figure 2 shows the type of price action I mean.

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FIGURE 2 Soybeans 12-M

This is not a recommendation to go short. There is no pattern to suggest a change in trend is imminent. Before going short, I would need to see an 18-d Lagging Change in Trend or at least a 5-d Forecasting Pattern (see Nature of Trends). However, given the maturity of the 60-month uptrend, now is not the time to rejoin the fray.

By the way, as an observation of my own trading, I tend to exit at the end of a secular trend 3 to 9 months too early. In the US stock market, I exited all positions in July 1999; the final top in the S&P did not occur till March 2000. I tend to misjudge the madness of crowds. As Lord Maynard Keynes once said: “The markets can remain irrational longer than you can remain solvent”.

So, don’t go shorting Crude Oil, at least not yet. If long, make sure your stops are in!