Historic Volatility - A Market Review

This is going to be a long post and it is definitely one of the more important postings I have made so far.

In view of the historic volatility experienced last week, I will be adding a number of postings this weekend.

It is important that I crystallized my thinking and strategies via writing on the blog. It helps others but most important it helps me!

Technical Review

I like to start with an overall technical review of the market.

Technically, the market has decisively turned bearish.  A lot of technical damage has been done. Volatility was very high. VIX  reached the mid 40s last week and I shorted VXX for a quick trade to make use of the volatility. I will discuss this trade in a separate post.

The market did find some support last week. The price actions of last week points to a short term bottoming, consolidation in the last few days and the indices moving higher.

The DOW indices show similar patterns. However, the NASDAQ or QQQ clearly shows a bottoming process but hitting resistance. If it can break 53.6 next week, it should be short term bullish. 

I opened some covered call trades on Friday rebound for WYNN – which has high momentum. But I must be willing to add puts or get out if turn bearish if it fails in this rally.

There are a number of possible future scenarios for the current situation. Usually, the market will test the low last week again. If hold, it will probably be bullish for the rest of the year. If not, the bearish trend will accelerate. Any accelerated downturn will be most probably triggered by some major economic event like a default in Italy, downgrade for France indicating  the European contagion goes out of control.  

I will show more details of this in my trade on a separate posting for WYNN. As a matter of fact, I opened a number of bullish trades last week which I will discussed separately. Prompt execution of secondary exits become extremely critical that I set alarm on each trade on my trading platform.

NYSE Advance Decline Index

The NYSE cumulative A/D index looks like a double top. It is a little overextended short term but it could go up, hit resistance and come down or just come down straight in the next 2-3 weeks

 Fibonacci Retracement

The S&P 500 has already pierced the 38.2% retracement level, which was 1,238. The next key is 50% which implies 1,200 — almost where we are now. A complete reversal, which is 61.8%, points to very critical technical support around the 1,162 area.  This is a point where the indices will usually hold for a while.
Technically, we could see downside pressure.




The Bullish Case 

So far earnings has been strong. 75% of companies reported earning beat their estimates - many of them includes top line revenue and bottom line earnings.

Corporation are holding >$1.4 trillion of cash. Companies are cash rich.

The Conference Board issues a LEADING indicator which comprises of manufacturing weekly hours, claims for unemployment, manufacturer's new orders, supplier deliveries, new orders of nondefense capital goods, building permits, stock prices, money supply, interest rate spreads, and an index of consumer expectations.

Overall the LEI is still climbing. There are no signs of a recession.






Industrial Production if flat and it shows economy steady so far. But it can change quickly

One of the common complaints is that with QE 2, banks are not lending. They are keeping it to strength their balance sheet. But the date recently shows that lending is on the increase. Although with the recent events, banks may slow down their lending.

Consumer sentiments are still overall positive.

Jobless claims are in the positive direction.




















Bearish Case


Debt


In 2008, it was a mortgage crisis. In 2011, it looks like it will be the sovereign  debt crisis. It will be more severe than 2008.

Fundamentally the 2 years’ rally is build on straws and not bricks. It is mainly driven by big liquidity provided by the FED.

USA credit rating was downgraded last week. To finance USA debt, you need about $7 Trillion and that is 50% of GDP.

In Europe, the 90 largest banks must finance $5.4 to 7 Trillion in the next 24 months. If you include the sovereign debt, it is another $1.5-$2 Trillion. So a tip over like a downgrade of France credit rating will immediately create a domino similar to 2008 mortgage crisis.

So far, some optimism was in Europe with the creation of European Financial Security Fund ( EFSF ) which will be able to provide funding for Greece, Spain, Portugal and even Italy till 2013 although this Germany unprecedented economic power and control over Europe without going through a war. The EFSF no longer works as planned since the facility’s AAA rating is critically dependant on France and Germany obviously maintaining their pristine rankings. French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (so-called) stress test organized by the European Banking Authority need to roll a total of €5.4 trillion1 (!) of debt over the next 24 months.

Also does Italy deserve a A+ rating now?  How can France be higher credit rating than USA now? 

When the subprime crisis started, we were told by numerous authorities (including Ben Bernanke) that the problems would be "contained." But by 2006 it was clear to anyone who studied the toxic instruments that the losses would be in the hundreds of billions. I estimated $400 billion, which just goes to show that I'm an optimist. That crisis spread to banks all over Europe and then back to the US

Eerily, this is so similar to 2008 when Lehman Brothers fall. It triggers the start of the crisis. Similar, if Italy falls or France receive a downgrade, it will definitely accelerate the decline of the overall market and causes a collapse. The probability is still frighteningly high.


The whole world is printing money including China and Japan. It is a matter of time we reach the end game. When it comes, it will be sudden and shocking. It will come with a big bang! I watched an excerpt from youtube on the Movie “Rollover” made in 1981. All the seemingly exaggerated situation could very well be real if the situation is out of control. For the time being, the probability of this happening is still low in the short term.



Price action is positive ended last week. Indications are the market will move higher. But there are lingering questions in my mind:

Has the U.S. suddenly gotten it's budget balanced?

1.     The failed auction last week by the Treasury was a BAD sign. Bonds fell. It is a sign of loss of confidence despite the government and many analysts trying to run down S&P for downgrading USA. China bought more treasury recently despite their complaints. They have no choice. But other holders of treasury are selling.

2.     Are Italy and Spain suddenly solvent? Italy's debt-to-GDP is still 118%, isn't it? It's still going to take upwards of $3T euro to "bail them out".

3.     Last I checked, several big, European banks are teetering on the edge of insolvency due to their government bond and CDS exposure. Has this changed?

4.     In the U.S., Bank of America is insolvent due to a terrible book of mortgages and an even more awful book of CDS exposure. Is that even fixable?

Economic

Although 75% of companies reported earnings so far beat their estimates. Even the revenue increased. We need to remember this is a lagging indicator. . According to research cited in the FT, nearly 70% of the few (76) that have provided guidance have reduced it, and in the most cyclical names as well (Tyco, Illinois Tool Works, Netflix, Texas Instruments). David Rosenberg also cited this in his latest economic report.
Q2 earnings season had been stellar, but the lack of guidance —two-thirds of reporting companies did not provide any — points to reduced visibility.

There was a string of lower economic indicators. GDP has dropped below 2%. It is noted that every time GDP dropped below 2% - a recession followed.

In his speech on Tuesday Fed Chairman Bernanke points to a difficult times ahead thus will maintain zero interest rates till 2013. I speculate that it must be really quite bad for him to admit that and extend a zero interest environment to stimulate the economy or force investors to move funds to stock instead of treasury.

The ‘six-month outlook’ subindex sagged 20% to 31.7, undercutting the December 2007 low (the first month of the last recession). Nearly 30% of respondents reported having someone in their household who is unemployed —the highest ever and well above July’s 24% showing. This was the weakest reading on record, going back to 2001. This is grim. Fully 45% of folks with just a high-school diploma cannot find a full-time job, and that metric is disturbingly elevated at 25% for college grads.

Consumer credit soared $15.5 billion in June, three times as much as projected and the biggest monthly gain since August 2007. That this was the same month that consumer confidence slid to an eight-month low strongly suggests that credit was not being tapped for spending as much as to meet the unpaid bills. During the last 3 recessions, it began with similar high consumer credit and subsequent defaults.

OECD leading indicator fell to 102.2 in June — the lowest since November 2010 — from 102.5 and is down now for three months running and the declines were broad based across the G7 and emerging Asia.
Friday, we saw German industrial production decline 1.1% Italy showed 0.6% slide. The reserve Bank of Australia cut 2011 growth outlook to 2% from 3.5%. China industrial production was weaker than expected and Indian car sales fell 15.8%.

Yes, we receive a good employment report that results in a rally of >500 points in an oversold market. But is it really that good. To me it is like getting “D” instead of “F” for the report.

Seeing all these, are we still expecting a year end rally? It looks like it is no longer a replay of mid 2010. The global economy is slowing down much faster and problems surrounding sovereign debt are far more acute.
The next hope is QE 3. Will it really help? It has failed twice! Also, does the FED has the ammunition now politically and financially.


GOLD and SILVER


I have been a gold and silver bull for many years. There are no reasons for me to change my views until the sovereign risks and currency printing points to some possible slow down and solution.

Gold hit new high last week and corrected about 80 points. With the low COT commitments or shorts by the commercials, there is high probability that this correction will be shallow. I should be adding to my gold positions with this correction.

During the 2008 crisis, I was caught with gold dropping 30% and gold stocks dropping more than 50%. I got out of 40% and held on to the rest. My portfolio was down 30% by the October of 2008. However, I added to my positions by beginning of 2010 and many positions were closed with >100% gains at the end of 2009. By end of 2008, my portfolio broke even.

Similar scenario can happen this time. Except I hope to be more nimble to be able to get in and out. I have to admit it is a very difficult game especially with juniors where there are no options available for me to hedge. My strategies remains the same as I wrote previously in my blog for trading junior stocks.

Gold miners are extremely cheap but it could get cheaper if there is a credit crisis and liquidity squeeze. Longer term, there is no doubt in my mind, gold miners will get much higher. The question now is whether any liquidity crisis will drive all the gold miners a lot lower.

Situation is a little different this time. Gold continues to rally. In 2008, gold fell 30%. It may still fall. If it does, it will be a great time for me to add to my positions again.

If I see some acceleration in the crisis, I will probably cut my gold miners positions by 50% or more and waiting to get back again when the situation is stabilized. Where there is panic, gold miners ( especially juniors ) falls fast.

Having said this, it may not happen this time as gold has exhibited a lot of strength so far. As long as gold does not turn bearish and breaks the trending channel, I will keep the miners.

Silver is looking interesting after the recent correction. There is little doubt in my mind silver will go a lot higher – more than what many people can imagine. It can easily move to triple digit price. But it may drop from current $30 to even $30 or $25. If that happens, I will definitely load up.

I am actually looking to add on my silver position next week with some hedges. If it goes up, I will add to my positions. If it goes down, I will increase the hedge until it stabilize and double my positions.

Fundamental factors are very solid. But the volatility make it very difficult to trade. Retrospectively, if I had held on to my gold and silver, I would have made a lot more money. I had held on to my core positions of silver and gold in the last 4 years and it has made me >300%. I wish that I had not been an active traders for these positions. But this is part of my risk control.



Concluding Remarks


Obviously, I am more bearish than bullish.

Last week’s rally actually gave me some glimpse of hope. It must have follow through. It will come down  but must hold and be followed by some strong upside with reports of stability of Europe financial situations without breaking its low.

If it breaks the low, the downside will certainly be speedy and brutal.

Although data are overwhelming bearish for me, I still ride the trend last week. I bought AAPL, WYNN, TQNT, IOC and VZ – all covered calls positions. I will be converted some to collars ( like AAPL ) or just take profits if there are signs of bearish. I will add more puts to turn this positions in a neutral or bearish once there are technical and sentimental signals that points to an accelerated downtrend.

What I am trying to do is more difficult than it seems. The market is very unpredictable. So, all my strategies are based on probabilities but with an anchor on longer term fundamentals and guidance from short term technical indicators and sentiments.

Because of my bearish bias, I will certainly add on to my shorts using strategies that I wrote earlier. I will look for segments and companies with weaker fundamentals. I look for companies with high debt,
questionable accounting practices, weak fundamentals and in an accelerated downturn, even high flyers with huge P/Es like LNKD, NFLX and CRM should be shorted. For the latter, it should be done only if the downside acceleration is triggered. For now, the financials and “for profit “ education sectors look like good shorts. I should be posting some of bearish bias trades next week

There is still a probability that market can turn bullish after the severe downturn recently. Will it be a repeat of August 2010 where there were so much negative sentiments? I also remembered the Hindenburg Omen which predicted the market would fall apart. The market went on to a strong rally with the announcement of QE 2.  I made a lot of money by the end of the year.

Will it repeat like last year? My gut feel is that this time that the market will fall. I will let the market tell me what to do.