Tag Archives: s&p 500

What a Cycle Part 2


What a Cycle! – Part 2

The first part of this cycle generated large amount of feedback. Many customers were calling with the same questions. “How do I do it?” How do I use commodity futures hedge my portfolio if I think there is further downside?” I also received the opposite question, “I don’t think this will last forever. How do I take advantage of the move back up?”

First, let’s deal with some basic mathematical issues and market barometers. The Dow peaked at 14,198 on October 11th. Currently, we are around 10,600. This is a decline of almost 3,600 points or, 25%. Now, if we were to bottom here, and I’m not saying we will, the 25% decline lost in the blue chips will need a rally of 34% to reach the same highs.

Here is a table for the other indices:

Market High Current % Decline % Rally to Reach Highs

S&P 500 1576 1140 25 38

Russell 2k 857 658 23 30

Nasdaq 100 2239 1137 49 97

NYSE Comp 10301 7319 29 41

The Point here is to illustrate that an account that is off 25% is going to need far more than a 25% rally to get back to even. Now, the month of September was particularly brutal. The S&P lost more than 13%. I went back to 1970 and I could only find nine other occurrences when the S&P lost more than 9% in one month. Unfortunately, the months following the decline don’t show a clear pattern. However, a couple of general assumptions can be made. First, the worst of the decline is usually over. The market is steady to higher in eight out of nine observations. Also, the market can rally substantially from oversold levels as we saw in 1998 and 2002.


close price

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Now, for the practical concerns of implementing an equity portfolio enhancing futures strategy we can begin with some practical portfolio composition issues. Let’s assume that one has a $100,000 portfolio and at this point is allocated to 50% stocks, 30% bonds and 20% cash. Using the S&P as a broad market proxy, the equity portion has lost 25% of its value and now has a current market value of $37,500. Sobering, isn’t it? As we discussed earlier, the S&P will have to rally 38% for the equity portion of this portfolio just get back to where it was one year ago. Does anyone want to add in the attrition of a 5% inflation rate?

Here are the tools we have to work with.

Market Contract Size Margin

S&P500 $285,000 $22,500

Mini S&P $57,000 $4,500

Russell 2K $329,000 $26,250

Mini Russ $65,800 $5,250

Dow $106,000 $7,005

Mini Dow $53,000 $3,503

Also, we have an entirely different commodity futures product called Single Stock Futures. These have been around for a couple of years and have built up pretty good volume. There are a few important things to know. First of all, SHORT TRADES are allowed. Secondly, they are 100 share contracts at 10% margin. In other words, Microsoft trading at $26 dollars a share in single stock futures would be worth the trade price multiplied times 100 shares or, $2,600. The margin, at ten percent of contract value, is only $260.

Therefore, these products can be used by smaller accounts or, to protect individual market sectors and individual issues. For example, there is a single stock banking industry contract, as well as several others. The Narrow Based Indexes can be traded just like the futures indexes because they are cash settled, which eliminates any delivery issues.

Here are the single stock futures with the highest open interest as of 9/30.

Verizon Kraft Chevron Corp. Bristol-Myers Squibb Wyeth

Juniper Networks Inc. Exelon Corp. Boeing Co. Marsh & McLennan Co.

I think this provides a good detail of the products that are available and the actual dollars involved in trading. The last step is making the transition from cautiously reading and internalizing the information to actually putting this information to use in your own accounts. I understand that no one wants to accept the current values of their portfolios. Believe me, I get it. However, for those who did nothing on the way down, hoping that it would, or will, turnaround, I strongly suggest putting these products to work in your own accounts. I will be happy to discuss an appropriate combination that makes sense for your portfolio and your objectives.

What a Cycle!

Sixteen years ago, I considered myself a rookie trader on
the floor of the Chicago Mercantile Exchange. Bright eyed and eager to learn, I
followed every market I could. I actively traded the S&P 500 but, I always
went in early for the currency and interest rate openings, as well. I actively
and, knowingly took advantage of any of the major market players willing to
have a cup of coffee with me. The economic times were significantly different
than those of today. Trading volume was ushering in a major stock market bull-
run, even as memories of the ’87 crash still lingered. The trading floors were
flush with people who made more in one day than most make in a year or some, in
a lifetime. The technology wave was just beginning to trickle in and financial
modeling was at the forefront of quantitative investment strategies.

I still come in early and I still actively trade the stock
indices. I still actively and knowingly pick the brains of the market players I
am fortunate enough to gain an audience with. Sixteen years later, I find
myself at the beginning of the cycle…..again.

I know many of you are thinking that I must be nuts.
However, if you give me a chance to explain, I think I can tease this out in
terms simple enough for myself to understand. I’ve read so much over the last
month that I feel like I’ve learned an entirely new language. Separating the
wheat from the chaff and allowing myself an opportunity to collect my thoughts,
thank goodness for rainy weekends, I’ve come to the conclusion that we’re near
equilibrium and will extend beyond the mean before finally reverting and
building a base very similarly to the process of the early 1990’s.

Economically, the circumstances couldn’t be more different.
In the 90’s, many of the excesses of the eighties had already been purged. The
savings and loan crisis had been effectively dealt with (net cost- 85 billion) and
the stock market crash provided everyone with a whole new perspective on what
risk really was. Interest rates had been coming down for more than a year,
falling from 7.25% to under 3% in less than a year. The U.S. Dollar was still
king having been defended effectively from the Pound by George Soros. This
helped check global inflation and kept commodity prices low while commodity
demand remained, primarily, domestic. Finally, on a quantitative note, the
S&P 500 was at 415 and had a price/earnings ratio of 19.6.

Trading volumes are soaring as technology has removed so
many of the barriers between the pits, the customers and finally, the world.
Money has never moved at a more rapid pace (good or bad).  This same technology brought with it a
generation of misguided applications. Historically, it will be my generation
that brought computer modeling to the financial and commodity markets. We are
the poster generation for “GIGO” garbage in – garbage out. Computer modeling
and optimization provided us with “statistically valid” risk models that would
allow us to take on more leverage and increase the bottom line. Apparently, the
one market excess able to survive the savings and loan crisis as well as the
’87 crash was greed.

History has proven time and time again that there is no
economic free lunch. The tech boom of the ‘90’s made millionaires out of John
Doe’s the same way that the crash made overnight millionaires out of pit
traders. Intelligence and ability should never be confused with being in the
right place at the right time. The separation of those with ability from those
with geographical good fortune can only be told over the course of time. The
trading pits took away the free lunch of pit traders (The Epitome of Free
Trade) just as the dot com bust erased other, unearned fortunes. Currently, it
is the financial industry being forced to endure their comeuppance. Their
computer modeled diversification of bundled risk and carefully designed
tranches sold to global institutions allowed them to over leverage low interest
rates and put people into homes and businesses that should never have been put
into existence. The models that were designed were put into action based on
their ability to compress risk while adding to the bottom line. Does anyone
remember Long Term Capital Management or Enron?

Finally, it is the long term global nature of hubris and
contrition that drives the long term cycles of the stock market. Contrition is
clearly the leading factor since October. Fortunately, just like the oil
market, we have tools to tell us when the fat part of the move may be over.
Fundamental analysis of the Commitment of Traders Report to find under and overvalued markets
fairly successfully while our humility has allowed us let the markets tell us
just what over and undervalued means in real terms. I’ve been writing for more
than six months that the stock market will revert to its mean… and then some.
Markets always overshoot. If this is a normal bear market, we can assume the
following set of parameters.

ratios decline by approximately 60%. The peak for this run was around 43.

decline is approximately 30% form peak.

length is around 14 months.

If we look at these figures, it appears as though it’s going
to be a gloomy holiday season. I believe we entered an, “official” bear market
at a 20% decline from market peaks. Depending on the index, this started in
July. The P/E ratio, even with today’s declines, remains near fair value, at 17
and change. Just as markets tend to overshoot on the upside, so too do they
overshoot on the downside. We will grind our way through and there will be
rallies and failures, just as there always are. The question investors should
be asking themselves is, “How do I best manage my way through this period
without affecting my long term goals or, giving into short term emotions?”

I believe that this is where the commodity futures trading industry, through
stock index futures like the S&P 500, Dow, Nasdaq 100 and Russell 2000
should be employed. They are offered in a wide range of sizes and can be
tailored to cover most any equity portfolio. The margins and account sizes are
exceptionally favorable, as well. Currently, an individual can still protect
$30,000 worth of tech holdings with a $5,000 account.

Individuals who don’t utilize the futures markets to limit
their losses on the way down or, to maximize their return on the way up are
simply hiding their heads in the sand and pretending that they don’t know better.
Any investor who feels they are responsible for the lifestyle of their
retirement should act in their own best interest and take advantage of these
opportunities. I thank goodness that I can see the beginning of the next
sixteen years far more clearly than I was able to see the beginning of the
first sixteen.


Multiple Confirmations

Chart traders often find themselves with conflicting commodity trading signals. On the same chart, one man’s failing rally is another man’s bull flag. While looking at multiple time frames of the same chart can yield drastically different projections. How often has a daily chart given a strong indication one way, only to have the weekly chart totally counteract it in the context of the bigger picture?

One analysis technique I like to use when individual charts are yielding conflicting signals, is correlated chart analysis. For example, while the Dollar Index may yield mixed signals, I can use the Euro, Yen, Pound and Canadian which make up 57, 14, 12, and 10% of the index, respectively, to develop a consensus of the markets traded against the Dollar.

Another example would be to use interest rate futures to determine a bottom in the stock index futures. In times of duress, money flows out of the stock market and into the safer government backed securities. This is the, “flight to quality,” so frequently discussed in print and on t.v. Currently, there is much debate as to whether the bottom is in for the stock market or, not. As a trader, I’m not concerned about the rest of the year, only finding quality trading opportunities. Recent statistical analysis is suggesting the stock market rally may continue (see, “Counter Trend Moves…What’s Next?) However, conflicting evidence manifested itself during yesterday’s stock market decline. The flight to quality generated a significant rally (higher price/lower yield) in interest rate futures. However, it’s important to keep in mind that interest rates were rallying off their lowest levels in a month. Yesterday’s action suggests a further rally in in interest futures and declining yields over the coming weeks.

So, we now have statistical analysis that suggests a two week rally in both 5yr. Notes and the S&P 500. Has using multiple market analysis created more confusion than clarity?

Fortunately, macro economic theory holds that, in a healthy normal market relationship, we will see a positive correlation between interest rates and stocks. Therefore, if the pressure is off of the stock market and we are turning the economic corner, it is very possible that we see rallies in both of these markets. It is reasonable to suggest that yesterday’s correction in the stock market was a necessary correction in a market that bounced off of its lows too far and too quickly. Furthermore, given that the interest rate quadrant did not fall through the June lows as the stock market bounced does suggest that we may be seeing a return to “normal” market behavior. Lastly, given the election season, the Federal Reserve Board is far more likely to cut rates at the next meeting than to raise them.

Counter Trend Moves…What’s Next?

This week’s commodity trading featured many strong counter trend moves. Many of the markets saw swift turnarounds in trends that have been established for weeks and months. The 64 million dollar question is; “What’s Next?”Here is what I’ve defined as established trend and counter trend moves.The following markets are share the following traits:

1) They are all near their respective 13 week highs or, lows. The market began within spitting distance of its  recent extreme.

2) Their weekly sentiment readings are > 70 or < 30, respectively. Each market has a large, one sided public following.

3) They’ve experienced a large 5 day counter trend move. All week the market has moved conter to the public’s expectations.

4) Thursday’s ranges were larger than average. The market has moved far enough to force traders into action.

These criterea do a reasonable job of establishing a market direction and bias. Now, what can we learn from this. Is the counter trend move done? Does the longer term trend hold? Are the market’s topping or, bottoming out? Based on the following statistice, we can see that not all of the markets react in the same way.

Here is what to look for in a general sampling for the coming week. We can expect, in order of predicted strength, the following markets to bounce from the week’s declines.PlatinumNatural GasCrude OilSoybeans

Sugar looks like it will continue to decline, reaching a projected low of 1111 approximately 7-8 weeks from now.

The S&P 500 shows the strongest statistical bias. According this week’s events, we can expect the S&P to continue its rally over the coming month, peaking around 1312.

The “Market Book” as a Trading Tool

RJO Vantage has a tool called the “Market Book.” The Market Book provides live access to the resting bids and offers in the electronic market. The effectiveness of the Market Book becomes more and more apparent now that 90+ percent of total commodity volume is executed via electronic trading platforms. As a former pit trader in the S&P 500, I find myself used to looking at the depth of the market’s bids and offers to establish any strength or weakness biases the market may have at a given price level. I now use the market book as much as I do the Commitment of Traders Reports.     This morning’s action in August live cattle was an excellent example of how the Market Book can increase the effectiveness of one’s trading strategies. Cattle have run up considerably for the month of June without any type of pullback. Over the last week, the market has consolidated just above the 103 level. Knowing that cattle prices tend to peak around Independence day and given the month’s run up, I felt like we could see extended selling on a penetration of the support at 103. I was watching the market as we neared the support this morning looking for the tell tale signs of a stop run to begin the decline. I expected to see standard volume on the available bids….maybe 2-6 contracts on every bid price under the lows, with an occasional 10 lot. Had I seen this, I would have been anxiously looking for a bid to hit to get my contracts sold. However, as the market declined to the support / breakout level, it was greeted with 10 – 85 contracts at each bid. This is an exceptionally large and supportive bid in the cattle market!    Therefore, rather than rushing to get my contracts sold, I decided to wait. As I waited, the market climbed and climbed.     The point is, had I placed an entry stop at the breakout level, I would have found myself stopped into a short position in a fully supported market. The beauty of the market book is that I was able to get a “read” on the market’s bias and avoid putting my accounts in harms way. If you haven’t spent any time with it, I highly recommend that you do. The market book can be a valuable tool in a trader’s arsenal.Any questions, please call.866-990-0777.Andy.