The Stock Surfer

Will July 4th Weekend Bring A Rally? Or Panic? Or Both?

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Time for a context check.

There will be a bear market rally at some point. The beginning of a bear market rally never feels good--usually you're so sick of the downtrend that you want to puke up your stocks at the first sign of better prices. Are we close to that point? I don't know. I should mention that I didn't sell any of my short ETFs today, although I was tempted. What stopped me? The panic didn't seem panicky enough.

The market's been going down--almost straight down--for around a month now. Sentiment is terrible, and the word "bear" is being used more than the word "bottom." These are ingredients for a counter-trend bounce. Even a smallish bounce could cause shorts to cover, which would push stocks up quickly. The sharpest rallies, they say, occur in bear markets.

Traders want a big capitulation day (extreme selling) and a huge reversal (extreme buying) to signal a turn in the bearish trend. This type of volatility is measured by the Volatility Index, a.k.a. "the VIX", a.k.a. the "fear gauge." As a rule of thumb, when the VIX is high, fear is high, and extreme VIX levels are usually good buying opportunities. In August, November, January, and March, the VIX hit 30, which is panic territory. That signaled a 2-month rally August 15-October 9 (+9.7% in the S&P 500), a choppy "sort of" rally November 12-December 10 (+4.3%), another choppy rally January 22-Feb 26 (+5.4%), and the sharp 2-month Bear Stearns rally March 14-May 19 (+10.8%). Bottom line: buying these spikes is usually profitable. Another bottom line: The S&P 500, despite those rallies, is still down -11.6% since March 15. That's a bear market.

There's a strange similarity between the last 3 trading bottoms: they all occurred around holiday weekends. November 12--Veteran's Day; January 22--Martin Luther King Day; and March 15--St. Patrick's Day. Put that in the "meaningless but interesting" category. Could we see the same situation play out around the 4th of July?

Again, I don't know. In the current round of selling, the VIX got up to around 25, but it hasn't yet scaled previous panic peaks above 30, suggesting we're not yet ready to rally. But I'm trying to keep in mind that many great opportunities don't "feel right" at the time. I'm also trying to keep in mind that there will be plenty of time to participate in the rally if it shows some legs.

Sorry to ramble on here, but I'd like to reiterate that we are in a bear market, and even if we see a tradeable rally, I think it will eventually fail--remember that when everyone starts saying "blah, blah, bottom, blah, bottom." The financials still have huge problems. The housing bubble has greater implications than the tech bubble, so we should see at least a similar level of pain over at least similar a period of time. Oil is an issue, and the Fed is in a box trying to stop it. Normally the Fed would raise interest rates to fight inflation, but that also hurts lenders (which are already hurting) and cools the economy (which is already cool). Normally the Fed would cut interest rates to encourage the economy, but that also spurs inflation (which is already high in people's minds). So the Fed has few options.

We could be facing a perfect storm of economic trouble. Todd Harrison of Minyanville spoke recently of the potential for a major dislocation in the market, such as a 10% drop for the major indices in a few days. The thought of some type of crash or major panic has crossed my mind--no predictions here, just context. We could rally, we could crash, or we could simply grind along slowly. The point is, what are you and your portfolio ready for? And what if you are wrong? I ask those questions of myself frequently.

If you're wondering where I'm positioned, I'm about 50% in cash and bonds overall, including my long term retirement funds. In my more active trading portfolio, I'm around 25% cash, 20% short ETFs, and 13% Gold (GLD) and Natural Gas (UNG), which are obviously defensive / inflation plays. And I'm ready to adjust quickly.

Good luck out there.

[Positions in GLD, UNG]
Visit my personal blog for pictures and links: www.thestocksurfer.blogspot.com

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Buying Despair

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Today I wanted to sell everything and go very short. Sure, I regret not buying and holding the Ultrashort Financial ETF (SKF) at 100 (I'd have an 80% gain right now). In hindsight, this all seems quite obvious. But now is the time to look ahead.

In general, I don't recommend buying on the way down. However, sometimes there are opportunities where risk/reward should be considered. These opportunities should be played with money one can afford to lose, or at least take a small hit on.

I am not crazy enough to buy Fannie Mae (FNM) or Lehman Brothers (LEH) here. But I am crazy enough to buy some biotech on this dip. Elan (ELN) is down 4% today, and Celgene (CELG) is down 2.5%. They are in strong uptrends, and this is a dip to buy. I'm also crazy enough to look at a credit card company, like Visa (V). In times like these, people need the plastic. Visa has been finding support around 75. Finally, check out THQ (THQI)--trading up today after hitting near its 52-week low. Of course, I'm hedging these longs with the Ultrashort S&P 500 (SDS).

Look, I'm a bear over the next year, or two, or three. I think we'll see Dow 9,999. I think we'll see bank failures. I also think we'll see bear market rallies and continued volatility. At some point, sellers will be exhausted and value players will step in.

I highly recommend reading this article by Jeff Saut of Raymond James, courtesy of Minyanville. For those that won't, here's his conclusion (and he's been remarkably correct most of the year).

The call for this week: I began this week's report with a quote from the Wall Street Journal: "The nerves mean not panicking or getting swayed by fear, at the bottom, or greed, at the top." Last November, my firm wrote about the Dow Theory "sell signal" when prices were high yet participants wanted to "buy." Now we're writing about the Dow Theory downside non-confirmation; prices are low, yet participants want to let stocks "go" (sell stocks).

Meanwhile, it's session 33 in the "selling stampede"; my firm's proprietary oversold indicator is more oversold than it was at the March 2003 "low" (we were bullish there as well); the spread between Lowry's Buying Power Index (demand) and Lowry's Selling Pressure Index (supply) is the widest in the 75-year history of Lowry's (indicating that stocks are severely oversold); corporate insiders' selling is at rock-bottom lows; and I'm seeing numerous indices not confirming the Dow Jones Industrial's "downside dive."

It's not that I'm turning aggressively bullish, but I think that, unless the markets are in "crash mode," it's time to consider a corrective stock market rally. B.J. Thomas is warming up the song "Raindrops" in the wings.

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Update On Current Action, Starring Morpheus

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So, the market *might be* bouncing today. Perhaps I was a mere 2 trading days early in my call for a bear market rally. Alas, still wrong as I had to respect stop-losses.

Then again, by the end of the day it could be down 200. We just don't know. As Morpheus says, "What is real?"

That's why the wise approach (in contrast to my prediction on Friday) is to wait and have dry powder in those guns. If it's a real rally, there will be follow through in the days to come. It will last a few weeks, perhaps more, like previous bounces, and we will have ample opportunities to buy. Buying too soon will result in getting whipped around, and probably triggering very appropriate stop-losses.

It'd be tempting to jump into the Ultra Financials (UYG) today. It'd also be quite a gamble. More banks could fail tomorrow. I'm looking at other areas that have been strong all day: biotech and video games. Trading especially well today: Activision Blizzard (ATVI), Nintendo (NTDOY), Gamestop (GME), Biotech (IBB), and Gilead (GILD).

Take the blue pill. Or was it the red...?

Disclosure: Long ATVI, NTDOY, GME, IBB, GILD
Posted, with pictures, on my personal blog: www.thestocksurfer.blogspot.com

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Same News, Different Reaction

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In my trading portfolio, I'm currently taking more risk on the long side than I've taken in months. I don't think we've bottomed out and started a bull market, trust me. I think that the market will end the year lower than where it stands today. Do not listen to those who say the worst is behind us. I think eventually we could see Dow 9,999. So what gives?

Stocks are in demand right now. Since May, investors have been dumping stocks like crazy, and the selling reached a point of exhaustion. Many shorts had to cover because of the Fannie / Freddie plan and some new government regulations targeting short selling. It doesn't really matter why for now, what matters is that some calm has been restored. This is what a bear market rally looks like.

Another sign that the rally could hold for a few weeks is that we continue to have bad news and the reaction isn't that bad. American Express (AXP) and Wachovia Bank (WB) reported terrible earnings, and yet the financials are up. Even Apple (AAPL), Google (GOOG), stocks that people love to love, have disappointed the street with their earnings reports--yet, the market is taking it in stride. (The drop in oil helps, but I consider that more of a red herring compared to stabilization in the banks.)

I said on July 17:

--Since August, we've had 4 rallies, documented in a previous post. During those rallies, the S&P 500 has gone up an average of 7.5% over an average period of 45 calendar days. The shortest rally was +4.3% over 28 days, the longest was +10.8% over 65 days. Remember that, when all seems well.

So, I'm playing this move with time and price in mind. When mid-August comes around, it'll be time to start getting defensive once again. Even now, I have skepticism and tight stops.

One last point: individual stocks are still quite dangerous due to earnings season. Even a decent report can send a solid stock down 10% (as I experienced with Gilead Sciences (GILD) last week). One way to play the rally but avoid this is to focus on ETFs. My picks:

* Biotech (IBB): One of the strongest sectors right now. It's not economically sensitive, and there's merger activity to boot.
* China (FXI): I like the FXI above clear support (at 120) with the Olympics on deck.
* Ultra Mid-cap (MVV): Mid-cap has been outperforming both the Dow and S&P.

Note: Article also posted on my personal blog, which charts and pictures!
Disclosure: Long IBB, FXI, MVV, GILD

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Reader Question: Do I Have A Selling Problem?

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[Note: The following was posted on my personal blog, with charts].

Dr. Stock Surfer,

I've gradually come to see the light on Trading Rule #1: No big loser. The 8% rule (or 5%, whatever one's tolerance) has stopped me out of more positions that turned out to recover soon than those that plummeted, but I haven't had any more 20+% loses (See AXP, AIG). However, what about losses on stocks that have done well? Exhibit A: I bought JRCC early in 2007, and was thrilled to watch it go up 120% in about 4 months. However, I then watched it slide over the next few months and ended up exiting with something like a 60% gain. (We've dated many times since then, and though most dates have had happy endings, I tired of the volatility and decided to "move on" this spring.) I've since placed stops - or partial stops - on some other winners with mixed results.

This seems to be somewhat a psychological question: While I won't tolerate a 8% loss from scratch, I seem to willing to overlook a 20% drop if the stock has already appreciated 80%, when the only real difference in the two positions is that I happened to purchase stock B at a more opportune time. What's the Rx? Do you use the 8% loss rule on winners?

Signed,
Investing student with a selling problem

Dear Investor,

You pose an important question that has no easy answer. Indeed, there may be no "correct" answer. Some people make money using a buy and hold strategy, others make money day trading--in each case their rules for selling match their time horizon and tolerance for pain. I will try to lay out my own selling philosophy, which I don't always stick to but I try to.

PHILOSOPHICAL REASON FOR SELLING DISCIPLINE?

The most compelling reason I have for my own selling discipline (i.e. using rules) is that I recognize my own ignorance, skepticism, and limited resources. I am not a financial analyst and cannot determine the "fair value" of a company. Furthermore, I am skeptical of those who are financial analysts and think they can determine what a stock price should be. Exhibit A is Bill Miller of Legg Mason, who beat the market for years before holding Bear Stearns (BSC) and Countrywide Financial (CFC) all the way down. He's a smart guy, but perhaps overconfident in his analysis. Take a look at his top holdings, and shudder. Finally, I am not Warren Buffett, so I have limited resources. I'm not prepared to wait for 5 years for Starbucks (SBUX) or Whole Foods (WFMI), once market darlings, to return to glory. That money is better used elsewhere.

IMPATIENT WITH LOSERS AND PATIENT WITH WINNERS

I don't think it's a contradiction to treat winners and losers differently, because the goal is to make money. As Dennis Gartman says, "Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large."

A good rule of thumb to consider is to use a percentage stop-loss for selling losers, and a trend break for selling winners. That way, you avoid any big losers, but give your winners room to run. A related question, of course, is this: When did you buy the stock? If you bought a dip close to a trend line (say, the 50-day), it's easy to set a stop just below that level. If you bought a parabolic move, you are more likely to get stopped out even if the trend remains intact. Thus, it is wise to buy dips on strong uptrends, or near technical support, because it gives a clearer plan for the exit. Don't let a bad trade turn into a long term "investment".

I generally will sell losers with a 7-8% loss. Sometimes the stock will then turn around, and although that's frustrating, "Opportunities are made up easier than losses." (quoting Todd Harrison of Minyanville.com and his Trading Commandments). And yes, it is mostly for psychological reasons, as I've had losing positions become monkeys on my back in the past, tying up both my money and my emotions. I know myself: If I don't sell a stock with rational discipline at an 8% loss, I will puke it up in disgust at a 15% loss. Again, Dennis Gartman: "Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital."

If setting a percentage loss seems too arbitrary, you can set stops just below moving averages. Most pros use the 50-day moving average. When the 50-day is decisively broken (meaning the stock tries and fails to get back above it), you may be looking at a change in trend. Here are some examples. First, your boy James River Coal (JRCC). During the bull run, it didn't break the 50-day decisively. Now it clearly has (click for chart).

I had a similar experience with Dryships last year. Since the break, DRYS has been muddling with no clear trend (click for chart).

Of course, keep in mind that those are examples of 2 extremely volatile stocks that had meteoric rises. If you pull up charts of oil (USO) or Chipotle (CMG), you'll see the same thing. For the slower moving broad indexes (indices?), like the S&P 500, many pros use the 200-day moving average. For my long term retirement account, I'm using the 200-day as my guide. Example from the 5 year chart of the S&P (click for chart).

One final point. This is a bear market, and a very volatile one at that. It is not surprising that if you have selling discipline you will be whipped out of many new trading positions. I would not recommend dollar-cost averaging down in individual stocks during a bear market. Save that for very long term investments in index funds.

I hope that was stimulating--I'd be interested to hear any feedback, whether in agreement or dissent...

PS: I leave you with 2 more bits of wisdom, somewhat related, once again from Gartman:

To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

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What To Do Behind The Woodshed

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If you've been trading this market at all, you've probably been taken behind the woodshed once or twice. I certainly have. Today, for example, Nintendo (NTDOY) is my woodshed buddy, and we are feeling the pain of a 10% drop. At least we're in it together.

Most often this happens after an earnings report or a piece of big news, and there's nothing you can do about it. Sometimes the news isn't even that bad (NTDOY had a solid quarter). Doesn't matter. The stock gaps down and you are helpless. You've woken up on the wrong side of the shed.

WOODSHED REACTIONS

You have 3 options when reacting to the pain. You can:

1. Sell (some of your shares, or all of them)
2. Buy more
3. Sit and do nothing

Your response will depend on your personal style and your relationship with the stock. With Sohu.com (SOHU), I sold immediately because I bought the stock for a trade only. With NTDOY, I do not plan on selling because it's an investment. One is much more patient with a girlfriend than a blind date.

WOODSHED PROTECTION

Of course, you can try to be more proactive by preparing ahead of time for the bad days. If you see the earnings report on the calendar (Yahoo and Google both provide the dates), you can sell some of your position ahead of time. I did this recently with THQ (THQI) and Electronic Arts (ERTS), and I'm glad I did. You could also buy a put option on the stock for protection, but options can be complex if you're not used to them (I have no expertise whatsoever in options). In both strategies, you will lose money on something (either the stock or the hedge) no matter which way the stock moves. There's nothing you can do to avoid the anguish altogether.

WOODSHED OPPORTUNITIES

Sometimes you'll see an unlucky victim behind the woodshed, and if you are a benevolent soul--or even if you are a conflicted and reluctant hero like the Dark Knight--you can try to rescue the battered stock. This should be done with care, lest you get hurt "catching a falling knife." But with a sensible stop-loss, this can also be a great opportunity. Last year I picked up some cheap Take-Two (TTWO) after the delay of Grand Theft Auto.

Some folks I actually like to see out back are small to mid-sized biotech stocks. When one of these companies has bad news regarding a drug, they get absolutely whacked. But if you pull up 6-month charts of REGN, ISIS, ONXX, MYGN, BIIB, and ALNY, you'll see big moves down on big volume (a.k.a. capitulation) followed by nice recoveries. Here's an example--notice the drop, the volume, and the recovery in ISIS (click for chart).

Yesterday, it was Elan (ELN), a stock I was eager to buy for months, down 40%. Ouch. This was more than woodshed, this was the final scene in Braveheart. Mercy, William! Mercy!! But am I thinking of a rescue attempt? To the Batcave!

Disclosure: Long NTDOY, ISIS, ALNY
Note: Posted simultaneously on my personal blog, with charts and pictures.

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