06/29/2013 When everyone agrees, they are usually wrong

Sector Model	XLU & XLB	-1.74%
Large Portfolio	Date	Return	Days
CAJ	9/25/2012	-4.45%	277
BOKF	2/4/2013	14.93%	145
ABX	4/11/2013	-34.96%	79
TPX	4/22/2013	-4.59%	68
TTM	5/6/2013	-11.98%	54
DLB	5/13/2013	-2.51%	47
GMCR	5/24/2013	3.14%	36
MATW	6/6/2013	0.32%	23
OKE	6/17/2013	-6.83%	12
TSCO	6/24/2013	6.66%	5
S&P	Annualized	8.90%
Sector Model	Annualized	22.72%
Large Portfolio	Annualized	28.41%

 

Rotation: selling GMCR; buying BTI (in the tobacco industry).

Hmm… selling coffee and buying cigarettes.  Not much guidance there for the total market.  Maybe the recent volatility has pulled us all awake and now we need a cigarette to calm down…

The sector model has XLU in first place and XLB in second place.  I’m tracking the returns of both sectors together (typical for a margin account that can trade all whipsaws).  A cash account would instead avoid the whipsaws by buying in the first position, holding through the second, and selling in the third.  XLU and XLB are both sensitive to the threat of rising interest rates.  Since most threats are overblown, the model is looking for them to recover faster than the other sectors.

In any case, last week I talked about how to do a simplified approximation of logistic curves by simply plotting long term and short term linear regression lines to see where they cross.  The point where they cross is where the market THINKS it is going.

This week I’ll introduce a second idea to simplify log-periodic behavior.

If you want to dig into the math, these two places are a good start:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1752115

http://www.journal.eco.ku.ac.th/upload/document/thai/20110903121703.pdf

Long time stock chartists will yawn and recognize this by its more mundane name: a wedge pattern.

Basically what happens is that the high points are where we run out of buyers and the low points are where we run out of sellers.  After a while people on both ends of the fear and greed game notice a pattern and everyone starts to trade the pattern instead of the underlying fundamentals.

This is just two sides of a trend.  But what happens is that folks start buying and selling closer and closer together in both price and time, until the lines reach a point of perfect logical and rational order (yes, that was sarcasm).

Those two lines cross in May 2014 just above 1900 on the S&P.  Right now the buyers and sellers are acting as if the market is worth at least 1518, but no more than 1694.  As long as “at least” is less than “no more” it kind of makes sense.  It may not be RIGHT, but at least it MAKES SENSE.

But what happens on the other side after those lines cross?  Well, in July 2014 one could say “no more than 1956 but at least 2007 on the S&P.”

Right, such a statement makes no sense at all.  It’s like Noam Chomsky’s quip “colorless green ideas sleep furiously.”  You can’t be “at least 2007” but “no more than 1956” at the same time.

And that’s why “rising wedges” normally break down with a sharp rise in volatility.  Everyone’s been lulled to sleep until someone tries to wake them up with smelling salts that have been laced with LSD.

Now, physicists are congratulating themselves by having discovered log periodic power laws.  But most of us will do well enough to realize that once the buyers have a higher price in mind than the sellers, it’s time to step aside long enough for them to make up their freaking minds.

All that said, I don’t want to dismiss the introduction of mathematicians and physicists in the marketplace.  Some of them are quite successful, and all of them are a threat both to traders and to the market itself.  A good little introduction to what they are up to is “The Physics of Wall Street” by James Owen Weatherall:

http://www.amazon.com/Physics-Wall-Street-Predicting-Unpredictable/dp/0547317271/ref=sr_1_1?s=books&ie=UTF8&qid=1372558195&sr=1-1&keywords=the+physics+of+wall+street

The most salient ideas for us are:

1) Market returns are randomly random, and

2) When they stop being randomly random, watch out!

That second part has to do with the log periodic behavior (a.k.a. rising wedge pattern) that normally precedes a crash.

You don’t HAVE to have such a pattern for a crash, and you don’t HAVE to have a crash when you see that pattern.  But they do often go together for the simple reason that the market stops making sense and people don’t know what to do when “at least” gets ahead of “no more than.”

Truth is, the market COULD go to 1000 or 2000 before the end of next week.  That’s the “randomly random” part of the first premise.

I try not to worry about it.  I’d rather try to go up a little more and down a little less than the market and sleep at night.

But if you ARE a market timer, this is definitely something to pay attention to.  There is money to be made there – and lost.

Tim