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March 21, 2006

Weekly Wrap-up: Earnings, Interest Rates, and the 2nd Derivative
by Adam Oliensis

The following article was originally published at The Agile Trader Website on March 19, 2006.

Dear Speculators,

Last week the Dynamic Trading System took profits of +9% on the Nasdaq 100 E-mini futures contracts and +32% on the S&P 500 E-mini contracts. Since inception on July 15, 2005 the Index Futures Portfolio has netted +378% in position/trading gains and has garnered +107% in total return (net of all subscription, commission, regulatory, and exchange fees in auto-trade accounts).*

Click here if you would like to read more about The Agile Trader Index Futures Service.

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I was asked to do an interview last week on the subject of my involvement with the stock market and my approach to trading. Since, in this space, we generally focus on a longer-term overview of the markets, I thought it might be productive to share a longer-term overview of shorter-term trading.

QUESTION: How did you first become interested in trading the markets?

ADAM OLIENSIS: When I was 9 years old I bought one share of Automatic Data Processing (ADP). We had family in the business and, though they didn't need it, I wanted to express support and solidarity. The company and the stock have been a real American success story. I held that one share until it was 32 shares...and it was at the same price point that I had bought it at; $44. So, I've always been aware of the stock market and of the power of compounding.

Then in the '80s I got a hot tip on a stock from, of all people, a singing teacher. I averaged in at about $6. The stock ran to $60. I remember scanning the New York Times stock quotes as I was standing in front of Grand Central Station. $60! It was a 10-bagger! I could hear my grandfather's voice in my head, screaming "Sell! Sell! Sell, Adam! Sell half!"

I called my broker from pay phone on 42nd Street and Madison Avenue. I said, "I want to sell half." He said, "Adam, I've seen stocks like this go to $90." I acquiesced to the greedy voice in the telephone and not my grandfather's voice in my head and I held the whole position. That was on October 2, 1987. On October 19 the stock dropped into the $20s. I ended up selling for 1 5/8 sometime in 1989.

It wasn't until about 4 years later that it dawned on me that it would be a good idea to invest in computers. Then about a year after that I got married and started having kids. That's when I became seriously interested in investing.

In 1995, I began educating myself on fundamentals. In 1996 I started exploring technical analysis. I read everything about TA that I could find and started playing with charting software. I began trading more actively and in 1997 I started trading options pretty seriously. By 1998 I was in it full-time and started developing a loose following of people to whom I would e-mail charts.

I really sort of backed into the whole thing and it took a number of years before it turned into a primary occupation.

QUESTION: Which do you prefer, short-term trading or longer-term trading?

I prefer short-term swing trading and day trading. I've found some technical keys that make the statistical risk/reward scenarios over a period of days (and sometimes weeks) pretty advantageous and clear. As with the weather, I find it's easier to forecast over shorter time frames than out a number of months or years.

QUESTION: What are the things you like best about being a trader?

AO: I love the fact that every day, every signal, unfolds as a mystery. It's a puzzle. We try to set up what we think are statistically likely scenarios, but we never know where we'll be at the end of the day until we see it unfold.

QUESTION: How do you treat losses and account drawdown?

AO: I treat losses and drawdowns in 3 ways.

Intellectually, I try to understand them within the probabilistic context of my Dynamic Trading System. They're inevitable and necessary. No trading system in the real world wins all the time. And I make every effort to keep that in perspective.

Spiritually/psychologically I try to look at each loss as a golden opportunity. It's an opportunity to utilize discipline, to stick with the strict parameters that are laid out when each trade is opened. It's an opportunity to make certain that I haven't become complacent, arrogant, or numbed to what "risk" really means. And it's an opportunity to humble myself as well as to make sure that I react correctly (with discipline and without hubris) when I am "wrong."

Emotionally I react to each loss as though it's a complete and utter catastrophe. As a professional trader I'm not supposed to admit that, but I hate losing. I hate hate hate it. I'm bad at it. I'm a bad sport about it. Not much anymore but I used to stand up from my chair and scream at the market. I screamed at my monitors the same way I screamed at the TV when I was 11 years old for the Green Bay Packers' defense to strip the ball from the Vikings' running back when the Pack was down 23 points in the 4th quarter. And that character flaw, that relentless competitive stubbornness, my natural inability to take a small judicious loss, is precisely why I forced myself to develop a trading system that would keep my "head" probabilistic about both wins and losses.

After years of practice, now I'd say I react with about 65% of the equanimity I would hope to achieve if I were really an evolved person.

QUESTION: What are some of the key rules that you feel are most important for a trader to keep in mind when evaluating any potential trading opportunity?

AO: First and foremost, define the maximum risk that you are willing to take, set your loss-cut, and stick to it. "Survival" is the most important thing in trading. And here's the most important understanding to have before trading, I think:

TRADING-CAPITAL IS SCARCE. OPPORTUNITIES TO TRADE ARE PLENTIFUL. BE STINGY WITH WHAT'S SCARCE AND BE PROFLIGATE WITH WHAT'S PLENTIFUL. IT'S BETTER TO MISS ONE OF THOSE PLENTIFUL OPPORTUNITIES (THERE WILL BE MORE TOMORROW) THAN TO LOSE SCARCE TRADING CAPITAL (THERE MAY NOT BE MORE TOMORROW).

It's fine to be stopped out of a position and take a small loss. It's frustrating, it may make you want to pull out your hair or stand up and scream but it's fine. The most important thing is to avoid big losses and to live to fight another day.

As a corollary to that rule:

ZERO AND INFINITY (WINNING AND LOSING) ARE NOT SYMMETRICAL. ZERO IS A LIMIT THAT IS OFTEN REACHED. INFINITY IS UNATTAINABLE.

If your account goes to zero, you're out of the game.

Look, if I lose 50% I have to make 100% to get back to breakeven. And if I gain 50% and then lose 50%, I'm at 75% of where I started, not at breakeven. Losing is much easier than winning. And money management along with risk control are the cardinal rules of trading--more important than chart reading, more important than understanding the economy, more important than deriving valuation models or growth projections, and more important than optimizing gains.

And finally: find a trading methodology that gives you a good idea of your statistical probabilities in trading, then use the method, stick to it, and keep a probabilistic perspective about it. If you don't, your ego will get involved, your temperament will get the better of you, and there's a real good chance you'll end up putting not just your net worth but your self-worth in jeopardy.

QUESTION: What are your favorite markets that you like to trade and do you ever use options?

AO: At this point my favorite markets are in S&P 500 and NASDAQ 100 instruments. I trade in the SPY and QQQQ Exchange Traded Funds, the leveraged Rydex funds in these markets, in the E-Mini Futures markets for these indices, and in the SPY and QQQQ options markets.

QUESTION: What is your most memorable trade?

AO: My most memorable trade was one of the single stupidest things I've ever done. It was late 1999. I was very, very long Qualcomm (QCOM) stock. And I had much less experience than profit with the tech bubble at maximum expansion and on the verge of popping (which, of course I didn't know). I had taken all sorts of profits from trading in the options markets, piled them into Qualcomm stock and Leaps, and the stock was rocketing up skyward on the strength of some freakish liquidity factors that were probably resultant from the Fed's fear of the putatively impending Y2K crisis (remember that one?).

If I remember correctly, Qualcomm was in the mid-400s, and I sold short calls something like a hundred points out of the money against my long position in the stock. I figured, hell, if the stock goes up a hundred points I'll be overjoyed to be called out.

Well, the stock went up 100 points and then some. And I ended up buying back to cover the short calls at a huge loss on the calls, which effectively raised my cost basis on the stock...all this just as the NASDAQ and tech stocks were priming themselves to enter the worst cyclical bear market in 70 years.

I had become so intoxicated by the upside that I had was insensitive to risk and stupidly violated my own trading plan. It's the single worst trade I ever made both in terms of the size of the losses I ultimately incurred and in terms of the whimsical impulsiveness I exhibited in violating my plan.

QUESTION: With all the different technical analysis tools out there how does a new technician avoid information overload or "analysis paralysis?"

AO: Test your indicators. Don't trust what other people say about MACD or Stochastics or moving averages or RSI or directional move indicators. Look at your charts. Observe them carefully and make note of your impressions. Then find a charting program that allows you to TEST your impressions, observations, and indicators. See if what you think you see is in FACT profitable. See if your indicators do what you think they'll do and what they're "supposed" to do. And in your tests determine where your stops should be. Otherwise you'll be guessing, you'll lose confidence in real time, you'll impulsively violate your plan...and your losses will effectively become very expensive tuition.

QUESTION: What kind of technical analysis and fundamental analysis tools do you employ?

AO: After years of "wandering in the Sinai," I have cut way back on the indicators I use. I LOOK at a lot of indicators but I USE my Dynamic Trading Oscillators explicitly. I look at Bollinger Bands and MACD. And I look at the VIX, the VXN, the Put/Call Ratios, the New Highs, New Lows, and historical Volatility. I could go on and on. I've probably done extensive research on hundreds of indicators...but I USE the oscillators I derived myself.

Fundamentally, I look at a host of factors each week in my Weekly Wrap-Up. I look at the market's PE, earnings growth, which sectors are displaying upward revisions and which sectors are suffering downward revisions, interest rates, the yield curve, Equity Risk Premium, and finally my Risk Adjusted Fair Value calculation, which is a variation on the Fair Value calculation that the Federal Reserve employs.

QUESTION: What mistakes do most people make in the markets?

AO: The worst mistake people make is to either not have a trading plan or to have a plan and not stick to it.

QUESTION: How important is money management in your overall approach to trading?

AO: Money management is probably the first, second, and third most important thing in trading.

QUESTION: How would you characterize your approach to the markets?

AO: My Dynamic Trading System (DTS) swing trades signals, both long and short, derived from a set of proprietary algorithms applied to the DTS Oscillators. The DTS was developed via extensive testing in over the past 7 years' data (in bull, bear, and flat markets), and applied through seasonal and cyclical filters. The System has enjoyed a very profitable statistical edge in the past and we continue to tweak the System to learn from the markets in real time.

Our approach is probabilistic. The System places trades that, based on historical testing, have an optimal probability of profitability. We try not to get too involved in any one particular trade, (we want to avoid my doing a lot of screaming) but look to measure the System's results over months and years of data.

QUESTION: What do you think are the greatest misconceptions people have about trading and investing?

AO: That there could be somebody who knows everything. And that it could be "me" (oneself). In real time, we never know what the market will do next. Trading is not about being right. It's about maintaining a probabilistic approach to what is likely to be profitable. It's about being disciplined, and it's about recognizing an optimal time to acknowledge when a trade is not working...and then maintaining discipline and exiting.

QUESTION: What would you say are the most reliable chart patterns and indicators for a trader to watch out for and monitor?

AO: That's a really tough question. I think it depends on the market, the time frame, and a variety of underlying conditions. Right now I'm enamored of slight violations of support or resistance that FAIL. For instance, the SPX has just broken out to a new 4-year high. Should it FAIL to hold above 1300, one could well imagine that a lot of new longs in the market who are buying the breakouts...those longs will turn into sellers should 1300 fail. So, I guess in terms of formations right now I'm enamored of fake-out breakouts and shakeout breakdowns. I really enjoy the reversals that follow these.

In terms of indicators, the most reliable ones I know of are my Dynamic Trading Oscillators. I do not know of any other indicators that have been as rigorously and successfully tested. I'm sure there are others out there. But these are the most reliable ones I know about at this time.

As for the future, I continue to research different time frames and various markets. And we hope to have new products available for shorter-term day traders as well as for players in international markets later this year.

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EARNINGS, RATES, AND THE FED

The Consensus for Forward 52-Week Operating Earnings for the SPX (blue line) has hit a new all-time high at $86.26. Trailing 52-Wk Operating EPS and Reported EPS (yellow and pink) have also both hit new all-time highs at $78.12 and $75.92 respectively.

Top-Down estimates for CY07 have been published at Standard & Poors and the consensus estimate for the SPX is $89.15.

That represents +5.1% growth Y/Y for, which follows a consensus of +10.9% growth for CY06, actual +12.9% growth for CY05, and actual +23.7% growth for CY04.

The trends are still sloped in the right direction, but Wall Street loves the "2nd Derivative" (the rate of change of the rate of change) and deceleration looks to be name of the game over the next 21 months.

Now, look at this chart, published by Ed Yardeni of Oak Associates.

Looking at this chart was a real "aha" moment for me. The correlation between the Y/Y change in F52W EPS and the Y/Y change in the Fed Funds Rate is astonishingly high over this 22-year period. I only had the data for the series beginning in 1994, so I did my own study. Here's what we see upon inspection using a higher-powered magnification.

Over the last 11 years the correlation between these 2 series is a whopping +0.88. (1 is perfect and -1 is perfectly inverse.)

The yellow highlights represent points at which the 2 series have diverged such that the Fed might be accused of being "behind the curve."

Several things appear fairly obvious from this chart: the Fed looks at the growth of earnings (it would be bizarre to think that this correlation is purely accidental over a 22-year period); the Fed waited longer than normal to raise rates once earnings re-accelerated out of the market's 2001-2002 slump; the FF Rate is probably up ABOVE neutral by this metric; as F52W EPS growth decelerates the Fed is once again behind the curve, this time in lowering rates; if the Fed continues to raise rates by 25 beeps at each meeting the red line will stay up near 2% and the blue line will very likely continue to be driven down, at least in part by the restrictive FF Rate.

On the other hand, all the Fed has to do to get the red line to begin moving down is to stop raising rates. They don't actually have to lower rates. (The red line measures not the FF Rate but the Y/Y change in the FF Rate, so the red line will move down if the Fed simply stands pat.)

So, the funky thing here is that if the Fed continues to raise rates, the blue line will probably tank hard, forcing the Fed to lower rates more aggressively in the not-too-distant future. But if the Fed stands pat sooner than later, the red line will begin to drop, decreasing the Fed's relatively near-term imperative to chase the blue line down by lowering rates more aggressively.

The Y/Y change in F52W EPS now stands at +13.7%, down from about +20% in 2004. However with the 3-month annualized GR hovering well below +10%, the "2nd Derivative" (rate of change of the rate of change) on the Y/Y line (blue) is likely to continue to be negative. (The blue line will continue falling.) And, as we have discussed in the past, once that blue line falls below +10% with a negative 2nd Derivative (or if the blue line is below 0%) the market often enters a difficult phase for the bullish case. (Grey highlights.)

With the Consensus now at +10.9% EPS Growth in CY06 and at +5.1% for CY07, the odds are greatly increasing that we will see the Y/Y GR for F52W EPS fall below +10% in the months ahead.

For the 2nd straight week the SPX closed above our RISK ADJUSTED FAIR VALUE price. Prior to last week it had been 21 months since we had seen this.

We calculate RISK ADJUSTED FAIR VALUE (RAFV) by dividing F52W EPS ($86.26) by the sum of the 10-Yr Treasury Yield (TNX, 4.674%) and the median post-9/11 Equity Risk Premium (ERP, now +1.95%).

(ERP is the difference between the F52W Earnings yield on the SPX (6.6%) and TNX (4.67 %). (6.6%-4.67%= 1.93%, which is below the median post 9/11 ERP).

$86.26 / (0.04674+.0195) = 1302.

In order for the SPX to move higher from here the market would have to believe some combination of these things: earnings growth will reaccelerate over next 12 months, TNX will fall, and/or the post-9/11 world is once again becoming less risky.

Our view is that earnings growth will continue to decelerate, that TNX will move up toward 4.9-5%, and that (with oil still over $60) the markets continue to perceive the post-9/11 world as about as risky as it has been.

With TNX at 5% we could very well see our RAFV calculation look like this:

RAFV= $86.26 / (.05+.0195) = 1241

While the SPX has modestly broken to a new cycle high, extending this rally beyond the time frames of the analogous rallies of 1966 and 1994, we would continue to look for the market to be entering a retrenchment phase (for the reasons discussed above) between now and October.

Factors that could change our minds from ursine to bovine include:

1. Crude Oil breaking below $58/barrel, which would quell inflationary pressures on the Headline and allow the Fed to
2. decelerate the increase on the Fed Funds Rate, as discussed at length above.
3. A successful test of the 1297-1300 as support. Should that band hold...well, it's tough to be too aggressively bearish when the market continues to make and hold new cycle highs.

Of course we have numerous technical concerns about the stock market at this point, including, but not limited to relative weakness on the Nasdaq 100 and the Philly Semiconductor Index. Please join us in as we explore these issues among others in our daily work at The Agile Trader and The Agile Trader Index Futures Service.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

IMPORTANT DISCLOSURES

ALL PERFORMANCE RESULTS ARE HYPOTHETICAL.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKET IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

DOG DREAMS UNLIMITED INC.(DDUI), WHICH OWNS AND OPERATES THE AGILE TRADER, HAS HAD LITTLE OR NO EXPERIENCE IN TRADING ACTUAL ACCOUNTS FOR ITSELF OR FOR CUSTOMERS. BECAUSE THERE ARE NO ACTUAL TRADING RESULTS TO COMPARE TO THE HYPOTHETICAL RESULTS, CUSTOMERS SHOULD BE PARTICULARLY WARY OF PLACING UNDUE RELIANCE ON THESE HYPOTHETICAL PERFORMANCE RESULTS.

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