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April 24, 2006

Morning Call - Meatballs: It Just Doesnt Matter!
by Adam Oliensis

The following article was originally published at The Agile Trader on Sunday, April 23, 2006.

Dear Speculators,

The Dynamic Trading System's auto-traders took net gains of +10% and +31% last week, bringing net position gains to +456% since the Index Futures service was launched 40 weeks ago. Net Total Return for our model portfolio now stands at +150% since its launch.. Over this period the System has performed in line with our expectations in terms of W/L ratio (74% winners) and better than expected risk-adjusted terms (monthly Sharpe Ratio up around 3.0, above the System's result of 2.4 in historical back-testing).

(The Sharpe Ratio is a measure of the risk-adjusted return of an investment, derived by Prof. William Sharpe, one of three Nobel Prize winners in Economics in 1990 for their contributions to Modern Portfolio Theory. Prof. Sharpe's web site at http://www-sharpe.stanford.edu/ has several papers on this topic. A Sharpe Ratio of 2.0 or higher is considered to be very good. A Sharpe Ratio of 3.0 is considered outstanding.)

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Now, on to the titular subject. If you remember the 1979 movie "Meatballs," starring Bill Murray, you'll now doubt also remember the twinkle-eyed nihilistic war cry with which Murray's character (a camp counselor) motivates his campers:

Even if we play so far above our heads that our noses bleed for a week to 10 days; even if God in Heaven above points his hand at our side of the field; even if every man, woman and child joined hands together and prayed for us to win, it just wouldn't MATTER because all the really good-looking girls would still go out with the guys from Mohawk because they've got all the money! It just doesn't MATTER if we win or if we lose. It just doesn't MATTER!

And all the campers join in on that last phrase in a resounding, repetitive chant: IT JUST DOESN'T MATTER! IT JUST DOESN'T MATTER!...

Well, 27 years after "Meatballs," the stock market has apparently taken up the chant...once again.

It just doesn't matter that Gold has risen in price by about 50% since last summer. The S&P 500 (SPX) continues heedlessly grinding away, chewing up percentage points in a shallow, low-volatility uptrend. It just doesn't matter that Gold is up about $70 since the last FOMC meeting. It just doesn't matter!

It just doesn't matter that the 10-Yr Treasury Yield (TNX) is up from sub-4% levels to 5%+ and rising on a bullet, probably on a fair amount of foreign selling. The SPX is immune to the effects of rising interest rates (and a bear steepening of the yield curve --higher long-term rates). It just doesn't matter!

It just doesn't matter that Crude Oil has burst through resistance to an all-time high with a breakout target of $82.

Note the astonishingly strong correlation between the Residential Construction Sector and XOIL (set back 24 trading days) that persisted until very recently. But what has happened? The constraining effects of higher interest rates and the flattening yield curve had been containing the upside on both these charts until Geopolitical/Supply worries, a speculative frenzy, and a surge of liquidity propelled Crude higher at the end of March -- not particularly coincidentally on the very same day, March 28, that the Bernanke Fed released its inaugural Policy Statement. (Crude is up $12/barrel since the dovish conversations took place that comprised the most recent release of the FOMC Minutes.)

High oil prices? Gas at the pump chasing $4/gallon? It just doesn't matter!

Meanwhile the stock market is headed into the teeth of the weakest part of its 4-year cycle. (But, no worries, right? It just doesn't matter!)

Each of these cycles on this chart is taken to have begun at roughly the October low of every 4th year beginning in 1962. We are currently in the 11th cycle since that date (thick red line) at Trading Day # 889 in the cycle.

The only 2 cycles that sustained their strength this late in the game were 1982-86 (shortly followed by the crash of 1987) and 1994-98, even more closely followed by the crash of July-Oct '98. (But this time it's different, right? Because "history....?" It just doesn't matter!)

Could the market keep working its way higher? Sure it could. Judging by these 10 prior cycles it looks like there's about a 20% probability of the market continuing to advance between now and July. But history suggests that if that unlikely scenario obtains, then the stock market will be developing critical imbalances that will end up being violently corrected.

More likely in our view (and ultimately more supportive of a longer-term bullish case), would be a correction that takes the SPX down to something like +46% above its October 2002 low (down about -10.5% from the current price of 1311), which would put the index near its October '05 lows around 1173. That would put the SPX performance on a par with the least violent 4-year-cycle corrections over the past 45 years.

Frankly, it makes no sense to suppose that the FOMC, which has described its own policy stance as data-dependent, would not react hawkishly to the developments of the past 4 weeks in the commodity and interest-rate markets. And it would make just as little sense to suppose that the SPX should feel no effects from these price spikes.
While the Fed's tightening program has recently gotten some traction in the Housing market, with rising interest rates slowing both buying and building, just the opposite has happened in the commodities markets -- and indeed the frenzied parabolic moves on those charts resemble nothing so much as the Tech Stock charts of 1999...(How's that for unstable?) And it's not just a narrow group of commodities that are enjoying upside runs. Orange Juice futures are at their highest levels since 1992. Copper and aluminum are taking pleasure in exponential price spikes. Indeed, the CRB Index, a good measure of broad array of commodities markets, has surpassed its 100% breakout target of 345 and continues on a full-fledged orgy of buying.

Now, let's consider what will happen to this and other commodity charts if the Fed takes its foot off the brake. Do we think that these charts will roll over, or kick into a previously unimagined new "overdrive?" (I suspect the latter.)

So, the very thing that the stock market is operating under the illusion that it WANTS (an end to the rate-hike regime) is precisely the thing that would be worst for it (huge and ongoing increases in input prices).

Are the risks in the stock market high or low? To me they look increasingly high. Either the FOMC will stop raising rates or it will not: if the committee stops raising rates then commodity prices, among others, will likely continue to soar and inflation will accelerate (bad for the market). If it does not stop raising rates, then fears of too-restrictive monetary policy will likely cause a mid-term correction in the stock market (mid-term pain, long-term gain).

One way or another, the stock market will "pay." Either it will delay paying and pay more in the long run (viz. 1987 and 1998) or else it will pay sooner and pay less (viz. 1966 and 1994, as we have studied at length in the past).

With all due respect to Bill Murray, it really DOES matter. The stock market and the economy will be the healthier if stocks and commodities do NOT soar to nose-bleed heights before cleansing the markets of excess. But, whichever route the stock market "decides" to take, we'll be positioning ourselves to profit from it using the Dynamic Trading System's time-tested signals.

In our daily issue of the Morning Call we'll examine the technical charts on the leading and lagging indices this coming week, as we seek confirmations and divergences on the major market indices. If you'd like a free, no risk 1-month trial to our daily work, please join us at The Agile Trader. And if you're interested in auto-trading futures based on our Dynamic Trading System (model portfolio has netted +456% in realized position gains since July '05), click on The Agile Trader Index Futures Service to read more about our service and to subscribe.

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.

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Trading commodity futures may involve large potential rewards, but also carries large potential risks. You must be aware of the risks and be willing to accept them in order to invest in the futures markets. Dont trade with money that you cannot afford to lose. The past performance of any trading system or methodology is not necessarily indicative of future results.

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