Thursday, January 24, 2013

LCR Keeps Dropping Despite New Highs in Major Indices

The GGT Long-Cash Ratio is exactly that: a ratio between two values. Understanding how these two values are derived is the key to understanding the power of the LCR.

GGT is an optimized system -- it constantly optimizes, day over day. It SELF optimizes at the stock level -- each stock looks at its own price, volume, and price rate of change performance, and if the values are above some threshold, then it gets some form of a "long" recommendation. Conversely, if the values are below this magic threshold, then the recommendation is cash.

When we take about 3100 stocks and do this calculation, we can separate stocks into two main groups: those with a long recommendation, and those with a cash recommendation. Hence, the LCR.

I've been doing this daily since September 2008 and the LCR is a powerful indicator of what is occurring in the database. It does not predict, it does not forecast, it only tells us what is happening up to the data it has been given. BUT, when combined with momentum, projections can be made that have a high degree of correlation to the SLOPES of different moving averages, as well as SLOPES OF THE SLOPES on the LCR.

For those of you who paid attention in Physics 101, you'll recall that slope is rate of change, or velocity. It's a measure of how fast something is going, and in the case of the LCR, the slopes of different moving averages tells me how fast in stocks per day are becoming long (positive values of LCR), or alternatively, how many are moving to cash (negative values of LCR).

If you really paid attention in your college days you'll also remember that the slope of the slope was the rate of change of velocity, or acceleration. For my purposes, a positive acceleration with respect to LCR means that we're starting to become more optimistic, and conversely, a negative acceleration means more pessimistic.

Take a look at the following figure:

Right click on the figure to open in a new tab or window.

On the far left, next to the date, is the raw LCR value. We closed Thursday down another -4% at 3.638. This means that for every 36 stocks that are long-rated, 10 are in cash (or 363/100 or ...). We peaked on January 10th at 4.212, and we've been slowly unwinding our way down to the 3.6 level ever since. 

Note that we took a few pauses and jumped back up to 3.9 and change a couple of times. Good, solid, healthy bull market.

What is concerning to me is that we are dropping in the LCR values but we are making new highs on the S&P500 and Russell 2000. GGT index also, but you're not as familiar with that as I am. This is a divergence, and it's not necessarily sustainable. Think about it. In order for individual indexes to go up the constituent stocks must be going up, but if an increasing number of those stocks are underperforming (dropping LCR), then the stocks that are performing well must have to disproportionately increase to keep pushing the indexes higher. 

The conclusion here is that if the same number of stocks were present on 1/10 (the LCR high) that are being calculated now on 1/24 (market highs), and the indexes are higher but more of these stocks are underperforming (lower LCR than on 1/10), then fewer and fewer stocks must be pushing the indexes higher and higher. This is a problem and is not sustainable.

Take a look at the slope fields. We have bearishness creeping in to the 2d, 3d, 5d, and 8d. The 13d is 1% away from flipping to 0. The negative value of the 8d slope is telling you that 3% of the stocks in the database (3098 * 3% = 93 as of 1/24) are moving to cash status every day, yet we continue to make higher markets day over day.

Because slope of the slopes must change before the slopes (why? ask if you do not understand), seeing as much red on the right side of the table across all measured time frames is worrisome. Continued red on the right side tells me that the day-over-day change is more negative, e.g., we are accelerating day-over-day downward in the number of stocks transitioning to cash (underperforming). Again, not the view we want to see.

To get your head around this, look back up at the presentation around 11/19. Look at the slopes, which were JUST beginning to move positive, but look at the slopes of the slopes, which were green long in advance.  We have the converse developing now.

We're turning more and more red in the slopes of the slopes, and this is not good for our profits.

All of this being presented, we certainly can continue to grind higher. POMO injections, irrational behavior by the retail market ($DDD), all can fuel us higher. As long as the LCR continues to drop but we keep making new highs in the indexes we are getting on thinner and thinner ice.

I strongly suggest that you tighten stops, take some profits, whatever makes you feel good about the work you've done since November. Sure, you may leave a few percent on the table. It's better than giving it up in one day and hoping that the markets have overreacted and will continue upward.

My 3 cents (jumping off my soap box).