Optimizing the DOW 30, for April 1, 2011

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Optimizing the Dow

Earlier this week I distributed some internal notes to GGT subscribers which outlined concepts on picking stocks out of major indexes with the intent of beating the index but not taking on a huge amount of risk in the process.  The following describes this process a bit more.

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Here are some terms that you will need to understand, at least in basic concept:

Risk-Free Asset:  think Government bonds, typically 3 months in duration.  The principal in guaranteed, as is the rate of return.  For all intensive purposes the variability of returns is 0.  As of this writing I'm using 0.25% as the annualized rate of return for risk-free assets.

Volatility:  many people equate risk and volatility as the same thing.  They are not, but one does approximate the other over various time frames.  Typically, they are directly proportional -- as volatility goes up, risk goes up.  As you will see, this does not mean that gains go up in direct proportion; it's possible to have incredibly high risk but overall poor return in a security, which obviously is a bad place to have your money.

Return or Excess Return:  "Return", by itself, is how much gain you have on a security in some particular time frame.  "Excess Return" is the same thing, but you subtract the return of the Risk-Free Asset described above.  In most of my plots I will plot "Return", as we are most familiar with it.

Correlation:  this is a mathematical value between -1 and +1 that describes how well two securities, or a security and an index, move with respect to each other.  If something has a correlation of +1, they move exactly the same, e.g., if the broad index S&P500 goes up 1%, the ETF SPY will also go up 1% by design, and the correlation is +1.  Conversely, if two securities are negatively correlated with a value of -1, then if the S&P500 goes up +1%, the ETF SH will drop by -1%, again by design, because they have a correlation of -1.  Stocks and bonds tend to be negatively correlated between 0 and -1, stocks (in general) are positively correlated with other stocks and their correlation is generally between 0 and +1.  When two securities have a correlation of 0 they do not move at all with respect to each other.

Capital Allocation Line:  if all your money is in a risk-free asset, then your return is the risk free asset return and the volatility is 0.  If all your money is 100% in one security, then your return is that security's return, and the volatility (risk) is the volatility of that security.  Hence, the line connecting a security's return/risk value to that of a risk free asset represents all the combinations possible for owning the security (100%), owning a portion of the security (e.g. 40% security, 60% risk-free asset), or owning 100% of the risk-free asset.  Typically, the line connects the risk-free-asset return (volatility = 0) to the return/risk of an index that you are comparing to.

Efficient Frontier:  In the Capital-Allocation-Line (CAL) description above, where we have the choice of 100% in a risk-free asset, some percentage X in the risk free asset and the balance (1-X) in a security, or 100% in the security, the CAL describes a curve called the Efficient Frontier.  In this two-security case (one risk-free with 0 variance), the Efficient Frontier is a straight line.  In the case where no risk-free asset exists, two securities combine to have variable rates of return as well as variable levels of risk.  This rates of return and the risks are related by the term correlation as described above, AND ARE NOT LINEAR (a straight line).  The more securities that are introduced that have positive and negative correlations, the more "bullet shaped" or "hyperbolic"-looking the Efficient Frontier becomes.

Portfolio:  a combination of securities, and as I use it in my work, all have variance (risk) > 0.  This means that while I'll compare to a risk-free-asset, I'll not actually invest in a risk-free asset in my portfolio until I understand how my portfolio behaves (more on this later).  The basket of 30 stocks comprising the Dow Jones Industrials is considered a portfolio.

Tangency Portfolio:  You'll see this below in a figure, but it represents where the Efficient Frontier of all securities being considered intersects the Capital Allocation Line.  The point of intersection represents the best possible combination of return and risk, given the alternative of simply investing in an index AND a risk-free asset.  At the point of intersection, which is where the line is tangent to the curve, you are 100% invested in stocks in some ratio that represents an optimum reward/risk level.  More on this below.

The diagram above was taken from the Wiki link on Modern Portfolio Theory.  Here, they use "Standard Deviation" on the x-axis, where I normally use "Volatility".  The two are related -- all things equal, standard deviation is the square root of volatility.  Many people use either term interchangeably, which is mathematically incorrect, but the concepts are equivalent.

Starting on the left of the figure above, where Standard Deviation = 0, we have the Risk Free Rate (RFR) as described above.  As we introduce a security to the equation -- just 1 -- we have a choice of some proportion of our money in the RFR and some remaining proportion in the security.  This is described by the "Best Possible Capital Allocation Line".  It is assumed that the single security being considered has a rate of return greater than the RFR -- why would we invest in the security if we could get a higher rate of return at no risk by investing 100% in the RFR?  This guarantees that the line moves from the lower left of the figure towards the upper right.

The golden dots of Individual Assets shows their performance, over some period in the past, of Standard Deviation and Expected Return.  Let's make this more concrete in the figure below.

Here, I'm using the RFR (risk free return) = 0.25%, and you see two stocks:  AA and IBM.

• The unmarked yellow diamond in the middle represents some arbitrary portfolio ratio between some percentage in AA and the remaining percentage in IBM.  In this case it was 50/50.  Note that the yellow diamond is ON THE BLUE CURVE.
• The blue curve is constructed by running through all the combinations of owning IBM and AA.  This is why you see that a 50/50 ratio between the two stocks falls on the blue curve.   It is a coincidence that AA lies on the Efficient Frontier of these two portfolios; that is not normally the case. 
• The red line is the CAL that connects the RFR and the unknown portfolio.  At the point of intersection (purple diamond) the percentage in IBM and AA is unknown, but common sense would tell you that if the yellow diamond is 50/50, and AA is to the right of the yellow diamond and IBM to the left, that the intersection of the two lines is where we have "more" in IBM and "less" in AA.

It's important to understand that above where the CAL intersects the EF curve (purple diamond), RISK IS GETTING WORSE FASTER THAN GAIN IS IMPROVING.  YOU ARE TAKING ON MORE RISK FOR A SMALLER AND SMALLER INCREASE IN GAIN.   If you hold a 50/50 ratio between AA and IBM, you are accepting more risk than you should!  If we want to be 100% invested, e.g., no cash, then the best reward/risk point is where the purple diamond is located, e.g., where the CAL and EF intersect.

The obvious question now is how to find the exact amounts of the proportion where we are 100% invested in AA and IBM but not taking on more risk for some desired gain.  I'm not going to go into the details here, but download this presentation if you are interested in more details on how to solve the two-security problem as well as the n-security problem.  This presentation forms the basis of how I'm doing what I'm doing now.

Of course, you could say, "I want 30% gain out of these two stocks", then put a constraint in the system and it would come up with the ratios to get there.  For just AA and IBM, you'd be looking at a 1-year volatility of greater than 24% ... what's YOUR ulcer index?  Alternatively, you could say "include the RFR amount so that I have THREE positions -- RFR, AA, and IBM", and it would generate those proportions.  The choice is completely up to you.

Note here too that past performance is no guarantee of future performance.  If the behavior observed is the result of the past 252 trading days, then we have a reasonable expectation that day 253 will perform within some boundary of the performance of the previous 252 days.  The same goes for 260 days, as well as 290 days.  All this means is that we have to re-evaluate periodically, and other literature that I have suggests that we should rebalance at least quarterly, and some of my own work shows that rebalancing monthly should suffice to keep us on track.

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So, with the background established, let's take a look at the DOW 30, Yahoo! symbol ^DJI.

The figure above shows the Efficient Frontier for all the stocks of the Dow 30, complete with their historical volatility and return over the past two years.  

• Again, I'm using the risk-free-return value as 0.25% per year, based on 3-month Treasury notes.
• The unmarked yellow diamond represents the portfolio performance with 100 shares held in each stock (arbitrary).
• The close proximity of the yellow diamond and the purple diamond is pure co-incidence; if I weighted the stocks by equal dollar value the yellow diamond would have moved to a different location on the blue curve.

The important concept in the picture above of the Dow 30 is that there are numerous stocks which have poor return and low volatility (not so dangerous but would underperform over the long haul, e.g., KFT and TRV), poor gain and higher volatility (dangerous, still underperform and would give you ulcers, e.g. INTC and PFE), and higher gain/higher volatility (generally desired if you are going after risk).  The key here is to understand which stocks we would want to consider if we were to "beat the Dow Jones 30 Index"...

Take a look at this next graph:

Here, I've drawn artificial lines over the optimum location where the CAL intersects the DJ30 EF boundary. These lines divide the figure into quadrants -- let's take a look at what each quadrant tells us.

1. Quadrant I.  These stocks have above average gain than our optimum point, which is what we want, but above average volatility, which is what we do NOT want.  Despite this, we expect that higher volatility (risk) means that we should have higher gain, and these stocks meet that criteria.
2. Quadrant II:  There are no stocks here, by definition, because the origin (crossing of the two axis lines) lies directly on the Efficient Frontier boundary, and there is no combination of stocks that gives us higher gain than the optimum point but lower volatility than the optimum point.  Of course, there are stocks that fall into Quadrant II -- but they are NOT part of the Dow Jones 30.  These would be GREAT stocks to find, relative to the stocks in the DJ30, because they would boost gain but lower risk.  Note that for future reference, we want stocks that have historically returned more than 20.9% over the last year and have volatility below 13.1%; this is where the "optimum" point lies.
3. Quadrant III:  These stocks have lower volatility, but poor gain.  There is no way that adding these stocks to a portfolio can increase gain -- all they can do is reduce portfolio volatility AND reduce gain at the same time.  They may be candidates for balancing reward/risk, but in general, they are to be avoided.
4. Quadrant IV:  These stocks have above average volatility and below average gain than our ideal point. Again, adding these to a portfolio cannot result in any form of increase in gain, all they can do is lower it.  Furthermore, adding these to a portfolio cannot reduce volatility, all they can do is increase it.  Hence, stocks in Quadrant IV MUST be avoided.

What you should conclude here is that stocks in Quadrant I are the only stocks we should consider once we know their relative volatility and returns, compared to a target weighting.  As we search for our basket of stocks we would love to have stocks that fall into Quadrant II, but for now, that subset is empty.

What we need now is a method to select only those stocks that perform well.  Enter the Sharpe Ratio.

The Sharpe Ratio gives us a metric to evaluate individual stocks in terms of return, risk-free return, and volatility.  The optimum CAL/EF point has a 12-month return of 20.88%, a volatility of 13.10%, so using the risk-free rate of 0.25%, we have the SR = (20.88 - 0.25) / 13.10 = 1.58 [just as a point of reference, this is an amazing SR value.  If we were to consider multi-year time frames the value would be much less, because we would be including the drawdown period of 2008/early 2009 combined with much higher volatilities and RFRs.  This shorter time frame is justified on many fronts, but namely, it is based on work conducted by RiskMetrics].

With a basket like the DJ30, and when restricting ourselves to just those stocks in Quadrant 1, we're left with 15 total stocks out of the 30.  Let's simply get a benchmark of what those stocks, when properly combined and weighted, will reveal in terms of our previous results.

The figure above shows all 15 stocks of Quadrant I, combined as a portfolio.  Note the location of the purple diamond:  25.08% return, 15.97% volatility, and a Sharpe Ratio of 1.55.  Given that the original portfolio had a return of 20.08% and a volatility of 13.1%, yielding a Sharpe Ratio of 1.57, we have achieved nearly the same reward/risk ratio (1.55 vs. 1.57) while improving the gain 5% per annum.

We can say that for data through April 1, 2011, that we if restrict our investment decisions to this basket of 15 stocks of the DJ30, we can significantly improve our returns over investing in the ETF DIA without introducing significant risk to the portfolio.

I understand that 15 stocks still is a high number of stocks; the obvious question is whether we can further increase our gains while not taking on any additional risk, or at a minimum, keep the Sharpe Ratio constant near a value of 1.55 to 1.57?

We know that uncorrelated assets, when added together, reduce volatility.  It's not unreasonable to conclude that if we start with the highest return asset (AA, to maximize gain with n = 1) and then select the most uncorrelated asset shown above (HPQ), and repeat this process, slowly adding the next uncorrelated asset to the portfolio while watching how far off we are from our target Sharpe Ratio with n =15, we can make a reasonable estimate at the marginal contribution of each asset towards our target Sharpe Ratio.

To do this, I generate a correlation matrix of how each stock behaves compared to the other stocks.  Here's the matrix for the 15 stocks:

In the chart above, it's obvious that AA when correlated with itself will return a 1.0.  Since AA has the highest return, we can see that the stock with the lowest correlation to AA is HPQ @ 0.35.  We can create a portfolio containing just AA and HPQ and take the measurements.  Once we have this, and knowing what our target at n=15 stocks is, we can then determine the error.  This is called a marginal contribution analysis.  Here's the table:

The table is constructed by taking AA+HPQ and determining the composite return, volatility, Sharpe Ratio, and known error from our goal of n=15.  In this case we see that the n = 2 combination, comprised of AA and HPQ, which are the two poorest correlated stocks to be considered, result in over 18% error from the target return/risk ratio.  This obviously is unacceptable and I never would trade such a portfolio.

Next we add HD, so that the portfolio looks like AA+HPQ+HD.  You can see how "Error from Goal" improved from 18% to just under 10%, and this is due to diversification with n = 3 stocks.  You also see an entry in the column "Marginal Contribution", which simply shows that the Sharpe Ratio improved 10.2%.

Continuing, you see the trend.

What is important here is that at n = 11 stocks we are less than 1% from our target reward/risk ratio when n = 15 stocks.  At n = 11, returns with the basket shown above are about 26.0%, with 16.6% volatility.  The Sharpe Ratio only improves 0.54% by adding 4 more stocks to complete all the stocks that were in Quadrant I, so we have effectively reduced the basket from n = 30 to n = 11 and have taken on incremental risk while significantly adding return to the basket.

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But wait!  There's more!

Simply jumping in to this basket of stocks is detrimental to your portfolio's health.  If we take the top 11 stocks as listed above and put them on the GGT dashboard, we get the following recommendations:

Here, we see that 3 of the 11 stocks are not being recommended for entry at the present moment.  Correspondingly, it is prudent to wait until these flash a New Long signal, at which time I would evaluate entry.

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The final aspect of this is to determine the relative weightings of positions.  This is NOT a equal-dollar-into-11 -stocks; each stock is position-sized based upon relative gain and volatility within the portfolio.  For April 1, here are the allocations of the 11 stocks:

Note that JPM indicating 0% allocation is not a typo.  The Efficient Frontier calculations, with this set of stocks, have established that JPM does not add anything in terms of return or risk reduction when bundled with these other stocks AND given their recent behavior.  This is a bonus ... and then there were TEN stocks!

These allocations will be valid for the month of April unless I discover an error (always possible, as this is new work and I don't have anybody looking over my shoulder that I can bounce ideas/calculations off of).

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Summary

I've presented a considerable amount of material here which represents several weeks of work.  Results are preliminary, but I feel that we can use this methodology to meet/beat indexes.  The question is whether this is able to be put into practice.  What have we learned?

1. The concept that there exists an optimum reward/risk ratio given a set basket of stocks.  We can find this optimum reward/risk ratio using standard tools.
2. The concept that we can eliminate under-performing stocks in a given basket, based upon historical return and volatility, and improve the basket performance (in hind sight, of course)
3. The concept that we can selectively pick stocks from a subset of stocks that comprise an index and improve our chances of outperforming the index without taking significant additional risk.
4. That we can take these new candidates, apply GGT timing methods, and the result will improve overall performance because we will not be participating in the stock when it is underperforming.

Of course, it must be stated again that we cannot predict the future, and because of this, we must rebalance.  Presently, it appears that monthly rebalancing is all that will be necessary in order to implement this strategy.  This is subject to change, further testing is required.  For now, it appears that it will work "good enough".

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As always, you are responsible for your own investment decisions, and I am not.  Please do your diligence, and please take ownership for your actions.

Regards,

pgd

Continuing to Hold the Long Side ...

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Summary

• The GGT Price index hit a all-time new high of $34.05 on Tuesday on volume that was 19% below the 50d average.  We had rising prices in December 2010 on poor volume, and we cannot discount the impact of POMO buying.  New price highs are bullish overall, period.
• All the pricing moving averages are positive and pointing upward.  This is bullish for our bank accounts.
• The GGT Price Accumulator Oscillator is at +14, it's maximum reading, and is indicating that we should not buy new stocks on the long side as the short-term chance of decline from today's levels is above average.
• GGT Strength is at 74%, and indicates that there is considerable fuel in the tank to power higher.
• The short-term timers are both LONG, but I would not chase them from here.
• The Long-Cash Ratio (LCR) closed above 1.0 on Tuesday at 1.058, the first time since 3/7.  While the absolute value is not important, the trend is up, at least through the 34d moving average.  The 55d and 65d moving averages are still negative, which means that we do not have 100% confirmation as far as the broad base of GGT stocks are concerned.
• Investor's Business Daily finally joined the party Tuesday evening and has announced that we are in an uptrend.  There is comfort having them on our side.

Conclusions:  Stay the course on the long side.  While we are approaching overbought levels on a short-term basis, suggesting a slight pull-back, I think we'll be okay through the rest of this week.

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Holdings

I'm presently holding AZO, CAT, FXP, OPEN, PCLN, and SJM.  I unloaded positions in DOG and SH yesterday, and lightened my position in FXP, all for a significant loss I may add, but Effective Volume action at the end of the day suggested that any further holding of the positions would be at the peril of my account balances.  I am mirroring this portfolio in the GGT, LLC account and it too realized the loss.

While you may be inclined to say that EV is a poor signal to base selling decisions, I think you'd be mistaken.  I simply remind you of the FTNT situation in January when LargeEV was increasing but price was decreasing  -- we had the same situation for SH and DOG until about 3 pm yesterday.  This is one of numerous examples.  All I can say is that many people took a hit yesterday, including our micropercentage compared to the masses.  Until I see compelling evidence to the contrary I'll let EV continue to guide selling if there is any consternation.  Of course there are other indicators to tell me to exit, but the majority of them have been mixed, as folks have not believed this latest up leg.  Finally, I'm reminded of a discussion I had with a full-time trader recently -- she indicated that when a hedge comes off, there's a loss, or there would be no reason to have the hedge in the first place.  Point taken.

Here's what I'm seeing on the positions being held:

1. GGT has all of the stock positions as "Long", so there is no compelling reason to unload anything.
2. AZO saw a significant uptick in the last 30 minutes of trading in terms of LEV and a simultaneous decrease in SmEV.  Price moved upward, so the big boys were stepping in.  I feel better about this stock, although I'm not overly pleased about how it's been acting over the last week or so.  I do note that it just cleared a weekly Darvas box, so combined with the breakout of the daily Darvas box on 3/24, we have a good setup.  I'm 17% below my target holding position of 16% total.  My price target is still around $300.
3. CAT saw a turnaround in LEV yesterday, with steady, linear accumulation while SmEV dropped throughout the day.  CAT also just cleared a weekly Darvas box, and again, like AZO, when combined with the daily breakout of the box, we have a good setup for higher prices.  I'm 59% below my target allocation of 40% in CAT, so will most likely add early but not all, especially since the GGT Price Accumulator Oscillator is maxed out, saying we're due for a pullback.  I'm looking for a price target of about $114.
4. FXP is frustrating me.  With the close yesterday I have mixed signals on the weekly time frame, and also with the close yesterday FXP has fallen outside the lower right corner of the daily Darvas box, an ominous sign.  Given this, LEV upticked at the end of the day as buyers stepped in.  Also, in looking at the price series over the last 40 days, it's visually easy to see that we're near a lower active boundary, so when combined with the mixed weekly signal, FXP actually appears to be a good play.  Nevertheless, GGT has FXP as a CASH recommendation, and I need to follow my own rules unless LEV skyrockets today (along with price).
5. OPEN continues to perform well, and coincidently, has just cleared a weekly Darvas box in concert with a daily Darvas box on 3/24.  With recent strength my target allocation has fallen to nearly zero (volatility has been spiking, a bad sign), so I will place a target stop loss/profit point OCO order and exit the position with some form of gain.
6. PCLN is marching upward nicely.  I'm 23% below my target allocation of 13%, so most likely will add those shares early this morning.  My price target is still around $540.
7. SJM underperformed yesterday, which is worrisome when a stock does not participate in the broad market.  I'm slightly underwater on the position in both accounts, with a worse-case of -0.44%.  LEV held steady on Tuesday though while prices dropped, which is a good sign.  Any weakness in LEV will be cause for removal, especially since yesterday's price closed below the Darvas Box ceiling of $72.09.  We'll see how it behaves early in the session and if it lags, it's gone.

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Remember, you are responsible for your own investment decisions, and I am not.  Please do your diligence, and please take ownership for your actions.

Regards,

pgd

Stay the Course on the Long Side

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Summary

• The GGT price index fell -0.35% on Monday on volume that was -20% below the 50d average.  There was no conviction in the selling so I am not concerned at this point.
• All of the pricing moving averages are gaining on a day-over-day basis.  This is bullish for prices.
• The GGT Price Accumulator, which guides me on entry of new stocks/ETFs, remains at a value of 0 which is dead-smack-right-in-the-middle-of-the-scale, e.g. neutral.  The markets can go either way on us, and the risk/reward profile for entry of new positions is balanced.
• Database strength fell on Monday to 69%, and indicates that we have a considerable amount of fuel in the tank should the markets want to go higher.
• The short-term timers are all still LONG, although they gave up some ground yesterday.  The earliest these timers could move to CASH would be with the close of markets on Wednesday, and both days would have to be Long-Cash Ratio down days.
• The intermediate-termed Elder Force Index timer is solidly LONG, and has been for 3 consecutive days. This is bullish for stocks.
• Despite the GGT price index falling, the Long-Cash Ratio (LCR) INCREASED yesterday, showing underlying strength in the database.  Granted, the change in the LCR was only +5%, but an increasing LCR when prices are falling on poor volume is bullish for stocks.
• The LCR moving averages are more-or-less unchanged from yesterday (see yesterday's blog).

Overall, I'm bullish on the short-term market, given the data through the close of Monday, March 28th.

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Holdings

I'm presently holding AZO, CAT, DOG (laughing out loud right now ... "CAT", "DOG", get it?), FXP, OPEN, PCLN, SH, and SJM.  I received a note over night asking how I'm managing my positions so here's a blow-by-blow accounting of my thought process for each:

• All the non-ETF positions are rated as GGT LONGs.  There is no reason to sell from GGT's perspective.
• AZO came under pressure yesterday, but Effective Volume (EV) remained constant/somewhat increased on the day, giving me confidence to hang in there.  AZO cleared a Darvas box on 3/24 and made a new 52w high on 3/25 on increasing volume.  17d, 50d, and 200d moving averages are all in an uptrend.  My price target for AZO is presently 8.1% over my purchase price, or about $295.  The reward/risk level with AZO is lower than I like (presently 0.479), but it has consistently beat earnings since 2008 so is a quality company.  I'm trying to get to a 15% position in my portfolios in AZO.
• CAT has been falling out of favor in terms of institutional sponsorship as of late, making the recent series of new 52w highs somewhat tenuous.  The stock has solid 50d moving average support and is well above the 17d line.  Volume has been steadily increasing for a couple of weeks, despite the lack of institutional buying.  CAT recently issued earnings guidance that beats estimates, which is a good sign.  CAT has consistently beat earnings estimates since April 2009.  My reward/risk ratio for CAT is better than AZO at 0.896, but with a dividend yield of 1.61% we're near my ideal consideration point of 1.0.  My price target is about $114. I'm trying to get to a 39% position in CAT.
• DOG is the inverse ETF on the DJ30 and all I'm trying to do here is hedge the top of the markets right now.  I'm down -2.22% on the position since entry, but EV has been steadily increasing, as has average volume on both the 8d and 40d time frames, so I am not alone in my thinking that a hedge is a good place to be right now.  I have removed my stop loss on the position(s), simply because I hate stop losses. If it closes below $41.39, which is the floor of the Darvas box that it is operating within, I will have to seriously evaluate exiting the position early the following day.
• FXP is the inverse ETF on the Xinhua 25 exchange in China, and it is presently down -4.44% since my entry.  Volume has been increasing with this one, and someone liked it enough on 3/23 to purchase 354K shares in a 1-minute block.  It's still operating within a Darvas box with a ceiling of ~$31.16 and a floor of ~$27.31, so there is no reason to exit at the present time.  Of course, a close below the floor of the Darvas box will cause me to reconsider.
• OPEN has short-term institutional support, as determined by an 8d EV window, but the 40d is relatively poor but is increasing.  OPEN has beat earnings estimates every quarter since it went public in 2009.    The stock broke out of a Darvas box on 3/22 and hasn't looked back since, making 52w highs nearly day-over-day (except yesterday).  17d, 50d, and 200d moving averages are all upward-trending.  Again, the reward/risk ratio is a bit low for my liking at 0.573, but it is performing nicely at the present time.  It is nearing it's upside target of $104 so I may be exiting soon (I should have exited yesterday at my profit target but I was away from the PC and omitted setting a stop target).  I'm presently a bit overweight in OPEN, with a target of 2%.
• PCLN has good EV and good 50d support.  It has consistently beat earnings every quarter since 2007.  It is presently guiding in-line for the next quarter, to be released ~ May 10th.  The stock made a new 52w high on 3/24 and it continues to push higher, with the 17d, 50d, and 200d all pointing upward.  A bit of a warning sign is that while EV is good, average volume is decreasing, giving me pause to the higher prices.  The reward/risk ratio is 0.582, again lower than I like.  My price target on PCLN is ~$540, and my position weight is 10%, which is my target.
• SH is the contra ETF on the S&P500, and it is down -1.63% since my entry.  Effective volume has been increasing steadily on this one as the price has fallen, so many people are flocking to this as a hedge.  Average volume has been decreasing though, and overall, it's not a good long-term core holding.  It just fell outside of the lower corner of a Darvas box so I'm in conflict -- it should be sold if it closes below $42 (which it did last night), but the steadily increasing EV shows good institutional support, effectively putting a floor in.  I intend to hold SH as a hedge unless it breaks down in EV.
• SJM has great institutional support and continues to experience significant buying, independent of price.  The stock is experiencing a bit of declining average up-volume, so as we make new highs, this is somewhat worrisome.  It broke out of a Darvas box on 3/21 and has been bouncing around against a new 52w high since then.  The 17d, 50d, and 200d moving averages are all in an up trend.  It is presently above my price target and if I see EV break down in any regard, I will sell it.  Note that every time the price dips that Large EV moves upward, showing increasing institutional support.  SJM has beat EPS estimates every quarter since August 2008.   I'm significantly under my target position weight of 34%, and given that we're above my price target, I will NOT be adding to the position in the short-term.

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Trading Plan for Tuesday

I'm more or less sitting pat today.  Stocks are bouncing around as of 10.a.m.  I moved 100% of my wife's TSP into stocks yesterday, so it will be interesting to see how that experiment works with a good chunk of change.  I've got a solid watch list of stocks for consideration, all with above-average reward/risk profiles, so we'll see how they perform throughout the day.

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Remember, you are responsible for your own investment decisions, and I am not.  Please do your diligence, and please take ownership for your actions.

Regards,

pgd

Move Long Confirmed, Well, Almost...

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I've presented some analysis of various signals that I watch at my TSP blog, which can be found at http://ggt-tsp.blogspot.com.  I suggest that you review that material to understand today's title a bit better.

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Summary

• The GGT price index has hit an all-time high of $33.88, taking out the high of $33.45 on 2/18/11.  New Highs are bullish.
• Volume remains below the average 50d MA level.  We saw this same behavior during December, so don't get lulled into thinking that lack of volume can keep the market from moving higher -- it moved much higher in December 2010, on very poor volume overall.
• The Elder Force Index timer has confirmed a 2-day move upward into positive territory, and this is a new bull signal.
• GGT Bull Strength, which is the ratio of GGT New Longs compared to GGT New Cash recommendations, has made two consecutive days of being above 1.  This means that more stocks are appreciating in terms of price and volume than are falling below historical optimized levels.  This is bullish.
• The slopes of moving averages on the GGT price index are all positive and pointing upward.  This is bullish for higher prices.
• The GGT Price Accumulator Oscillator is mid-scale at 0, showing that it is an equal reward/risk ratio to enter the market with new long positions on Monday.
• The GGT Short-Term Long-Cash Ratio (LCR) Change Timer, which is just what it name implies, has been long since 3/18/11.  It has gained +3.95% in this time frame.
• The VTI Short-Term Timer, which is the tradable ETF on the GGT Price Index, has been long since 3/21/11.  It has gained +0.8% in this time frame.
• The LCR has gone up a consecutive 6 days running, moving from a value of 0.297 to 0.900.  This is a large change in a small amount of time, but is bullish.
• The slopes of the LCR moving averages are turning more positive and are confirming an expanding database.  Historically, this has been a good time to buy stocks.

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GGT Pricing Slopes

When we take the GGT price and apply moving averages of various lengths, namely 5days through 65, we get a feel for what the market is doing in terms of prices on these time scales.  Here's the table view:

On the left is the slope of each of the moving averages.  If it's positive (e.g., price is going up day over day on that time frame), it's green, and if it's negative, then it's red.

As you can see, this week was a bullish week, with the prices all turning green on all time frames since 3/21/11.  This is bullish for prices and tells us that the trend is UP.

On the right is the "slope of the slope".  This literally tells us if the end of the moving average is pointing down (red) or pointing up (green).  More red means bearishness, and more green means bullishness.  This is a leading indicator over slope because we need the moving average to point a given direction before the slope will transition from red to green or visa versa (why?).  Make sure you understand this.

As you can see, we've been nearly GREEN for three consecutive days.  We typically don't get FOUR consecutive days of being "green", so I'm expecting a bit of a short-term pullback in terms of prices.

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GGT Long-Cash Ratio Slopes

Much like the presentation above, we can apply various lengths of moving averages to the ratio of stocks in the database with a "LONG" recommendation to those with a "CASH" recommendation.  Hence the name.  When we apply these moving averages and look at them through the same lens, we get an idea if the database is expanding or contracting.

I've shown in the past that we should buy when the database is expanding and avoid buying when it is contracting.

Here's the table:

The left side of the table above shows that we've been thawing a considerable amount since 3/21, and this week's action was quite beneficial to the bulls.  I would like to see the 55d and 65d LCR slope averages move to into the "Green", indicating that they are positive, which may happen this week if we see continued bullishness in the markets.

Remember, the GGT system requires both price AND volume to be appreciating for a long call, so even though we're seeing reduced volume across the entire GGT database, we are seeing a greater number of stocks move to the long side than are bleeding to the cash side.  This is bullish.

The right side of the figure shows the "slopes of the slopes", and tells me if the moving averages are pointing upward or downward.  This is a classic case of demonstrating the leading nature of this method -- note how the solid green block PRECEDED the move to the long side -- this is because to follow a trend, the trend has to develop, and this "slope of the slope" method detects new emergent patterns early in the trend formation.  It's very powerful, and shows us that this signal is real. 

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Price Change Oscillator

Recognizing that the market ebbs and flows, the price change oscillator helps me to determine when to enter new stocks.  Here's the chart:

The chart shows three regions -- pink/red, which is an overbought area, white, which is neutral, and green, which is oversold.  Also on the chart is the last 6 months or so of the GGT price index.  You can see that in general, when we're in the pink zone that the GGT price index has stayed horizontal or has fallen, and when we are in the green zone it has moved upward.   On the long side it typically pays to buy in the green zone and avoid buying long in the red zone.  The converse is true for shorting.

We are presently at 0, which is neutral.  The market can go either way on us for Monday.  Consequently, so too can our purchases.

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Portfolio Management

I'm presently holding both long and contra ETF positions, and given the new flurry of "go long" signals, I'm looking to unload the contra ETF positions with minimum damage.  As indicated above, we are several days running into consecutive "up days" in terms of the pricing "slope of the slope" indicators, and we typically pull back and recover a day or two before resuming the advance.  I've got stop losses in place, so we'll see how things react over the next few days.

I'm gradually changing my approach to trading/investing, as I've been working to better understand how to compete against a benchmark(s) and hopefully beat the benchmarks in the long haul (if you can't beat the benchmark, then we are compelled to invest in an index and be done with it).  I'm also under greater demand in my day job, so I need to transition to more of an "evening" investor rather than watching the markets throughout the day.

If I look at the past performance of the last 13-26 weeks with my present set of holdings, and use that as a proxy of performance (return and volatility) going forward, I have a reasonable expectation of achieving about 17% gain with a bit more than 19% volatility with the current portfolio over the next year, provided that I'm 100% invested.  As of this writing, I'm only 5/13 invested on the long side, so given this allocation in cash, the expectation drops to 7.25%/7.09% return/volatility respectively.  This is too low, and there is no hope of beating a benchmark with such a high position in cash.

Using the DJ30, which has outperformed all other indexes the past 13 weeks (5.75% compared to S&P500/4.46%, Russell2K/4.12%, NASDAQ/2.83%), we are underperforming the DJ30 on an annualized basis but are outperforming everything else, so we're in the ballpark, again provided that I'm fully invested.

There is nothing in the tea leaves that suggests I shouldn't be fully invested so my goal is to add to the positions.

In terms of allocations, I presented some work in the GGT/TSP group over the weekend that shows how to allocate for maximum return/minimum risk using a metric called the Sharpe Ratio.  The suggested portfolio combinations using my present holdings are as follows:

Here, various combinations of weightings produce estimated returns/volatility, and the goal is to maximize return while not disproportionately increasing volatility (risk).  As you can see, the optimal value of weighting produces 17.7% gain at about the same volatility, whereas right now, with my present allocations, I'm underperforming in terms of expected return and taking on a bit more risk than I should.  You can also see that I've listed a portfolio combination that provides minimum risk (10.27% expected return and 13.30% volatility) -- in this case the expected return is whatever pops out at the distant end of the calculation.

Optimizing by the Sharpe Ratio has limitations -- it presumes that a buy-and-hold mentality has occurred over some period of time in the past, and that the future will continue to hold the same basket of stocks.  As a market timer, this is not my reality.  I've modified the textbook optimization of the Sharpe Ratio by using data only if GGT indicators are LONG for the given stock, omitting data when the individual stock is a GGT "CASH" rated stock.  This gives us upside volatility in the calculations, which is more representative of how this portfolio will be constructed.  I'm also using a technical document from JP Morgan/RiskMetrics (pp 94 - 102, Section 5.3.1.2) that applies a weighted average to data, effectively using only the last 100d or so to provide better estimates than the usual "use all the historical data available and hope" model.

All of this presumes that the next 13-26 weeks (or next year, for that matter) will behave like the last 13-26 weeks, which is a difficult proposition but my analysis has to start somewhere.  All of these stocks are GGT "Long" rated so they are performing well relative to their past.  All of these positions have favorable Effective Volume on a 40d scale.

Additions to the portfolio must raise the Sharpe ratio without sacrificing gain.  If a position becomes a GGT "CASH" ranked stock and is sold, then the portfolio will need to be re-evaluated based upon the new composition.  Luckily, the evaluation process is automated, so given a basket of stocks, I can see the overall performance.

I've found that it is very difficult to find a combination of stocks that maximize gain yet minimize volatility.  I've also recently found that using leveraged ETFs multiplies both the return AND the volatility by the same factor, so more often than not, there is no advantage to using leveraged ETFs in a constant-volatility model (in fact, I've actually found that volatility for leveraged instruments increases faster than it does for the 1x instruments, and this has to be a function of market demand).

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Individual Stock Recommendations

I'm getting out of the business of providing daily stock screens based upon GGT and Effective Volume on this blog, and will be transitioning to a subscription service. I spend considerable time screening stocks, and I have 100% confidence in the GGT/EV methods.  You can subscribe to Effective Volume candidates at Pascal's site. You can review my past blog entries and evaluate my picks yourself; you will see that they largely outperformed the broad indexes after they were suggested.

I'm also now providing coaching services, and this area needs my focus.  I will continue to post my holdings, strategy, and actions and will continue to blog on a daily basis, when I am available.

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Trading Plan for Monday, March 28th

• As I indicated in the GGT-TSP blog, I'm moving my TSP funds from 100% cash to 100% invested in the market.
• I intend to gradually exit from the remaining contra positions that I hold, but will do so selectively as the contras show strength, not as they show weakness.  I know this seems counter-intuitive, but we are due for a short-short-short-term pullback, which will reduce my losses in the contra positions.
• I intend to add to my present holdings to build my present portfolio.

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Remember, you are responsible for your own trading decisions.  Please do your own work, and please take ownership for your actions.

Regards,

pgd

Position Disclaimer:  as of this writing I am holding the following equities:  AZO, CAT, DOG, FXP, OPEN, PCLN, SH, SJM, SLV

Friday 3/25 Update - VIX Ribbon Confirms Move LONG

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(as I slurp my coffee, still attempting to wake up ...)

In my review of my indicators this morning, I note that the VIX Ribbon indicator that I have been using to confirm moves definitely shows that a move to the LONG side occurred with the close of markets on WEDNESDAY, MARCH 23rd.

Here's the chart; click on the chart to launch in a new window or tab:

The closure of the VIX below the lowest EMA, the series which comprise a ribbon, has provided a good indicator of when we should be moving back into the long side.

Based upon this, I will close all contra positions for a loss today.

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Regards,

pgd

No Solid Confirmation of a Bull Leg; Being Selective

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I finally landed from the west coast about 1 a.m. Friday morning so this will be abbreviated, in that I've not been able to review my watchlists in detail.

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Summary

• The intermediate-termed timing model that I use (Elder Force Index) is mixed and has NOT confirmed this move upward.  I'm looking for two consecutive days of both methods closing in positive territory; we're not there yet.
• GGT closed at an all-time high with the close of markets yesterday.

The key here is to buy "test" positions in strength; some of my ideas are below.

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GGT + EV Stocks

Here is my watchlist of stocks that I'm considering

• AEM - good 40d and 8d support, just cleared 200d, volume is increasing
• AZO - newly showing 40d and 8d accumulation, very close to 52 week high, new breakout of Darvas box so watch it to take out the 52w high
• EZPW - riskier trade, but is breaking out and is starting to show accumulation.  Has lacked institutional support prior to this breakout; new Darvas box breakout
• FMC - showing increasing support and looks that it will take out 52w today if it continues higher
• GWR - showing solid momentum to the upside
• NFX - failed a close above the 52w this week but is in a definite uptrend and has accumulation
• PCLN - looking very strong, about to issue a buy signal in terms of correlated volume and price action.
• CTSH - also looking strong on multiple fronts
• EFX - just took out 52w high and has good institutional support
• CLH - not attracting massive short-term accumulation, but is marching higher on good volume
• THS - same as CLH, and keeps setting new 52w highs each day
• UPL - showing new strength, but a volatile stock
• YUM - showing good accumulation on the 40d and increasing volume in a range
• WAT- solid accumulation but volume appears to be dropping slightly
• SUN - just cleared a new box and set a 52w high and is attractive, but beware of doji on Thursday

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Trading Plan for Friday

I'm net bearish in my positions, which are down about 2%. I intend to hold onto these and add selected stocks if they show strength today.

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Remember, you are responsible for your own trading decisions, and I am not.  Please do your diligence and please take ownership for your actions.

I'll provide a detailed review over the weekend.

Regards,

pgd

A Pause or a Reversal? The LCR Has Been Here Before ...

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I'm away on travel most of this week to the west coast so blog entries will be curtailed.
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Summary

• The GGT price index rose +1.02% on volume that was 29% above average.  I attribute some of the volume increase to quadruple witching, but rising prices on volume is a good sign.
• All of the pricing slopes have turned up, with the exception of the 13d (no idea why it's holding out).  This is necessary for us to make money on the long side.
• The pricing accumulator, which tells us whether we should enter stocks on the next trading day or not, is telling us to avoid entry of stocks on Monday, as the likelihood of a downday is increasing (reward/risk is poor).  The value is presently pegged at overbought, and given past history, there is only a 13% chance that today will be an up day (futures up 1% as I write this so it looks like we'll be in the 13%...)
• The Elder 13d Force Index is in CASH.
• The slopes of the Long-Cash Ratio (LCR) EMAs are all negative but are pointing upwards.  This a good first step to moving long.

Conclusions:  while there is no signal to move long, the overall indicators are not deteriorating, and to some extent, are showing a very slight improvement.  I intend to sit pat on Monday.

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Market Internals on Friday

Friday wasn't a day to get excited about, as far as I'm concerned.  Here's a view of the behavior of the market, as determined by the average performance of 2x and -2x ETFs, relative to the 2x S&P500:

I explained this figure last week, so refer backwards a few days to get the details.

The top trace is the SSO, which is the +2x ETF on the S&P500.  The middle trace is the SSO minus the average of 9 +2x ETFs, all in different sectors of the economy.  The result is a relative behavior of this average to the SSO.  The bottom is the average of 9 -2x contra ETFs, basically the opposing "pair" of the +2x contras, and I subtract the SSO from this result.

When the middle trace is red the 9, +2x ETFs are underperforming the +2x S&P500, and this is the condition we see right now.  We also see in the lower trace that the -2x contra ETFs actually improved throughout the day, relative to the opening, showing that the S&P500 was under pressure all day.

This combined presentation is not one that I would call one of strength and because of this presentation, I think that the volume we saw on Friday was due to options/futures expiration and not much else.  While the bears certainly did NOT claw their way back they made great progress on Friday, and because of this, I am wary to whether this soon-to-be three-day up leg can be sustained.

The opposing position would have been supported if the picture above had solid green for the middle trace, e.g., all of the sectors (or the majority of them), as measured by the +2x ETFs, would have outperformed the S&P500.  I would have also liked to have seen strength in buying into the weekend, but instead, we saw gradual selling of long positions throughout the day.

Conclusions:  we're not as healthy as we would want to be to move aggressively long for the intermediate term.  I intend to remain largely in cash for the next day or two at a minimum.

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GGT Pricing EMA Slopes

This next figure gives me the state of the health of pricing EMAs within the GGT universe:

This figure shows the slopes of various moving averages, from 5days in length to 65d, on the left, and the daily change of these slopes on the right.  Here's how to interpret:

1. On the left, we've been in a pattern of increasing downward-pointing EMAs.  This has been evidenced in more "red", with the red growing from the shorter EMAs to the longer EMAs.  Consider this increasing bearishness as the calendar days click off.
2. On the left, there are periods where we reverse the "redness", and see a couple of days of apparent recovery.  It will be incredibly important to see more than two days of "green" if we are to break the present pattern.
3. On the right, we bounce between a couple of days down, a couple of days up, then repeat the cycle.  We've just experienced two days upward.  We'll need several of these days up to get me to move long.  Looking back over recent history, 4 continuous days up on solid volume would be a strong influence on my present outlook.

Conclusions:  The damage has stopped, based upon Friday's action (almost green across multiple time frames).  We need several days like this (more than 2) in order to have confidence to re-enter the market on the long side.

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GGT Long-Cash Ratio Slopes

Whereas the pricing slopes tell us the pricing behavior of the database, as well as give us a short-term indicator of where the prices are moving, the GGT LCR slopes tell us how much support is under the price moves.  

Here, I'm looking for an increase in the LCR value, relative to a few days ago, as well as "green" in terms of the slopes or change in slopes.  Here's the presentation:

Here, we see the raw Long-Cash Ratio on the left, the slopes of LCR in terms of redness and greenness, and on the right, we see the change in slopes on a day-over-day basis.  Here's how to interpret:

1. As you can see on the far left, we've had a significant number of consecutive down days of the LCR.  In fact, this is the longest streak (-7 days) since 11/9/10, which also was 7 days in length.  I note with interest that we also had a -7 day streak that started on 10/14/10, so we dropped in October, went up for 5 days, then dropped again for -7 days.  Relating this to recent action, we're "more or less" at the ending point of the first wave of down days, and we may/may not see the second wave down.  I would consider a test downward as healthy, as it would test the bottom formed over the last week or two.
2. On the left, the slopes of the LCR are all "red", meaning that they are all negative.  I'd like to see some green here, first appearing on the left with the 5d and 8d periods, before I'd move long into this market.  Right now the database is NOT confirming the price action, which causes me to pause.
3. On the right, we've had two days of "greenness", indicating that the slopes, while negative in value, are pointing upward.  This is the first condition to a sustained bull ... we need more green on the right to show that we can pull ourselves out of the abyss.  We're not there right now.

For the curious in you, here's the presentation from OCTOBER 2010 of the same LCR conditions that we seem to be experiencing right now:

If history is any indicator, we MAY be at the date corresponding to 11/1/10, but of course, your crystal ball is as good as mine.

Conclusions:  The LCR EMA behavior is not supporting the aggressive price EMA behavior, even on the shortest time scales, so this too gives me pause to entering the market on the long side.  I want to see continued days and increased "greenness" on the left side of the LCR slope presentation, which will reaffirm any sustained upward pricing movement.  Until then, I'm sitting more-or-less pat.

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GGT + Effective Volume Stocks and ETFs

I've posted the stock and ETF updates in the Yahoo! GGT forum in the files section, and you can download the file to view stock candidates.  Simply refer to the "DashboardEV" file.  Because of market conditions, I do not plan to enter any of these stocks today, as the reward/risk levels are poor.  I'll re-evaluate tonight after I land on the west coast.

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Trading Plan for Monday

Well, I'm presently holding contra ETF positions.  I'll most likely hold these as I think the likelihood of a decline, short-term or not, is fairly large from here.  My position in BIDU is also not performing well, and if we have a strong up day and BIDU decides not to participate, I'll cut it loose.

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Remember, you are responsible for your own trading decisions, and I am not.  Please do your own work, and please take ownership for your actions.

Regards,

pgd