Dan Zanger, Male Model

In a recent post I discussed using the Adoption/Diffusion model in conjunction with the Wyckoff model of market stages. At the time, the indexes moved through a stage of distribution into mark down according the Wyckoff model, signifying the Innovators unloading inventory to the Laggards according to the Adoption/Diffusion model. During this period the possibility of further redistribution and mark down as First Adopters began to support Innovators came into question.

Since then however, the landscape looks much different and it is becoming clear that First Adopters did not show up in support of the move. I do not know for a fact that they won't show up, but they've neither signed the registrar nor have been seen at the party. Further, recent evidence shows that the Innovators are moving to the long side. Through the process of the Adoption/Diffusion study, the modeling of Innovators, who they are and whether or not their actions can be identified and modeled seemed like a logical follow up- but where to begin wasn't quite clear.

It wasn't until I saw a couple of tweets on StockTwits that I realized I had my model of study- Dan Zanger.

Dan Zanger Tweet August 26

What suddenly stood out was the swiftness with which he changed his mood. Until recently many of the charts he posted indicated further downside and his tweets cautioned getting chopped up in this tape and keeping one's powder dry.  Within a few hours after posting another cautious tweet he switched on a dime and opened a long position.  I thought, if there is someone who has an understanding of their risk tolerance along with knowing when leadership begins to emerge before the indexes make up the lag time, and would be considered an Innovator it would be Dan Zanger. So if he is suddenly becoming opportunistic I would consider this a change of market sentiment by an acknowledged market technician and worth paying attention to.

Harvesting the Fields and Rotating the Crops

The fields tilled by the traders of yore yield much wisdom.  One theme that keeps cropping up in the five books that I am currently reading and/or rereading is sectors.  From Livermore and Wyckoff to Weinstein and O'Neil, the understanding of sectors and cyclical cycles is repeated through their works, which is to be expected after all since in many regards they are branches from the same root limb.

In order to get a composite of sector rotation to better my understanding I set up some simple metrics and ran 5 scans through TeleChart and screen captured the results.  Using Morningstar Industry Groups as the universe I decided to scan the current list using a simple formula of C/C20 and C/C165 which gives the change over a shorter term 20 day cycle and medium term 165 day cycle and ranked these from high to low, taking the top 20.  I then modified the formula to scan for the same cycle 100, 200, 400, and 600 days ago (the last being approximately 1 month into the bull run since March 2009).

04/21/2009 Sector List (600 Days)

11/20/09 Sector List (400 Days)

01/26/2010 Sector List (200 Days)

03/30/2011 Sector List (100 Days)

Now that the composite of days 600, 400, 200, and 100 has been completed, questions can be framed around this information.  What did Resorts and Casinos jumping to the top of the 20 day list in April 2009 say about the prevalent attitude at the time vs. the market's attitude?  How are people getting to the resorts? Cruises?  Air planes?  Will these sectors come into play?  Looking at the image from November 2009 shows not only did Resorts and Casinos have duration and were clearly one of the leading sectors of the bull move, but also Airlines did enter the mix as well.  Additionally, in noticing the persistence of Resorts and Casinos over a period of time, are laggards beginning to reap the sector strength benefits as well?

08/19/2011 Sector List

Using this composite during the bull move as a reference to the current list, it can clearly be seen that this list is composed primarily of defensive stocks and there is a story being told here as well.  A defensive stock is described by Investopedia as:

The utility industry is an example of defensive stocks because during all phases of the business cycle, people need gas and electricity. Many active investors will invest in defensive stocks if a market downturn is expected. However, if the market is expected to prosper, active investors will often choose stocks with higher betas in an attempt to maximize return.

source: http://www.investopedia.com/terms/d/defensivestock.asp#axzz1Vmmetw7v

This list is unadulterated information and simply states that over a 20 day and 165 day period these sectors have shown greater price appreciation.  Regardless of what is being said on television, radio, the internet, semaphore, or smoke signals, the simple fact is this: the price flow is speaking quite clearly and it is chanting: "Defense! Defense! Defense!"


Using this context of defensive positioning and returning to the first image from April 2009, what can be seen during the initial stages of the bull market is a mixture of cyclical and higher beta sectors.  Using this as a model, paying attention to which sectors begin to rotate into this list may lead to clues about investor sentiment and money flow and when first adopters begin to get more aggressive as well as lead to clues about where the next leadership may be found.  Additionally, learning to ask questions about the data may lead to further insight and undiscovered sectors or germinate some ideas to harvest later.

Far From the Tree

Earlier this week I quipped, “When talk of  'Did you see what happened to APPL?' replaces 'Did you see what happened to the market today?'... will be a good indicator of public sentiment."

If there is one bell weather stock that is on the minds of the masses with acolytes the likes one expects from a cult with great lawyers, it is Apple. Their rabid following insists the stock is on a space shuttle trajectory and any cross talk otherwise is blasphemy. This is definitely one stock that is tightly coupled to the company in the public conscious.

Apple has not been the only story stock during the past few years, but it is the one that has held attention the most as each product release has been bought into with the frenzy of Cabbage Patch Kids. So, when talk begins to shift from the market to Apple, a company and product that is heavily discussed , to me this indicates a further shift in public sentiment. For the time being nothing seems to have shaken out the bullishness during this massive sell off even with volatility the likes not seen since the Great Depression. The mentality remains to buy this dip and APPL is still the star of the show. Should APPL fall a little further from the tree, perhaps a shift will take place but thus far...

“The S&P 500 appears to be firmly in the jaws of bears, but data actually show that U.S. investors are slowly turning bullish on equities again. Mutual fund data from research firm TrimTabs suggests that retail investors are bottom-fishing, dipping a toe into the pool of U.S. stocks.   ...TrimTabs says that preliminary figures show that U.S. equity mutual funds saw inflows of $6 billion on Aug. 15 and Aug. 16 after redeeming $41.8 billion in the previous 12 sessions.“

source: http://www.thestreet.com/story/11224173/1/investors-turn-bullish-as-market-crumbles.html

Additionally, the AAII sentiment indicator has increased in bullishness and decreased in bearishness over the past two weeks. On the other hand, one indicator that has shown some bearishness sinking in as of late is the CBOE Put/Call Equity Ratio which has crept up during the past week to 1.04, the second time this reading has dipped above 1 during the past two weeks.

With a number of market breadth indicators yet again showing extreme readings it a useful reminder that a number of them also showed extreme readings on the way up which persisted for months at a time. It is also important to keep in mind that what has occurred over the past three weeks is an outlier and as such breadth indicators that are relied upon under more “usual” circumstances may not return the expected out look. The market can continue to deteriorate and push these readings further than any expectation.

As a side note, the local Border's has been holding a going out of business sale since July 22^nd and I figured the inventory of interest to me would be long gone so I never bothered to pop by to see what remained. A couple of days ago I was in the neighborhood so I did, and to my surprise I found two trading books I wanted for 50% off. Sure I could have waited longer and tried to get 60%, but there was neither a guarantee they would be available at that price or still in inventory.

Is the merchandise the market is putting on sale price today sufficient to incur interest or is there still a lack of demand to buy at these prices as inventory sits on the shelf languishing? Sentiment thus far indicates that the prevalent belief is that this market is on sale at a discount, but judging the the put/call ratio the past few days, concern is beginning to creep in as well. Trading against the public when there is conviction is much different than when the public becomes uncertain for in that frame of mind they are more capable of doing anything- perhaps even panicking.

Adoption/Diffusion Model and Market Timing

Over the course of my post, I've used the $USHL5 as a tool to better understand and interpret market breadth. During the course of this past week a series of events transpired that began to interconnect disjointed knowledge resulting in my acknowledging that after months of staring at this chart on a daily basis I had only a perfunctory knowledge of what this data represented and the story it tells. So for this weekend's project I made the commitment to look deeper into exactly what this indicator is and how the underlying mechanics of it operate.

However, before delving in, I've recently been inspired by a number of concepts from The Three Skills of Top Trading by Hank Pruden, specifically the relationship established between the Wyckoff Model of market stages coupled with the use of the adoption/diffusion model.

 

The adoption/diffusion model is described as thus from Wiki:

Diffusion is the process by which a new idea or new product is accepted by the market. The rate of diffusion is the speed that the new idea spreads from one consumer to the next.

Adoption:

Adoption is similar to diffusion except that it deals with the psychological processes an individual goes through, rather than an aggregate market process

Adoption/Diffusion Model Graph

• Innovators – venturesome, educated, multiple info sources;
• Early adopters – social leaders, popular, educated;
• Early majority – deliberate, many informal social contacts;
• Late majority – skeptical, traditional, lower socio-economic status;
• Laggards – neighbours and friends are main info sources, fear of debt.
  

source: http://en.wikipedia.org/wiki/Diffusion_of_innovations

Using the above model, I've roughly broken down the SP weekly chart over the past 3 years into each of these phases to give a pictorial view of the cycles. The three key phases are Innovators, Early Adopters and Laggards. Innovators are the first individuals to adopt and take risks. This is also a critical point where many emerging trends get buried as ideas, concepts, fashion, technology etc... that does not make it into Early Adopters will most likely fail to stick and carry over to the Early Majority. 

SP Weekly Chart

Phase A is where the Innovators come into play. At this stage it is their buying that begins to stabilize a market bottom. Their buying may stick if it carries over into Early Adopters, or the move may fade and the downside continues if it is not. It is this area that also coincides with the phase transition of markets between markdown to accumulation and mark up to distribution.

Phase E is the stage where the public enthusiasm for the market begins to froth and is also the location of distribution to these Laggards before the mark down process begins. The general market participant is greedy when they should be fearful and fearful when they should be greedy and this typical cycle is expressed in Phase A where they will sell to the Innovators and Phase E where as Laggards they will buy from the Innovators. 

Understanding this model of behavior assists in generating greater insights into the Wyckoff model of accumulation/distribution. By the time the fad has basically played out and the Innovators are on to other pursuits, the average person is buying the product at a discount retailer or second hand store. In the market however, the average person is doing the inverse and actually paying a premium for the hand me downs of the Innovators, which is not only counter intuitive, but counter productive too.  The next step is to see how this relates to the $USHL5 indicator.

The USHL5 indicator is defined thus by StockCharts:

The index is computed by counting up all of the US stocks (on any of the three major exchanges) that are making new 52-week highs and subtracting all of the US stocks that are making new 52-week lows.  That gets you the "Daily" version of this index ($USHL). To get the "Weekly" version, you add up the daily values for the past five days and plot that.

The construction of this is simple enough, subtracting new highs from new lows. But it is helpful to dig a little deeper and understand what exactly happens when price makes a new high. On the surface a new 52 week high seems blatantly apparent, price that closes higher then it has over the past year of trading, but in addition academic research indicates that buying new highs can achieve abnormal returns, so there is an underlying market mechanism behind the significance which can result in abnormal returns. Also, stocks that make new highs show demand- an establishment of market of strength- the more new highs, the stronger the market tends to be.

However there is also another significant factor that often gets over looked in the discussion of new highs and that is time factor.. As a stock increases in price over time and hitting new 52 weeks highs, it is perhaps simultaneously, increasing it's 52 week low as well. What this means is that the floor price increases over time. The inverse is also the case as a stock continues to hit new 52 week lows- the 52 week high over time will decrease as well.

The following 3 year chart of the $USHL5 when addressed from this frame of reference in conjunction with the Adoption/Diffusion and Wyckoff model of accumulation/distribution yields valuable clues to interpreting the underlying market structure.

3 year $USHL5

 

The action in from October 2007 to October 2008 is useful in understanding this phenomena in action.  In October of 2008, the cumulative reading bottomed at -16664. This bottom is nearly a year to the date after the market topped out in 2007. With each passing day during this period the 52 week low moved against price action until they crossed and when they did the reading cascaded downward. The underlying mechanics of how this indicator operates can more further refined in this context..

Within a month of this reading, this indicator snapped back 16000 to -547. What can be inferred at this point is that that over the duration of the correction, the 52 week highs dropped towards proximity of the 52 week lows, enough so that minimal buying pressure was sufficient to snap this back 16000. This makes sense since at this point so much has become so beaten down that it does not take much to snap back so quickly.

It is also during this phase that eInnovators begin to make their presence felt. Additionally it is a zone where new leaders present themselves and begin to buck the dominant trend in the market and start making new highs. As indicated on the chart a divergence begins to show up where the index continued to make a lower low, but the $USHL5 did not. With new leaders emerging and early buyers being supported by early adopters, the index in turn moves higher and the USHL5 continued to make new highs.

As with the up cycle, so with the down. At some point this oscillation will continue in the other direction and the flip side of the coin is indicated by the establishment of higher peaks through April 2010, the zenith being 3852 and from there followed a correction after the flash crash that bottomed in August of 2010. Each subsequent peak of the USHL5 thereafter was lower yet the index continued to make new highs. It is also at this point, being two years into a bull cycle that the new lows over time have also increased, so as the floor rises towards the ceiling, the ceiling falling through the floor can happen rapidly as evident by the recent -4345 low that printed.

Using the Wyckoff model, it is evident that the market underwent distribution and is currently in a mark down/redistribution period. Layering the adoption/diffusion model on top, it is clear that Laggards are entering the market and the Innovators are selling their inventory to them and also beginning operations on the bearish side which may resume the decline should Early Adopters begin to pile on which will lead to a period of further markdown. Additionally, the time factor begins to make its presence felt as price begins to drift towards 52 week lows which continue higher with each calendar day dropping off.

Anything can happen in the market and keeping an open mind and preparations to act at a given time and being on constant vigil and alertness for conducive periods should always be the primary focus of any participant. Although anything can happen does not mean however that the probabilities of events should not be weighed and the current evidence indicates that this is a weakening market and the path of least resistance at the moment is to the downside. Should another range establish itself in this area, it will still take time for the damage done to price to firm before further upside continuation is probable.

Now What?

“A threat is more powerful than its execution.” -Tarrasch

The concept of a threat being more powerful than its execution (variations of this term also attributed to Tartakower, Nimzowitsch, Mason and Eisenbach) stems from the chess concept that the defending side saddled with consistent pressure of a threat is placed in a position of constant vigilance and as the threat persists, the inducement of an inaccuracy becomes increasingly probable.

The mere preoccupation with the threat may produce heightened anxiety resulting in a blunder and immediate loss of game, or a more subtle situation where the defending side positions pieces to defend the threat resulting in exploitable weakness elsewhere on the board, or the even more nuanced- giving up a critical square. The longer the threat is present the more foreboding and grander in size it psychologically becomes. It's not the actually threat any longer, but the possibility that at any moment it may come to fruition that is the root of the problem being faced.

So what can be expected once the threat is unleashed? The position may still be lost, but the anxiousness also subsides. What was once of great concern now exists and if one had the fortitude to withstand the mounting pressure and can now look clearly at the situation at hand and assess the present position on its own merits, all may not be as horrible as it first seems and the game may still be salvageable.

The threat of an SP downgrade became reality over the weekend and the market responded thus: 5% to 8%+ drops in the major indexes with 98-1 downside to upside volume, with 1301 in my universe finishing down 8%+ or $5+ and 2486 down 4%+. In addition, the Put/Call ratio tipped 1 today indicating bearish sentiment has increased. It does appear that panic is beginning to seep into the market place.

Now that panic is beginning to enter, will capitulation follow? With so many stocks sitting in the barber chair for so long, eventually someone will find a use for all the trimmings littering the floor and begin making wigs. When this occurs is any one's guess, however what we do know is that there are a number of news related events being addressed in markets around the globe as participants digest the current state of affairs, which thus far have been mostly negative. Additionally what we know now are that many of these threats have been executed while a handful remain.

What I'll be paying attention to over the next week or two is whether or not more panic enters the market and whether or not “bad” news begins to get bought with conviction. If these occur and the market begins to curve out a bottom than the bull phase may still be salvageable, otherwise with most of the indexes approaching the 20% threshold delineating a transition from bull to bear cycle, the path of least resistance suggest more downside.

Are We Bear Yet

It's the battle cry of children on road trips. Are we there yet? No. Are we there yet? No. Are we there yet? NO! But... are we bear yet?

Two weeks back I took some time off. The majority of the post on my blog thus far have been about market timing, with a focus upon range bound and topping markets. At the time of my departure the market continued its churn and finding no edge in trading during this period I thought it would be in my best interest to take some time off and head to the mountains for some respite. One of my goals was to enter Yosemite and see a bear, but considering this year has had the largest number of visitors and queues to get into the valley were up to two hours long, I opted to spend time at the river and watering hole instead.

For the first few days of my trip I spent some time in the Bay Area and would open my lap top on occasion and glimpse what the market was doing, but once in the Sierras I refused to be distracted and get caught up in the disillusion that I was surely missing something. I didn't see what I could possible be missing in the mountains that I wasn't witnessing in the city. This was time to simply get away and let everything I've studied and applied during the previous 7 months settle in. Not much appeared to have changed since I was away, but after my return how differently things look indeed.

The range that I thought would surely catch me off guard and break to the upside just as I became most frustrated broke to the down side with a vengeance just as I had become most relaxed. On the surface the drubbing that occurred on 08/04 is obvious- one look at the NASDAQ being down 5.08% is sobering enough, but a deeper look shows some staggering numbers from a breadth perspective:

In the last 20 trading days there has been consistent distribution with 5 out of 20 days showing downside volume upwards of 9-1 culminating with the 91-1 down to up volume on 08/04., the largest since the flash crash in May '10. (Note: Not adjusting the range of the box was intentional as the break of this range would be apparent.)

08/05 SPX

On 08/04, 498 of 5082 stocks in my universe were down 8%+ or $5+, 2002 were down 4% or more reducing the breadth thrust to the lowest number- currently .17- that I have seen since tracking this and using it as an integral part of my market timing and trading strategy.

08/05 Market Monitor

I noted in my last post that as the indexes approached within 2% of new 52 week highs, a distinct divergence could be seen as the number of stocks reaching new 52 weeks highs was nearly half. If there was any question about whether this movement was fuel or fumes, the list of participating stocks making new highs clearly gave clues. With the amount of damage done to charts across the board, a stabilization of this indicator is worth watching.

08/05 $USHL5

Lastly, looking at the $BPNYA it is clearly evident that this indicator has been in a free fall over the past two weeks, undercutting the flash crash low and if scaled further out, the lowest reading since the March '09 pivot of 12.11.

08/05 $BPNYA

So, returning to the question, “Are we bear yet?” It certainly is an ugly looking landscape the likes one sees after clear cutting, yet there doesn't appear to be enough panic yet. On Friday the indexes were down 3% and from 52 week high to this low the SP dropped 17%, the NASDAQ 15%, and the Russel 25% and then buyers stepped in. Across the board, nearly all indicators are at some overbought or extreme level the likes rarely if ever seen, so from this vantage point the story is much the same and one belief is that a bounce is due, perhaps even a retest of the range low and determine if support is now resistance.

In this regard there is confluence so taking this to another level may help further clarify the landscape. Is there still too much bullishness in this market? The Put/Call ratio finished the week at .93 and the recent AAII survey, while showing an 18.4% increase in bearishness still reads under 50% over all. Is there a buzz of bank runs surfacing again? Is the window washer at the cafe giving you advice on gold? Are grizzly sightings increasing on the cover of Barron's or the Economist or in British Colombia?

An eye on sentiment this week will be telling as news of the down grade hits the market. Instead of looking for the doom and gloom assessments on the major media hubs, this would be a good time to take a step back and watch those around and hear if the clerk at the check out engages when seeing the cover of Time and talks about the market or follow up on the AAII numbers and see if they've increased. Avoid the echo chamber of Wall Street and listen to the chatter on a bus going down Main Street for a clue if we're bear yet.