weight of evidence Archives | Opportunity Identified

January 17, 2015 | Posted by David Zarling, Head of Investment Research

Important Levels On S&P 500 (SPY) Identified

Over the past two months, we’ve provided evidence that the probability of a correction in the US stock market was increasing. We have not made a full blown correction call because the most important piece of evidence still pointed to higher prices in the overall US stock market. However, that most important piece of evidence, price, has begun to capitulate. What does that mean? If you remember our article about price, you’ll remember that it is the only thing that matters. You can have every indicator, piece of inside information, or strong opinion you want. In the end, price is always right [anyone envision Bob Barker when you read that?]. Price trumps all other pieces of information you deem to be important. And since releasing our research, price has begun to deteriorate. The price of the S&P 500 is lower than it was when we began to identify problems back in November. It is time to pay close attention to price action in the near term. The U.S. stock market (represented in this article by the S&P 500) must re-establish new highs quickly or risk a trip to the 1800s (which increases risk of lower lows if that take place).

Using the chart below, we’re going to identify some important levels. Every trade we enter has to have an entry and exit plan. If we are going to establish a long position in the S&P 500 using the ETF, SPY, we need to know where to enter, when we’re wrong, and when to exit. The same is true for taking a short position. For us, we’ll us ETF, SH, to establish a short position on the S&P 500. As annotated on the chart, our game plan is to change from long to short with a daily close below 200.00. This is our if/then line. We are long above it, short below it. If price moves below 200.00, we would add to our short position with a close below 197.00. Keep in mind, that we will need to nimble with our short trade as we would be going against the upward price trend (as identified by the “360 green” channel). Each of the shaded areas and the lower green trend line would be logical places to reassess what price is doing and either add to our short position or change back to long. At each of those levels, we’ll analyze price and make adjustments as needed. With risk management, no game plan is static. We continually reassess our game plan to minimize loss and maximize gain. This game plan is not for everyone. We’re not saying going long or short is right for you. Cash is a position too. Some of the best trades are those that aren’t made.

Trade safe.

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January 10, 2015 | Posted by David Zarling, Head of Investment Research

A Little Fear About The FEAR Index

Back on November 13, 2014, we wrote about our concern over elevated volatility as part of our seven-part series on evidence currently warning of a possible trend change in the overall U.S. Equity market. Almost two months later, none of the issues identified have resolved and remain cause for concern that stocks are weakening and could lead to a large correction. The only piece of evidence, and the most important, that has held up is price. Since November 13, the S&P 500 has traded sideways in a volatile fashion with large percentage moves in either direction. The market is at a very important inflection point. Buyers need to step up in a big way to prevent another visit to the 1800s (-10%) on the S&P 500.

This brings us back to revisiting what is currently taking place with the FEAR Index, or VIX. As a reminder, the CBOE Volatility Index (VIX) is a forward looking instrument calculated from option activity, and reflects the market’s expectation of 30-day volatility. We like to look for divergences between the VIX and the US Market. We look for odd behavior. Normally, as would be expected, when fear/volatility increase, stocks decrease in price – and vice versa. However, sometimes a change in market sentiment from greed to fear (and the opposite also applies) can tip its hand. When we see fear/volatility increase along with market prices, we take notice. This is odd behavior and could be a warning sign that market participants (big money managers) are changing their mood. This was taking place back in November and continues to be an issue today. As George Soros once noted:

Volatility is greatest at turning points, diminishing as a new trend becomes established.

The chart below is an updated version of what we provided you back November. Note that volatility has continued to increase, both in the VIX and now in the price fluctuations of the market. This needs to resolve quickly. Those long this market need volatility to drop and new highs in the market to reestablish. Otherwise, the opposite will apply – new highs on the VIX and new lows in the market. A revisit to the 1800s would be likely. This market will require traders be nimble in the coming weeks+. Keep in mind that price is the final arbiter of value.

For your reference, I’ve provided a chart of this scenario from the 2007 top below the current day chart. This doesn’t have to play out again, but we should always sit up and take notice when volatility increases.

Trade safe. Don’t trade what you think. Trade what you see.

VIX Fear Index 2007 — 2007 Elevated Volatility

December 9, 2014 | Posted by David Zarling, Head of Investment Research

Risk Management. A Must For Every Investor. [Weight of Evidence, Part 7 of 7]

If price is the most important piece of evidence in identifying opportunities, then risk management is the most important part of taking advantage of those opportunities. From a risk management perspective, technical analysis is ideal for identifying when any trade thesis is wrong. Knowing when you’re wrong or knowing when to exit is crucial to successful trading. We don’t care about being right. We care about being on the right side of the trade. Technical analysis allows us to do that on a consistent basis.

Technical analysis allows us to identify logical entry and exit points to maximize gains and limit loss. Every time we enter into a trade, we must have an exit plan – both for locking in gains and stopping any losses. Too often, investors will enter into a trade without a game plan. That is, without targets and stop losses. This is like entering an unknown and crowded room without identifying any exits or escape routes. Not wise. At 360 Investment Research, we try to identify the most logical entry and exit points before entering any trade. For each investor, entry and exit points will vary based on risk tolerance and individual styles and preferences. Regardless of the aforementioned, all traders, including you, should know exactly when your current trade is wrong. We don’t want to get into a psychological game of chicken with the investment of choice. If/then game planning allows us to remove emotion from the trading process and eliminate as much bias as possible. How do we this? Some examples of setting up if/then scenarios can be found in two great trades we shared with our readers this year: Nike (NKE) and Russia (RSX).

For another example of game planning and risk management, we can look at the current state of the S&P 500. We like to use ETFs to capture markets, sectors, or segments. In this case, we’re long the S&P 500 using the ETF, SPY, as our vehicle. As we’ve previously highlighted in parts 1-5 of this series, we’re seeing some negative evidence appear that is causing us to watch price (the most important piece of evidence) very closely. So we’re long the S&P 500 with some warning signs that need to resolve. What’s our game plan? Where is our exit (which can also be an entry going short)? Let’s take a look. The chart below is of SPY. As you can see, price has been steadily making higher highs and higher lows within the green upward channel. The exceptions being lower lows in February and October, which were subsequently countered with new higher highs. So the trend is up and we are long this market. What will it take to change our long stance? Simple. Breakdowns below previous areas of likely demand (aka previous highs) and below the green price channel. As annotated on the chart, our game plan is to change from long to short (using SH) with a daily close below 204.00. This is our if/then line. We are long above it, short below it. If price moves below 204.00, we would add to our short position with a close below 200.00. Each of the shaded areas and the lower green trend line would be logical places to reassess what price is doing and either add to our short position or change back to long. At each of those levels, we’ll analyze price and make adjustments as needed. With risk management, no game plan is static. We continually reassess our game plan to minimize loss and maximize gain. This game plan is not for everyone. We’re not saying going short is right for you. But, cash is a position too. And for right now, the lines in the sand are pretty clear.

Trade safe and stay curious, investor.

December 2, 2014 | Posted by David Zarling, Head of Investment Research

Want to Make Great Investment Decisions? Just Look Left. [Weight of Evidence, Part 6 of 7]

Using a weight-of-evidence approach is valuable for making quality decisions on desired or current investment positions. As technicians, we have a wide variety of tools at our disposal to anticipate potential rough spots, corrections, or buying opportunities. But that is all they are – tools of warning or anticipation. They give us an edge in identifying when and where to take on risk with limited downside. Finding asymmetric risk/reward opportunities is the epitome of what we do at 360 Investment Research. We don’t care about being right. We only care about being on the right side of the trade.

Over the past 5 posts, we’ve identified some warning signs for the overall U.S. equity markets. All of the posts carry weight as we analyze our long exposure to U.S. stocks. But none is more important than what we write about today – price. Price is the most important evidence. It carries the most weight. We can have all the common and proprietary indicators in the world and they mean nothing without the confirmation of price. Below is a diagram so you can visualize what we’re saying.

As you can see, we like to look for evidence to support our investment decisions. The best piece of evidence is price. What is it doing? What’s its direction? If price is making higher highs and higher lows, the trend is up. If price is making lower highs and lower lows, the trend is down. By analyzing price itself, we can determine the general trend and the potential change thereof. Using the diagram above, which shows the current status of the market, we can see that price moving to the right side of the scale would cause it to tip dramatically to the right into a new and potentially strong downtrend. In the same light, if the evidence on the right shifted to the left side of the scale, the swiftness of the uptrend would increase. So at this point in time, we are watching price like a hawk. How do we do this in reality? Simple. Just look left. When we analyze price using charts, we find the current price and look left. See the daily price chart of the S&P 500 below. Notice that price has been steadily making higher highs and higher lows. It is a beautiful staircase upwards, hallmarking an uptrending market. The exceptions are back in early February (SPX made a lower low and tested the trendline from the 2007 top) and back in mid-October (SPX made a lower low and tested previous highs/lows near 1825). Each time, the market recovered by subsequently making new higher highs without recording a lower high. When we consider this most important piece of evidence, the scale is easily tipped towards an uptrending market. All the other evidence only provides perspective in the event price changes and makes lower lows and lower highs. All the other evidence indicates caution is warranted. But, that doesn’t mean we need to short or be out of the market. Right now, price is telling us to remain long this market. As for the future, we’ll let price dictate what we should do next.

Look for our series finale on game planning and risk management soon.

November 13, 2014 | Posted by David Zarling, Head of Investment Research

The Curious Case of Elevated Volatility [Weight of Evidence, Part 2 of 7]

“Fear tends to manifest itself much quicker than greed, so volatile markets tend to be on the downside. In up markets, volatility tends to gradually decline.” ~ Philip Roth

The CBOE Volatility Index is often referred to as the FEAR Index. This forward looking index is calculated from option activity, and reflects the market’s expectation of 30-day volatility. We like to look for divergences between the VIX and the US Market. We look for odd behavior. Normally, as would be expected, when fear/volatility increase, stocks decrease in price – and vice versa. However, sometimes a change in market sentiment from greed to fear (and the opposite also applies) can tip its hand. When we see fear/volatility increase along with market prices, we take notice. This is odd behavior and could be a warning sign that market participants (big money managers) are changing their mood.

Below are two charts: one from 2007 and one from today (2014). Both show that while the US Market (in this case, the S&P 500) is making higher highs, the VIX is making higher lows. They are moving together. Odd behavior. In 2007, this was a clue that a change in trend was approaching. And as you can see, the same is taking place now. Does it mean that this is the top of the market for the foreseeable future? No. But, it means we’re going to keep close eye on the price action from here until this odd behavior resolves itself. Those who are looking for the bull market to continue want to see lower lows in the VIX and the market to hold onto these highs.

Stay curious, investor. Check back again tomorrow as we’ll have more to add. And if you find this information useful, make sure to share the wealth using the share buttons at the bottom of this article.