Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article February 2011 Market Update: Normal Strong Bull by Van K. Tharp, Ph.D.
• Trading Education Peak Performance Home Study
• Trading Tip February 2011 SQN™ Report by Van K. Tharp, Ph.D.
• Workshops Germany Workshop Dates Announced
• Mailbag SQN Calculations with a Large Number of Trades

by Van K. Tharp

I always say that people do not trade the markets; they trade their beliefs about the markets. In that same way, I'd like to point out that these updates reflect my beliefs. If my beliefs and your beliefs are not the same, you may not find them useful. I find the market update information useful for my trading, so I do the work each month and am happy to share that information with my readers.

However, if your beliefs are not similar to mine, then this information may not be useful to you. Thus, if you are inclined to do some sort of intellectual exercise to prove one of my beliefs wrong, simply remember that everyone can usually find lots of evidence to support their beliefs and refute others. Just simply know that I admit that these are my beliefs and that your beliefs might be different.

These monthly updates are in the first issue of Tharp's Thoughts each month. This allows us to get the closing month's data. These updates cover 1) the market type (first mentioned in the April 30, 2008 edition of Tharp's Thoughts), 2) the five week status on each of the major US stock market indices, 3) our four star inflation-deflation model plus John Williams' statistics, and 4) tracking the dollar. I will now report on the strongest and weakest areas of the overall market as a separate SQN™ Report. And that may come out twice a month if there are significant market charges.

On Monday, February 28th I left for Australia, so I wrote this update over the last weekend in February based on the 2/25 close.

Even after some large down days recently, the market type is still in a strong bull mode, but the volatility measurement moved up from the quiet range to normal.

Part I: Van's Commentary—The Big Picture

Several days ago, I ran across an article comparing what’s going on today with what happened in the 1930s. The numbers were quite eye-opening, so I thought I’d share some of them with you here.

The market has basically doubled since its March 2009 low and this was the fastest doubling since the mid-1930s. The 1930s’ double was followed by bad market conditions; our current fundamentals, however, are worse than in the 1930s. Does this mean the rally will end? Yes…someday. Right now, though, the market type is strong bull and this is generally a good time to be in the market.

Second, the S&P 500 currently yields about 2%. During most of the 1930s, the lowest yield was about 5%.

Third, PE ratios are near their historical averages and this is the closest they have been to that figure since 2000. However, in 2008 they spiked to between 45 to well over 100. Contrast this to the S&P PE ratio of 5 reached in the 1930s after the first down leg of the crash. PE ratios typically bottom out in the single digits at bear market bottoms.

The comparisons of today to the market in the 1930s surprised me, but if you look at the big picture in the economy, they shouldn’t seem so surprising. If you have been following these updates for some time, you already know the following:

1. The US has unsustainable debt levels.
2. The US is increasing its debt at an unsustainable rate.
   
3. The Federal Reserve published a paper saying that the US was bankrupt—this was before the subprime crisis.
   
4. The US has massive fiscal problems at the state and local level.
   
5. The world cannot sustain the dollar as world’s reserve currency.
   
6. The baby boomers start retiring this year and social security cannot support as many retirees as are about to need retirement payments. In fact, the economic crisis has added pressure to this problem as it has forced many of them to retire now rather than work (or try to find work) for a few more years.

So enjoy this bull market period right now. I can confidently say it will only last so long.

Part II: The Current Stock Market Type Is Now Strong Bull Normal

Each month I look at the SQN calculation of the daily percent changes over 200, 100, 50 and 25 days. On February 25th, the SQN 100 (my primary measurement period) was in the strong bull range, but the 200, 50, and 25 day SQN calculations were all still in the bull range (the two shorter ones were just barely in the bull range).

The next graph measures market volatility. Last year, market volatility was very low in April and May 2010. After the spike in June last year, volatility started a long trend down to a level even lower than last year. It picked up again around the first of the year and has now just moved into “normal” territory.

The only real negative technical data I can find on the stock market comes from Jason Goepert’s Sentiment newsletter. Dumb money is now 63% confident in a rally, whereas smart money is only 42% confident in a rally. Those figures are less negative than last month and last month’s numbers were less negative than two months back.

Here are the performance figures for the three major indices over the last month. All of them are up nicely and the DOW actually closed over 12,000 on February 1st.

Part III: Our Four Star Inflation-Deflation Model

We'll now look at the two-month and six-month changes during the last six months to see what our readings have been.

It’s interesting that the recent crisis caused gold to discontinue its normal annual seasonal correction and move near new highs.

We are in an inflationary environment unless we have another massive derivatives collapse. Inflation could remain subdued, however, until the banks start lending again and then it could become interesting.

Shadowstats.com estimates the M3 growth is about -2%—up from -3% last month. And the St. Louis Federal Reserve shows that the banks are still not multiplying printed money because the current money multiplier is less than 0.9. Worse, banks seem to be on a new trend of lending less money as shown by the following graph from the St. Louis Federal Reserve.

Part IV: Tracking the Dollar

Here is a futures chart of the US Dollar Index.

In February, the dollar bounced up a little and then came back down. As I mentioned, I’m going to be outside of the United States for the next month, so I would expect to experience the Tharp effect in action. (When I travel internationally, the US dollar always seems to weaken, and I get less and less for my dollar.)

General Comments

The secular bear market continues its long term trend and it will continue until there’s a dramatic reduction in valuations. As mentioned before, lower valuations will take the S&P 500 PE ratio to the single digits. Fundamentally, conditions certainly support that trend even though in some secular bear markets the economy can seem to do quite well. And as I said last month, the next down phase looks like it has been put off for a bit; bear markets don’t generally spring out of normal volatility conditions. This is a trader’s market, not a buy and hold market. Market conditions in nearly every country right now, are great for trading.

Once again, it’s my opinion that you should use the information in these monthly updates to discern when to switch trading systems—not to forecast the market. It’s imperative that you know how your trading systems will perform under various market conditions so you know which systems to trade and which systems to leave on the shelf for each market type. If you haven't heard this before or the other ideas mentioned above, read my book Super Trader, which covers these areas and more so you can make money in any kind of market.

Crisis always implies opportunity. Those with good trading skills can make money in this market—a lot of money. There were lots of good opportunities in 2009. Did you make money? If not, then do you understand why not? The refinement of good trading skills doesn't just happen by opening an account and adding money. You probably spent years learning how to perform your current job at a high skill level. Do you expect to perform at the same high level in your trading without similar preparation? Financial market trading is an arena filled with world class competition. Additionally and most importantly, trading requires massive self-work to produce consistent, large profits under multiple market conditions. Prepare yourself to succeed with a deep desire, strong commitment, and the right training. Until the March update, this is Van Tharp.

About the Author: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at vanktharp.com.  

Trading Education

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Trading Tip

by Van K. Tharp, Ph.D.

I now use the SQN calculation to measure the market performance of countries, currencies, commodities, and various business sectors in my world model. I use the SQN 100, which is the SQN calculation over the daily percent change of the various ETFs we follow over the last 100 days. A score over +1.45 is strongly bullish; a score below -0.7 is very weak.

• Green (strongest): Those that are more than one standard deviation above the mean (about 1/6 of the ETFs scanned).
  
• Yellow (the next strongest): Those above the mean up to one standard deviation (about 1/3 of the ETFs scanned).
  
• Brown (weak): Those within one standard deviation below the mean (about 1/3 of ETFs scanned).
  
• Red (very weak): Those more than one standard deviation below the mean (about 1/6 of the ETFs scanned).

World Market Summary

Once again the U.S. markets look very strong. Look at the top center box. All aspects of the US stock market are solid green, with two indices having readings over 2.0. The US hasn’t been the strongest area in some time. And all this is occurring with a weak US dollar. Enjoy it everyone.

The only other countries with SQN ratings above 1.0 are Japan and Canada.

The strongest sectors are Energy, Oil and Gas Exploration, Oil and Gas Equipment, and the Semiconductor Industry. It’s nice to see that trends can still persist. Many U.S. sectors are dominating in relation to the same sectors in the world.

Chile, China, India, and Brazil all look very weak with the Yuan looking quite bearish (but not as much as the dollar). These are typically very strong areas. Someone recently told me that Indians generally don’t like my idea of a 25% trailing stop as a substitute for buy and hold because of the tremendous volatility of the Indian market. I bet many of them now, however, wish that had adopted such a strategy.

Business Sector Performance Plus Strongest and Weakest Areas

Editor’s Note: The table that normally shows the color coded performance of commodities, real estate, interest rates plus the strongest and weakest ETFs is absent from the article this month. While Dr. Tharp has his laptop with him in Australia, for some reason, he is unable to update the data and cannot reproduce the table. Look for the return of the table next month in his report on March.

The top 12 ETFs are all Energy ETFs. Do you have exposure in this area? Do you have a tendency to get in at the top? If so, it simply illustrates the importance of psychology that we always talk about. Work on yourself first, and then you can respond to what the market is doing.

The bottom six ETFs are all US short funds. And world stocks seem to come in next as generally weak.

In the commodities sectors, commodities, agriculture and silver all are showing good strength. And, as usual, the one weak area is natural gas. Hmm, isn’t natural gas energy? Why is oil so strong and gas so weak?

In real estate, the only strong ETF in the sector is for US real estate. Chinese real estate looks very weak. I find this interesting as the situation is usually reversed.

Finally, as we’ve seen for several months, all of the bond funds, except junk bonds, are very weak.

What’s Going on: My Interpretation

The bond bubble burst. One of the reasons for the strength of the US stock market is the tremendous amount of money pouring out of bonds. It has to go someplace and people are rushing for the safety of US stocks. Yes, “the safety of US stocks.” That has an ominous tone to it, I think. More problems lie ahead when people find that there is no safety in holding US stocks—just trading them, and then only if you know what you are doing.

It is a crazy world.

About the Author: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at vanktharp.com.  

Workshop

Dates Announced for Germany
And
Three new dates added to June for USA workshops!

Click here to see our full workshop schedule with details

Click here to see our workshop guide for information about attending, locations, hotels, etc.

Mailbag

Q: I have been developing trading strategies for some time and am interested in the System Quality Number calculation. The problem I have is what to do about it/how to interpret the results where a large number of trades are given on my backtest.

For example I have a strategy backtested over 3 years across multiple pairs, with about 3,000 trades. It has an excellent looking equity curve. One recommendation from one of your books is to limit the number of trades, if > 100, to 100. However, if I do this I get a poor SQN calculation, which I don't think is reflecting the quality of this system. If I plug in the actual number of trades, I get an almost holy grail answer. What should I do?

A: Dr. Tharp believes that the high SQN calculation from trading systems with lots of trades induces a false sense of confidence in traders. Even when a system performs at such levels, it’s still possible to make a trading mistake or for exogenous events to hit the market. Dr. Tharp prefers taking a more conservative approach as he believes you have never seen your worst trade and black swan events occur more than they should (see Nassim Taleb’s work in this area).

While I don’t have all of the needed figures to understand the system you tested, it’s apparent that it has a very wide range of results compared to the expectancy. If you were to graph that distribution of R-multiples, the curve would be relatively flat and wide. A higher curve grouped around a tighter set of R-multiples would generate a higher SQN calculation and then allow you to use position sizing™ strategies more flexibly or aggressively to achieve your objectives. A lower SQN system does not mean you should necessarily abandon a particular trading system, although it does mean that you are not able to use position sizing strategies to easily meet your objectives.

You could consider pursuing several paths for your system:

1. Trade it within the recommended position sizing strategy limits found in the Definitive Guide to Position Sizing for systems with an SQN calculation of 1.
   
2. Analyze the trade results with the intent of reducing the proportion of negative trades or increasing the proportion of positive trades.
   
3. Seek ways to increase the size of the winners and/or decrease the size of the losing trades. Given your standard deviation, it looks like a large proportion of the losing trades have losses greater than -1R.
   
4. With a MA crossover system, you might also look at a way to evaluate the market type and avoid trading the system during non-trending conditions when such systems get whipsawed. The relevant question for you to answer in this area would be, “How do I know the market/stock/contract is trending now?” There are various and numerous ways to answer that question, but you have to define those conditions so that they fit your beliefs.
   

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