New highs next?

Subject:	Is the correction over at the August lows or not?
Last updated:	25.12.2015

H1	The rally from the low on Septemper 29 is the beginning of a new move to new highs.
H2	A new leg down will start soon.

Evidence	H1	H2	Comments
E1 - NYHL is showing some strength.	+	+	There is not enough strength to invalidate H2.
E2 - Short term macro indicators look ready to bounce.	+	+	This does not invalidate any of the hypothesis.
E3 - TRIN 13dma has shown some weakness  on the latest rally.	+	+	Anything can happen given the TRIN at these levels.
E4 - Everybody seems to be bearish, expecting a bigger correction, me included. (Jeffrey Saut said it after discussing with many fund managers).	+	-0.50
E5 - The November rally has been an opportunity for participants to exit massively from US equity funds.	-0.50	+	A first month of massive redemptions seems to have followed previous bigger corrections.
E6 - Indicators of breadth have been very weak. For example 22d adv. It has gotten oversold only on the consolidation in December.	-0.25	+	This could be just a measure of the extreme bearishness.
E7 - Valuation looks high. Profits are at extremes and they could start to fall, especially if the slowdown in the % yoy rate of GDP continues.	-0.50	+	This looks like a strong argument against new highs but valuation is always hard to time.
E8 - The LT trend has been higher and has not been broken. The correction can be enough (12-13%) in an ongoing secular bull.	+	-0.25	Another leg down would break the rising trend but not decisively.
E9 - The Fed has started to hike rates.	+	+	The hike could bring some turbulence but in previous hiking cycles,  equities have been higher after some time from the first hike.
Total:	-1.25	-0.75

Conclusion:

H2 is winning.  A new leg down will start soon. This conclusion neglects the signal given by the generalized bearishness, but this could be ok because weak sentiment is sometimes leading and, also, if the new leg down is short, the bearishness could be exacerbated, producing a very good buying opportunity. The main evidence that made H2 a winner are the massive exits from mutual funds and valuation. Are they reliable enough? I think so. Note that classical indicators (like breadth, momentum are not useful - they will only signal an entry point)

To Taper or Not to Taper

I think it's time for an ACH (click for an introduction to ACH) on the much discussed tapering issue, more so, as it looks likely to be announced at the December 17-18 meeting (by tapering I also mean the communication that precedes the actual slowdown in QE).

So the hypotheses are:

H1 - the Fed will taper at the December meeting;
H2 - the Fed will not taper at the December meeting.

Here is a matrix with a score measuringmy judgement on how much each piece of evidence invalidates each hypothesis.


                             Evidence                                                       H1                     H2
---------------------------------------------------------------------------------------------------------------------------------
E1 - the economic indicators have been strong lately
and the Fed wanted to start tapering in September                       +                      -0.75

E2 - the latest GDP report has been strong but only
due to rising inventory                                                                -0.25                    +

E3 - the Fed has not started to communicate its
possible tapering intentions yet                                                   -0.75                   +

E4 - a slowdown in Q4 is expected                                             -0.25                    +

E5 - Bernanke could take upon himself the responsibility
to announce the taper                                                                    +                   -0.5

E6 - the December meeting is followed by a press
conference, a good opportunity to start tapering                              +                   -0.75
communication

E7 - the stock market has risen and the bond market
was flat after the strong NFP report, which could                            +                    -0.5
encourage the officials to start tapering sooner

E9 - inflation is still trending lower                                                -0.5                    +

E10 - the 7% unemployment threshold, which
has been mentioned by Bernanke early 2013, has                           +                     -0.5
been reached        
---------------------------------------------------------------------------------------------------------------------------------
                                                            Total                              -1.75               -3.00


Conclusion:

H1 is less invalidated, so it wins. The mechanical conclusion of the analysis is that the Fed will start at least communicating the taper at the next meeting.

What should be seen if, indeed, the Fed were to taper? I would guess that some early signaling by Fed officials (today there are three such speeches) but also the markets could anticipate such a decision somehow - the markets were not taken by surprise in September when tapering was postponed even if everybody was ready for it to happen.

Lastly, the conclusion of this analysis is not to be taken for granted. This framework is more of a way to put arguments in order and to see the pivotal ones. Expressing conviction in probabilities is much better. In this case, I would say there is a 60% chance for the Fed to start at least communicating the tapering.

ACH on Feb14: Correction over?

3 hour ES chart

The market has already corrected almost 20 points on the daily chart and the short term (chart above) looks bullish with a cup & handle forming (blue) and a break out of a triangle(red). So here are my hypotheses:

H1 - the correction is over and the market has started rising again;
H2 - a bigger correction has just started and a top is forming around these levels.


Evidence:


E1 - the 5 d ema of the put/call ratio is suggesting the market is/was oversold;
E2- the NYHL (52 Week New Highs - Lows) has already retraced to levels that market higher lows in past uptrends;
E3 - the short term market action is bullish with a break out of a triangle taking place;
E4 - the market has risen a lot on the weekly chart and it could at least consolidate for a longer time.


Matrix:

	E1	E2	E3	E4	Total negations
H1	+	+	+	-0.5	-0.5
H2	-0.5	-0.5	-1	+	-2

Conclusion:


H1 wins. It is important to note that mainly the shorter term action is tilting the balance towards this hypothesis. Thus, a trade on the long side will not be justified if the short term weakens (for example, the break-out attempt fails).

ACH on Feb08: Take the money and run?

Weekly chart of the March ES contract

The March ES contract is up against the 2011 highs, the weekly IT upleg is up ~ 18% and the rise on the daily chart since the last correction is already greater than 50 points. What to do? Take profits here and wait for a correction of at least 20 points to reenter, or just hold longs because the market will only consolidate in a range of about 10 points?


Hypotheses:


H1 - The market will correct at least 20 points from somewhere around these levels;
H2 - The market will consolidate in a ~10 point range before moving higher.



Evidence:


E1 - NYHL (52 week NYSE New Highs - Lows) has spiked to +400 a few days ago and has been weak since then - a typical behavior before daily pullbacks;
E2 - The weekly bull leg is already 18% long and against strong resistance, similar to November 2010;
E3 - The market action resembles acceleration on the daily chart before a bigger correction, similar to Jan 14-20, 2011 or May 1-7, 2009;
E4 - The Fed has just become more accomodative and the latest employment report is consistent with economic strength so the market may just surge higher.



Matrix:

	E1	E2	E3	E4	Total negations
H1	+	+	+	-0.5	-0.5
H2	-0.5	-0.5	-0.5	+	-1.5

Conclusion:


H1 wins. I will go with the scenario of a correction of at least 20 points from here. I will add to this analysis as more evidence will become available during the next days. Until then, I am waiting for an opportunity to take profits on the remainder of my long position.

ACH on Feb06: Up from 1330?

The market has dropped 12 points near the ES 1330 daily support after strength into the end of last week and a good NFP report. Will this drop get longer, say 20 points, or will the market start rising back to 1340?


Hypotheses:


H1 - The market continues its drop, clearly breaking below 1330;
H2 - The 1330 ES daily support holds and the market starts rising again, reaching 1340.



Evidence: 


E1 - Short term TRIN stayed more than 1 day below 1.0 recently, before corrections on the daily chart (see chart below);
E2 - The first pull-back into daily support will be bought by those that liked the strong NFP number;
E3 - The market action may, by and large, resemble what happened after the Jan03, 2011 or Mar23, 2009 moves;
E4 - Uncertainty about the situation in Greece resurfaced;
E5 - Strong up moves are usually followed by smaller rallies during the next days.





Matrix:

	E1	E2	E3	E4	E5	Total negations
H1	-0.5	-0.5	-0.5	+	-1	-2.5
H2	+	+	+	-0.5	+	-0.5

Conclusion:

H2 is the winner. The market has good chances of reaching 1340 before decisively falling below 1330, although a dip to 1327 cannot be ruled out. Thus, we should see strength today, a close near the 1330 level greatly increasing the odds of a bigger correction.

Chart:

ACH on Jan31: Straight up from here?

I was getting ready to analyze the possibility that the correction has ended, but the evidence is overwhelming against a continuation of the correction so I am focusing on something more useful: Will the market go straight up or it will correct 8 points or more in the next day or two before moving higher?


Hypotheses:


H1 - the market continues rising without corrections greater than a few points;
H2 - the market corrects 8 points or more today or tomorrow before moving higher.



Evidence (I only kept evidence that has some relevance for the analysis):


E1 - two previous analogue cases (10/27/2010 and 01/13/2012) suggest there will be a greater intraday correction  today or tomorrow;
E2 - the rhythm on the 3 hours Globex ES chart seems to be 17-21 points rallies followed by at least 8 points corrections;
E3 - European lunch entry was strong, suggesting strength further in the first part of the US session.



Matrix:

	E1	E2	E3	Total
H1	-0.5	-0.5	+	-1
H2	+	+	+	0

H2 is winning. The market will probably correct 8 points or more today or tomorrow before moving to new highs. That correction will probably be a good buying opportunity.

Also, notice that evidence is scarce. This is because there are not many indicators or signs to determine whether the market corrects or not over the short term.

ACH on Jan28 Updated

The ACH method allows updates and corrections as new evidence comes in or as things become clearer. After all, it is dealing with continuously flowing data and uncertainty.

Here is new evidence or evidence that I disregarded/overlooked for the ACH on Jan 28 and here is how it influences the score of each scenario:

E9 - the market did not correct more than 20 points after the January break-out and now it is not against any big resistance - the next resistance on the weekly chart is around 1340.  (E9 was not a valid observation; I rewrote it below);
E9 - the weekly ES chart hit strong resistance at 1330, which can lead to a greater than 20 points correction ( I  overlooked this);
E10 - the market dropped about 10 points in 30 minutes after the GDP report on Friday (in my experience this kind of drop is strong evidence that the market has enough momentum to go further lower - I wrongfully disregarded this.).

Here is the updated/corrected matrix:

	E1	E2	E3	E4	E5	E6	E7	E8	E9	E10	Total
H1	+	+	-0.5	+	+	+	+	+	-0.5	-1	-2
H2	-0.5	+	+	+	-1	+	+	-0.5	+	+	-2

The score becomes equal.

Anyway, the market is dropping to new lows as I am writing this which clearly invalidates the 20 points correction scenario (H1). Given that this comes after consolidation on Friday we could see a trend day down today. In an uptrend a trend day down usually takes the market to the bottom of a small correction.

Introducing ACH

I've decided to continue writing the blog. I have some new plans, I have refined some tools and also got new ones. I hope to make it interesting and useful for the readers.


A new tool that I want to present is the Analysis of Competing Hypotheses (ACH). This is a framework in which decisions can be made by comparing different hypotheses (scenarios) with the help of evidence/observations at hand. It is a method inspired from the book Psychology of Intelligence Analysis, written by Richards J. Heuer, a CIA analyst. The book can be downloaded for free at the CIA website.

The method relies on identifying possible scenarios from a certain point and then trying to invalidate each scenario using the available evidence. The scenario that is the least negated is also the most probable. I adapted and simplified a lot the way it is done in the book as it will be seen. I have used it for some years but never methodically. Recently, I noticed that, if used methodically, the ACH greatly improves the process of decision making by focusing attention on multiple pieces of continually changing evidence, by eliminating the "confirmation bias" and by leaving a trail that can be reviewed later.

Here is an example. (This would make this post quite lengthy but it is just for the first time as I introduce the method.)


ACH on Jan28


Will the market correct more from these levels, maybe 40-50 points, or will it start rising after the ~ 20 points correction on the daily chart without going lower than ~ 1307 ES? (the analysis is done in the context of a developing bull market - this is in itself a subject of analysis but the evidence is overwhelming against the bear market so I am taking it as given).