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Sunday, February 22, 2009

DAXRant: Go On, You Know You Want To...

Note - from June 24th 2009, this blog has migrated from Blogger to a self-hosted version. Click here to go straight there.

I've been phenomenally busy of late - I hope to get back to posting more regularly sometime this week. For the moment, here is a free piece of genius that will make you a small fortune, if the analysis holds up.

The carnage in financial markets this week has done some serious technical damage - the Dow's breach of the November low (I TOLD YOU SO) has brought the Industrials into line with the new lows made by the Transports, and thus a new Dow Theory bear market confirmation has been borned.

Add to this, that the investing public seems to have completely lost faith with the Magic Mulatto and his band of 'more of the same' dills, and you have a recipe for Dow 6000 in relatively short order. I fully expect that to occur later this year, but the Herd expects it to occur next week.

So for the present, I think it's time to skin some newbie-short nuffnuffs.

Confession: I got torched this week, having taken a position trade (long) in DAX futures. 

The confession comes with a caveat: as with the 30-year bond short, this has a horizon longer than its life to date. 

Like the bond short, it went underwater - hard - which would spook anyone who wasn't as good as me. 

Like the bond short, it will finish profitably, but in over a shorter timespan than the bond short (which is still live). 

The DAX long was undertaken with the market already oversold on all but the weekly timeframe... and now the DAX is weekly oversold as well (it's even oversold on a monthly basis).

When it comes to the decision to take a position - rather than a series of scalps - your beloved GT doesn't just decide to do a thing in the heat of the moment: although the analysis is reasonably straightforward, it is comprehensive. (Note - 'position' here means something that has a trade life of more than a couple of days, and anticipates an exit with the underlying instrument priced 5-10% higher than the entry level).

So let's look at the DAX position. This extends to equity markets more broadly, although Australia was spared much of the week's carnage and thus will not bounce anywhere near as forcefully. 

For sentiment analysis I'll use US data (OEX option put-call, S&P futures CoT), because although DAX-specific data is available (only from me - I produce it myself), the US serves well as a proxy for all equity markets at sentiment extremes. Also, if I use non-proprietary data you can check the US-data calcs easily using public resources, whereas you can't check anything I say about things that only I generate for European markets (unless you do a lot of tedious data-collection and calculation).

The analysis proceeds based on a few core measures, which can be grouped under two primary headings: Technical Extremes and Sentiment Extremes. Of particular interest are divergences between the instrument and its CCI, coupled with a heavily oversold reading on the Williams %R.

Our lietmotif is that the crowd is always wrong when they all think that there is free money in the same direction as the dominant trend.

You will notice that I have said nothing whatsoever about valuation or any fundamental measures - PE, Yield, or what-have-you. That's because I am not advocating the end of a bear market: I fully expect the market to bottom at an undervalued condition (with the PE on the S&P500 at between 7 and 10 based on trailing earnings), at an S&P level of at most 450 - with a 25-30% chance of a final Dow level of 1000. Sounds terrifying, but that's just how it is: we're not going to get there in a straight line, and we're not going to get there next week or next month. 

All we are talking about in this exercise is a bear-market bounce which will clear a very heavily oversold condition. We are not looking for a new bull market, and in fact we are not even looking for a bounce which would be good enough to remove portfolio hedges; Australian markets have not fallen as far, and will not bounce as far, as either US or European markets. But it will be eminently hold-able - probably for two weeks starting after a crack downwards in the German market in the first hour of the cash market on Monday.

First, let's get a handle on the oversold-ness of the DAX at present. By the end of this post you will see the sentiment stuff as completely unnecessary, but I will post it tomorrow if I have the time. Suffice it to say that journalists are talking about a bear continuation - that ought to be enough to signal a contrarian snapback.

Everybody who reads the Rant knows my preferred oscillator combination: during a downtrend (do you think?) a long position on a given timeframe can only be taken if there is a CCI divergence on that timeframe. For a divergence to be valid, the conditions are reasonably onerous: 

  • the initial CCI extreme must be greater than 200 in absolute value (+200 for shorts, -200 for longs); 
  • the Williams %R must be in appropriate 10% of its range (-90 for longs, -10 for shorts); and 
  • there must be at least one period in which both the low (high, for shorts) of the bar is higher (lower) than the low (high) of the initial CCI extreme.

 For counter-trend moves, the exit is to be taken at the next %R overbought (oversold, for shorts) or the intervening swing high (low, for shorts), whichever occurs first.

A diagram will help bring this out (click on the chart below to get a bigger version):

DAX chart showing divergence
DAX Daily Chart - Was Ist Los?

So let's break it down - look at the divergence back at the late October low: The first low (on October 11th) was at 4306 (marked as 'A'); CCI was deeply oversold, and %R was solidly in oversold territory too. This deeply oversold condition was followed by a little burst upward to as high as 5383 on the 15th - a thousand DAX points in two sessions.

Once this bounce (and more) was given back, the DAX retreated to a closing low of 4267 on October 28th (marked as 'B'), but note that the CCI made a higher low

Thus a divergence was born - and the swing high (5383) became the target for the bounce.

Just 6 sessions after the CCI divergence, the DAX closed at 5307: it was within the day's range of the target day, and more importantly the %R registered an overbought reading.

So that's how a CCI divergence works (and they work about 80% of the time).

For the current divergence ('C' and 'D', with 'C' a slightly messy non-divergent range), the target is as shown on the chart as 'Target B', which is a DAX level of 4688, some 675 points above the Friday close. At present the %R target would be 3894+0.9×(4695-3894), which equals 4614 (which is within the trading range of the day marked as Target B): if the bounce takes place in less than a week, that will remain the target.

A second string to the analytical bow on the oversold-ness front (for daily timeframes) is the deviation from a longer-term moving average: to guage position entries I prefer the 200-day.

There have been four periods since 1991 during which the DAX has been 25% or more below its 200-day moving average: September 2001, October 2002, March 2003, November 2008 and January 2009. 

All have coincided with subsequent rallies, the smallest of which was 500 DAX points. 

More importantly, from the first day on which a 25% deviation from the MA200 occurred, an exit 400 DAX points higher was possible every single time.

The latest day on which the DAX dropped to a level 25% below its 200-day MA was February 17th, at a closing price of 4216: adding 400 DAX points to that level as the minumum upside objective gets you to - again - 4616... within the day's range for the swing high marked as Target B.

This is the Technical Case for holding a DAX long. The targets are grouped around the 4615 level, with a maxuimum objective of 4688.

As I have mentioned, my current long position which was well underwater on Friday, was taken off near the close in order to be re-established at a lower price on Monday, since the DAX will almost certainly open with a small gap to the downside.

When the DAX hits 4600-odd (it is actually possible that this happens before the end of this week) you will shake your head in amazement, and I will say "I told you so".