Today we serve up Part III of “The Journey: From Floor Trader to Family Office Manager,” in which Jack interviews Deep Alpha, a close friend and seasoned trader of 30+ years. (If you haven’t read Part I, go back and start here.)

In Part II, “Big Positions On,” Deep Alpha described her monster grain trade in the epic drought of 1988.

Now, in Part III, we follow her journey off the floor, beyond grains and into the world of position, swing and day trading… global markets… and Market Profile.

This interview series is part of the Mercenary Vault, an archive of exclusive high quality materials available to Mercenary Dispatch subscribers.

The Dispatch is our means of direct communication (via email) with Mercenary community members — and it’s free! Sign up here and don’t miss out on future exclusives.

And now to Part III…

Note: This interview is part of a series. Also available:

• The Journey, Part I: From Floor Trader to Family Office Manager
• The Journey, Part II: Big Positions On

JACK: To pick up where we left off: You liquidated all your positions on the Rockefeller-style cab driver tip, then high-tailed it to Europe. Before we cover what happened next, what was it like being a female in this testosterone-filled world of trading?

DEEP ALPHA: It was quite interesting. I was all business when on the floor, and only had one small incident with a chauvinist attitude. It was when I was first on the floor as a runner and, at that time, we were allowed to stand in the pit. So I would try to observe as much as I could by watching  the brokers and the commercial activity.

One cocky trader said to me, “so you think you can be a girl turned trader?” Without blinking, and looking straight ahead, I replied, “we have an actor about to be President (Reagan), so I guess anything is possible.” The other guys cracked up, and it was that kind of humor and demeanor which helped me. I also had the good fortune of growing up with a strong father and brothers, who were all good athletes and competitive. Another factor in my favor — there were a few women that were already members, and that paved the way.

JACK: You were never intimidated?

DEEP ALPHA: No, they knew I was serious and, in time, I was not afraid to trade size. As long as you are managing yourself well, avoid carrying an attitude, and show a strong desire to win, respect follows.

JACK: What about the stories you hear about the intense physicality of the pits? Guys who look like linebackers pushing and shoving each other.

DEEP ALPHA: As I mentioned earlier, I did a lot of spread trading, so I was not standing in the pit where guys were at each other’s throats. I was towards the back, and I would also use the brokers I know to fill orders for me. I had a good working relationship with the large floor brokers, as they filled my orders when I was upstairs doing hedging for companies and farmers.

JACK: You were never in there throwing elbows or screaming at people.

DEEP ALPHA: No, that was not my style. Scalping for small increments was not my focus. I also never intended to stay permanently on the floor. I wanted to experience it firsthand and then head back upstairs.  Markets were evolving and changing, and I was becoming more interested in expanding my knowledge.

JACK: You wanted a bigger view than just the pit.

DEEP ALPHA: It was an exciting time. The early 1980s had ushered in profound changes lead by computerization, global trading, and the growth of  computerized trading systems. The information age and technology were exploding. Currency futures, interest rates, stock indices and metals seemed fascinating, and I wanted to study and trade these instruments. The idea of trading a more global approach was appealing. Soybeans, corn and wheat were a good training ground, but I wanted more.

JACK: How did you approach this next phase of your trading?

DEEP ALPHA: I should share with you that, after the grain trade in ’88, I started to make all of the classic mistakes. Not using stops, over-trading… it was humbling and frustrating, and I realized I did not yet have a methodology I could use consistently across markets. I naively thought I could somehow transfer what skills I had learned in grains over to financials, and you can imagine the  lessons.

The bond market in particular was challenging,  and the S&Ps were brutal. But, I never traded these in any big way in the beginning, so I just had a lot of up and down in my equity. Flat-lined for a while. I laugh now at how little I knew. And I thank my lucky stars I did not burn out or give up.

JACK: What kept you in the game?

DEEP ALPHA: I took  three important steps that altered my relationship to the markets, all critical to my survival.

First, I realized my emotional package needed rebooting. Mark Douglas had come out with his first book,  “The Disciplined Trader,” and I devoured it. I called him and hired him as a coach. He really helped me identify my weaknesses and work on my consistency.

He also had me confront my issues around money. While I was hungry to make it and become a good trader, there was a lingering conversation going on in my subconscious.

JACK: How did you figure that out?

DEEP ALPHA: Through a series of questions, and then, bingo — I remember the “ah-ha” moment.

We were talking about my upbringing, how money was discussed in the home, that kind of thing. I remember telling Mark how upset I was when my mother first came to visit me at the CBOT. I was so proud of my workplace, showing off the exchange and touring the trading floor. She seemed like she enjoyed it, but was also a bit distracted.

Well, that night she phoned my father to tell him all about her day, and she was describing the beautiful, huge statue on top of the Board of Trade. My mother said, “and there on top of the building is Ceres, the goddess of greed.” My heart sank. The goddess of grain became the goddess of greed.

JACK: Wow, that is some filter.

DEEP ALPHA: Exactly. In her mind, the idea of people just standing on the trading floor to make money for themselves was too selfish. At some level, I had to deal with that and let it go.

JACK: Mark Douglas helped you with all of that, including self-defeating behaviors in your trading?.

DEEP ALPHA: He did, and he was just what I needed then. Around that same time, it was dawning on me that I still knew so little about the stock market and economics in general.

JACK:  How did you teach yourself about finance?

DEEP ALPHA: I sought out a teacher. I was fortunate enough to know an amazingly bright and successful stock investor whom I paid to help me learn. He certainly didn’t need the money, but I think he got a kick out of having a student and took it seriously.

Homework was in order, and I had a long list of books to read, from “The History of Interest Rates” by Sidney Homer to “The Road to Serfdom” by F.A. Hayek. He had graduated number one in his class at Wharton, and was scholarly and strict. I had to subscribe  to a number of  newsletters (some of which I still get today), and he would give me pop quizzes on the markets.

He wanted to make sure I was grasping the implications of monetary and fiscal policy as it relates to the market. He was not a trader, he was an investor, and an intense student of the markets. That time with him  was invaluable to me.

JACK: Sounds like you had a crash course in economics. What was the third factor that helped you?

DEEP ALPHA: I knew my understanding of technical analysis was shallow. Sure, I used moving averages, Bollinger Bands and drew my trend lines, but I had never embraced a technical method that felt truly comfortable. I had experimented with some systems — such as a neural network program that was useless — and a volatility breakout system, which was actually good. But, I wanted something I could use on a number of markets that I could understand. That was when I discovered Market Profile.

I had been hearing a lot about the success of Peter Steidlmayer, another Board of Trade member from the soybean pit. He was trading and teaching his own methodology, called Market Profile, which is very different from traditional technical analysis..

JACK: In what way is it different?

DEEP ALPHA: Most people look at and study bar charts with indicators that overlay the charts. Bar charts are basically linear – you have an open, high, low and close. They show an inflexible horizontal axis with no variance.

In other words, during a given day, each time slot goes forward without reflecting the extent of market activity at different prices. Steidlmayer set out to change this by introducing more complete data that exhibits the vertical price bar alongside a horizontal bar.

JACK: What does that look like?

DEEP ALPHA: The data creates a beautiful graph, where you can see the auction process more clearly. Think of Market Profile as a structure that uses the components of time, price and volume.  These are combined and displayed in a horizontal and vertical distribution — much like a statistical bell curve which, with understanding, reveals pricing patterns and value.

JACK: How did Steidlmayer come up with this?

DEEP ALPHA: In his book he talks about how he took a statistics course at Berkley in 1958, where he was introduced to the concept of a bell curve. He then went on to study Graham and Dodd, and began to see that, in any market, the relationship between price and value usually represents opportunity.

He set out to combine the concepts of price and value, and Market Profile was the result.

JACK: If he created a new way to look at market data, how did he gather the data and use it?

DEEP ALPHA: Steidlmayer was a director at the Board of Trade. In conjunction with the exchange they created something called the Liquidity Data Bank (LDB). In a simplistic sense, the data lets you see how much actual trading is occurring at each price. Up to that point, there was no way to create these Market Profile charts. With the LDB,  you could now feel like you were stepping into the auction process and visually see value being built..

JACK: So the liquidity bank was a real-time data collection project?

DEEP ALPHA: That’s exactly it. Collecting the data in this form, so it could be represented on a chart. And not a linear chart, but a three-dimensional chart, with so much more information than just “high, low and close.”

JACK: Was this being taught in a formal classroom?

DEEP ALPHA: Yes, and the classes were conducted after market hours at the Board of Trade. Market Profile intuitively made sense to me, though it took  time, dedication and practice to feel competent at understanding and recognizing the patterns.

JACK: How many Market Profile patterns are there? How many do you use in your trading?

DEEP ALPHA: There are a finite number of patterns that continuously repeat. These help me to assess whether a market is in balance or out of balance. And then there are different  strategies to adapt to the various patterns that keep reoccurring.

It’s kind of a dance, where the steps are the same but the music changes. Again, the basic tenet of Market Profile is that prices tend to follow a bell-curve distribution during any given day. How the market develops this curve provides clues as to the type of day shaping up. As the market auctions throughout the day, the shape of the bell curve helps to determine potential high probability trades.

JACK: How do you determine a high probability trade setup?

DEEP ALPHA: The Market Profile charts allow you to see what’s called “the point of control,” or the area with the highest market activity. This is dynamic — in real time — and is always changing with new market activity. As a result, a trader can see in real time if the market is accepting or rejecting critical areas.

JACK: Do you use this for short-term trades only, or longer term trading too?

DEEP ALPHA: It is a great day trading tool. I also use it for swing trading. My longer term trades are usually more fundamental, though I will use all of my tools to help execute and manage the trade.

When Market Profile was first made available to other traders, you could only view each individual day’s activity. As the technology evolved, you could merge two days, ten days, thirty days and more. So it has become useful for many time frames. It provides a visual three-dimensional display and, to me, it’s like poetry in motion.

JACK: Do you switch back and forth between time frames?

DEEP ALPHA: Yes — it is useful to look at the big picture, and then go to smaller time frames to get an overall feel. For example, if I am swing trading, and I see in a bigger time frame that we keep rejecting what was once a major value area, then that is a good heads up the market is probably going lower. Of course, there are other indicators and information I will use, but Market Profile gives a good indication of the tone.

JACK: So you will use Market Profile on a macro level to look at, say, bonds for instance?

DEEP ALPHA: Absolutely. And when it aligns with some of the classic signals, it’s just –

JACK: Like double or triple confirmation something powerful is happening.

DEEP ALPHA: Exactly. And I still follow fundamentals, what I see going on… when I get a sense of what I think is happening, and it all gels with Market Profile and some of the classic technicals, that’s when you really get aggressive. But my way of trading is not to put on a big package in the beginning — instead I will add, and then I’ll keep adding.

To be continued…

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]]> http://www.mercenarytrader.com/2012/05/the-journey-part-iii-embracing-market-profile/feed/ 0 http://www.mercenarytrader.com/2012/05/view-from-the-turret-jpmorgan/ http://www.mercenarytrader.com/2012/05/view-from-the-turret-jpmorgan/#comments Mon, 14 May 2012 14:06:19 +0000 Mike McDermott http://www.mercenarytrader.com/?p=22107 US markets finished last week under pressure from an unexpected headwind.

JPMorgan Chase & Co. (JPM) announced quarterly earnings which included a surprise $2 billion trading loss.  The news sent the stock spiraling  10% lower and raises significant questions about the company’s ability to manage risk.

On the surface, the trading loss could be brushed aside as a “one-time” mistake, that doesn’t really affect the overall market.  Aside from the trade, JPMorgan’s “ongoing” business was relatively stable for the quarter

But in reality, the loss is a startling reminder of how vulnerable the global financial industry has become, as a result of a number of factors:

• Europe’s sovereign debt issues are creating risk scenarios that are very difficult to quantify – and even more difficult to hedge against.

• A faltering domestic economic recovery leads to uncertainty for a number of key elements affecting ban’s “traditional” business lines (mortgages, lines of credit, commercial lending etc.)

• The “Bernanke put” has not only caused individuals to reach far out on the yield curve for income – it has forced the banks to accept more risk as well.

In a ZIRP (Zero Interest Rate Policy) world, investors have to become more and more creative to generate income – and that is true for corporations as well as individuals.  Banks in particular have an irresistible incentive to take more trading or business risks in order to generate returns on capital they can access for nearly zero cost.

So whether Jamie Dimon categorizes the loss as a poorly executed hedge or a flat out speculative position (or even “hedging their hedge” as the WSJ reports), the bottom line is that risks are accumulating to the point where it is impossible to determine the potential outcome scenarios – which by definition increases the risks for the industry, and in turn the entire market.

Even without the JPM trading loss, equities have been weakening throughout this quarter’s earnings season.  Industry leaders like Apple Corp. (AAPL) are failing to hold key support lines, and more speculative growth stocks with high multiples are particularly vulnerable.

Below are a few trading areas we are watching this week…

A New Batch of Risk for Financials

JPMorgan Chase is likely to be the new poster child for the Volcker Rule aimed at curbing the amount of risk banks take through their trading desks.  Under the proposed regulations, these trading desks will be relegated to hedging activities rather than speculative trading.

But the argument Jamie Dimon is making is that the botched trade in question would have actually complied with the rule as it was actually put on to manage risk.

So is that supposed to be comforting?  “Don’t worry that we lost $2 billion because it was actually just an incompetent attempt to manage our risk.”

Institutional investors now have to take a much more serious look at the risks for the mega-banks, and are very likely to reduce their industry allocations.  As capital flows out of the sector and into “safe haven” sectors, chart patterns are breaking down for financial stocks.

A breakdown in the banking sector brings back not-so-distant memories of the 2008 crisis – and fears of a repeat situation could accelerate the drop.  Aggressive short sellers piling into positions just as fearful investors begin to bail could easily set off a firestorm that would quickly spread into other areas as well.

We’re watching the financials closely, looking for potential entry points with reasonable reward-to-risk setups, and also viewing action in the financial sector as a good barometer for institutional risk appetite.

Emerging Markets Decelerate

As if the risks from financials and the European debt crisis wasn’t enough, traders are also dealing with a major deceleration in growth from emerging markets.  Economic reports out of China have been particularly soft (and there’s a good chance that these numbers are still being positively “skewed” by the government).

Last week we learned that industrial production for April was up 9.3% – the slowest growth in nearly 3 years.  India’s industrial production actually fell 3.5% versus last year – a major concern for emerging market bulls.

The good news (if you want to call it that) is that decelerating growth along with lower inflation numbers gives policymakers more latitude for stimulative measures.

The propensity for central banks from all sides of the globe to attempt to manufacture stable growth has had a significant effect on chart patterns – which in turn has affected traders who rely on the chart patterns to generate signals.  While the macro picture still leaves traders vulnerable to choppy conditions, breakdowns in emerging market indices have the potential to create good reward-to-risk scenarios – providing the positions are managed carefully.

Cisco Drops Its Own Earnings Bomb

Aside from the JPMorgan surprise $2 billion dollar loss, traders also had to deal with a grim outlook from Cisco Systems (CSCO) CEO John Chambers.

On the third quarter earnings call (CSCO operates with a July fiscal year end), Chambers noted a dramatic slowdown in corporate spending – which he claimed was an industry-wide phenomenon, confirmed by his colleagues from competing firms.

The stock plummeted Thursday and tacked on substantial losses Friday as well – as investors bailed out of an apparently sinking ship.  A few weeks ago, we noted weakness in networking stocks, and outlined a number of targets in the sector.

Now that CSCO has confirmed the weakness in the industry, the likelihood of bearish follow through is very strong.  The very best scenario would be for networking stocks (along with semiconductors and possibly the hardware and software areas) to catch a relief rally or consolidation, giving us an opportunity to set up new short entries with a manageable risk envelope.

As the technology industry heads lower, trading opportunities are becoming more attractive, and we are willing to commit more capital to bearish bets.

Equities are opening soft to start the week with more Greek drama and plenty of risk in play.  We’re comfortable with our bearish exposure, and tightening our risk points to lock in profits.

This week we have a number of key retailers announcing earnings (TGT, WMT, ANF, LTD, GPS etc) along with plenty of news from Europe, the financials – and of course the Facebook IPO.

Stay nimble and alert.  There are plenty of crosscurrents even as some of the haze is removed from the bearish big picture.

Trade ‘em well this week!
MM

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

• View From the Turret: Pick & Roll…

Within the charting community — especially among the practitioners of “pure” technical analysis, i.e. no fundamentals allowed — there is a new meme going around.

That meme is as follows: High Frequency Trading (HFT) has ruined the markets.

Thanks to those damn robots and their wicked brutalization of support and resistance levels, this meme says, it’s just hard for a chart trader to make a buck anymore.

It’s a frustrated rallying cry — and an effort to place blame. You can almost picture the laid off mill worker slumped heavily at the bar, muttering into his beer… the machines — damn those machines…

This meme was crystallized for me by Mike Harris of Price Action Lab (whom I had never heard of, but discovered via Josh Brown).

Here is the Harris dramatization of the situation at large:

Surrounded by robots he knew the end was near. One chartist against 1,000 HFT robots. One man trying to predict the future against 1,000 robots that create the future. He pulled out his last chart and he looked at it again a few times. He had to be right this time around in the name of all chartists who have fallen in the line of duty. He opened the chart analysis book written in 1929 and he looked at the pattern in the stock of Horse Food Packers International. The book said that this is a bearish pattern. This looked identical to the current pattern in SPY. He made his call. He knew that this was his last chance.

There are still a few around that refuse to give up but again most got nothing to lose. Chart analysis alone is a doomed activity. Chart analysis can be helpful in providing a context for evaluating the significance of signals obtained from algorithms that measure probabilities of directional price moves based on the analysis of price, volume and time. But charts alone are mere illusions…

- The Last Chartist (Price Action Lab)

Okay. As someone who cut his teeth using charts, I’m going to be blunt here: This sounds like whiny bullshit to me.

(And by the way, who’s trying to predict the future? The game is odds and probabilities, not prediction — but I digress…)

The following are my comments in the TRB discussion thread of the Mike Harris piece — views I shall expand on momentarily:

As a counter one could argue that blaming HFT is just a new version of sour grapes, i.e. “the market is rigged” blah blah blah.

There are plenty of alternative explanations for why markets have been so tough for traders as of late — for one big thing, the “head in a mixer” back-and-forth dynamic between bullishness off Federal Reserve stimulus and bearishness off the ongoing risks of eurozone crisis and China implosion / global slowdown.

The utter chaos of current top down conditions is further bolstered by the poor performance of top notch hedge funds who don’t use technical analysis as a general rule: Quantum Fund lost 15% last year and Maverick Capital (Lee Ainslie’s fundamental driven long / short fund) lost 30%. Do you think they are blaming the death of technical analysis too?

Anyone who points to the slamma jamma reversal action on a chart in this environment and then blames robots, rather than recognizing the extreme swings of investor sentiment these days caused by massively conflicting top down macro signals, is oblivious to the utterly confusing nature of the fundamental environment, and possibly blaming their failures on a proximate scapegoat (robots etc) without understanding what the real drivers are.

And yet, on the other hand, hey — the more traders who throw in the towel and give up the better. Properly applied strategies are more profitable when less followed.

And my second rejoinder in the same discussion thread, defending against the assertion that charts have become useless:

Agree that a lot of technical analysis is “voodoo,” pseudoscience, delusions in the eye of the beholder etcetera. But there are also reasons why well-designed non-HFT mechanical systems work, with explanations as to why they work.

As for what candlestick charts can and can’t do, I agree deeply with Kovner, paraphrase: “TA says nothing about the future; it tells you what other market participants have done up to the present. You have to use your own experience and judgment as to what happens next.”

There is a view of technical analysis that sees TA as a window of investigation for further possibilities; a sharply expanding range bar on significantly higher than average volume, for example, is not some kind of magical pattern but simply a clear indicator that something interesting is happening — like an arrow that points to potentially meaningful sea change in  investor sentiment and institutional capital flow.

Many so-called “patterns” fulfill this function; TA can effectively be viewed and used not as a standalone crystal ball, but as a highly compact and efficient represention of sentiment and capital flows, with flags of interest popping at the interesting intersection where shifts occur. This use of TA — in conjunction with a deeper understanding of what drives markets on a fundamental level — sits in too high a timeframe and too case-by-case an application set to be degraded by “bots” or other operators in the high frequency space.

But then, what I describe here is not really “true” TA in the first place, to the extent that true TA represents a slavish devotion to the idea that chart patterns actually have intrinsic meaning, instead of merely being two-dimensional abstract representations of aggregate buying and selling activity and nothing more.

“Okay then,” the frustrated chartist club responds.

“If high frequency trading hasn’t @$#ed up these markets, then what has? Because you can’t deny these markets have been screwy…”

To which I say yes, markets have been screwy, Daffy Duck screwy even, to the point of making chart traders — some, but not all — want to punch monitors and tear their hair out.

But as the title asserts, it ain’t HFT  I tell ya — it’s the macro!

As someone who looks at 300+ charts a day AND consumes the informational equivalent of half a dozen newspapers per day, I feel reasonably well qualified to pitch in my two cents on this.

To me, the Occam’s Razor explanation for why charts have gone Daffy Duck is not because of robots, but simply because the macro environment has been bizarre… like “unprecedented in history” bizarre. And it’s been this way for a while now.

This week’s trading action is a perfect example.

As I write this at my desk, trading screens flashing on my second monitor, the S&P is acting like a cartoon character on crack. It’s been that way all this week:

• Monday was quiet, when a downside blowout on Greece was expected.

• Then the downside blowout came on Tuesday — but it almost completely reversed, with an impressive clawback for the bulls.

• Then today, Wednesday — a repeat of Tuesday’s wackiness! Nutty drop, nutty retracement… what gives? The robots run amok, right?

Nope. It fits the fundamentals. Click the chart for more legible text:

click to enlarge

How much you wanna bet this bizarro action continues?

Half the traders out there are remembering the lesson of Lehman Brothers, waiting for Europe to bust this sucker wide open, while the other half are recalling all the “Boy-Cried-Wolf” episodes where the eurozone drama du jour was resolved at last minute, leading to a melt-your-face-off risk-on rally, sung to the tune of “crisis over, everything’s super.”

With a backdrop like that, you don’t need robots to explain the “Mr. Market on drugs” phenomenon.

They say truth is stranger than fiction. As a long time practitioner of the global macro style, I can say I have never seen such “stranger than fiction” markets in my lifetime. And older generation trader friends with double my time in the saddle say something similar.

The macro is just nuts, ok? I mean everywhere you look, you run into some version of “irresistable force meets immovable object:”

• The debt-laden West is on an irresistable path toward economic reckoning and the need to “clear” excess leverage — yet the printing press enabled Federal Reserve is the immovable object opposing it.

• The eurozone is caught between a ridiculously hawkish Germany (“we’re not budging”) and a ridiculously dead-in-the-water periphery problem (Spain, Greece et al = toast).

• China — and by extension Australia — are headed for a massive property bubble / commodity / infrastructure bust, and yet the People’s Bank of China has the biggest war chest of all central banks with which to stave off the reckoning.

• Serious inflation and serious deflation are both reasonably argued possibilities for “what’s next.” There are sharp guys arguing short treasurys are the trade of the decade and sharp guys backing up the truck / buying treasurys with both hands.

• Now take all the above and consider that 1) America might actually recover (thanks to unexpected economic resilience and a housing bottom), but 2) America ALSO might be completely screwed (economically speaking, in the medium term, as a result of false housing bottom and bad-to-worse crisis response policies).

• So… is it any wonder these markets are screwy?

One other point, re, screwy charts and where to place blame. In light of the above, consider this Stevie Cohen quote from Stock Market Wizards:

[Wharton] taught you that 40 percent of a stock’s price movement was due to the market, 30 percent to the sector, and only 30 percent to the stock itself, which is something that I believe is true. I don’t know if the percentages are exactly correct, but conceptually the idea makes sense.

If as much as 40% of a stock’s movement is due to “the market,” which now includes bizzaro top down factors whippy enough to make investors howl like cats in a dryer, how could charts not be Daffy Duck in this “risk on, risk off,” coming-and-going blenderfest?

The Longer it’s Bad, the Better it Gets

I’ll close this  — my 2 cents turned into two bucks — with a positive outlook.

From a macro perspective, these markets have been “bad” (i.e. hopelessly screwy) for a while. But the longer they stay bad, the better they’ll be in future… particularly for chart-based traders.

Why? Simple game theory:

• These high-drama tensions will eventually clear, one way or the other. (Yes Virginia, the eurozone crisis will actually end some day.)

• The longer this mess takes to clear, the fewer “survivors” there will be on the other side.

• The fewer traders there are using a strategy, the more effective that strategy is likely to be (once the macro environment stabilizes).

So hey, wait a minute, what am I doing… I should be agreeing with the robot doomsayers.

Yeah, charts have gone bad forever — that’s the ticket… all of you should stop using charts immediately… throw in the towel, yeah… just kidding.

Chart debate aside, are there ways to still trade and prosper in this environment? Ways to preserve capital and make some decent coin too?

I say yes. It takes some adjustment, and a little bit of willingness to grind more than usual, but it’s definitely doable.

In a future piece we can talk about the successful “adjustment steps” Mercenary has taken to handle this persistent wackiness.

funny old world innit,

JS

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While the selling got started midway through the week, the intensity really picked up following the April jobs report which was a major disappointment.  For the month, payrolls rose by 115,000 – well below the 165,000 that economists had expected.  April marked the third month of decelerating job growth…

In the ‘lies, damned lies, and statistics’ category, the official unemployment rate actually dropped from 8.2% to 8.1% as the US workforce shrank for the second month.  According to the BLS, 342,000 people left the labor force last month.  Apparently, the market saw through the government charade as the S&P dropped 1.6%, the Nasdaq Composite lost 2.2%, and every single Dow component traded lower.

With the majority of recent global economic reports showing weakness (particularly in manufacturing, employment, housing, and consumer measurements), bullish investors are finding fewer data points to support their posture.

First quarter corporate earnings reports have held up as one of the last remaining bullish areas – thanks to the majority of companies beating expectations.  But according to Bespoke Investment Group the rate at which individual companies are beating expectations has declined steadily throughout the season.

It’s becoming harder to justify bullish positions as the market rolls over, and we’ve been methodically adding bearish exposure to our trading book.  With plenty of economic land mines still threatening investors, we’re growing more confident in methodically adding more exposure while still carefully managing our risk.

Below are a few of the specific opportunities that we are tracking this week…

The Australian Connection

While fielding questions from a group of traders last week, I was asked about my thoughts on the US dollar.  I responded by saying that the US dollar has plenty of problems – and ultimately may lose a significant amount of purchasing power…  but today, the US dollar remains stable versus the other major currencies whose problems are much WORSE!

My suggestion was to consider short positions in currencies that were tied directly to natural resources, as current weakness in emerging markets has the potential to shift the supply / demand balance  - which in turn affects the currency of resource-rich countries such as Australia and Canada.

In fact, the Mercenary Live Feed took a short position in the Australian dollar (via AUDUSD currency pair) last week as the currency resumed weakness after a brief consolidating drift.

Last week, the Australian central bank cut their current economic forecast from 3.5% to 3.0%, as an indirect result of weakening demand for resources.  The lower expectation gives policymakers more leeway to cut interest rates – which would be a natural headwind for the aussie.

Austerity measures in Europe add insult to injury as now both emerging markets AND a major portion of the developed world are running into constraints for manufacturing and building.  Now that the bearish Aussie trend has been confirmed, the pair could fall a significant way before running into a legitimate support area.

Speaking of Resources…

US equities weren’t the only group of securities that were under pressure last week.  Oil prices took it on the chin as well, dropping well below the $100 per barrel mark for the first time in months.

Spring is typically a bullish month for oil prices as traders anticipate a pickup in demand with the summer driving season.  This year, the supply side of the equation is getting more attention…

Oil inventories rose for the 6th straight week last week – hitting their highest levels ever for this time of year.  Couple that statistic with weakening manufacturing, employment and consumer spending, and you don’t need much of a catalyst for prices to start backing down.

The big question now is how investors will treat the oil producers…  If the commodity prices soften significantly, it will certainly cut into profit margins and lead to earnings disappointments.  The political environment is already heavily weighted against these firms, and yet any contraction in production would be viewed as “price fixing” – leading to more backlash.

The E&P (Exploration & Production) majors have been hitting key resistance areas on their charts lately – see weekly charts for Exxon Mobil (XOM), Chevron Corporation (CVX), BP P.L.C. (BP) as examples – and a breakdown for the group would likely set up some very attractive reward-to-risk short opportunities.

Another Technical Failure?

Technology stocks have not been immune to the broad market selloff.  Last month we took a look at a group of networking stocks – identifying a handful of vulnerable stocks worth watching.

In keeping with that overall theme, take a look at the current chart for the S&P Technology Fund (XLK)…

If the pattern looks familiar, simply pull up a chart of Apple Corp. (AAPL) and you’ll see why.  According to Morningstar, Apple makes up 18.31% of the ETF’s holdings – and of course Apple has been showing signs of breaking down since it topped in early April.

Technology stocks as a group are widely regarded as speculative positions – and while it’s not fair to paint such a diverse group with such a broad brush, the truth is that as institutional investors adjust their exposure to a more bearish environment, they will be active sellers of high-beta liquid stocks.

The technology group is also vulnerable to reduced corporate spending as companies back off on growth initiatives until the economic picture becomes more clear.  We’re isolating breakdowns in this area and watching for consolidation periods to set up better reward-to-risk entry points.

This week, traders will continue to focus on a full slate of earnings reports, the results of European elections, along with a few key inflation measures at the end of the week.

Greece is the major fly in the ointment Sunday night as pro-austerity parties received 32% of the vote (see Business Insider).  This makes it more challenging for current bailout deals to be pushed through (no austerity, no bailouts) and raises even more uncertainty.

Overnight futures show oil near $97, US equities down another 95 basis points, and the aussie dollar hitting new lows.

The trading environment still favors nimble participants – as there is still plenty of uncertainty.  The bearish action gives the fed more ammunition for additional liquidity measures – so don’t be surprised if the bulls try to pull that out of their hat.

Overall, the picture is turning decidedly bearish and we continue to be comfortable building short exposure as equities break down.

Trade ‘em well this week!
MM

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click to enlarge

I recently had the opportunity to go out for drinks during the week. I turned it down, saying I can’t consume alcohol on a school night.

Friend’s response: “You mean a work night?”

“Nope. For traders they are school nights — because if you don’t rest up and do your homework, the market schools you good.”

Within the context of the Mercenary trading style, doing our homework means staying on top of key developments, both fundamental and technical.

And not just somewhat on top of things, but COMPLETELY on top of things — “like Pamela Anderson on a can of spam,” as an old colleague used to say.

(Not sure what that means exactly, but it stuck…)

Anyway, in the interest of maximum awareness, we recently added a feature to our flagship advisory service  — the Live Feed Trend Tracker, as shown on right. (Click image to enlarge.)

In addition to the market analysis and top down perspectives you see in the main post stream (and receive via the Mercenary Dispatch), we regularly broadcast more portfolio-specific and trade-action specific material — including real time trade executions, position sizing guidelines, portfolio dynamics, and more — within the Live Feed.

Below is an example of our open book thought processes, posted to the feed stream early this morning (prior to the day’s carnage). To find out more about the Live Feed — or get a free 14-day trial — go here.

Danger Will Robinson!

1:41 am – May 4, 2012

This is a dangerous market with lots of crosscurrents. The major indices (Dow, S&P, Trannies etc) are right in their most precarious spot — threatening a breakout to new highs, but also threatening to break down and fall back into the wide-swinging range that’s been in place since mid-March.

Bulls look at the charts and see healthy “backing and filling” action. Problem is, the fundamental backdrop to this market is scary too. Lots of potential hand grenades out there — like European elections this weekend, for example, or various econ data points with the ability to spook markets one way or the other.

The trend tracker is still chock full of “caution” lights. Plus we are seeing budding uptrend breakouts getting smashed in the mouth with no warning. Just look what happened to semis and energy stocks on Wednesday Thursday — two groups that had bullish patterns the day before (click to enlarge):

Our portfolio exposure levels are pretty small right now, and we are happy to keep ‘em that way. Maximum trading profits are not accumulated at a steady drip-drip rate day after day, but over the course of repeating market cycles.

Within a market cycle, there will be times when conditions are excellent — that’s when you want to be trading big. Then there are times when conditions are crap — that’s when you want to be trading small.  Big profits are compounded through a combination of both: Exploiting excellent market conditions with smart aggression, and minimizing danger when conditions are subpar.

Within the next few trading sessions, there are two ways the markets could go:

• We could see a strong report or two plus benign Europe outcomes, leading to “risk on” relief rally and indices breaking out to new highs.

• OR, the fit could hit the shan in one or more places — terrible jobs report, scary Europe result etc — causing the majors to fall hard with renewed possibility of bearish downtrends to develop.

The first scenario is the less desirable, from a trading perspective, because 1) bullish setups are so scarce, and 2) because underlying fundamentals remain so precarious.

The second scenario is more desirable because, if the market begins a strong move lower, it will cause a lot of overbought stocks to “clear”, setting them up for a good crop of bullish patterns later — while providing good short opportunities here and now over a month or two of correction (if not longer).

We don’t get to pick the scenario, but we do get to choose our reaction. If we get scenario 1), a bullish push to new highs, we will consider that reason to grow even MORE cautious, as a move higher here would be more risky and silly than constructive. In this event we would probably keep hunting for swing opportunities, but reduce trade size as a function of minimizing exposure in crappy market conditions.

If things break to the downside, however, we will be more open to exploitation, as the embedded profit in a nice correction could be substantial…

So strap in once again and get ready for some turbulence. The next few days (Friday and on into next week) could get a little wild.

Once again, if you want more insight into how real traders, deploying real capital, make integrated portfolio decisions in real time, go here.

wondering where the rum’s gone,

JS

• Attention Frustrated Chartists: It's not HFT - it's the Macro!

• A Dangerous Market Full of Crosscurrents

• Euro Zone Crisis: Back on the Front Burner

• Concerning Gray Swans: Europe, China, Profit Margins and The Fed

• The Return of Ugly Goldilocks

• Gold Looks Terrible Part II: Clarifying Thoughts

• Home Builders (Technically Speaking)

• Downgrades & Mellonists: This is What the Market Fears

• The Bond King Gets Desperate

• S&P 400? The Deflation Shock Scenario

• Pension Funds and the Zero Bubble

• Milking the Consumer Cash Cow -- How Much Longer?

• The Great Compression

• Deeper Implications of Middle East Turmoil

• Pondering the High Cost of Food

• The Age of Cyberwar is Here

• Did China just ring a bell?

• Twelve Major Risks for 2011

• Why Investors Should Be Terrified of Deflation

• Strip Mining the U.S. Economy

• It's the Debt, Stupid

While the primary bullish trend lines were clearly broken earlier the month, the price action has rebounded – putting key indices back above important EMA support areas.

But at the same time the market has been pushing higher, the fundamental data has been less than encouraging.  The first quarter GDP report came in at 2.2% annual growth – well below expectations – as business investment showed particular weakness.

This “bad news” was essentially shrugged off by equity traders, who saw the weakness as a great opportunity for the Fed to renew its promises of ample liquidity with essentially zero interest charges for the foreseeable future.  Incidentally, treasuries posted their 6th straight positive week despite a modestly more “hawkish” FOMC announcement this week.

Midway through April, we had the chance to take a solid shot on some attractive R (reward to risk) bear scenarios.  A few of these trades resulted in quick profits.  And a few hit our tightened risk points during the rally last week.

The net result is that our overall exposure has been whittled down quite a bit in response to the market environment.  This type of situation is normal…  There are times when you get the chance to step on the gas, and then quickly have to maneuver around new obstacles.

Considering the cross currents that were introduced last week, the waters are a bit more muddy for short-term trades.  At the same time, there are a number of sectors and industries that look very promising.  More data this week in the form of earnings announcements and economic reports should help to clarify the action – giving us opportunities to set up new trades along the way.

Below are some of the area’s we’re watching this week…

Auto-Makers Backfire

Last week Ford Motor (F) reversed sharply lower after reporting earnings for the first quarter.  While the headline numbers were good, Ford reported an operating loss in China.  More importantly, management comments frightened investors as the picture is souring early in the second quarter.

During the conference call, management stated that “April has been challenging.”  Considering the fact that the stock has already broken below a key support area, this bearish fundamental data didn’t help the bull’s case at all.

After drifting higher early in the week, Ford reversed sharply – setting up a great bearish continuation pattern.

The bearish environment is confirmed by the price action in General Motors (GM), as well as key supplier Goodyear Tire & Rubber (GT).  Goodyear expects weakening volume as the company adopts a strategy to focus on premium tires – and investors interpret this to mean the company is finding less demand for its “standard” lines.

Private Equity Capitalizing on Opportunity

On the bullish side of the ledger, things are looking better for several private equity companies…

Last week, KKR & Co. (KKR) announced “economic earnings” of 99 cents – well above estimates for 73 cents per share.  The stock had a decent week, and is rebounding off a key support area (after bottoming in 2010).

It’s interesting to note that the company has been much less aggressive on the acquisition side.  KKR only made 2 major purchases in the first quarter – and is likely to see more profits from distribution of assets, IPO transactions, or other selling transactions.  When these events occur, it allows the PE firms to book incentive allocations – obviously good news for KKR shareholders.

An interesting note from the earnings presentation is that KKR made a $196 million shopping mall acquisition last week.  Commercial real estate (particularly retail-based) has been fairing well over the last several quarters.  Simon Property Group (SPG) has been trending sharply higher and had a blowout earnings announcement last week as well.

Picking up exposure to strong retail properties should be a cash-flow positive proposition for KKR in the short-run, with plenty of opportunity for capital gains if and when they decide to book profits on the property.

Both KKR and Fortress Investment Group (FIG) look like strong bullish candidates, provided the patterns remain intact and the overall equity environment doesn’t fall apart.

Fertilizer Stocks Back on the Radar

We have taken a step back from fertilizer stocks after the group faded into the end of the year.  But the recent action for the group has been much more encouraging, and last week CF Industries (CF) broke to a new high.

A warm spring across the northern hemisphere has led to a record planting season.  This of course leads to stronger demand for fertilizer – and inventories are being drawn down.

During the quarterly earnings call, Mosaic Co. (MOS) management stated that both domestic and international markets had strengthened significantly – comments which helped boost investor sentiment for the group.

Production activity is picking up for the group, and even larger conglomerates like BHP Billiton (BHP) and VALE Sa. (VALE) are exploring ways to boost their exposure to the area.

Heading into the week, equity markets are opening soft, and precious metal prices are particularly weak.  Earnings season is still in full swing and there are plenty of data points both on an individual stock level as well as reports that could move entire sectors or asset classes.

Risk management is the name of the game this week.  We’re managing our exposure carefully while still keeping an open mind for potential entries in attractive sectors.

Trade ‘em well this week!
MM

PS. Are you an active swing trader? Do you like the thought of consistent profits in 3 to 5 trading days? Then grab your chance to beta test our new High Probability Swing System (HPSS).Click here to find out more…

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

• View From the Turret: Pick & Roll…

Equipment stocks showed their true colors Wednesday (04/25), failing to keep pace with the major market indices…

While Apple’s positive earnings announcement sent the bulls into a buying frenzy, the major equipment stocks failed to show up at the party.  Bearish action in an otherwise positive environment is definitely a red flag worth digging into (no pun intended)…

There were two primary catalysts that drove equipment stocks lower.

• The first quarter earnings report for CAT failed to live up to expectations.

• The durable goods report turned out to be the weakest reading in a number of years.

First, the earnings announcement from CAT.  On the surface, the report was fairly positive.  Q1 EPS rose 29% over last year due to strong domestic sales and healthy demand from mining equipment.

Management even raised full-year guidance – although not as much as Wall Street was expecting.  Instead of focusing on the strong quarter and higher guidance, investors worried about weakening demand in China, Brazil and Europe – and dumped the stock on heavy volume.

Via the WSJ:

Chinese buying of construction equipment has plunged since the middle of last year as higher interest rates, have discouraged spending on machinery and building projects.

But Caterpillar expects Chinese demand to recover in the next few years.

Since the real opportunity for equipment makers is heavily weighted towards potential sales from China and India, a disappointing picture for emerging markets is certainly cause for concern.

This falls in line with our Gray Swans thesis – as a confluence of bearish macro-economic catalysts challenge the Goldilocks growth scenario.  Decelerating growth in China and austerity measures in Europe can’t help but dampen global demand for capital-intensive equipment.

But what about domestic sales?  This was an area of strength right?

Caterpillar may have reported a strong sales of construction equipment in the US, but yesterday’s durable goods report was much less optimistic.

For the month of March, durable goods orders declined by 4.2% – the largest drop since January 2009.  And just for good measure, the Commerce Department revised the February report lower – so March’s decline was actually worse than the headline number indicated!

Once more from the WSJ:

Wednesday’s durable-goods report followed a string of weaker regional manufacturing reports as well as industrial-production data that showed manufacturing production fell slightly in February, despite strength in several areas including vehicle and parts manufacturing…

Indeed, while new orders for durable goods slipped over the month, shipments were up. That means the slowdown in manufacturing, if it continues, is likely to take a bite out of second-quarter growth. The shipment figures, in fact, prompted economists at Morgan Stanley to boost their forecast for first-quarter gross domestic product to annualized growth of 2.9% compared with 2.7% before the report.

While the CAT may already be out of the bag (ok, that was really bad…), we’ve got our eye on a number of equipment makers that have bearish or weakening chart patterns along with fundamental vulnerabilities.

All of our trades are time stamped and reported in real time via the Mercenary Live Feed.

• Cummins Inc. (CMI) has a focus on diesel and natural gas engines, and relationships with OEMs who are selling directly to domestic and emerging market end-users.  The stock broke to a new high in February – but ran into overhead resistance and broke down.  CMI pays a 1.4% dividend yield (creating a negative-carry short position), but looks technically vulnerable in an industry that is under pressure.

• Deere & Co. (DE) manufactures equipment for agricultural as well as construction markets and is expected to grow earnings by 21% this year.  A heavy debt load (249% debt to equity) makes for a vulnerable financial situation, and the stock dropped sharply this month after a crop report hit corn prices hard.  With significant overhead resistance, DE shares should have difficulty trading higher, and there is plenty of room below before hitting significant support.

• Joy Global (JOY) sports one of the better growth rates (expectations for 30% EPS growth in 2012), but analysts have been revising their models lower as the economic picture deteriorates.  The stock has been underperforming its peer group this year (see chart above) and has established a predictable bearish pattern.  JOY is set to announce Q2 earnings on May 31 (fiscal year end Oct 31), and for now the stock is trading in-line with the increasingly bearish industry.

• United Technologies (UTX) has been under pressure due to low revenue and earnings growth.  For the first quarter, UTX logged a 2% decline in revenue, but cut costs enough to manufacture a 2% bump over last year.  The stock peaked in March and has been trading below the key 50 EMA since the beginning of April.  With earnings now out of the way, there are few catalysts that would send this stock higher, and plenty of vulnerability based on economic headline risk and industry trends.

• Caterpillar Ignites Fear for Equipment Stocks

• Networking Stocks: Ready to Short?

• Deep Value Solar Rebound Candidates

• Oil & Gas Stocks With Explosive Potential

• Gold Stocks Poised for Another Run

• Social Media Fantasy Trades

• Retail Stocks Getting Whacked

• Airlines Ripping as Oil Pukes

• Truckers Running on Fumes

• Rising Tide Lifts Shippers

In Part I of this interview series, you were introduced to “Deep Alpha” — a 30–year veteran trader with a broad and deep roster of experiences, both in the pits and out.

Part I further covered DA’s early educational background… her deep interest in cognitive biology and human networks… and the story of how she discovered grains and made her way up at the Board of Trade.

In Part II we pick up where the conversation left off — the transition to the trading floor, just in time for one of the wildest grain markets ever.

This interview series is part of the Mercenary Vault, an archive of exclusive high quality materials available to Mercenary Dispatch subscribers.

The Dispatch is our means of direct communication (via email) with Mercenary community members — and it’s free! Sign up here and don’t miss out on future exclusives.

And now to Part II…

Note: This interview segment is Part II of a series. Also available:

• The Journey, Part I: From Floor Trader to Family Office Manager
• The Journey, Part III: Embracing Market Profile

JACK: 1988 was the year of the epic drought.

DEEP ALPHA: Yes, and it was quite devastating. Thousands of lives were lost, due to extreme heat levels. Crops were decimated. Corn alone lost 45% of its crop. Farmers were wiped out and literally “lost the farm.”  And, it was costly. Up until Katrina, it was the most expensive natural disaster in history.

JACK: And you were in the grain pits of course…

DEEP ALPHA: I was in the grain pits. It was an unreal experience. My first real bull market. You know, I started my career at the end of the 1970s commodity bull market. Or, you could say I started at the beginning of a devastating secular bear market. Good timing!

Interest rates were spiking, production increasing… I had always wished I could have experienced those wild markets, you know, when gold, silver, soybeans, crude oil, you name it were all flying to the upside.   In retrospect, however, learning the craft at that particular time helped me develop key practices that kept me in the game.

JACK: What kind of things did you learn?

DEEP ALPHA: Capital preservation was critical, as it was tough to make it back. I learned that the hard way, as most of us do. I learned to trade with a healthy degree of fear, and a deep respect for how the market can just crush you. I also saw that it was not a right / wrong game. My job as a trader became clear – to manage risk well in markets that were going against me.

JACK:  That “not a right / wrong game” concept sounds related to your early interests.

DEEP ALPHA: Yes, it is non-Aristotelian logic. People tend to think in terms of duality, and this is limiting.

If you ask most people what they think is the most important part of trading, they will typically say, “being right.” Wrong! It is about how a trader manages their risk — especially on the wrong side of the market. There is so much I learned about ego and emotional management.

JACK:  Did you study other traders on the floor?

DEEP ALPHA:  Constantly. I observed, asked a ton of questions and took it all in. Up until 1988 I had been a fundamental trader. I talked all the time to other traders with a strong background in fundamental analysis and commercial knowledge.

I was always asking, “How do you know that?,”  “Where did you hear that?,” and “What are the big boys doing?”  Oh, and I was always asking what they read to keep up on markets, what books they would recommend. I spent most of my afternoons in the CBOT library, a treasure trove of market literature.

JACK: What were you trading in the summer of ’88?

DEEP ALPHA:  Up until 1987, I had mostly traded spreads in the grain markets. I learned these well, as the commercials were always involved in spread relationships. I would trade the inter-commodity spreads, such as long corn / short wheat. Also intra-commodity spreads, where you go long one month against another in the same market. Then there was the crush spread — long or short soybeans and short or long the products (soybean oil and meal).

Many times, spread relationships will give you a heads up as to the outright direction of the market.

JACK: So, spread trading was how you learned to trade.

DEEP ALPHA: Yes, and another fact I should mention: I didn’t have to put up margin when I was with Conti.

JACK: No margin! You could have really gone crazy.

DEEP ALPHA: I think they were watching, and size would have been a game changer, so I stayed low key. I can’t say that about later years, but that’s a whole other story… there were a number of leverage gifts going on back then that don’t exist today.

JACK: Such as…

DEEP ALPHA: One of the things a lot of people don’t know is that, in the 1970s,  there were a lot of small local firms who knew each other. It was definitely a club.

At the time it was easy for these local traders, who had memberships on the floor, to make a lot of money very quickly. A lot of them DID go crazy, and would go belly up, and be out of trading for a while. And the local firms would back them, and let them make it back, because they had their seat as collateral.

That was kind of the thing, helping each other out. A guy would go belly up, get new backing, and boom — he’s making millions again and back in the game.

When I came to the floor in the 1980s, there was a little bit of that still left. I went with a local firm, because I had a membership, and they gave me an incredible amount of leeway. They did it for two reasons: I was doing a ton of business, because I still had all my clients — the commercials and two huge speculators — and I was trading successfully on my own.

JACK: Right into the drought. Were you trading size then?

DEEP ALPHA: Yes. Those positions were huge for me, and I think they might have been huge for anybody. And it was just limit-up, limit-up, day after day. It was unbelievable.

JACK: How many contracts are we talking here? Thousands?

DEEP ALPHA: More than I would ever dream of doing today.

JACK: How do you deal with the emotion behind that? Riding huge open profits in multiple markets, limit-up day after day?

DEEP ALPHA: You live and breathe weather and pray it never rains on Lasalle Street. And my sleep patterns were awful. I never had a decent night’s sleep during this time. But other traders react differently, which leads to a funny story.

There was a famous floor trader, nicknamed “Ricky the Rocket,” who was a big player. He always had huge positions on. And his equity swings were volatile. Millions up, millions down and notorious for the swings.

Back then I would have breakfast every morning with three or four competent traders – lots of floor trading experience and  deep knowledge of the cash market — to strategize and talk about what’s going on in grains. One day, after one of these limit-up days had closed, we’re all at Sign of the Trader, the restaurant at the Board of Trade. We’re having drinks, talking, and Ricky the Rocket sits down.

I’m kind of freaking out at this point. I’m not sure if I can take much more stress –

JACK: Because of the size?

DEEP ALPHA: Because of the size, the  daily swings, and the amount of money I’m making. It is weird to make more in a few weeks than my father ever made in a year. Now, don’t get me wrong. I am loving it and the adrenaline rush is unlike anything else. I just knew I had to be careful. Adrenaline is highly addictive, and trading can quickly turn from treating it as a business to a  rush where you just need more to feed the beast.

Anyway, I’m starting to quietly panic inside. Something doesn’t feel right .

So I turn to Ricky, knowing he also had boatloads, packets on, and I say: “How do you do it? How do you sleep at night when you have these big positions on?”

And Ricky looks at me and says: “I CAN’T sleep at night unless I have big positions on.”

JACK: That’s a unique point of view. He must have been wired differently.

DEEP ALPHA: It was true for him, it really was.

JACK: What happened next?

DEEP ALPHA: The very next day I’m taking a cab down to the Board of Trade. The heat is just sizzling, I know it’s going to be another hot day in the fields… And the cab driver says to me, “How about those soybeans.” He wants to know what I think, knowing I’m going down to the CBOT.

I think to myself, “This is not good.” So I went in and methodically liquidated every position.

JACK: Every position??

DEEP ALPHA: Every position, still at limit-up. We’re talking wheat, beans, corn, soybean meal, soybean oil, spreads… out of everything by the end of the day. Then I called my best girlfriend — we were both single at the time — who was in advertising.

She knew what was going on, and I told her: “I just liquidated everything, and I made a fortune. If you can take two weeks off, I’ll pay for everything and we’re going to Europe. I have to remove myself from this place, or I’ll probably get back in and give it all back. I have to physically remove myself from Chicago.”

I don’t think she even blinked. She says  “Book it, Danno!” and hangs up. Next thing you know we’re on a plane… I didn’t even call in until the third or fourth day. Pouring rain, limit-down.

JACK: Beautiful. What happened to Ricky the Rocket? Did he come out ok?

DEEP ALPHA: I think he came out ok. He gave back a ton, but didn’t go belly up. He wound up buying a firm — getting into the commission business and all that — and his later claim to fame was a currency trade. He put on a huge currency trade, made multi-millions, then left the Board of Trade and went out West.

JACK: He went through all of his stress reserves and became a gentleman farmer.

DEEP ALPHA: Exactly — at some point he couldn’t take it anymore, and bought a ranch in Montana. I love it though: “I can’t sleep if I don’t have big positions on!”

Continued in Part III: Embracing Market Profile

Welcome back,

- “Welcome Back Kotter”

This week kicked off with more political crisis in Europe.

I know, we’ve heard all we can stand on Europe… but now things are getting serious again (hence the market’s non-trivial reaction on Monday). It’s a good time to revisit the basics of the situation.

In France, Nicolas Sarkozy lost the first election round to a socialist, even as the far-right party saw a historic showing; in the Netherlands, a budget crisis led to resignation. Both these items are directly related to the eurozone crisis, and a growing disgust on the part of the populace in respect to current policies.

Some quick recaps:

• Le Pen Shocks France as Far Right Hits Historic Heights (France 24)
• French Elections: How Democracy Could Destroy the Euro (Time)
• Dutch Prime Minister Resigns (WSJ)

Economist 2010 Redux

What is happening in Europe right now can roughly be described as a fiscal war between Germany and the periphery countries.

• Germany, the “deep pocket of Europe” (to use a Soros phrase), wants strict austerity, harsh budget cuts, and all-around “fiscal discipline” for the struggling periphery countries. The shared credit card was abused; now Germany wants spending privileges harshly cut back (if not outright revoked).

• Meanwhile the periphery countries — Spain et al — are sinking into deflationary downward spiral, headed for deep recession or worse. Citizens of these countries (now add France) are saying “give us room to breathe.” Germany is saying “nein!”

What’s worse, too much austerity can actually accelerate fiscal collapse.

This happens when government cutbacks and tax hikes lead to business closures and revenue declines.

Imagine a barber dependent on government employees coming into his barbershop; the government employees get laid off, the barbershop goes under, and the tax base declines further.

This problem is especially serious in heavily government-supported economies (like those in Europe). Government spending cannot simply be “withdrawn” without entrepeneurial dynamism to replace it, or the economy shrinks.

So, at a certain point in the spiral, “austerity” (budget cuts etc) actually accelerates the problem: If cutbacks lead to revenue declines, the remaining government debt burden becomes larger than before (relative to debtors’ ability to repay).

So, in a very real way, by demanding harsh cuts and minimal stimulus at such a delicate time, Germany is asking Spain, Greece et al to commit fiscal suicide. In the struggling periphery countries, that is the increasing perception of both government leaders and citizens.

But what else is Germany to do? Via the UK Telegraph, Germans are already 1) “boiling mad” over back-door bailout payments, and 2) dealing with “the lowest unemployment in 20 years and an incipient housing boom.”

This leads to another age-old problem — one that critics hammered on long before the euro was even introduced. It is very hard to have functional currency union when various economies in that union are operating at vastly different temperatures.

Imagine you have multiple pots on the stove, but only one knob to set all the burners at once. One pot is extremely hot and close to boiling over. Three other pots are ice cold and desperately in need of more heat. But you only have one burner knob, i.e. one monetary policy, that sets them all. What do you do?

It’s not a trick question. There isn’t any good answer. Which is why many euro skeptics (including yours truly) thought the project would be doomed to failure from the very start.

Markets are convulsing over Europe once again — welcome back crisis — because it is becoming newly apparent just how deadly serious this problem is. Someone is going to have to budge. Either Germany relents and cuts the periphery countries some slack, or one or more periphery countries leaves the eurozone and the experiment goes down in flames.

Spain ultimately gets a massive bailout — courtesy of Germany — or an exit visa, with all the fiscal horror that entails. France, too, is now feeling a similar form of political pressure. Notice how it keeps spreading?

In a recent Le Monde interview, George Soros — “The Man Who Broke the Bank of England” and a guy who knows a thing or two about currencies — articulated his belief that Germany is quietly seeding the crisis by being pig-headed (emphasis mine):

“The introduction of the euro has led to divergence instead of bringing about convergence.

“The most fragile countries of the eurozone have discovered that they are in a Third World situation, as if they were indebted in a foreign currency, with a crucial effect that there is a real risk of default.

“Trying to make them respect rules that don’t work just makes matters worse. Sadly, the authorities don’t understand this.

“Mario Draghi has launched extraordinary measures with his €1 trillion injection of liquidity through three-year loans. But the effect of this operation has been broken by the counter-attack of the Bundesbank.

“Watching the growth of the ECB’s balance sheet, the Bundesbank has realised that it risks heavy losses if the euro blows up and is therefore opposed to the (LTRO) policy. Let us hope that this does not become a self-fulfilling prophesy.”

Soros Le Monde interview, via UK Telegraph

Jens Weidmann, the head of the Bundesbank, of course flatly denies the self-fulfilling prophecy bit. “What we are doing is… preserving the stability foundation of the monetary union,” he says. “I am deeply convinced that the monetary union can only survive if the euro remains a stable currency.”

Sure, of course. How else would one expect Germany to respond?

It’s an ugly and dangerous situation because nobody wins and something will have to give. Again, either Germany is going to cave and write some big checks, or the Soros “self-fulfilling prophecy” will come about and the whole show will implode.

The Sarkozy loss in the first round was a big deal because of the “Democracy Destroys the Euro” argument. The current crop of pro-euro leaders (like Sarkozy) are being threatened by anti-euro challengers who stand with an angry populace in opposition to more austerity policies.

A gradual shift in political climate — with pro-euro leaders getting tossed out and hardline euro-skeptics voted in — could thus be enough for a critical mass of players to tell Germany to take their austerity and shove it.

And what happens after that, when all this sturm und drang hits a climax?

Does Germany cave in the face of full-on rebellion and a fiscal nightmare scenario?

Or does Spain turn into a country-sized Lehman Brothers — the scenario where everyone figures “oh they’ll get bailed out, they HAVE to…” and then they don’t?

Does the euro go into freefall and the $USD skyrocket? Or does a new “core” euro emerge, causing the reverse?

Nobody knows, really, and that’s why the market is so freaked out.

Funny old world innit,

JS (jack@mercenarytrader.com)

• Attention Frustrated Chartists: It's not HFT - it's the Macro!

• A Dangerous Market Full of Crosscurrents

• Euro Zone Crisis: Back on the Front Burner

• Concerning Gray Swans: Europe, China, Profit Margins and The Fed

• The Return of Ugly Goldilocks

• Gold Looks Terrible Part II: Clarifying Thoughts

• Home Builders (Technically Speaking)

• Downgrades & Mellonists: This is What the Market Fears

• The Bond King Gets Desperate

• S&P 400? The Deflation Shock Scenario

• Pension Funds and the Zero Bubble

• Milking the Consumer Cash Cow -- How Much Longer?

• The Great Compression

• Deeper Implications of Middle East Turmoil

• Pondering the High Cost of Food

• The Age of Cyberwar is Here

• Did China just ring a bell?

• Twelve Major Risks for 2011

• Why Investors Should Be Terrified of Deflation

• Strip Mining the U.S. Economy

• It's the Debt, Stupid

Even after a positive week, the primary US equity benchmark looks pretty ominous.  After four straight months of low vol – advancing action (six months of positive movement off the October low), the S&P has clearly broken its trend line and is now consolidating recent losses…

This week promises to be a busy one with plenty of catalysts that could set the next wave of price action in motion.

On Tuesday, macro traders will be watching  bond offerings from both Italy and Spain, and after the close we have an earnings report from mighty Apple Inc. (AAPL).  The bellwether has broken its three-month bullish trend and has been pulling the broad technology sector down as it corrects.

Wednesday, we have the completion of the Federal Open Market Committee meeting – including both the standard press release as well as a press conference with Ben Bernanke.  With the most recent economic reports offering a more negative picture for the domestic economic recovery, this will be an important event.

Heading into the week, our current exposure is about 2-1 bearish to bullish – with just a handful of profitable bullish scenarios and a growing roster of areas that are trading lower.  More importantly, our pending setups are nearly all bearish as the technical picture looks ominous and the reward-to-risk metrics favors setups that will profit as markets fall.

Below are a few of the areas that we’re tracking for the week…

Building Materials & Engineering

As expectations for the domestic recovery fade – and the emerging market picture becomes notably weaker as well – companies that are tied to global construction and engineering are feeling the pain.

More importantly for us as traders, the investment perception for these names is undergoing a massive shift.  Sentiment for construction and related businesses is directly tied to global economic expansion and contraction.  So as the US employment picture softens, and China continues to report decelerating economic growth, value investors are beginning to cut back on their allocations to this group.

The change in capital commitments can be seen in the charts, as these names begin rolling over and violating key technical barriers.

Last week, we added two materials companies which had broken multi-month bullish trend lines, and then drifted slightly higher to set up attractive entry points.

When determining how to enter bearish themes like this, we typically want to see a thrust lower – followed by a drift or consolidation.  Shorting a continuation move lower gives us both an attractive entry point (above the recent low), and also gives us an important resistance area so that we can set our risk point on the other side of this technical barrier.

The result is a high-probability short position with a relatively tight risk envelope.  The amount of capital we are risking (between the entry point and the risk point) is very modest compared to the potential profit we will be able to lock in if the stock trades meaningfully lower.

Trinity Industries (TRN) is one of our two existing trades in the area, and heading into the week, we’ve got our finger on the pulse of several additional construction / engineering stocks that are poised to fall quickly.

Chip stocks are in focus this week as Wall Street digests a number of important earnings announcements…

Advanced Micro Devices Inc. (AMD) released their Q1 report after the close last Thursday, beating estimates and actually issued guidance that was above the average analyst estimate for the coming quarter.

However, on Friday the stock reversed early gains, closing at the low of the day and posting a reversal bar on strong volume.  The bearish action fell short of a true “breakdown,” but was certainly a disappointment.  More importantly, the action in other semiconductor names has become quite bearish – setting up some great potential shorts for later in the week.

The tone of the semiconductor sector ties in with the notable weakness in networking stocks.  Fears of declining corporate spending, coupled with decelerating growth and premium PE ratios has put the group in a vulnerable position.  The overall “tech industry” has been trading higher – primarily due to AAPL’s influence – but is now shifting to much more bearish action.

Texas Instruments (TXN) will announce earnings after the close today, and should give traders a much better feel for the near-term action.  The stock is sitting just above a key support area – which, if broken, could be a major catalyst for capital to exit the sector, and drive a number of semiconductor stocks lower.

Emerging Markets Under Pressure

While much of the focus this week is on US domestic data points, the action in emerging markets is still notable.

China is obviously the most well known “growth engine” of this group, and has reported a number of consecutive quarters of decelerating growth.  But if Europe continues to struggle with heavy debt, and the US recovery comes under pressure, many other emerging regions will be in trouble.

As part of the Global Trend Capture weekly update, Nathan O pointed out  a bearish pattern evolving for the iShares MSCI Brazil Index (EWZ).  The ETF peaked in March and has established a bearish trend – now sitting well below the key moving averages.

A short position in EWZ is probably the cleanest way to trade this pattern, but Nathan also offers an alternative for retirement accounts that cannot directly short stocks.  The alternative is Ultrashort MSCI Brazil ETF (BZQ) which trades at twice the inverse of EWZ.

For inverse ETFs, be careful to size your position correctly, and of course you should be aware of the volatility decay issues associated with leveraged and inverse ETFs.  Still, this is a good way to profit from falling prices – even in the context of a tax-deferred or tax-free account.

As the overall environment becomes more volatile, short-term swing traders have a distinct advantage.  The ability to capture gains in 3 to 5 trading days and choose from a number of new setups each trading day can be a key factor in building a smooth equity curve with predictable profits.

Next week we will be rolling out our High Probability Swing System – giving beta testers a chance to see this system in action – and receive trade alerts in their inbox before each trading session.  Make sure you sign up today to receive your FREE 30 day beta trial.

Shortly before the open, equity futures are indicating a bearish open – which is great for our positioning and our potential trades for this week.  Buckle up and tie down any loose risk points because it’s going to be an important next few sessions…

Trade ‘em well this week,
MM

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

• View From the Turret: Pick & Roll…

According to the Mercenary community — and we agree — the interview with our good friend Peter Brandt was one of the best things we’ve ever done.

Well, if Peter’s interview blew you away, prepare to get blown away again… because now we’re excited to introduce “Deep Alpha,” or DA for short.

Deep Alpha is the code name for a female trader (still notable in this male-dominated world) with more than three decades of experience in markets.

DA is remarkable not just for her performance, but the depth and range of her journey. She began as a commercial hedging liaison at the Board of Trade, then moved on to financial futures and day trading.

As a floor trader in the grain pits, she rode thousands of contracts limit-up (for days on end) in the great North American drought of 1988.

As a hedge fund manager, employing primarily short-term strategies, she booked an incredible 280% annual return for her investors (that’s two-hundred-eighty, not a typo) in 2010.

Over the course of this multi-part series, she’ll tell you how she did it.

And her biggest encore is yet to come…

Having transitioned from floor trader to day trader to hedge fund manager, DA is now spreading her wings in the discreet world of family office management — hence the code name for this interview — where capital allocation runs into the hundreds of millions to billions.

In addition to all the above, DA is a close and dear friend of many years.

So without further ado…

JACK: Why don’t we start at the beginning. How did you get involved in trading?

DEEP ALPHA: Trading was not on my radar in college. I started out studying psychology. I had always been fascinated by human behavior.

But I was disappointed with psychology. It was taught, back then, with an emphasis on  dysfunctional traits — slapping on labels with all kinds of scary names. I decided to shift to an area that explored perception, consciousness, and how we know what we know.

I went into a major that was  built around general semantics — studying how we think through language — and general systems theory, which helps you think about how systems are organized. How the cells in the body organize themselves… how bees organize themselves… how humans organize themselves in thinking and in groups, and so on.

That combination was very interesting. And then I had the good fortune of spending a summer at a Buddhist school in Colorado, the Naropa Institute. This school was known mainly for cultural arts and poetry. But, the summer I attended,  a group of neuroscientists got together at the Naropa Institute to share ideas. They decided to turn those ideas into a course, to study things like the circularity of the mind, how consciousness is created, and so on.

This was at the forefront of the whole biology of cognition. I did not want to be a neuroscientist, but I did want to study this area. Unfortunately, back then, there were not any masters programs that focused on this, as it was just emerging. I came away fascinated by 1) meditation and how it quiets the mind, and 2) learning how the brain affects how we think, how through language we think about things in duality, and linearity, and so on. All important areas of study that have helped my trading.

Economics, on the other hand, held no interest for me in college.  I actually dropped economics. I just thought it was so dry…

JACK: Ha! Same here. I took a macroeconomics class at Macquarie University in Australia (part of my studies abroad), and walked out in less than two weeks. The concept of “rational economic man” was so offensive to my trading sensibilities, even back then, I couldn’t stand it. So I dumped the class and read “General Economic Theory” on my own instead.

DEEP ALPHA: Yes! Rational economic man — that was the driest stuff, and it just didn’t make sense to me. I hadn’t started reading the Wall Street Journal or anything yet, but it seemed wrong.

So I’m getting ready to graduate from college, and I’m kind of depressed, because there isn’t a masters program or a clear path in terms of all the things I’m interested in.

At this point, a major change is about to occur. When people say a book can change your life, this sure did apply to me…

JACK: Small world once again. The book that changed my career path forever – also in college – was “The Investment Biker” by Jim Rogers. Sorry to keep interrupting… what was yours?

DEEP ALPHA: A friend had given me this book, “The Merchants of Grain.” It rocked my world, as it was so different than anything I had read up to that time.  It was a history of the grain trade, dating back to the early 19th century, and a glimpse into the world of the secretive families that controlled it. This is the Cargills, Continental Grain, Louis Dreyfus..

JACK: Who wrote Merchants of Grain?

DEEP ALPHA: The author was Dan Morgan. I found the narrative about early commerce  to be romantic and intriguing, full of drama and power. I fell in love with the history and,  in the process , I learned how they started to use futures (called commodities back then) and hedging, and thought “Wow — this is really, really interesting.”

At that point I literally just got on a plane and went to Chicago. That’s where the commercials were… Continental Grain and Cargill and Dreyfus… and of course the Board of Trade was there.

So I go to Chicago, and go right down to the Board of Trade for the first time, similar to the way Peter Brandt did. But my reaction was a little different than his. I said to myself:  “This is, by far,  the coolest human lab I’ve ever seen!”

JACK: You saw it as a sort of giant psychological experiment.

DEEP ALPHA: Exactly, a full-on human laboratory. I thought it would be great to demystify the chaos, figure out how they were communicating, how the system works… but in the background my whole goal was to learn about the commercials, how they do what they do.

I started out as a runner with Conti –

JACK: Conti Commodities?

DEEP ALPHA: Yes, owned by Continental Grain. After a month or two of being a runner, they put me on the phones. When they realized I was good at communicating, taking orders and so forth, they put me with the top right-hand man of Michel Fribourg, who ran all the Japanese business and just put up some huge numbers.

I took orders from this guy — his name was Miles, since passed away — and Miles would give me these orders and I would run them in as fast as I can. We had a great relationship, and because of that my name got around Continental Grain.

At this point,  one of Continental Grain’s top producers needed a new assistant…

JACK: And what year was that?

DEEP ALPHA: It was 1980. I went through three different interviews with this top producer, Dave Milligan. A lot of people wanted the job, and I got it. That was one of the best experiences of my life. He had all commercial accounts, plus two huge speculators — very nice men from the Midwest.

We had accounts like Pioneer Corn, the largest corn seed company at the time, do all their hedging through us. A big Canadian company, who did vegetable oil and soybean processing, did all their hedging through us. Then we had a ton of farmers with big positions… and I helped build the business.

The bond futures were beginning to build volume, and I pursued clients  that needed to hedge interest rate exposure, branching out from grains. We created a nice balance of agriculture and financial hedging.

Within another year from that point, Dave made me partner. He knew he was sick — he had the same blood clot disease that Nixon had — and I think he wanted someone he trusted to take over the business. We had worked together three years, and in the fourth year he passed away suddenly.

With Dave gone, I inherited this huge business. And my goal at this time, by the way, was to get my membership and trade on the floor.

JACK: You’re not on the floor yet.

DEEP ALPHA: I’m not on the floor. I’m in an office at the Board of Trade. And all of a sudden, this succession happens overnight.

JACK: What is your role at that point? You have large commercial clients and speculator clients who give you orders… and you then give them to brokers on the floor?

DEEP ALPHA: Exactly. And I had a great relationship with all the top brokers on the floor, because I was feeding them such big business. Which is key to when I actually go down on the floor, because I already know everyone and they treat me well.

With Dave gone, all these other brokers were circling and going after my clients. At the same time, Conti had a huge trader in Texas that blew up. Michel Fribourg doesn’t want all this speculating business, he’s getting sick of it. So he sells Conti Commodities to Refco, right when I’m in the process of handling all these clients for myself now.

JACK: Did you go with Refco?

DEEP ALPHA: We were taken over by Refco, but we weren’t staying. Within a week I went to a small boutique firm. It was two men, long-term Board of Trade guys, who wanted to start a research and hedging company — primarily grains — and have great research, which they did.

I was with them for another year or two, with an assistant at this point. I had taken all of Dave Milligan’s clients with me, and didn’t lose one. That was a real coup, with Refco and so many other brokers circling. But there were some things I wasn’t happy with there, and I was still trying to build the financial side of the business…

JACK: This is still the early 80′s.

DEEP ALPHA: Still early 80′s, maybe 1985. By 1986 I’m getting antsy, and really wanting to be on the floor. This was also a time when commissions are starting to fall aggressively. We had clients doing huge, huge numbers, and we were still charging hefty commissions.

JACK: Nothing at all like today.

DEEP ALPHA: It was amazing how much brokers could charge back then. But, it was becoming  very competitive. I started shopping around at other firms, and my focus was still “start trading, get on the floor.” I had hired an assistant and trained her well — she was good at taking orders and so on — and that freed me up to buy a seat on the Board of Trade and start going down to the floor.

JACK: This was still 1986?

DEEP ALPHA: 1987 now. And the clients love it, because now I’m talking with all the commercial brokers, giving them great information — but my goal is still to really just trade for myself. So I hired yet another person — a broker — to help manage the client business, so I could focus on trading from the floor.

I did well my first year on the floor, and the broker did well with the clients too. He wanted to take over, and I was focused on the floor, so I started phasing out of the client side.

I would do some strategic things, but more on a weekly and monthly basis — the hedging programs — and by 1988 I was basically trading full-time on the floor.

Continued in Part II: “Big Positions On”

A cognitive bias describes a replicable pattern in perceptual distortion, inaccurate judgment, illogical interpretation, or what is broadly called irrationality.

In many professions, bias does not create a problem. In some it can even help.

A defense attorney, for example, could be well served by the notion that “all my clients are innocent.” In many circumstances, biases and beliefs — even irrational ones — can help performance (or at least not degrade it).

For traders, though, cognitive bias can be deadly. A lack of objectivity in markets will inevitably cost you money… only question being whether it is a little, a lot, or your whole wad.

How to guard against cognitive bias? Awareness is half the battle — so this comprehensive list of biases is a good place to start.

If you haven’t seen that list before, scan through it. Dwell on those items you suspect might impact your own trading.

You could discover leakage that you didn’t even know existed!

After awareness, a good defense is the cultivation of day-to-day checks and balances — simple action steps to keep bias minimized.

For example, what I like to call “the blind chart test:”

• The blind chart test: You have strong conviction on stock XYZ. To run the blind chart test, imagine looking at a chart of XYZ with no knowledge of the symbol. Pretend a stranger handed you this chart — not telling you the industry, the sector, or even whether it’s a stock, an index or an ETF — so all you have are the bars (or candles). Under those circumstances, would you still feel strongly? If the answer is “no,” your bias might be showing.

At the end of the day, human beings are frighteningly irrational creatures.

This excerpt from “The Blank Slate,” by Steven Pinker, gives eye-opening example of just how strong that irrationality (bias) can be:

One of the most dramatic demonstrations of the illusion of the unified self comes from the neuroscientists Michael Gazzaniga and Roger Sperry, who showed that when surgeons cut the corpus callosum joining the cerebral hemispheres, they literally cut the self in two, and each hemisphere can exercise free will without the other one’s advice or consent.

Even more disconcertingly, the left hemisphere constantly weaves a coherent but false account of the behavior chosen without its knowledge by the right. For example, if an experimenter flashes the command “WALK” to the right hemisphere (by keeping it in the part of the visual field that only the right hemisphere can see), the person will comply with the request and begin to walk out of the room.

But when the person (specifically, the person’s left hemisphere) is asked why he just got up, he will say, in all sincerity, “To get a Coke”–rather than “I don’t really know” or “The urge just came over me” or “You’ve been testing me for years since I had the surgery, and sometimes you get me to do things but I don’t know exactly what you asked me to do.”

Similarly, if the patient’s left hemisphere is shown a chicken and his right hemisphere is shown a snowfall, and both hemispheres have to select a picture that goes with what they see (each using a different hand), the left hemisphere picks a claw (correctly) and the right picks a shovel (also correctly). But when the left hemisphere is asked why the whole person made those choices, it blithely says “Oh, that’s simple. The chicken claw goes with the chicken, and you need a shovel to clean out the chicken shed.”

The spooky part is that we have no reason to think that the baloney-generator in the patient’s left hemisphere is behaving any differently from ours as we make sense of the inclinations emanating from the rest of our brains. The conscious mind — the self or soul — is a spin doctor, not the commander in chief.

Spooky indeed…

JS (jack@mercenarytrader.com)

p.s. Like this article? For more, visit our Knowledge Center!

p.p.s. If you haven't already, check out the Mercenary Live Feed!

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You can see the evidence, pulling up a chart of the iShares Russell 2000 Index (IWM).

The small caps ETF failed after breaking to a new high midway through March, and the chart pattern is now flirting with full-fledged technical breakdown.

Using traditional technology proxies, the warning signs are more difficult to pick up on.  The Powershares QQQ Trust (QQQ) and even the SPDR Technology ETF (XLK) are both within a few daily trading ranges of their 52-week highs. But digging into the composition of these ETFs explains most of the technology strength away.

How so? Because both QQQ and XLK have an enormous concentration in Apple Corp. (AAPL).  Apple represents a full 17.5% of QQQ, and nearly 20% of XLK.  So the strength in this largely consumer-driven momentum stock represents the prominent driving force behind the positive price action in these two technology ETFs.

Networkers Breaking Lower

The networking sub-sector is looking particularly vulnerable with a number of key components running into overhead resistance. The more speculative names in the group appear prone to a sharp selloff.

Analysts are ratcheting down projections for the Q1 earnings season, and while it is still early, disappointments from the likes of Google Inc. (GOOG) and Intel Corp. (INTC) are having an effect on the group.

Expectations for corporate technology spending were at one point relatively high, as investors and managers embraced the idea of a “stable” economic recovery.

But the March jobs report – along with disappointing corporate results – introduces more doubt into the recovery scenario.  Weakened outlooks for corporate technology spending have already affected investor sentiment for networking companies.

For example: Take a look at the weekly chart for Brocade Communication Systems (BRCD):

In BRCD the bullish trend from the second half of 2011 is now clearly broken, as speculative capital looks for a more “stable” home.  Mature networking names like CSCO confirm with breakdown chart patterns and price submergence below the 50 day exponential moving average – giving both swing traders and longer-term investors a rationale to lighten up on longs (or enter shorts).

F5 Networks (FFIV) represents one of the more “growth intensive” names in the group – and the company reports after the close today (4/18).  FFIV’s Q2 report (fiscal year ends Sept 30) will have a material effect on networking stocks – and we’re already seeing weakness as managers trim their positions ahead of the report.

The sub-group has a pretty diverse range of valuations / growth expectations (note table below), but the chart patterns are similar in that all names are experiencing distribution and could be high quality short candidates as we pick out attractive entries with reasonable risk points.

In the Mercenary Live Feed, we have pending short setups for QLogic Corp. (QLGC) and Brocade Comuniations (BRCD) which will trigger entry on a downside break of multi-day consolidation.

Once this minor consolidation area is broken, these names could trade down meaningfully before hitting any material support.  This evening’s report from FFIV could furthermore be an acceleration catalyst – sending the group lower as managers once again reduce exposure.

There is certainly potential for the networkers to gap sharply lower at the open tomorrow – which is why we prefer to use stop limit orders on our pending entries (to protect against poor fills on the open).

The best trades typically work quickly once they are triggered, so we will be managing our bearish exposure to the group carefully to begin with – requiring follow through action for us to stay involved on the short side.

• Caterpillar Ignites Fear for Equipment Stocks

• Networking Stocks: Ready to Short?

• Deep Value Solar Rebound Candidates

• Oil & Gas Stocks With Explosive Potential

• Gold Stocks Poised for Another Run

• Social Media Fantasy Trades

• Retail Stocks Getting Whacked

• Airlines Ripping as Oil Pukes

• Truckers Running on Fumes

• Rising Tide Lifts Shippers

Equities had to deal with a disappointing jobs report, an underwhelming bond auction in Spain, a handful of disappointing key earnings reports, and less-than-encouraging consumer confidence data.

For the week, the S&P 500 dropped 2%, the Nasdaq composite was down 2.2%, and the Russell 2000 small-cap index was down 2.5%.  Even mighty Apple Corp. (AAPL) posted poor weekly performance, challenging a bullish trendline that has been in place since the stock went vertical at the beginning of 2012.

Selling pressure has knocked the bulls back on their heels, with the major indices (S&P 500, Dow, Nasdaq Composite etc.) threatening to break below the key 50 day Exponential Moving Average – a key variable for many mechanical trading systems…

The broad averages are hitting critical technical levels at the same time that we enter the heart of earnings season.  Analysts and media outlets have already begun to characterize this earnings season as “disappointing”, paving the way for a significant sentiment shift over the next few weeks.

Does this mean a sharp trade lower is guaranteed?  Of course not…

Barron’s had an interesting weekend article titled “Why the Smart Money Looks Dumb” which outlined how institutional managers have been under-exposed to the first quarter rally – and may very well use a pullback to allocate capital back into risky equities…

A key fact of the 2012 stock market is that many sophisticated investors—the supposed “smart money”—have missed the rally, which has boosted some stocks by more than 50%. Because the eyes of the sophisticates are fixated on Europe’s economic problems, and their minds are searching for data to dispel evidence of a U.S. recovery, many of the funds and accounts they run are trailing their performance benchmarks. This most likely exacerbates some of the recent intraday volatility.

WHEN THE STOCK MARKET DECLINES in reaction to some data, the smart money trades futures contracts to pressure share prices. This crowd uses news and market commentary to paint a menacing picture worthy of Stephen King. Yet, at some point, even those nattering nabobs of negativity fill the bullish void in the options and stock market with buy orders. That helps stocks bounce higher.

What makes the smart-money put so powerful is that fund managers face real problems if they lag behind the performance of the stock market or their peers. The need to at least match—and ideally beat—performance benchmarks almost forces them to buy stocks. If they don’t deliver good returns, they may find that their investors flee into the arms of better-performing managers.

Performance anxiety can certainly provide underlying support during “normal” corrections.  But following a sustained mult-month rally with plenty of opportunities for the “smart money” to get involved, the rollover pattern looks much more ominous.

In the Mercenary Live Feed, we are methodically adding to our bearish exposure, while carefully tightening risk points on bullish trades that are holding up well – and cutting out the bullish positions that aren’t.

Below, a few of the areas we are particularly interested in this week…

Financials Fall on Disappointing Earnings

Wells Fargo (WFC) and JPMorgan Chase (JPM) dropped a bomb on the financial sector Friday after announcing first quarter earnings.

The major media outlets reported that the earnings figures were above expectations.  But the devil was in the details, and a closer look at the data showed that the earnings beat was largely a result of setting aside less in reserves for future losses.

Financial stocks (specifically, blue-chip banks) have been a significant supporting factor for the broad market, and without their influence, it will be much more challenging for equities overall.

This week, we have announcements from Bank of America (BAC), Capital One Financial (COF), Morgan Stanley (MS), as well as American Express (AXP).  If the group follows the disappointment trend set by WFC and JPM last week, the market tone could become quite ominous – quite quickly…

On a weekly chart, the major banks like WFC, JPM and BAC have significant overhead resistance issues.  A reversal at current levels would set up some very attractive short patterns – with plenty of room to run before hitting late 2011 support areas.

Small-Caps: Canary In the Coal Mine

While blue-chips have been steadily rising during the entire first quarter, the Russell 2000 Index (IWM) broke its trend line mid-way through February.  It’s important to note that while most US indices were breaking to new 3-year highs, IWM languished well below the 2011 highs.

Last week, the action saw IWM breaking through short-term support levels as managers once again embraced a “risk-off” mentality and dumped allocations to speculative positions.

The break of support followed by a three day “drift” higher, sets up an attractive entry point for us this week.  We can set up a conditional short position which will be triggered when the ETF breaks the 2-day low, with a risk point just above the high from last week.

There are actually a number of viable securities for us to use here.  The Small Cap Bull 3X Shares (TNA) may end up being a better short candidate as the volatility decay from this leveraged inverse ETF would actually work in our favor.  All trades are time stamped and reported in real-time via the Mercenary Live Feed.  You can sign up for a 14-day free trial to see how we are positioned heading into what looks like another challenging period for the bulls.

Doctor Copper Gives Poor Diagnosis

There’s a reason why copper is considered the metal “with a PhD in Economics.”  As global growth is called into question – China just reported its fifth straight quarter of decelerating growth – demand for this important industrial metal wanes.

During the first quarter when the broad averages were trending higher, copper hardly participated.  The metal sat in a tight range from mid-January through the end of March – well below its 2011 highs.

Last week, copper broke below the support area and now appears set to test the late 2011 lows.  Our trend following expert, Nathan O., likes the pattern and is partial to new trends that emerge out of tight range-bound setups.

We’re watching the action carefully and the iPath DJ AIG Copper (JJC) – an ETF tracking the commodity price – may very well be our next position in the Global Trend Capture service.

Heading into the open, the futures are indicating a relief bounce after last week’s breakdown.  This isn’t unexpected, and will give us a chance to determine whether the bulls really have what it takes, or if they are quickly overwhelmed (leading to a reversal day).

Choppy action isn’t a new phenomenon for us.  We’ve dealt with unpredictable swings for the better part of the last two years.  Continue to exercise proper risk management and position sizing as we jockey for position and carefully determine where we want to allocate our trading capital.

Trade ‘em well this week!
MM

Similar articles you might like:

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

• View From the Turret: Pick & Roll…

How  many times have you heard some version of that?

How many times have you said it to yourself?

Focus is indeed important, as the following quotes remind us:

Concentrate all your thoughts on the work at hand. The sun’s rays do not burn until brought to a focus.

- Alexander Graham Bell

Your current conditions do not reflect your ultimate potential, but rather the size and quality of goals upon which you currently are focusing.

- Tony Robbins

Do whatever you do intensely.

- Robert Henri

The successful warrior is the average man, with laser-like focus.

- Bruce Lee

But here is an idea worth exploring:

Is it possible to focus too much or too often? Can excess focus degrade performance? And if so, what can you do about it?

Great traders are obsessed with performance. That’s how they managed to become great in the first place. And not just portfolio performance, but personal / mental performance. (When it comes down to it, you can’t really separate the two.)

Great traders also tend to be “clutch players.” Wikipedia offers two useful definitions of what it means to be a clutch player:

• performing well under extreme pressure
• high levels of production in a critical game

Think of it as the “4th Quarter Mentality.”

As in, “it’s the big championship… there are two minutes to go in the fourth quarter… and you’re down by a field goal.” What do you do?

How focused are you in that situation? Amped to the max, right? Cool on the outside, perhaps, but in a bristling electric sort of way — like a power line with 50,000 volts pulsing through.

The trouble is, you can’t keep that level of intensity all the time. It’s too emotionally and physically taxing — like running the afterburners on a jet. If you leave them on too long, you burn up the engine.

The Lateral Thinking Problem

There is another reason why “too much focus” can be bad. It restricts lateral thinking — your imaginative problem-solving capacity and creative flow.

Take the expression “putting the blinders on.” Blinders are used to restrict the peripheral vision of a horse. With the blinders on, the horse can only see straight ahead and has less chance of getting spooked by something on the side of the path.

But you and I are not horses. We need to have awareness of the landscape around us.

In addition to the potential energy drain of “always on” 4th quarter intensity, focus is a deliberate act of putting the blinders on. You shut out those things that are not on your list of top priorities, or in your immediate field of vision.

Focusing like this increases your powers of concentration — but at the cost of creativity.

I was reminded of this by a post from Graham Morehead, CEOs and the Candle Problem. The essential argument was that financial incentives can actually degrade executive performance — because the CEO gets so wrapped up in short-sighted profit targeting, he (or she) loses the ability to think laterally and see the big picture.

A monetary reward will help your employees focus. That’s the point. When you’re focused you are less able to think laterally. You become dumber. This is not the kind of thing we want if we expect to solve the problems that face us in the 21st century.

Is your job like that of a button pusher? Or do you have to think creatively? What about a CEO? The results above apply more to a CEO than almost anybody, yet CEOs receive greater financial incentives than anyone. This practice is self-destructive. Now I understand why the CEO of Company X killed his golden goose. I understand why he decimated R&D. I understand why he upped the number of spurious lawsuits against competitors instead of investing in long term growth. He was incentivized. He was focused. The stock price was the most important metric of judgment. The same is true for many other companies.

- Graham Morehead, CEOs and the Candle Problem

Shifting Gears

So there is kind of a paradox here:

As high level performers in pursuit of excellence, we know the value of intensity and focus. But trying to keep “the 4th quarter mentality” on a 24/7 basis is draining… and when it comes to creative input and thinking laterally, the magnifying glass doesn’t work.

The answer (or at least my answer) is learning how to shift gears.

The idea is similar to what’s expressed in the MT Driver’s Manual:

In rally car racing, you do not maintain a constant acceleration. Instead your speed can change dramatically, from crawling along at a few miles per hour in rocky terrain, to carefully negotiating a hairpin turn, to going full blast in open stretches. Trading is similar in that exposure and aggression levels, like acceleration, vary significantly depending on market conditions.

- Intro to MT Driver’s Manual

For a trader, or most any knowledge worker really, different aspects of the job call for different mental states. Sticking with the gear shift analogy, we can imagine a continuum from relaxed / contemplative to full-on intense:

• 1st gear: Relaxed, contemplative, playful; deliberately unfocused
• 2nd gear: Still relaxed and contemplative, with calm emphasis on a specific area
• 3rd gear: “Getting it done” zen mode — execution without conscious interference
• 4th gear: “Getting it done” aggressive mode — consciously intense focus
• 5th gear: 4th quarter mentality — maximum intensity and focus

Playfulness and Creativity

Conceptualizing these gear shifts (different mental states) has value because, much of the time, your best ideas and “a-ha!” moments will come when you are NOT focused.

As a creative strategy, “big picture” type person with multiple irons in multiple fires, I generate ideas on a constant basis. My biggest and best ideas consistently come in one of three places:

• In the shower
• On the treadmill (or running trails)
• Snowboarding or hiking
• Afternoon walks in the sunshine
• Executing rote tasks (grocery store etc.)

What do the above settings have in common? They are all “1st gear” conducive, where the mind is relaxed and not required to focus on any one specific thing.

Relaxation is a key aspect because the mind is most creative when not feeling pressured.

There is a link between playfulness and creativity. The more playful you are feeling, the more creative capacity you have. When is your brain at its most playful? When you are happily engaged in some other activity that does not require focus — listening to your favorite music as you pound it out on a treadmill, or contemplating the beauty of nature on a ski lift — thus giving the mind time and room to roam freely.

99 Problems (But Creative Ain’t One)

If you are like me, you have a short list of projects, problems, and opportunities that occupy your mind at any given time. There could be as few as two or three things on this short list — or there could be two dozen or more.

Either way, it isn’t just your conscious mind working on these projects, problems, and opportunities. Your subconscious mind can handle the heavy lifting — but only if you let it.

Incorporating “first gear” time blocks into your day-to-day routine is thus vitally important, because that’s where your brain does its best creative work.

For top performers, with such an aggressive emphasis on focus, intensity, and being “on” all the time, it is easy to forget this.

But the beauty of this realization is that, by deliberately making time to relax, breathe, and dissipate your focus, you can improve overall performance.

This isn’t a recipe for second best. It’s a recipe for getting even better!

Because remember too, the “shifting gears” concept does incorporate the super high intensity, “4th quarter mentality” mindset into the roster of mental states… it just recognizes that there is a right place, right time for 5th gear — as determined by the situational landscape and the assessment skills of the driver (you) — and a right time for the other gears too.

So, to sum up, we can enhance performance through critical analysis of the focus intensity mix — dialing intensity up or down as the optimal execution / creativity balance requires, i.e. paying attention to not paying attention. (What is the sound of one clapping?)

Go Ahead and Have That Beer(?)

As a fun addendum to the above, consider this Onion-like headline (that is actually real):

“Drinking Alcohol May Significantly Enhance Problem Solving Skills.”

Drinking alcohol may enhance a person’s problem solving skills, according to a new study.

Scientists found that men who either drank two pints of beer or two glasses of wine before solving brain teasers not only got more questions right, they also were quicker in delivering correct answers, compared to men who answered the questions sober.

…Wiley said that the key finding was that being too focused can blind a person to novel possibilities and a broader, more flexible state of attention may be helpful for creative solutions to emerge.

“We have this assumption, that being able to focus on one part of a problem or having a lot of expertise is better for problem solving,” Wiley said. “But that’s not necessarily true. Innovation may happen when people are not so focused. Sometimes it’s good to be distracted.”

Wiley noted that the findings only apply to people who had only a few drinks and not when people drink to extremes.

“The bottom line is that we think being too focused can blind you to novel possibilities, and a broader, more flexible state of attention is needed for creative solutions to emerge.”

This isn’t an invitation to trade drunk any time soon. But it does underscore the “shifting gears” concept.

focused on enjoying the weekend,

JS (jack@mercenarytrader.com)

p.s. Like this article? For more, visit our Knowledge Center!

p.p.s. If you haven't already, check out the Mercenary Live Feed!

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What are the roots that clutch, what branches grow

- T.S. Eliot, The Waste Land

Tuesday (April 10th) was a remarkably red day. Bullish uptrends snapping like dry twigs underfoot. Downside range expansions everywhere you look, on heavy volume with closes at the lows.

So many sectors got crushed, it’s hard to distinguish between those showing internal weakness and those simply decimated by the broader market action.

Homebuilders are an easy example. Take a look at XHB, LEN, TOL, PHM. Nothing special there — just a microcosm of what’s happening all over the place. A good old fashioned “risk off” bloodbath, with the tiny but notable exception of gold.

The major indices were crushed too. Small caps were already weak, and the Nasdaq is hopped up on Apple juice. But as for yon Dow and S&P? Uptrends no more…

We have now entered an Eliot-like waste land — a no man’s land:

Now there is nothing magical or sacrosanct about a trend line (or a 50 day exponential moving average for that matter). Both are handily compact forms of regression analysis and little more.

Nonetheless, when you get a break that hard, and that fast — on surging volume no less — it tends to mean something. This will not be shrugged off. Even if the bulls claw their way back, they will do so badly shaken, and with a pronounced limp.

A Flock of Gray Swans

To those invested in the long case, Tuesday’s selloff was especially disconcerting given the lack of a major catalyst.

Europe is threatening to blow up in everyone’s faces again, yes. But hasn’t that been the on-and-off case for years now?

The following New York Times commentary is notable mainly because it is dateless — it could have come at any point in the past two years or so (emphasis mine):

Spain’s borrowing costs rose Tuesday to levels not seen since early January, raising concerns that the financial crisis in Europe was heating up again after a lull. Stock markets closed sharply lower across the region.

The latest market anxieties come on the heels of a Spanish bond auction on April 4 that barely met the minimum amount sought, a sign that some investors worry that Spain might eventually follow Greece, Ireland and Portugal in seeking a bailout.

Spain is entering its second recession in three years, and the government expects the economy to contract about 1.7 percent in 2012. With unemployment of around 23 percent, there is fear that austerity measures, deemed critical for winning back market confidence, could have the perverse effect of further depressing growth and creating a vicious cycle in which more budget cuts are needed to balance the public books.

- New York Times, Spain Bond Yields Rise, Renewing Fears of a Renewed Euro Crisis

Perhaps it is not so much one thing, but a distressing confluence of things.

What investors face now is a flock of “gray swans” — a series of unpredictable crisis events that, in actuality, were pretty predictable after all (with only the timing left in doubt).

Gray Swan #1: Austerity Fallout in Europe

The risk emanating from Europe may not be what it seems. Rather than a fear of Europe imploding, the real trouble may be if it doesn’t!

The European Central Bank (ECB) will print if it absolutely has to. We saw that with implementation of the “LTRO,” Europe’s version of QE3.

The real danger in Europe, then, may not be a full-blown crisis but a German incrementalist approach in which the periphery countries simply bleed out by way of austerity.

Instead of Lehman Brothers redux, picture Spain, Portugal et al as an old country version of Detroit. If the periphery countries are allowed to sink into recession bordering on depression, with crisis measures implemented grudgingly at just enough rate to keep them bleeding along, that is bad for everyone in global economic terms.

This reality is coming back to the fore as crisis persists. The trouble may not be a full-blown ripping apart of Europe, but the cold-water-in-the-face realization that Germany’s attitude towards fiscal stimulus could keep Europe in borderline recession conditions for the duration.

Gray Swan #2: Shadow Collapse in China

Things are bad in China right now. This should be a surprise to no one. If anything the surprise is how long the top-down economic management strategy lasted.

Nowhere in history, or even in the annals of feasible economic thought, does it make sense to imagine a country can grow at double digit percentage rates for decades on end, with major decisions being made by a centralized governing body, while yet avoiding any sort of hard landing.

It’s taken a bit of time, but now we are starting to see China’s internal fabric come apart at the seams, both economically and politically, in shades of the underlying rot that plagued the old USSR. (Anyone still remember what those letters stand for?)

Consider the following dispatches from the China front:

• Shadow Banks on Trial as China’s Rich Sister Faces Death (Bloomberg)
• Food Prices Push Rate of Inflation Up in China (New York Times)
• The Revenge of Wen Jiabao (Foreign Policy)
• Signs of a new Tiananmen in China (The Diplomat)

The Dragon has more back-stabbing drama right now than an HBO mini-series. Multiple pressures in respect to the Chinese economic miracle are coming to a head:

• China’s “shadow banking” network, which funds businesses to the tune of $1.3 trillion in unregulated funds, is coming under severe pressure. What happens when an informal funding system that big collapses? If the government let the shadow banking network get that big in the first place, how much control do they really have?

• The threat of civil unrest, as tied to high and rising food costs, has never been greater. There is no “safety net” in China — no social security, no welfare, no widespread network of soup kitchens. The people spend a large percentage of their income on food. When food prices rise high enough and fast enough, you get riots.

• The internal structure of the Communist party is imploding. Winston Churchill once compared Kremlin politics to bulldogs fighting under a carpet. Outsiders have no idea what’s happening, but every so often a corpse is thrown out. The same thing is happening at one of the most critical inflection points in the ruling party’s history.

• The odds of avoiding “hard landing” were marginal to begin with. A white hot real estate bubble, speculative copper hoarding, grossly inefficient state enterprises, manufactured growth through huge infrastructure spending… how does this story end any way but badly, at least in the medium term?

Bottom up investors are getting more and more excited about bullish domestic spending patterns in China. They should watch out for massive top down risks like falling boulders from above…

Gray Swan #3: Contracting Profit Margins

The Economist had an excellent recent article that asks, “Corporate profit margins are extremely high. Can they be sustained?”

Theory would suggest that profit margins will revert to the mean over time. If profits are very low then companies will go out of business, improving the competitive position (and thus the margins) of those businesses that survive. Similarly, if profits are high then more capital will be attracted into the industry (and existing businesses will be tempted to expand) and the resulting competition will cause margins to fall.

However, the current high level of profits is not leading to a surge in investment. As a proportion of GDP, American business investment is close to 30-year lows. This shortfall has been blamed on many things, from over-regulation in America to uncertainty about the outlook for demand when real incomes are being squeezed by higher fuel prices and the lack of wage growth.

Peter Oppenheimer of Goldman Sachs points out that the high profit share of GDP is simply a corollary of the low share taken by labour. “With high unemployment and further substitution of technology for labour, it is unlikely that this will change dramatically any time soon,” he says.

So the cash is going on other things. Robert Buckland of Citigroup says both American and European companies are choosing to spend their cash on mergers and share buy-backs rather than capital expenditure. As a consequence “while profits remain sensitive to the economic cycle, those waiting for the structural mean reversion in margins will continue to be disappointed,” he says.

- The Economist, Marginal Improvement

True as far as it goes.

But how long can such a devil’s bargain last, without inducing civil unrest and destructive policies in the United States, and/or inflationary stimulus (to counteract unemployment) that ultimately destroys margins through inflation?

We are coming back round to the bullish argument for gold here. But remember, we never said we were long-term gold bears…

Andrew Smithers of Smithers & Co, a consultancy, believes that executives are given incentives to boost margins in the short term at the expense of long-term value for shareholders. Pushing up prices boosts profits quickly, for example, but at the risk of losing market share over time. Similarly, executives might not begin a programme of investment that is vital for a company’s long-term health because of the effect on earnings per share. Woe betide any company that misses its quarterly earnings target.

If Mr Smithers is right, investors may be overpaying for current profits. The earnings forecasts of American equity analysts imply an increase in margins from current elevated levels, since they show earnings growing much faster than nominal GDP. Of course, to the extent that companies sell goods to the emerging markets, the profits of quoted companies can grow faster than domestic GDP. But that requires investment to keep the corporate sector competitive, and capital expenditure has not been happening on a sufficient scale.

This leads to another problem — one visible in the outperformance of multinational companies relying on overseas profits.

Namely, if Europe sinks into the austerity muck as China faces a hard landing, the “commodity supercycle” gets put on hold, stalling out resource-oriented markets too. And if emerging markets on the whole go through a period of economic retrenchment, another source of corporate profit outperformance vanishes…

Governments would like companies to start spending their cash piles. But as James Montier of GMO, a fund-management group, points out, that depends on their own behaviour. In terms of national accounts, massive government deficits are a counterpart to the surge in corporate profits. The surpluses and deficits of the various sectors of the economy (government, households, foreign and corporate) must balance, so a huge surplus in one sector must be balanced by deficits elsewhere. Governments spend money on goods and services (that are bought from the corporate sector) or borrow money to finance social benefits, which are then also spent on goods and services from the corporate sector.

This is not to suggest that chief executives should wish for permanent government deficits. But it does suggest that, as those deficits fall, profits might come under pressure. There is a “good” way that this could happen, as companies recruit more staff and pay higher wages, boosting tax revenues. But there is also a “bad” way for it to happen, if austerity programmes cause a slump in demand. Pray for the first outcome.

There’s another way that profit margins could contract — through the upping of “austerity measures” not just in Europe, but in the United States and possibly China too.

If Republicans win the next presidential election, there will undoubtedly be a new fiscal austerity wave. Even if they don’t, more rounds of “belt-tightening” and Mellon-style liquidation may be called for. (Remember the debt ceiling fun we had last August?)

Meanwhile, China may find its stimulus powers constrained by domestic inflation at home (too much risk of food riots etc).

Here come the earnings…

As a side note, earnings season starts this week — and that could be a mitigating or accelerating factor, depending on how good (or bad) the numbers are. The early look ain’t so hot — via Dow Jones:

Analysts expect the first quarter to be the worst period since mid-2009 for profit growth at U.S. corporations, even as stocks sit near multiyear highs.

On the aggregate, companies in the Standard & Poor’s 500-stock index are expected to report little or no increase in earnings for the first quarter. That represents a marked slowdown from two years of robust expansion fueled by cost- cutting in the wake of the financial crisis and could presage further debate about the prospect for equities.

“You can only squeeze your expenses so much. At some point you have to lean on revenue growth,” said Joseph Tanious, market strategist at J.P. Morgan’s asset management unit in New York. “That’s kind of where we are.”

– Dow Jones, Worst US Earnings Growth Since 2009 seen as Stocks Near Highs

Gray Swan #4: Federal Reserve Misfire

The final “gray swan” offers another ironic twist:

1. What if the Fed holds back this time because the news just isn’t dire enough?
2. OR, what if they do come rushing in… and the medicine fails to work?

The Good Friday jobs report was a disaster, but it could still be a somewhat isolated disaster (related to unseasonably warm winter weather patterns).

It’s thus possible that the U.S. economy keeps “muddling along,” at least enough so for the Federal Reserve to only jawbone, or act modestly, while holding back the big stimulus guns.

It’s also possible that Bernanke lets loose another blast, in the hope of keeping markets up so that President Obama gets reelected (allowing Bernanke to keep his job)… and that the blast yet fails.

If THAT happens — and the Fed appears “out of bullets” after three years of coordinated global central bank efforts to beat back the deflationary beast– all hell could break loose.

We’re talking 2008 freefall redux, Dr. Peter Venkman style: “Human sacrifice, dogs and cats living together… mass hysteria!”

In the Mercenary Live Feed we are heavily weighted towards short exposure now, with good concentration in China-related global slowdown plays.

Gonna be a fun summer…

JS (jack@mercenarytrader.com)

(I guess when you’re a billionaire you can get away with an awful looking earring.)

Many years ago, I came across “Parsons’ Rules” — a list of 16 rules for success in business and life. They struck me as pretty damn good.

I was reminded of Parsons’ Rules while tinkering with another project this weekend, and realized they also apply to trading.

So here they are (original list here):

1. Get and stay out of your comfort zone. I believe that not much happens of any significance when we’re in our comfort zone. I hear people say, “But I’m concerned about security.” My response to that is simple: “Security is for cadavers.”

2. Never give up. Almost nothing works the first time it’s attempted. Just because what you’re doing does not seem to be working, doesn’t mean it won’t work. It just means that it might not work the way you’re doing it. If it was easy, everyone would be doing it, and you wouldn’t have an opportunity.

3. When you’re ready to quit, you’re closer than you think. There’s an old Chinese saying that I just love, and I believe it is so true. It goes like this: “The temptation to quit will be greatest just before you are about to succeed.”

4. With regard to whatever worries you, not only accept the worst thing that could happen, but make it a point to quantify what the worst thing could be. Very seldom will the worst consequence be anywhere near as bad as a cloud of “undefined consequences.” My father would tell me early on, when I was struggling and losing my shirt trying to get Parsons Technology going, “Well, Robert, if it doesn’t work, they can’t eat you.”

5. Focus on what you want to have happen. Remember that old saying, “As you think, so shall you be.”

6. Take things a day at a time. No matter how difficult your situation is, you can get through it if you don’t look too far into the future, and focus on the present moment. You can get through anything one day at a time.

7. Always be moving forward. Never stop investing. Never stop improving. Never stop doing something new. The moment you stop improving your organization, it starts to die. Make it your goal to be better each and every day, in some small way. Remember the Japanese concept of Kaizen. Small daily improvements eventually result in huge advantages.

8. Be quick to decide. Remember what General George S. Patton said: “A good plan violently executed today is far and away better than a perfect plan tomorrow.”

9. Measure everything of significance. I swear this is true. Anything that is measured and watched, improves.

10. Anything that is not managed will deteriorate. If you want to uncover problems you don’t know about, take a few moments and look closely at the areas you haven’t examined for a while. I guarantee you problems will be there.

11. Pay attention to your competitors, but pay more attention to what you’re doing. When you look at your competitors, remember that everything looks perfect at a distance. Even the planet Earth, if you get far enough into space, looks like a peaceful place.

12. Never let anybody push you around. In our society, with our laws and even playing field, you have just as much right to what you’re doing as anyone else, provided that what you’re doing is legal.

13. Never expect life to be fair. Life isn’t fair. You make your own breaks. You’ll be doing good if the only meaning fair has to you, is something that you pay when you get on a bus (i.e., fare).

14. Solve your own problems. You’ll find that by coming up with your own solutions, you’ll develop a competitive edge. Masura Ibuka, the co-founder of SONY, said it best: “You never succeed in technology, business, or anything by following the others.” There’s also an old saying that I remind myself of frequently. It goes like this: “A wise man keeps his own counsel.”

15. Don’t take yourself too seriously. Lighten up. Often, at least half of what we accomplish is due to luck. None of us are in control as much as we like to think we are.

16. There’s always a reason to smile. Find it. After all, you’re really lucky just to be alive. Life is short. More and more, I agree with my little brother. He always reminds me: “We’re not here for a long time, we’re here for a good time!”

Bring me that horizon,

JS (jack@mercenarytrader.com)

• Parsons' Rules

• Lessons from the King of Blackjack

• Jeremy Lin, Role Model for Traders

• Trader Vic's Principles of Trading

• Wisdom from Kovner

• "Think Only Of Cutting"

• Insight From "The Philosopher"

• Wisdom From Bloomberg

• The Wyckoff Spark

• Billy Walters and the Fourth Horse

• Four Lessons From Druckenmiller

• Where Do Trading Profits Come From?

First, a comment on the JOBS act. Here’s an excerpt of President Obama’s signing ceremony remarks:

“Here’s what’s going to happen because of this bill.  For business owners who want to take their companies to the next level, this bill will make it easier for you to go public.  And that’s a big deal because going public is a major step towards expanding and hiring more workers.  It’s a big deal for investors as well, because public companies operate with greater oversight and greater transparency.

“And for start-ups and small businesses, this bill is a potential game changer.  Right now, you can only turn to a limited group of investors — including banks and wealthy individuals — to get funding.  Laws that are nearly eight decades old make it impossible for others to invest.  But a lot has changed in 80 years, and it’s time our laws did as well.  Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people.  For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in…”

There are some pretty big Wall Street changes coming as a result of this — and some folks are having a hissy fit, as the following article sampling shows:

• Investors’ Prying Eyes Blinded by New Law (WSJ)
• Ex-Con Man Says JOBS Law Makes Guys Like Him Rich (Bloomberg)
• Analyst Banker Firewall Weakened (Bloomberg)
• Get a Piece of My Hedge Fund! (Fortune)
• How to Protect Yourself from the JOBS Act (Forbes)

The short version gist of the above: Innocent investors should beware — the JOBS act is a return to the unregulated Wild West, with con men and fraudsters coming out of the woodwork.

This is where my inner libertarian responds: “Are you serious? Give me #$#@ break.”

It’s no wonder that nit-picking regulators are hyperventilating over the JOBS act. That’s what self-styled protectors of the people like to do whenever their authority is challenged.

As some whiny guy from the Nebraska Department of Banking & Finance has put it (via Forbes), “Congress has just released every huckster, scam artist, and small business owner and salesman onto the internet.”

To which I would respond: Where have you been, guy? Did you really think Wall Street was a safe and trustworthy place BEFORE the president signed this thing?

The reining motto of all investment decisions — and ESPECIALLY decisions where the salesman seeks you out — is “Caveat Emptor,” let the buyer beware.

Not only that, but there are plenty of fully vetted “legitimate” investments that are/were risky as hell. Groupon, anyone? Nor does it matter how big a research staff you have — look what happened to John Paulson in Sino-Forest ($700 million, ouch).

Look, John Q. Public could lose his shirt in some shady Boca Raton scheme, or he could lose it top-ticking the Facebook IPO. Either way, Caveat Emptor applies.

Will the freed-up restrictions of the JOBS act result in more gullible investors getting fleeced at the margins? Almost certainly. Most shady operators take the motto of Canada Bill Jones: “It’s immoral to let a sucker keep his money.”

Is the JOBS act still a good idea anyway? Almost certainly, because of the good it accomplishes.

You can only expend so much effort and energy protecting the gullible from themselves. And by cutting away red tape for entrepreneurs and investment managers, there is potential good being done in terms of new capital formation and new wealth creation.

The schemes at the margins are worth the legitimate opportunities. There was no heavy-handed regulator protecting John Q. Public back when America was the most dynamic growth story of the 20th century. And the really sharp hucksters will find a way to circumvent any and all red tape rules.

Not only that, but removing the illusion of safety can be a net positive for those in danger of being fleeced. Who is better off: The investor who naively believes the authorities are “protecting him” from the Bernie Madoffs of the world, or the investor who knows damn well there’s no true safety net, and ups his due diligence accordingly?

Agree? Disagree? I’m curious: jack@mercenarytrader.com (or just use the comments)…

The JOBS act will have some very interesting implications for traders, by the way. We’ll be bringing you Q&A with a seasoned legal professional on that very subject in the next couple weeks.

Bad Friday

Okay, off the soapbox. Now on to the market action. Good Friday (a stock market holiday) turned out to be “Bad Friday” thanks to an ugly shocker of a jobs report.

Last week we talked about “The Return of Ugly Goldilocks,” which can also be seen as a normalization meme.

In other words, as the U.S. recovery “normalizes” against a continued low-inflation backdrop (excluding food and energy), the Fed withdraws stimulus, causing gold, treasuries and possibly stimulus-inflated equities to fall.

If the macro bears are correct, though — if U.S. growth slips and we return to global recession conditions, with no exemption for the United States — odds increase that the Federal Reserve returns to an active stimulus stance, arresting and possibly even reversing the downtrends in gold and bonds.

That is the threat that the crapola jobs report (technical term) poses. If the recovery is in doubt, potential stimulus is back on the table.

Musical Chairs

This is another case of “memus interruptus” — a little fake Latin there — as investors now have to decide 1) whether the recovery has lost its legs, and 2) whether a lone jobs report will really bring the white knight riding to their rescue that quickly.

In addition to gaming the above, there is the question of “Sell in May and Go Away” — and whether the old advice has now been pulled a couple weeks forward.

It’s a game of financial musical chairs, where a tune plays for a while and then suddenly stops, with the abruptness of a needle scratching a record. Then a different tune starts playing, with one less seat, and the musical chairs game starts again.

One area to watch will be small caps — the weak link in the equity bull run. While the Dow, S&P and Nasdaq have left their 2011 highs in the dust, small caps have been constrained.

For small caps in particular, ugly action in the next few trading days could lead to the first meaningful submergence below the 50 day EMA (exponential moving average) in 2012. That would be a bad sign.

Whither bonds and gold?

The action in bonds and gold will also be instructive. The stronger the perceived chances of QE3 and economic downturn, the stronger the odds that bonds and gold both reverse higher.

Even still, are these trends to hop on from the long side? We don’t think so… it isn’t clear how the final jobs report reaction will play out, and uber-bearish chart patterns don’t turn on a dime.

It would likely take a few weeks for gold and bond bulls to undue the damage of recent breakdowns — either that, or an extremely large and ugly macro surprise.

China no good?

Whether or not bulls shake off the jobs hit, China continues to look ugly.

If the U.S. recovery is indeed running out of gas, that just strengthens the already strong prospects for global slowdown. Again as I write on Sunday night, copper, crude oil and the Aussie dollar (AUDUSD) are all trading lower.

This continues to be a choppy, challenging trading environment, with central bank holding patterns and surprise data point reversals all over the place. Last week it looked like bonds were off to the races, but this week it’s a mulligan.

Such is trading… the key thing is being Johnny-on-the-spot, with size, when the real move commences.

Trade ‘em well this week (as my boy Mike would say),

JS

I keep a close watch on this [trade] of mine

- Johnny Cash, “Walk the Line”

To trade in the Mercenary style, there is a concept you should know about. It’s called the zero line.

What is the zero line?

• In cash game poker, the zero line is the point at which your session is profitable. Above it, you have more chips than you started with. Below it, you have fewer.

• In business, the zero line is your minimum profit threshold. Above the zero line, the business is turning enough profit to stay healthy and viable. Below it, trouble looms.

• And in trading, the zero line is the point at which your entire portfolio – the sum of all actions — is profitable on the year. Above it, you’re in the black. Below it, red.

Those with a sharp eye will note I said “cash game poker” above, and not just “poker.” That’s because tournament poker is different.

Rising Tide

In tournament poker, the zero line is not fixed. It moves steadily higher as a function of blinds and the average stack.

Let’s say a poker tournament begins with 1,000 players, each with 10K in chips, for a total of 10,000,000 chips in play.

The average stack at this point is $10,000. A full day later, when half the field has busted out, there are still ten million chips in play – but now they are divided up among the remaining 500 players, for an average stack that has doubled in size from 10K to 20K.

In situations like this, it’s not good enough to stay “even” — you have to advance at a steady rate. If you aren’t keeping up with the average stack as blinds increase and the player pool shrinks, you are falling behind.

I mention this because business and money management can be like that too. The zero line is not always fixed – in a competitive environment, it can move. For investors, cost of living and inflation considerations act as a moving zero line too.

But let’s keep things simple here and go back to the fixed case. Why is the zero line such a useful and important trading concept?

For lack of a better term, it has to do with “life force.”

Use the Force Luke

Life is kind of a black-and-white concept. You are either alive or you are dead. But life force is more subtle. That is something that can wax and wane. When you are feeling healthy and powerful and invigorated, your life force is strong. When you are sick or tired or run down, your life force is weak.

The same idea applies to the health of a chip stack, a business, or a trading portfolio. It’s not quite as cut and dry as this, but there is a general relationship here:

• Other things being equal, life force is correlated to distance from the zero line. The farther above the zero line, the stronger you are. The farther below it, the weaker you are.

To avoid confusion, I want to quickly address an old trader’s saying: “Losses make you strong; profits make you weak.”

That seems to be the opposite of what we just said – but it addresses something different. “Losses make you strong” is true in the sense that setbacks sharpen a trader’s mind and force a reclarification. “Profits make you weak” is true in the sense that large doses of success can invite hubris and complacency.

There is wisdom in that saying. But we are talking about something else here. The zero line concept is focused more on financial capital than mental capital, and proper stewardship of that capital for maximum long-term results.

Don’t Waste a Drop (Bip)

Mental capital is important, and a subject worthy of deep treatment elsewhere. But financial capital – i.e. your total dollars available for trading – is just as important.

As a trader, your financial capital is your inventory. It’s like oxygen to a scuba diver, jet fuel to a pilot, or ammunition to a sniper dug in behind enemy lines. You can’t afford to waste it or deplete it. You want to replenish it when you can and have plenty of reserves at all times.

Another way to think of it is like this: Whether your starting capital is five thousand dollars, fifty thousand dollars, or fifty million, in basis points (bips) it is always the same.

A basis point is 1/100th of a percent. So if you risk 100 bips on a trade, that is 1% of capital. Regardless of size, everybody gets 10,000 bips on January 1st. No more, no less. You want to add to your bips, not deplete them. If you can help it, you don’t want to waste even one.

The zero line — in conjunction with P&L expressed in basis points — is a simple way to monitor how your financial capital is doing.

Full Functionality

There is another concept from poker that may help explain the zero line’s importance.

A “fully functional” poker player is one who has full access to his strategic playbook. The fully functional player can play loose or tight as he chooses. All styles and tempos are available to him.

He can do things like run a multi-stage semi-bluff… push another player off a hand with the implied threat of future bets…  play highly speculative hands at exactly the right time… or carefully “massage the pot” with a concealed monster to win all his opponents’ chips on the river.

To do all of the above, though – to have access to the full playbook – our player must maintain a healthy chip stack.

As his chip stack becomes depleted by losses, this same player goes from “fully functional” to “marginally functional.”

As he keeps sliding, his status then drops from “impaired” to “severely impaired” to “desperate” (a place you never want to get to).

This happens because, as the chip stack diminishes, the cost of losses goes up — in both stack-percentage terms and psychological terms — even as the effectiveness of strategy goes down (because other players simply give less respect to a diminished stack, and show less fear in challenging you).

Don’t Let the Bastards Grind You Down

When you are ground down and short-stacked instead of healthy, you just don’t have the ammo or the table presence to make many of the nuanced, multi-stage moves you could have made before. Your options have grown limited. Down in the short-stack zone, you have to restrict yourself to basic, one-dimensional plays with rock-solid premium holdings.

The short stack has to pick his spots very carefully, and rely intently on the strength of the cards in his hand. It’s either that, or push all-in and pray for a good result. His other weapons have been taken from him.

In trading it works the same way: The farther you drop below the zero line, the more likely you are to see a transition status from “functional” to “impaired.” And the more impaired you are, the more that run-of-the-mill statistical outliers (like a string of unexpected losses) become a threat.

You don’t want the above to happen, if can avoid it. You want to maintain full functionality, and you do so through careful risk management and keen awareness of the zero line.

Ken Grant, risk manager to many of the top hedge funds in the world, talks about this as the “risk management investment.”

We’ll explore that further – along with what to do at, below, and above the zero line – next time.

JS (jack@mercenarytrader.com)

In today’s carnage we added to our precious metals-related shorts — FCX, silver, and a few other selected plays — as the bearish metals thesis plays out.

While we are not long-term bearish gold (in the long term we are neutral for now), the near term price action has been fairly compelling.

Regarding our “Gold looks terrible: clarifying thoughts” piece, Mercenary community member Luke writes in:

I am an “open minded” gold investor, so I loved the article; however, my concern is that the US Government cannot AFFORD to let interest rates rise at all or the government debt servicing will eat up all of their revenue. I agree with most of your points, and it would make sense that interest rates SHOULD rise shortly – but if that means unsustainable debt servicing, then don’t you think the Fed will do everything to fight an interest rate rise?

First off, good on you for being open-minded Luke. As we like to say, “Love your family — not your positions. Be loyal to your friends — not your trades.”

Your concerns about debt service issues are valid. The problem has to do with timeframes!

I believe it was Brian Gelber in Market Wizards who first pointed out the timeframe problem. There are significant issues when it comes to pairing long-term fundamental factors with short to intermediate term moves. Simply put, you can’t trade weekly or monthly time frames off what could amount to a multi-year view!

Take the mother of all cases-in-point: Japan.

The land of the rising sun has a deadly serious “interest rate affordability” problem too. At some point, in relation to retirement demographics and spender-vs-saver calculus, Japan will experience “exploding debt dynamics” and the fiscal situation will collapse.

But here’s the rub: While that statement is true, it has been true for years!

Roughly speaking, the Japanese Goverment Bond (JGB) market is 95% supported by domestic savers. When the demographic tipping point materializes, the JGB market will hit “the end of the line” as Mrs. Watanabe crosses from saver to spender in her advancing age.

When this happens, falling JGBs coupled with rising debt service costs will result in epic disaster… and the vaporization of the yen in monetized support of the bond market, as the BOJ is forced to “destroy the currency for the sake of the economy” (to paraphrase Von Mises’ biggest prophecy).

But WHEN will this happen? Heck, it could be happening right now (which is why we’re short yen). But it might not happen until 2013… or 2017… who really knows?

Getting back to U.S. fiscal issues: You may be correct that government debt service issues will eventually force the Fed to go “nuclear,” essentially vaporizing the dollar (by way of printing press) in an effort to monetize (stabilize) the bond market.

But again, when will this happen? There are duration risk and “can kicking” factors to consider. And what might gold do in the meantime?

Our central argument is not that the long-term gold bulls / dollar bears are necessarily wrong… but rather that gold could fall precipitously between here and there (even if they are right).

For trading and even investing — though far moreso the former — timing is critical, and must be factored into your convictions.

There is nothing wrong with making a conviction-based investment and holding through short-term adversity, if such is your style and temperament… as long as you can quantify the worst case adversity scenarios (in terms of unfavorable price action) and anticipate your reaction to them.

If you are truly committed to the long gold case, for example, you must quantify what that means in regard to near term “uncle points:”

• Will I still like my gold position if we go back to $1500 per ounce?

• Will I still like it if we go back to triple digits ($999 per ounce)?

Both outcomes are entirely theoretically possible, even if your long term forecast for U.S. government debt service issues turns out 100% correct.

(And the question of whether the debt service issue really is a bull factor for gold is a whole ‘nother can of worms, by the way — having to do with monetary theory — that we have discussed in past but will not get into here for the sake of time.)

Being traders and Soros-style fallibilists — always aware of our potential to be wrong — we embrace the virtues of flexibility, sticking to the mantra that “the small loss is the best loss” and taking a short bias to gold in the near term (always having the option to flip long later).

Ugly Goldilocks

The real problem with gold right now is a scenario in which the U.S. economy “recovers” at just enough pace for inflation to remain low and stimulus to be withdrawn.

This is the “ugly goldilocks” scenario — one in which things are muddling along, but the poor position of middle class consumers, stubbornly high unemployment and stagnant wages keep inflation concerns in check.

Consider the following headlines, which together paint a very ominous picture (for gold that is):

• U.S. Economy Enters Sweet Spot as China Slows (Bloomberg)
• Car sales surge as recovery gains steam (Reuters)
• Fed turns down volume on stimulus talk (YF/Reuters)
  

You see the picture that paints?

The average situation for Joe Sixpack sucks and Wall Street knows it. But middle class pain is also reining in “core” inflation — not including food and gas prices, of course, but the Fed doesn’t care about those.

This results in a positive equity, “abandon gold” scenario where, once again, the imminent inflation and fiscal destruction is put on Japan-style hold. (Did I mention that bets against the Japanese government bond market have been going sour for so long, they call it “the Widow-Maker Trade?”)

Goldilocks could whack equities too

As this note is being written, live trades executing in the background, the S&P is seeing its most meaningful correction in a while (down a little over 1% as I type).

This speaks to another irony — the same hole that gold has fallen into could suck in equities too. It works more or less like this:

• Ongoing Federal Reserve stimulus has led investors to believe Ben Bernanke is their savior and friend.

• But the Federal Reserve’s main goals are to 1) protect and enrich the banks and 2) stabilize the economy.

• The banks are doing ok now (seen the share prices for WFC, BAC and C?) and the economy appears to be stabilizing.

• These conditions naturally lead to potential “stimulus withdrawal” of the sort that could lead to a Wall Street temper tantrum (i.e. sharp market correction).

The above, in fact, is what Tuesday’s action was all about. The Fed minutes were not a game changer in and of themselves, but a harbinger of probability shifts in the direction of the stimulus withdrawal scenario.

Now, it may be that Bernanke reverses position and starts talking “QE3″ again — sooth saying the market — IF general economic conditions deteriorate.

But if general U.S. economic conditions do NOT deteriorate — if “ugly goldilocks” continues apace — then we could actually see the stock market correct meaningfully!

In this scenario, good news (for the economy) is bad news (for the stock market) due to stimulus withdrawal.

And also bad news for bonds…

“Trade of the Year” Candidates

If you’ll forgive an uncharacteristic bit of horn tooting, on February 14th we wrote “Long bonds and Yen: Big Shorts for 2012?”

We put our money (trading capital) where our mouth is on both of those positions, to good result.

Then, on March 30th, yours truly tweeted the following:

http://stks.co/39XI If you want to hop on the bearish long bond train, this may be your chance…

We took that opportunity to agressively pyramid our existing TBT position. You see what happened next…

CLICK TO ENLARGE

Furthermore, on March 20th we tweeted the following:

http://stks.co/2xcJ Short Aussie could be one of the biggest trades of the year on global growth fade

And you can see how that one is going:

CLICK TO ENLARGE

What’s the moral here? Follow our tweet streams?

Better yet, follow the Mercenary Live Feed. That’s where we tell you what we’re thinking and why, every day, and share our real-capital trade executions, along with position size metrics and portfolio composition, in real time.

Look, there is no crystal ball at Mercenary headquarters. We get our share of stuff wrong. But that’s the whole idea behind the trading game… when you are wrong keep it small… “the small loss is the best loss.”

Then keep your eyes open.. look for opportunities to ramp up exposure in premium situations as they unfold… and know how to dial it up when Mr. Market tips his hand.

By the way, we love questions and comments in respect to market action, themes and trends, economic theory etc… in addition to discussion points, some of you have even forwarded your own trading theories and high quality research pieces, which we love.

This kind of interaction is what the Mercenary community is all about. Write to us!

You can ping us directly via jack@, mike@ or nathan@, or general purpose via feedback@mercenarytrader.com.

funny old world innit,

JS

• Attention Frustrated Chartists: It's not HFT - it's the Macro!

• A Dangerous Market Full of Crosscurrents

• Euro Zone Crisis: Back on the Front Burner

• Concerning Gray Swans: Europe, China, Profit Margins and The Fed

• The Return of Ugly Goldilocks

• Gold Looks Terrible Part II: Clarifying Thoughts

• Home Builders (Technically Speaking)

• Downgrades & Mellonists: This is What the Market Fears

• The Bond King Gets Desperate

• S&P 400? The Deflation Shock Scenario

• Pension Funds and the Zero Bubble

• Milking the Consumer Cash Cow -- How Much Longer?

• The Great Compression

• Deeper Implications of Middle East Turmoil

• Pondering the High Cost of Food

• The Age of Cyberwar is Here

• Did China just ring a bell?

• Twelve Major Risks for 2011

• Why Investors Should Be Terrified of Deflation

• Strip Mining the U.S. Economy

• It's the Debt, Stupid

Barron’s noted that this was the best quarterly start to the year since 1998 with the Dow rising 8% and the S&P 500 gaining 12%.

It’s interesting to note that more speculative issues have been stronger as investors willingly take on risk to boost returns.  The Nasdaq Composite rose 18.7%, driven not only by strong performance from AAPL, but also renewed optimism in the technology sector.

Bull markets often climb a “wall of worry” and this period is no exception.  There are a number of key issues that economists are concerned with:

• Europe’s debt situation is still unstable.
• China’s growth is decelerating
• High oil prices weigh on consumers

But as Jack discussed on Thursday, overbought markets tend to stay overbought and we have not yet seen any signs of volatility that typically accompany a change in direction.

As we kick off a brand new quarter, the Mercenary trading book has a relatively balanced assortment of exposure, with bullish positions in technology, shipping, consumer staples and biotechnology – offset by bearish positions in metals, for-profit education, domestic drillers and the Australian dollar.

The second quarter promises to be a dynamic period, with earnings season offering clarity as to whether investors have become too optimistic, or if the recovery really is propelling robust corporate earnings.

Below are a few of the key areas we are watching this week…

Long Bonds Peak

After multiple promises of low interest rates, ample liquidity, and multiple quantitative easing programs, 20-year treasuries have been sitting at historically high prices (bond prices obviously trade opposite to interest rates).

But as economic growth finally begins to pick up momentum, Fed officials are becoming less committed to an era of permanently low rates.  The fear of inflation is becoming a more serious issue and bond traders are taking note.

The UltraShort Lehman 20+ Yr Treasury (TBT) ETF trades inversely to long-bond prices.  So as long-dated treasuries come under pressure, TBT is breaking out of its slump and could turn out to be a tremendous trade for us this quarter.

On February 17th, the Mercenary Live Feed took an initial position in the ETF as the price action appeared to be ready to break out of a multi-month consolidation.  Our initial entry was just a bit premature as bonds didn’t actually end up breaking down until midway through March.

But after a significant break on March 14th, and mild two-week consolidation, long bonds are breaking down again heading into the second quarter.

We used the action on Friday to pyramid our position – adding more exposure and tightening our risk point on the entire position.  As long-term interest rates naturally adjust higher, long bonds should continue to fall – giving us opportunity to capitalize on a new emerging trend with plenty of room to run.

Natural Gas Slide

Natural gas prices have been under pressure for years now.  This is not “new” news, but it still surprises me to hear how many traders are bullish on gas – simply because prices are the lowest we have seen in decades.

Let’s think about this for a second…  there is a reason natural gas prices are so low.  Fracking technology has opened up vast reserves that were previously unable to be produced, leading to a domestic glut.

An article in Barron’s this weekend noted that as oil producers ramp up drilling for liquids, the production of gas as a bi-product continues.  So even though major producers like Chesapeake are shutting down vast amounts of production (due to lower prices), the gas glut continues to rise.

Tack on a historically warm winter (very low natural gas consumption) and the glut gets even worse.  The Barron’s article noted that there is a distinct possibility that the US will run out of storage capacity for natural gas by October this year.  So given the dynamics it is pretty tough to make a bullish argument for natty…

As part of Global Trend Capture – our trend following service – Nathan O. has been consistently short the United States Natural Gas Fund (UNG).  His most recent position was entered on 3/1 at a price of $19.84.  We’re trading from a position of strength, with our current risk point locking in a solid profit – and UNG appears to be accelerating lower as we enter a new quarter.

Managed Care Reacts to Supreme Court Debate

Towards the end of last week, the managed care (or health insurance) industry got a boost from the Supreme Court discussion of Obama’s healthcare mandate.  Below is an excerpt from a Thesis Notes penned over the weekend as part of the Mercenary Live Feed.

This past week, the United States Supreme Court has been debating the universal health mandate passed into law under the Obama administration.  Overall, the healthcare law has been under pressure and there is a very good chance that the legislation will be considered unconstitutional in its current form.

Specifically, the issues of “pre-existing conditions” and the “individual mandate” are being debated.

Early in the week, the arguments appeared critical of the individual mandate – which requires all citizens to buy healthcare.  Obviously if the Supreme Court strikes down this mandate, it will be bad news for the health insurers who will no longer have their client base compelled to buy their product.

More importantly, if the individual mandate is taken out of the law, insurers will be required to provide insurance to all consumers who request it – and will NOT be able to turn away customers based on pre-existing conditions.  This gives individuals an incentive to operate without healthcare insurance – and then enroll themselves once they have an ailment.

Late in the week, the Supreme Court turned their attention to pre-existing conditions – noting that it made no economical sense for the managed care companies to shoulder all of the expenses without the individual mandate.

Managed care stocks spiked sharply higher when it became apparent that the court understood the economic implications of not allowing the insurers to consider pre-existing conditions.

From a trading perspective, we’re not interested in buying into the hype initially.  Purchasing an over-bought stock is a recipe for getting shaken out and sustaining losses.

But if the managed care companies pull back for a few days and then continue their bullish trend, it would give us a chance to enter a few of these names with reasonable risk points – allowing us to profit from a continuation of the bullish action.

An hour before the opening bell, markets look relatively tame with traders waiting for the ISM factory index to be released later this morning.

We’ll be watching the flows carefully as portfolio managers put new capital to work.  The broad market is in a very stable trend, but various sectors and groups have plenty of shifting dynamics in play.

Trade ‘em well this week!
MM

Similar articles you might like:

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

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- Paul Kedrosky, 03-27-12

As the stock market corrects into quarter’s end, bulls are starting to get nervous. Is the levitating act of equities in doubt?

CLICK TO ENLARGE

Here’s a quick point of perspective:

The QQQ, powered as it is by Apple, has only touched its 20 day exponential moving average ONCE in 2012 — and that for but a single day.

Maybe the techs should be discounted, though, because of the Apple phenomenon. After all, AAPL has become its own asset class, with a bigger cash hoard than the GDP of small countries and the most successful product line in the history of mankind.

But what about the S&P? That’s been levitating too…

CLICK TO ENLARGE

If you are inclined to see a bleak future, this “levitation act” looks like trouble. Macro level bears — those who still have fur  — have been salivating at the prospect of a broad market break.

In line with that, trader chatter is increasingly focusing on top calls for the S&P. But why?

This doesn’t make a whole lot of sense — as far as broad market bearishness goes, there are problems on multiple levels:

• Overbought markets tend to stay overbought. Just as oversold markets tend to stay oversold. Oscillators are like Wall Street analysts: If you rely on them too much, they fail you at the worst time. It’s indeed possible that this broad equity strength fades out. But it’s also possible that we see a continuation of domestic U.S. equity strength that leads to some kind of blow-off top. The “1987 scenario” — in which we go a lot further before falling off a cliff — seems as plausible as an early crap-out.

• Volatility is a sign of trend change — which we haven’t seen yet in the major indices. A paraphrase from the palindrome (Soros): “Volatility is greatest at turning points, diminishing as a new trend is established.” Words of wisdom to live by. Look at SPY, DIA, QQQ. See any thrashing around? See any big upsurge in volatility yet? If not, then as a trader why anticipate it?

• Conditions are benign, and April is the best month of the year for stocks. Institutional money managers have reason to be happy. The U.S. economy is “muddling along,” the Fed is committed to an ongoing accomodative stance (even if QE3 is a question mark), and April is historically the sweetest month of the year for stocks. The worm may yet turn, but why now?

• There are plenty of OTHER places to be bearish (without fighting AAPL or the S&P). This is the most amusing part. Why waste time and energy trying to fade strength in the major indices, when opportunities in China-related areas of the market have been excellent?

CLICK TO ENLARGE

Consider the Australian dollar (as pictured above).

China is rolling over right now — take a look at FXI, PGJ, HAO, and the Shanghai composite — and it is taking the entire industrial metals complex with it.

This is not only a very bearish development for the Australian dollar, it’s bearish for a wide swath of “commodity supercycle” stocks: Base metal miners, steel producers, oil service, and so on.

For a long time after 2008, we had “all or nothing” type markets, where risk assets seemed to have a correlation of 1. Either everything was up, or everything was down.

Now, finally, we have some massive divergences — which is great news for a balanced long / short trading portfolio.

CLICK TO ENLARGE

Our winners on the long side include groups like semiconductors, biotech, and financial exchanges — all extremely strong. Why fight the tide when you can go with the flow?

On the short side, we have heavy (and profitable) exposure to the industrial metals complex — on China rationale and compelling chart confirmation — along with select oil service and precious metals names.

Speaking of gold (which we called out as terrible last week): The biggest problem for precious metals right now has the initials BSB — for Benjamin S Bernanke.

Why? Because Bernanke clearly has the “whip hand” when it comes to manipulating market sentiment as relating to gold and the $USD.

• On February 29th, gold saw one of the most brutal one-day drops on record, on a few handwaving comments from the Fed Chairman suggesting QE3 might be postponed.

• More recently the Chairman changed his tune, suggesting more stimulus might be in the cards. Gold bulls got excited, pushing PMs back to resistance at their 20 day averages. But it was a short-lived respite (gold and silver again looking punk today).

• The real problem, however, being the readiness of gold bulls to turn tail every time the Fed Chairman clears his throat. If the yellow metal starts getting its mojo back, what’s to stop Bernanke from bringing out the giant cartoon mallet once again? Yes, at “some point” inflation expectations may get “out of control” — but we’d rather wait than anticipate, thanks very much.

In the Mercenary Live Feed — where we trade real capital and report executions in real time — we like to jockey for position and play for the big moves. As such, modest corrections in the major indices don’t mean all that much — until the volatility tells us a significant shift is happening.

Meanwhile, groups on both sides of the ledger are working well.

As a final note, if you are worried about a potential correction, check out what Coke has done the past few days:

CLICK TO ENLARGE

Group strength is a critical concept because of institutional capital flows.

Just as surely as money is flowing out of energy stocks and the industrial metals complex right now, it is flowing into “safe” areas of the market like pricing-power-enabled consumer staples stocks. We have a couple of these in the on deck circle.

Bring me that horizon,

JS (jack@mercenarytrader.com)

Lieutenant Colonel John “Jack” Churchill, aka “Fighting Jack Churchill,” aka “Mad Jack,” was a British soldier in World War II.

“Mad Jack” was known for fighting with a longbow, arrows, and a Scottish broadsword.

In World War II!

His famous quote was, “Anyone who goes into action without his sword is improperly armed.”

I’m not sure how that translates to markets. Maybe “Anyone who goes into a trade without his risk point is improperly armed.”

But Mad Jack deserves recognition simply for being the ultimate gentleman badass — elegantly dispatching foes, Braveheart style, with his longbow, broadsword and top hat.

(Okay, maybe no top hat.)

The other guy did something of a more recent vintage:

Don Johnson — no relation to the Miami Vice guy — took $6 million in one night from the Atlantic City Tropicana casino. Not long before, he hit Caesars for $4 million and the Borgata for $5 million.

And he did it all playing blackjack.

The tale is fascinating. You can read it here: “The Man Who Broke Atlantic City” from, oddly enough, The Atlantic magazine. Here’s an excerpt:

Dozens of spectators pressed against the glass of the high-roller pit. Inside, playing at a green-felt table opposite a black-vested dealer, a burly middle-aged man in a red cap and black Oregon State hoodie was wagering $100,000 a hand. Word spreads when the betting is that big. Johnson was on an amazing streak. The towers of chips stacked in front of him formed a colorful miniature skyline. His winning run had been picked up by the casino’s watchful overhead cameras and drawn the close scrutiny of the pit bosses. In just one hand, he remembers, he won $800,000. In a three-hand sequence, he took $1.2 million.

You may think this is another “card counting” story. Some famous and successful traders, like Blair Hull in New Market Wizards, and more notably Ed Thorpe and Bill Gross, got their start counting cards at the blackjack table.

Later on, Ben Mezrich wrote a book called “Bringing Down the House” about an MIT blackjack team that made millions in Vegas.

(The book was later turned into a crappy movie with Kevin Spacey. I normally like Kevin Spacey, but this time he was slumming for a paycheck. Or so I heard. I read the book but missed the flick.)

Anyhow, when you hear about someone making millions at blackjack, you automatically think “card counting” — the spotter, the big player, doing a smash and grab on the casinos, that kind of thing.

But what is so fascinating about Don Johnson’s multi-million dollar scores is, he didn’t count cards (which would have gotten him thrown out anyway).

The edge he found was actually much more subtle, and brilliant, than that. Here is the money excerpt:

Johnson is very good at gambling, mainly because he’s less willing to gamble than most. He does not just walk into a casino and start playing, which is what roughly 99 percent of customers do. This is, in his words, tantamount to “blindly throwing away money.” The rules of the game are set to give the house a significant advantage. That doesn’t mean you can’t win playing by the standard house rules; people do win on occasion. But the vast majority of players lose, and the longer they play, the more they lose.

Sophisticated gamblers won’t play by the standard rules. They negotiate. Because the casino values high rollers more than the average customer, it is willing to lessen its edge for them. It does this primarily by offering discounts, or “loss rebates.” When a casino offers a discount of, say, 10 percent, that means if the player loses $100,000 at the blackjack table, he has to pay only $90,000. Beyond the usual high-roller perks, the casino might also sweeten the deal by staking the player a significant amount up front, offering thousands of dollars in free chips, just to get the ball rolling. But even in that scenario, Johnson won’t play. By his reckoning, a few thousand in free chips plus a standard 10 percent discount just means that the casino is going to end up with slightly less of the player’s money after a few hours of play. The player still loses.

But two years ago, Johnson says, the casinos started getting desperate. With their table-game revenues tanking and the number of whales diminishing, casino marketers began to compete more aggressively for the big spenders. After all, one high roller who has a bad night can determine whether a casino’s table games finish a month in the red or in the black. Inside the casinos, this heightened the natural tension between the marketers, who are always pushing to sweeten the discounts, and the gaming managers, who want to maximize the house’s statistical edge. But month after month of declining revenues strengthened the marketers’ position. By late 2010, the discounts at some of the strapped Atlantic City casinos began creeping upward, as high as 20 percent.

“The casinos started accepting more risk, looking for a possible larger return,” says Posner, the gaming-industry expert. “They tended to start swinging for the fences.”

Johnson noticed.

“They began offering deals that nobody’s ever seen in New Jersey history,” he told me. “I’d never heard of anything like it in the world, not even for a player like [the late Australian media tycoon] Kerry Packer, who came in with a $20 million bank and was worth billions and billions.”

When casinos started getting desperate, Johnson was perfectly poised to take advantage of them. He had the money to wager big, he had the skill to win, and he did not have enough of a reputation for the casinos to be wary of him. He was also, as the Trop’s Tony Rodio puts it, “a cheap date.” He wasn’t interested in the high-end perks; he was interested in maximizing his odds of winning. For Johnson, the game began before he ever set foot in the casino.

Did you catch that? Here’s the breakdown:

• The odds on most casino games are unbeatable, as most everyone knows. (How else could they pay that $500,000 electric bill every month.)

• “Whales,” i.e. players willing to drop huge sums, are a casino’s most profitable patrons by far — and the casino will bend over backwards to keep these whales happy. But only if they reliably lose.

• When times get tough and revenues drop, casinos offer special deals to high rollers to try and pull them in — essentially saying “We will shave down our statistical edge against you, if you agree to come and play.”

It’s estimated that the house has a 2% advantage over the typical blackjack player.

That 2% edge is like a biased coinflip — big enough for the house to win all the money over time.

With 100% correct theoretical play — not counting cards, just playing every hand in mathematically optimal fashion — it’s estimated that the house edge is whittled down to 0.5%.

Now you are getting very, very close to 50/50 odds… but that 0.5% is still enough for the house to make good.

Johnson figured out how to drive the house edge even lower. Through hard negotiations, he got it down to (by his estimate) just one quarter of one percent.

That’s super close to dead even — but still not quite enough. And then came the coup de gras: With some negotiated loss discounts on top of that — agreements for the casino to reimburse a certain amount of if Johnson lost — he actually flipped the overall edge in his favor without the casino realizing it.

House management got played by a math shark:

So how did all these casinos end up giving Johnson what he himself describes as a “huge edge”? “I just think somebody missed the math when they did the numbers on it,” he told an interviewer.

Johnson did not miss the math. For example, at the Trop, he was willing to play with a 20 percent discount after his losses hit $500,000, but only if the casino structured the rules of the game to shave away some of the house advantage. Johnson could calculate exactly how much of an advantage he would gain with each small adjustment in the rules of play. He won’t say what all the adjustments were in the final e-mailed agreement with the Trop, but they included playing with a hand-shuffled six-deck shoe; the right to split and double down on up to four hands at once; and a “soft 17” (the player can draw another card on a hand totaling six plus an ace, counting the ace as either a one or an 11, while the dealer must stand, counting the ace as an 11). When Johnson and the Trop finally agreed, he had whittled the house edge down to one-fourth of 1 percent, by his figuring. In effect, he was playing a 50-50 game against the house, and with the discount, he was risking only 80 cents of every dollar he played. He had to pony up $1 million of his own money to start, but, as he would say later: “You’d never lose the million. If you got to [$500,000 in losses], you would stop and take your 20 percent discount. You’d owe them only $400,000.”

In a 50-50 game, you’re taking basically the same risk as the house, but if you get lucky and start out winning, you have little incentive to stop.

So when Johnson got far enough ahead in his winning sprees, he reasoned that he might as well keep playing. “I was already ahead of the property,” he says. “So my philosophy at that point was that I can afford to take an additional risk here, because I’m battling with their money, using their discount against them.”

Now I’m no blackjack player (and never will be). There are bigger games to play, with better odds and less headache (like poker for example!).

But from a trading perspective, what Don Johnson did is absolutely fantastic:

• He waited patiently for a huge edge to develop (refusing to play on anything but his own terms).

• He used observation, psychology and math to exploit one of the biggest strategy blunders in casino history (giving big loss rebates to an unknown high roller that wiped out the minimized house edge).

• He protected his capital and ensured the risk would be minimal, even if he lost.

• When he saw that he was ahead, he chose to pyramid — press his bets — and absolutely crushed the tables, to the point where they simply wouldn’t let him play anymore.

That, friends and neighbors, is the epitome of trading excellence.

Finding an incredible reward to risk opportunity… cultivating your edge through careful analysis and bold decision making… stepping up with proper capitalization and risk control… and then maximizing that opportunity to the hilt.

And as a side note, how many “random walk” academic theoreticians would have said it’s even possible, in the known universe as we know it, to make circa $5 million at the blackjack tables in one night… and repeat the feat twice more… and to do it all without counting cards?

“No way,” they would say. But of course there was a way. Johnson did it.

Point being, it’s no wonder the efficient market theorists have no clue — they cannot conceive of the opportunity sets that arise, or the dynamic features of the fitness landscape, when it comes to the sufficiently motivated and creative human mind.

The edges are out there… and you don’t have to be a Don Johnson to find them.

JS (jack@mercenarytrader.com)

• Parsons' Rules

• Lessons from the King of Blackjack

• Jeremy Lin, Role Model for Traders

• Trader Vic's Principles of Trading

• Wisdom from Kovner

• "Think Only Of Cutting"

• Insight From "The Philosopher"

• Wisdom From Bloomberg

• The Wyckoff Spark

• Billy Walters and the Fourth Horse

• Four Lessons From Druckenmiller

• Where Do Trading Profits Come From?

Unlike trend trading, which typically covers a “defined universe” of specific vehicles, swing trading stocks requires the ability to winnow down thousands of candidates to a manageable list of names. This takes more energy and effort to sift the gold flakes from the pan.

Fortunately, there are some great tools out there to narrow the search.

It’s possible to begin with fundamental screens, looking for the most attractive stocks from a growth or value perspective.

You can also find excellent fundamental screening tools, of the sort provided by Investor’s Business Daily (IBD) and others, that give rankings of the most attractive growth names in the market.

IBD also ranks thousands of stocks by industry group, with proprietary scoring methods for strongest to weakest. And while everyone loves the “IBD 50” – the hot growth stock list – sometimes the weakest and least loved industry groups are good hunting grounds for trend moves in future, as beaten down industries can have the most powerful turnarounds.

The other starting point for a screening method is technical, i.e. chart-based.

With the help of various tools and services, for example, you could decide to only look at stocks that are above their 20 and 50 day moving averages. Or names where the 20 just crossed over the 50. Or where volume and daily price range have simultaneously expanded, or 40 day highs were broken, or a candlestick formation created a certain pattern… point being, the computing horsepower available today is immense, and there are many ways to identify the patterns you seek.

Once you have identified your “on deck list” of swing candidates through the requisite slicing and dicing, the most effective thing to do next (in our opinion) is implement a mechanical set of trading rules.

This does not mean writing a software program and handing over your trading account to a computer. What it does mean is having a specified list of trading rules and guidelines that make management of the trade very simple and straightforward once you are in.

These rules should cover things like when to tighten risk points (and why), implementation of profit targets (unless it’s a trend trade), standard rationales for exiting the trade, and guidelines as to when to “pyramid” (add to the position) if required.

The more comprehensive and standardized your trade management rules become – i.e. the more mechanical they become – the more the trade “takes care of itself” once you’ve triggered an entry.

Here are some of advantages of mechanical trade management:

Advantage #1: Taking the emotions out of the trade.

Human nature being what it is,  the natural tendency is to take the wrong action at the wrong time. In addition to this, many character traits that serve us well in life turn into dangerous detriments to a trading account.

Loyalty, for example, is something honorable and excellent in life outside of markets. But when it comes to trading, loyalty to any position or market opinion is dangerous. Worse still, loyalty to a point of view can creep into your trading decisions on the sly in the absence of hard and fast rules to counter it.

Mechanical trade management acts as a sanity check – it forces you to exit a position for logical reasons if price is not “acting right.” We also know, from hard experience, that discipline matters most when we wish to apply it least. Those times you really want to override your rules, are often when it’s most dangerous to do so!

If you are using predefined profit targets, bracket orders can also be a big help. (A bracket order lets you enter a protective stop and profit-taking order simultaneously.) Instead of worrying over whether to take profits or hang on, if your bracket order is in place the trade will close itself for you (leaving emotion out of the equation).

Think of rule-based bracket orders like a safety feature that automatically fastens your seat belt after you get behind the wheel. Once the position is in place, you can just observe and keep tabs on any small adjustments that have to be made. The bracket order will take you out of danger if your risk point gets hit – or if the profit target is hit, so much the better.

Side note: Some trades work better with targets and others without. But if you do decide to use targets,  you want to follow your discipline as a rule. (If you decide to change your methodology, change it for the next trade – not in the middle of the one you have on!)

Advantage #2: Enhancing consistency of returns.

Skillful trade management cannot guarantee returns. A bad system, whether mechanically managed or not, will still bleed money. And if you randomly use a different strategy / approach with every trade you take, it becomes very hard to find and polish an edge.

If you have a consistent and rule-based management approach, though, it becomes easier to do post-analysis on your trades to determine what worked and what didn’t, and thus incrementally improve results overall.

For example: If you look at your past 50 or 100 trades and discover your standard profit target was missed by a small amount in too many cases, you can find a way to tighten your targets. Or if you discover you were leaving too much on the table, you can widen your targets, or switch to a moving average trailing stop. If you further discover your trades have a tendency to either work quickly or go bad, you can implement a time stop rule that closes the trade at the end of X days and so on.

There are many combinations of entry / exit / risk point management improvements that can come from intelligent post-analysis of trades.

But you can only do this kind of analysis if you have a consistent, rule-based management method in the first place! If you are just throwing darts every time you decide to enter or exit a trade, you don’t actually have a methodology to improve on.

Advantage #3: Ease of Use and Peace of Mind.

To some die-hard discretionary traders, mechanical trade management may sound like an unacceptable loss of control. Who wants to hand over their decision making to a list of rules?

In actuality, though, mechanical trade management provides freedom, not constraint. How so?

Because with clearly defined management rules, you don’t have to worry about the trades you have on. You’ll know the trades will “take care of themselves,” in terms of the rules you follow, thus freeing up extra time and energy for you to pursue new trading ideas, new research projects, system improvement efforts, and so on.

All good traders are pressed for time in terms of so many new opportunities to explore, and so many promising research avenues for finding that extra edge.

By perfecting your mechanical trade management rules, you can spend less time sweating over the trades you currently have in play, and more time raising your trading game overall.

N (nathan@mercenarytrader.com)

p.s. We are currently working on a free special report that gives deep detail on exactly how we swing trade: The full nuts and bolts, from screening and setup selection, to trade management and execution. We are also working on a new trading advisory (still in pre-beta) devoted exclusively to short-term swing trading ideas.

If you would like to be notified when more on this comes available, or have specific swing trading questions, let us know: feedback@mercenarytrader.com

• Advantages of Mechanical Trade Management

• What to Look For – And What to Avoid! – in a Short-Term Trading System

• Why You Should Consider a Short-Term Trading System

• Adding Efficiency To Your Trading Process

• The Trouble With Inverse ETFs (And Other Structured Securities)

• Trend Trades vs Mean Reversion Trades

• Swing Trading in Two Sentences

• Proportion and Perspective (Give That Chart Some Room)

• On the Importance of Themes (and Getting Around)

• Why Trades Are Like College Interns

• How to Avoid 'Sitcom Syndrome'

• The Viking Remedy: Concentration as Salvation

Small cap growth stocks are particularly strong with the iShares Russell 2000 Index (IWM) trading near the top of its recent range, and posting a strong bullish close on Friday.  Nathan O. has a conditional buy set up for our Global Trend Capture service – and a move higher this week is likely to trigger a new long position.

The action sets up an interesting juncture for markets as the dynamics in China are important in terms of global growth, and yet the majority of sectors simply shrugged off the news and continued higher.  Even the iShares Emerging Market Index (EEM) found support at the 50 EMA and reversed higher on Friday.

With the overall market holding up well, we have been able to add bullish positions to the roster – while tightening risk points on existing trades as they move into profitable territory.  But at the same time, high oil prices and weakening China dynamics have led to breakdowns in a few key areas – allowing us to set up offsetting short positions.

A balanced trading book is important at this juncture, because the slowdown in China, coupled with a still uncertain picture in Europe, could cause markets to deteriorate quickly.  Major sentiment shifts can be sparked by unexpected catalysts and if institutional managers find a reason to reduce their risk exposure, the short side of the book is situated to capture gains as managers bail out.

Heading into a new week, we’ve got our eye on the technology sector (semiconductors look particularly strong), industries linked directly to Chinese weakness, and a few oil-related sectors.  The Mercenary Live Feed has a fairly wide roster of existing positions and pending trades (long and short) as we continue to adjust to the shifting dynamics.

Below are a few of the trades we are particularly interested in for the week ahead:

Base Metal Miners

As China’s economy goes, so goes demand for the base metals.

For base metal miners, tack on the additional cost pressure from higher oil prices and you have a very difficult environment for turning a profit.

This dynamic isn’t lost on institutional asset allocators who have been pulling capital out of the key base metal miners for some time now.  Quickly scroll through the charts of the following major mining companies:

• BHP Billiton (BHP)
• Rio Tinto (RIO)
• Vale SA (VALE)

All three have fallen below the 50 day averages and are dealing with major overhead resistance.  Recent short-term rallies or drift up patterns have set up excellent short opportunities for continuation trades.

With the entire group basically confirming the bearish price action, we have been able to build horizontal exposure – increasing our odds of a major profit as confidence in China’s growth evaporates.

Aussie Aussie Aussie!

It’s no surprise that the Aussie has turned south as China’s growth has been called into question.  But what is really exciting is the magnitude of this potential move if the Aussie dollar continues to roll.

After completing a double top in February, the AUDUSD pair has traded sharply lower – but still has plenty of room to run before hitting a support level near 0.9600.  If you pull up a longer-term weekly chart, you can see another support area near 0.8060, followed by the 2008 low near 0.6000.

While we’re not necessarily predicting carnage for the Aussie, our short trade is particularly attractive because we can enter a short position with a very narrow risk envelope, and plenty of room for profits.

Currency markets can be a great place for longer-term trend patterns, and if the Aussie falls and then consolidates a few times along the way, we should be able to pyramid into a much larger position (with ever-tightening risk points) along the way.

Of course there is no guarantee that the trade will be successful (we’re not all that into making predictions), but the setup in terms of reward to risk could lead to one of our most best overall trades this year.

Weekly Fail: BATS IPO…

This past week’s “fail” award goes to Bats Global Markets Inc. (BATS) – an electronic stock exchange that essentially dropped a live hand grenade on the very day of their initial public offering.

Talk about embarrassing, the exchange not only halted trading on its own (new) stock, they also caused the NYSE to halt trading on a number of other major stocks including Apple Corp. (AAPL).

According to weekend reports, BATS is expected to retract their IPO and refund investor’s money – in what has to be a nightmare logistical issue, costing the firm and the underwriters hundreds of thousands (if not millions).

The BATS flop could end up being a good thing for competing exchanges.  The NYSE and NASDAQ are both publicly traded, and have been setting up bullish patterns over the past few months.  We have been building positions in clearing and execution companies as the industry has seen capital inflows and some attractive breakouts.

NYSE Euronext (NYX) recently broke out of a six month base and then took three weeks to consolidate the gain.  This is a great pattern for a continuation trade – made better by the relative strength for the whole group.  If BATS failure causes more mutual funds  and other institutional investors to clear more through the major exchanges (versus ECN’s), NYX and NDAQ will likely see strong growth this year.

With markets still close to multi-year highs, we’re being very careful with adding bearish exposure.  Counterbalancing our bullish risk is helpful in managing the overall risk to capital, but the big money is still made in the big swings.  For that reason, it is important to remember that we’re still in a predominantly bullish environment…

Trade ‘em well this week!
MM

• View From the Turret: JPMorgan Touches Off A New Risk Firestorm

• View From the Turret: The Aftermath

• View From the Turret: Muddy Waters

• View From the Turret: The Drift Before the Storm…

• View From the Turret: Sell In… April??

• View From the Turret: The Beat Goes On…

• View From the Turret: What About China?

• View From the Turret: The Trend Continues

• View From the Turret: Shakeout or Smackdown?

• View From the Turret: Pick & Roll…