Stocks are Undervalued, Oversold and in the Process of Bottoming

I hear a lot lately that stocks are in a bubble, over-extended, over-valued and about to top out.   Although anything is possible, and the top pickers will eventually be correct one of these days, I do not come to this conclusion.

In this post, I would like to share two very long-term charts that I hope will show US stocks in a different light.

The first chart goes back to year 1982 and shows the relationship between stocks and bonds during this time:

The chart above shows that US stocks were in a true bull market from 1982 to the year 2000.   Since that time however, stocks have been in a corrective consolidation period for the past 12 years.  It is only now, at long last, that stocks appear to breaking out of this bullish channel.

From this long-term perspective, stocks do not appear to be in a bubble to me.   If a bubble does exist, it is more likely to be in the bond market - not the stock market.

Moving on, the next chart shows the long term relationship between stocks and gold:

Similarly, we see that stocks were in a true bull market from 1982 to the year 2000.    Interestingly, though, through the lens of real money, stocks truly only bottomed in the year 2012 and have only recently broken out.

From this perspective, stocks actually appear undervalued and oversold to me.   Paradoxically, it is gold, the metal that everyone seems to think is nearing a bottom, that is over-valued.

Five ETFs that I am Selling Short: TZA, TLT, FXP, UNG, FXY

I like to short sell ultra ETFs that are in major downtrends.  Since I have discussed my reasons for doing so before, I will not go through the rationale again here.   However, here are 5 new ETFs that I currently have positions in:

Trading in the Direction of the Long Term Trend: Stocks, Yen, Silver, Bonds

As a trend following trader, I always trade in the direction of the long term trend.    Doing so keeps me on the right side of the market most of the time and helps give me an edge.

I define the long term trend by using a 100 and 150 exponential moving average crossover.  If the 100EMA is above the 150EMA, the trend is up.    If the 100EMA is below the 150EMA, the trend is down.   Following such a rule is simple, objective, unambiguous and emotionless.

Here are 4 different markets for which I have charted the long term trend.  While these charts are not meant to be predictive (they are reactive), it is worth noting that a trend in motion does tend to stay in motion.

1) US Stocks: 

The chart above displays the long term trend for the ETF SPY going back to 1996.   As I have mentioned numerous times throughout this blog, the trend is up, which is why I have continuously been buying stocks.

2) The Japanese Yen: 

Another market that I am keeping an eye on is the Yen.   From both a purely trend following perspective and also from a classical technical analysis perspective, the Yen appears bearish to me.

3) US Government Bonds

The long term trend for bonds turned down last summer and remains in a downtrend today.    As fellow chartist Olivier Tischendorf astutely points out, this could be the beginning of a mega-trend.

4) Silver

The price of silver has surprised many by falling 60% from its high, but had one followed the pure price action of the metal, one would have avoided a great deal of financial pain. And just because silver has already fallen 60% does not meant it cannot fall another 60% - a trend in motion tends to stay in motion.

Five Reasons Why I Would Never Buy Twitter Today

1) The stock will not have an Average True Range (ATR).    I use the stock's volatility to determine how many shares to trade, so without this key missing ingredient, I do not know how much to buy.

2) I would not know where to place my stops.   I place a stop 2X the ATR below my entry price, so without the ATR I cannot optimally place my stop loss.

It is true that many traders use percentages to place their stop losses.   This is, to be fair, much better than nothing, but it is sub-optimal.   For example, a 7% stop loss for a blue chip stock like IBM is totally different from a 7% stop loss on an ultra ETF like NUGT.  Thinking in terms of volatility makes everything an apples to apples comparison.

3) There is no short term trend.   I need the 20 day moving average to be above the 50 day moving average, as a minimum, for me to consider a stock.

4) There is no long term trend.  When I buy a stock, the long term trend should be up.

5) I wouldn't know where to take profits.  I generally ride a stock higher as long as it stays above its 20 day moving average, however the stock is too new to have formed that.

The bottom line is that it is impossible to technically analyze or trend follow a stock like Twitter.  When I buy a stock, I need to have an edge, but with a stock like this, it's really just pure gambling.

Larry Hite on Risk Management for Trend Following Traders

I have mentioned before that the world of trading is filled with paradoxes.   Another paradox in the trading world is that the subject that will determine at least 90% of your results is hardly ever mentioned.    That subject is risk management.

The greatest piece of advice I can give to new traders is that they should only risk 1% of their account equity on any given trade.   This means, for example, if you start off with $10,000, place your first trade, then get stopped out, your account equity should now be $9,900.

By risking only 1%, your account is able to survive many losing trades in a row.   But how many losing trades in a row should you prepare for?

Let us say that 50% of your trades are winners.   The table below illustrates how many losing trades in a row you can expect, mathematically:

As the table above shows, over the course of the next, say, 100 trades, you can expect to run into 7 consecutive losing trades in a row.

The next table shows the resultant drawdown you can expect from those losing 7 trades in a row based on different bet sizes:

The table above shows that, for example, if you bet 5% on each trade, then 7 losing trades in a row will drawdown your account equity to $6,983.   And this is the scenario based on just your next 100 trades. If you trade over the course of years and decades, you could easily run into a patch of 14 or 15 losing trades in a row.

This is why, in my studies, I have come to the realization that all old traders bet small.  The reason is that had they bet big over the course of 15, 20, or 25 years, they would have gone extinct and I would not have been studying them in the first place.

Bottom Line:  If you don't understand bet sizing and risk management you will, mathematically, go bankrupt eventually.

  • Two basic rules:  1) If you don't bet, you can't win.   2) If you lose all your chips, you can't bet.
            -Larry Hite