The law of Supply and Demand and ... Style

Not much has changed from last week as the trend is still up and the market is now hitting a short term resistance line extending from a previous high of 12,500 which also happens to be a potential double top supply area.

We have no definitive clue yet as to whether we are tracing a H&S accumulation formation or just went through a "W" or "V" bottom. It should all become clearer this week if the volatility remains relatively constant. The severe stock by stock overbought condition has been reduced as the majority of securities are now trading somewhere between over valued and under valued..

For next week, I would expect more gradual increases in market prices until we reach the resistance zone of 12,700-12,850, my immediate target for this current column of "X" (upswing). On the other hand, should we get a reversal into a new column of "O", I would be very quick to do whatever it takes to protect my portfolio because we would receive a [-2] channel resistance signal which would suggest another painful leg down with the potential of a breakdown which would confirm a downswing.

This week I would like to discuss MY strategy in terms of the style of professional portfolio managers. Every week I evaluate where the market is situated with respect to manager's style and I try to estimate the true potential of any uptrend. The reason I do this is that as I figure out the dominant style of the trader buying, I can also figure out the style of the seller and thus adjust my weekly tactics to where we are in the market because not all strategies work all the time. If you have interviewed prospective managers as I have done numerous times when I was a "professional" in the financial world, they will describe themselves with a specific style. I happen to believe that every "leg" of an intermediary uptrend is owned by different manager's types.

The uptrend starts with "deep value" managers buying the falling knifes. They are followed by "value" managers coming in typically once the bottom has been behind us. What follows is the most numerous type of managers in the industry, the "growth at a reasonable price" manager who typically will buy higher on the upswing once there is some confirmation that the trend has some more legs. Typically, a breakout above the 50 days moving average is when they wake up. The next type is the Growth manager who is willing to pay a higher price (and multiple) for a perceived or estimated higher earnings growth. Finally, we have the momentum manager who has received all the indicator signals required to play the momentum game all the way up to the top.

Many will cut the universe of available securities between large cap, mid cap and small cap and the TSX has done just that by designing such market sub indices. We can also divide the market between Value and Growth and also add Momentum to the mix.
Value managers will look at financial statements Book Value, Leverage and Dividend and compare these to the current market price in order to estimate value.
Growth managers will look at earnings,earnings yield, cash flow and revenue, they will make projections into the future, look at the analysts estimates and revisions of estimates and evaluate a purchase given the current market price. Momentum managers will look at Price and evaluate volatility, trading activity and momentum of price (derivative and second degree derivative) and then market price to decide on a trade. I would say that most Technical Analysts are momentum traders. That's how it works!

As a swing trader, I will use the following tools to estimate where we are in a trend, what are the probabilities of a reversal of trend, and how to get into a long or short trend with respect to the risk that I am evaluating:

-1- The long term Point and Figure "traditional" chart.
-2- The shorter term Point and Figure chart with a box size typically half or the long term chart.
-3- The daily candlestick chart with Ichimoku cloud.
-4- The 60 minutes chart with Ichimoku cloud.

I picked a Canadian Small Cap ETF (XCS.TO) as a random example. I cannot explain everything I do but will highlight some ideas. I currently own this ETF.

Long term P&F

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Small caps are trading above the long term support line of $10.50. We can observe a large bullish flag which has found support at $13.50 after a double bottom breakdown at $15.00. It is trading above this sell signal and will soon be testing double top at $17.00.

Short term P&F

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The flag is more apparent in this shorter term version of the previous chart. A first double top ($15.50) breakout ($15.75) buy signal was given and was followed by a correction with a bottom at previous resistance of $15.50 which clearly hints at demand for this ETF. A double top ($16.25) breakout would go a long way at increasing the probabilities of clearing the flag. Notice that the long term support line break at $13.50 was actually a "bear trap" as the ETF found support based on a July 2010 previous bottom.

Daily chart


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We need to focus on the Ichimoku cloud which I feel is an excellent tool to view support and resistance but also style purchasing and selling. Three times (red arrows) the ETF failed to breakout of the cloud which acted as strong resistance. We can see that when XCS broke above the 50 days moving average in July 2011, it was able to reach the top of the cloud. Momentum traders and Growth traders were putting selling pressure on the stock. We are now in the sweet spot again. Deep Value and Value managers have a position. Recently GARP (Growth at a reasonable Price) managers/traders have been buying the MA50 breakout and we can expect some selling pressure at the top of the cloud ($16.39) and later at $17.14 because that would establish a higher high. The risk on this position (stop loss price) is a breakdown below the cloud at $15.50 which is confirmed by the short term P&F double bottom of the previous chart.

Hourly chart


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I am showing the hourly chart because this is the tool that I use to enter or exit a trade. Depending on my evaluation of the risk and/or the type of "style" trader that I want to be, there are five different levels when I can buy the reversal of a trend from down to up. Buy 1 is the more risky while Buy 5 is less risky. In a bear market, Buy 4 and Buy 5 are often too far away:

-1- Buy 1 = Cloud breakout
-2- Buy 2 = EMA(70) breakout
-3- Buy 3 = MA(140) breakout
-4- Buy 4 = MA(350) or 50 days moving average breakout
-5- Buy 5 = EMA(465) breakout

These levels work for me generally. Notice that since the initial Buy 1 signal, small cap stocks have behaved very well given that the Ichimoku cloud has acted as support to the trend as it traced higher highs and lows.

I will generally exit a trade when there is a cloud breakdown AND a 70 hours EMA breakdown AND a 140 hours MA breakdown

Finally, if we use some of the elements which I described to determine who is currently buying and/or selling as measured by some of my tools, we can illustrate the risks and opportunities for the next week:

Stocks trading above the daily cloud


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These stocks are the most popular ones as they are being bid up for various reasons. These days higher yield, expectations of a cyclical upturn, relative performance in defensive stocks are some of the reasons.

This is a one level screen of my stock database. I would however suggest one adds other criteria of your choice to the reduce the number to tradeable ideas.

For example, column [BR] shows the relative performance of the sector the stock is in with 1.0 being positive, -1.0 negative ,+2.0 trying to reverse up, and -2.0 reversing down.

Also, screening by the long term point and figure status is something I do if only to understand the risk of the trade. Buying a bullish stock is less risky than buying a bearish stock.

-1- Column [BS] evaluated the LT trend with 1 bullish (trading above the support line) and 0 (or a pink square) being bearish.
-2- Column [BT] provides the last P&F breakout/breakdown signal with 1 being a breakout and zero a breakdown.
-3- Column [BU] evaluated the current swing. A 1 means we are in an upswing (column of "X") while zero is a downswing.

Stocks trading below the daily cloud


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Many of these stocks have had dissapointing fundamentals more or less recently. Looking at the long term Point and Figure profile at columns [BS] to [BU] will reveal a lot about their character.

Stocks trading inside the cloud coming from below (Resistance?)


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These beaten down stocks have been bid up by the value traders/managers. The cloud is now acting as resistance which means that only those stocks which the GARP traders/managers like will cross above the Ichimoku cloud. Technically the P&F columns will give you a clue but looking at the fundamentals along the market valuation and the earnings growth prospects will also help you figure out the best prospects.

Stocks trading inside the cloud coming from above (Support?)


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I will give you a hint here. This is the list that I focus on every morning BUT you will need a very good oscillator here to evaluate the short term prospect of the stock. During the week-end I evaluate the value and growth prospect of everyone of these stocks. This is my watchlist for the week. Once upon a time they were trading above the Ichimoku cloud and perhaps they were overbought ( pay particular attention to this OB/OS condition as often is the reason for the pullback) and some selling has occurred. I would expect the cloud to act as support other things being equal and thus I will now be looking at the technicals (is it building a base? is there a wedge, a flag, a triangle or any bullish formation being traced) in order to execute a trade at the appropriate moment with a maximum risk reward opportunity. Typically, I will wait for my favorite daily indicator to flash the beginning of an oversold condition before I plan the trade. That happens when the stock trades below the half way point (midpoint on the scale) of the oscillator because if it is a strong stock it will rarely reach the extreme oversold level but will trade around 20% below the midpoint.

Pierre Brodeur