Letter To A Boston Boy.

This is copy of an email that I sent to one of the Boston Boys the other day in response to a question he asked me regarding Point and Figure charting {that's the PnF in the letter} and Dow Theory.  Since I don't follow either, my response  ended up not being much about either of those things.  I thought however that what I told him was timely enough to post with a few changes here at the blog.  Here goes:

"I don't really use PnF charts anymore because I believe that these stopped being useful after markets became decimalized.  I primarily use charts to look for information regarding money flows.  To do that I primarily take a look at:

1.  Over bought/oversold markets.

2.  Support and resistance levels.  {A possible subject for a future post.}

Years of looking at charts has made me skeptical of the folks who see certain patterns in charts and can place a value on what stocks should do based on that pattern.  To me the world doesn't work like that.  Instead I think you can use charts to give you a reasonable set of probabilities that you can plan around.  To me here is a similarity between chart patterns and river or coastal maps. If you have a map of a river and that map says that around a certain bend there's usually a sand bar then you have a higher probability of that being the case.  That doesn't mean this time around that it will actually be there because when you deal with rivers things can change.  However, a higher probability of it being there than along another point in the river suggests that you proceed with caution when you get to that bend.  

What I've found that works best over the years is to buy weakness and possibly be a seller into strength.  That seems to be the opposite of what most traders do but it's what's worked for me.  I generally try to look out on the time horizon 6-18 months.  That's not to say I'll never take advantage of something shorter term but for the most part that's the time period in which I operate.  

Your PnF question referred to the Dow and Dow Theory.  I don't have an opinion on Dow Theory but I'll enclose a chart of the S&P 500 because it trades similarly to the Dow.

By my work markets were oversold back in late June.  I invested certain client cash assets  back then.  Our investing was based on our different client strategies and subject to individual client investment perimeters.   For the most part we concentrated then on the S&P 500 and ETFs related to energy, technology and industrials.  That index as represented by the S&P 500 ETF SPY is now by my work over bought.  By my work it now has a higher probability at a minimum of being vulnerable to profit taking as it has worked it's way through last Springs resistance and has advanced a bit over 7% since the lows on 06/24/2013.  That doesn't mean SPY can't go higher, but to me it is a low probability buy for new money at this point.  {I'm adding a note here that readers  should also go back and read the base case scenario we've been using.}

A little over a year ago {June 19th to be exact} I said that I thought stocks were cheap and they were undervalued by between 8-24%.  The day I wrote that the index closed the previous date at 1,334.78.  Part of the reason I thought stocks would do well was that they were very oversold then.  

I don't point out the above because I'm trying to put out here some "puff piece" about how smart I was or am because I had no way of knowing that the markets would do this well.  What struck me back then was that you had both money flows and valuations working in your favor.  For investors with something longer than a day or few weeks investment horizon, stocks looked cheap and had in my opinion a higher probability of working higher.  They also had a lower risk entry point back then based on how oversold things were at that point.

By the way as much as I felt that our markets were undervalued back then, I feel almost the same way about foreign markets right now.  

I'll temper that a bit because I don't consider myself an expert on how individual countries trade.  But I know these things via certain ETFs that I either follow or own:

1.  Very out of favor asset class.  {Unloved by most investors today-bashed by the media}

2.  More favorable valuations.

3.  Most of the negatives are known.

4.  High dividend ETFs {Can be paid to wait}.

5.  Very oversold by my work and their charts look like these above.

6.  Finally there's this.  US markets have so significantly outperformed overseas assets that it seems to me that either US markets have to go to sleep at some point or over seas will catch up to us.  Since one of my principle arguments is that things are continuing in the main to get better at home from an economic standpoint, then I think there is a higher probability that markets "over there" may play catch up to us.

Again I don't know for sure what's going to happen and it could take awhile for me to find out if I'm right.  I wouldn't be surprised if these assets even head a bit lower first.  However,  I like what my probability schematics are telling me about these markets over a 6-18 month period.  In the meantime some of these ETF's dividend pay me to wait.  Also, If I'm wrong then I have some idea what I'll do as well.  I've had exposure to foreign markets since 2010 and  have recently accumulated on average a 5-10% exposure overseas and I'm willing to take that up to 15% of client portfolios depending on their investment mandates with me.  Will see.  Stay tuned."

.....And now a post script.  When I look on my investment actions in the past few weeks, in retrospect and with respect to the definitions of our market indicators we probably should have changed our shortest and intermediate term indicators to NET MARKET POSITIVE since on balance we have been net purchasers of equity ETFs.  Of course this is not a trading model.  We don't sell these indicators as such and we are under no obligation to communicate any changes to readers but strive to do so in order to be as open as possible with this blog.  I will also emphasize that this should never be construed as a trading indicator as that is not how we use it.  If you use it in this manner you are on your own as that was never its intent.  Never-the-less if I had been thinking more clearly I would have seen that what we were doing probably constituted a change.  

To be clear here is where we currently stand after the dust has settled.  On a longer term indicators are NET MARKET POSITIVE.  Short and intermediate term remains NET MARKET NEUTRAL.  However with respect to foreign based ETFs and given our investment activities we will change our shortest and intermediate term indicators to NET MARKET POSITIVE.  Hope that helps.  Sorry for any confusion this may cause.  I am growing unhappy with whether these current definitions accurately portray what I'm trying to convey so don't be surprised if I change these a bit in the coming months.

*Long ETFs related to the S&P 500 in client and personal accounts.  Long DEM in client and personal accounts.  Postscript.  Forgot that I was long EEM via calls in a personal account of mine.  {Updated 2:30 PM:  7.15.2013}

Charts courtesy of FINVEZ.com