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Turbo Model

Current Signal Performance

Turbo Signal
Trade Date
Turbo Model Returns (Long & Short Strategy)
Nasdaq 100
Russell 2000
S&P 500
  Classic Signal  
Trade Date
Classic Model Returns (Long & Short Strategy)
Nasdaq 100
Russell 2000
S&P 500

Market Update
U.S. stocks followed European shares higher early Monday with an agreement on Greek debt rumored to be near at hand. Domestic stocks quickly hit resistance, however, after their nearly nonstop January rally, leading shares to drop back to a mixed finish. Tuesday offered little resolution with stocks under slight pressure from a continued struggle to conclude the Greek debt agreement - e.g. what sort of losses holders of Greek bonds must take. The Nasdaq 100 ended the day at breakeven, while modest weakness in financial and railroad shares kept the Dow Jones and S&P 500 in the red. An overnight earnings beat from Apple gave markets a push higher at the Wednesday open. Markets found a higher gear when the Fed surprised investors with an announcement that they intend to keep interest rates at rock-bottom levels through 2014, a full year beyond prior expectations. Markets closed with gains around +1% for the day while commodities surged higher. The inability to perform better in the face of such happy news for stocks set the tone for Thursday and Friday. Both days offered mixed economic data, continued babysteps toward a Greek debt settlement, and a grab bag of earnings, with industrial bellweathers Caterpillar (CAT) and 3M (MMM) showing well while Chevron (CVX) disappointed. But stock investors struggled to build on recent gains as the Dow and S&P wrestle with overhead resistance. No major index was able to add to Wednesday's burst higher, though commodities continued to benefit from strength in the Euro/weakness in the dollar to build on this week's gains.

Despite some late week blahs, stocks were able to maintain weekly perfection in 2012 with most indexes posting their fourth straight week in the green. The S&P 500 (SPY) lifted to a key point of resistance this week ending essentially flat with a -0.1% dip. The willingness to embrace risk continues to show with the Russell 2000 (IWM) and Nasdaq 100 (QQQ) outperforming yet again this week. The small-cap index tacked on another +1.88% with the tech-heavy Nasdaq solidifying its move into new-high territory adding +1.05%.

The final week of our current World portfolio added +0.48%. This portfolio is comprised of the top 5 members of our world ranking from the December 30th ranking and will be rebalanced this weekend to a new top 5.

Both Classic and Turbo Models remain on Buy signals.
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Trend Timing School
Considering overbought conditions

A common note these days is that the market is very near a "top" and stock investors should be looking to bank profits from the recent surge higher. A simple indicator that we can point to as a "sell" signal is the standard 14-period RSI, Relative Strength indicator. This is a common indicator to measure whether the market is "overbought" or "oversold". This week, the S&P 500 hit "overbought" status for the first time since May 2011. We've heard the saying that markets can remain overbought or oversold for long periods of time. This statement comes from the same family as the one noting that "markets can remain irrational longer than one can remain solvent!". How do we consider these rather conflicting inputs? Is the market near a short-term top or does it have further to rally?

First, we obviously follow our signals for when to enter and exit positions. However, as a more day-to-day intrasignal guide, we find a certain rule very handy. If you look at your return on a trade/investment and can't believe your eyes, are really happy with the result, you should sell some piece of it. The result causing that reaction will obviously differ for everyone. But regret is such a powerful emotion behind our success as investors - one that can really hinder us - we have found it always very successful to bank the gain, celebrate the win whenever you feel a return has hit some mental target. We're not saying you have to sell the whole position, just take some action to lock in what you feel is a reasonable, "happy" gain.

Chart 1: How long a market remains in an extreme condition depends on
its underlying theme

How long a market remains in an extreme condition depends on its underlying theme
Selling at the RSI 14 overbought point is a great strategy in a bear market environment. In a bear market, indexes do not linger at this overbought condition, they tend to peak at these points before heading back downward. That's because a bear market's natural state is one of selling or, at least, a lack of consistent buying. Thus, the bear market has no problem remaining oversold; it does have trouble staying overbought. On the flipside, a bullish phase shrugs off overbought status, but uses oversold conditions as a good buy point. Chart 1 shows this behavior for the S&P 500 over the past few cycles:

In Chart 1, the RSI 14 indicator runs along the top with the S&P 500 price in the body of the chart. The green downward arrows are pointing to the RSI 14 during the market downtrends with the red arrows pointing at the market uptrends. The dotted vertical lines denote the first and last points where the RSI 14 becomes substantially overbought, meaning that the RSI indicator goes well beyond its upper limit. We can see how the market's downtrends rarely exhibit an overbought reading that lingers; as the market uptrends do not register extended periods of oversold.

The point being that the market's overall condition is critical as to whether this overbought reading is truly a good Sell point or not. If we are really still in a bear market, then the S&P 500 is likely very close to a near-term peak and banking some or all of our gains here makes sense. However, if we have pivoted to a bullish phase, then this market can get more overbought, and remain so, for an extended period of time. We should point out that making a "digital" all-or-none decision on profit-taking doesn't have to be the way we operate. Taking partial profits never hurt anyone and is always a good strategy because one thing we know for sure is that we won't hit the absolute top or bottom of the rally.

Chart 2: S&P 500 gets overbought, registering a Sell signal if a bear market condition exists

S&P 500 gets overbought, registering a Sell signal if a bear market condition exists

So, what's the answer then? Are we still in a bear market condition such that we should be selling into this rally? As usual, the answer is not clear. The Nasdaq 100 is behaving very similar to its early 2011 run - straight up with nary a pause along the way. Unlike early 2011, the market is emerging from a months-long period of volatility, stagnation, and generally bearish behavior. When looking at the Nasdaq 100 alone, it is reasonable to conclude that the bear has been sent back to his cave.

Chart 3: Nasdaq 100 looks to have broken out to new levels and commenced a new bullish phase

Nasdaq 100 looks to have broken out to new levels and commenced a new bullish phase

The standard-bearers of this bearish phase, however, do not offer such clarity - at least not yet. The financially-heavy S&P 500 and bear-market poster indexes, emerging markets and China, still have work to do. And some of the leaders of this recent market surge face resistance as shown in Chris Kimble's four-pack below. These indexes and sectors certainly are knocking on the door, if not pounding, after this week's Fed announcement of low rates well beyond the market's 6-9 month timeframe.

Chart 4: Leaders of recent rally encounter resistance

Leaders of recent rally encounter resistance

Given all these pieces of information, a couple of pathways emerge. The correct one will depend on your tolerance for risk, how happy you are with the gains you've realized already from the recent Buy signals, among other considerations. If you're thrilled with your gains, bank them. If you are afraid you'll miss out on further upside or a longer bull run, you can take partial profits and/or downshift into high yield bonds, preferred stock, or some other more conservative but still equity-correlated investment. Another approach would be to use this potential profit-taking point as a place to put a trailing stop on some or all of your position, letting the market decide what happens next. If it pulls back to work off this overbought condition, your position will get sold. If the market continues its recent approach of NOT pulling back, but merely trading flat to consolidate the gains, you will likely stay on board following the rally's next leg. Finally, if you're a more active trader, you could sell or place a tight trailing stop, reentering the position if the resistance noted in the four-pack gets broken.

Most technical analysts believe the S&P 500 will struggle to get past 1350 because doing so generates a new high and could be seen as confirmation that the correction/bearish phase is over. That point is only 2-3% above current market levels. It would be a prudent choice to buy back into the market upon a solid break higher of that level as many would view that as quite bullish. Until that 1350 level gets broken through, many will continue to view this rally as temporary in nature with only modest upside remaining and risk of downside significant. There is evidence that the bear has been sent back to its cave for now. But that evidence is not yet widespread. We should know in coming weeks whether the market's tone has truly changed or not. In the meantime, our Buy signals have led us well, getting us into this rally early on. We have solid gains as a result and now are at a point where personal preferences can influence how much capital we leave at risk.
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FAQ of the Week
Question: How do you recommend trading options on your signals?

Options can be a great investment vehicle for investors who are willing to perform a little more maintenance on their position. Options contain two main components to their price: an intrinsic value and a time premium. The time premium is simply a function of how much time exists before the option expires. Thus, a January 2013 option will cost a whole lot more than a February 2012 option because you are "buying" so much more time. As January 2013 comes closer and closer, the time premium will shrink until it is near zero as the option expires. Thus, option investing is a race against time as part of the value diminishes over time.

The second component is the intrinsic value of the option. This intrinsic value is the difference between the option's strike price and the current market price of the underlying security - e.g. the ETF or stock that the option is based on. If the strike price is below the current market price, then the option carries an intrinsic value. You could theoretically exercise this option and buy the stock for less than the stock is currently worth. If QQQ is selling at $60 and you have an option to buy it at $58, then your option carries $2/share of intrinsic value. The option price should reflect this intrinsic value. Thus, your option should sell for $2 + the time premium.

So, when buying an option you have a couple of basic considerations:
  1. how speculative you want to be
  2. how much you want to invest.
Chart 5: Option pricing example (using QQQ options expiring in April 2012)

Option pricing example (using QQQ options expiring in April 2012)
To be more conservative, you choose options that are further out in time and with more intrinsic value. These options cost more and are more similar to just buying the stock. You have plenty of time for the trade to develop and a large buffer of intrinsic value. Of course, your percent return will be more similar to just buying the stock as well.

To be more aggressive, you buy options that are nearer in time with less (or even zero) intrinsic value. This is a far more speculative approach. You don't have as much time for your option to work - you really are racing against time here. And you have little or no intrinsic value to work with. But your % gain or loss will be dramatic, way beyond what the underlying stock return would be.

Given those broad concepts, it comes down to your personal risk tolerance and ability to maintain your option. If you choose a short expiration date for your option, say next month, then you will need to take action sometime within the next month if the signal has not changed. A longer option timeframe allows a higher likelihood that you can just follow the signals as they come.

Finally, option prices are driven by supply and demand, so the prices include that component as well. Typically, the further away from where the security is currently trading the option strike price is, the more discounted it is - e.g. the intrinsic value and time premium get discounted because there is less trading action, less demand, at those prices; most of the action takes places very near the current security price and in options with rather short time to expiration.

Warm wishes and until next week.

The TimingCube Staff
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