Trading Strategy in an Inflated Market

Let's admit it that the market has gone too far. Valuations (P) have outstripped earnings (E) far too quickly and for the market to move further ahead, it needs to seek a breather. Well, basically either the P decreases, or the E has to increase to match a 'worthy' evaluation.

The first quarter of 2012 was basically brought about by a couple of changes.
1. Greece unlocking itself from the debt abyss; hopefully.
2. Improving US economic health
3. China seemingly avoiding a hard landing
If it is not clear enough, 2 out of 3 of the main factors contributing to the market's rise has been based on speculations and psychological perception of the future. Only the improving US economic health is real and based on truth.

We know the market is forward looking so there is some sort of an element that this is what we all expect. But there comes a time when evaluations are too high than what we should expect. And we have seen it in recent times. But on the other hand, there will be ones with evaluations too low that we miss in this euphoria chasing the rallying stocks. One huge example is the knowledge we all have that the big cap stocks tend to move first followed by the mid and small cap ones in a bull market. This is no special ingredient. As the big cap fulfills its valuation, people feel they are pricier and re-look at the mid and small cap ones that have yet been fully valuated.

Today, everything seems inflated.
So what can we do?
Look and relook.

One tendency that I find myself often doing is being fixated at a certain set of stocks that have participated in the rally. Even though their prices have ran far away from their 55d, 100d and even 200d averages, it is still tempting to buy. That is now, to me, trying to pick the peak. It will never happen and when it does, all it takes is a couple of days to return to square one or even much below.

So instead of trying to go heavy on these stocks that have already moved, my aim now is to look at stocks that have yet moved. Of course, this is not easy as a hard search is necessary but with some stock filters, doing so should not be too difficult.
Focus on a select few and monitor them for a couple of days or weeks if necessary and enter only when a huge move is possible. Things to look out for include a large white candlestick together with a larger than average volume that signifies a possible interest from the broad market. This bodes well with their low valuations that are lower than their moving averages whichever you decide to use.

Nonetheless, there are downside risks to this play since an unattractive stock may remain unattractive for long periods or even experience a whipsaw that leads us buying into the stock and getting ripped. These risks are real but they can be mitigated by some simple checks on analyst reports and annual reports gauging the fundamental performance of the company. Once satisfied, this method is definitely much more relevant and less risky in the inflated market of today.

The Tale of 2 Stocks

Yoma has been on the horizon of many traders and investors since last December, tracking the rise of Myanmar in the international arena. Coupled with the market bull run, Yoma has been enjoying a tremendous surge in its stock prices since December. Is the bull run ending? It does not seem so. 

Technically, there is a breakout today past the all time high in January. This is coupled with a strong buying volume. MACD has been treading up together with RSI. Very healthy rise yet again after taking a short breather over the last 2 months especially February. 

On the weekly, the stock has been increasing in volume clearly and MACD has staged a rebound and is treading upwards again. Although some caution to note is the RSI in overbought region. However, it is still of little concern to traders lately and it has been above 75 almost for the whole quarter of this year.

What run for this stock indeed. And to come.

Tiger, on the other hand has been hit by strong fuel prices that have been hampering its profits. Even after staging a comeback with strong flight on-time performance with renewed operations, this did not pacify most analysts and most have revised Tiger to Sell or Hold. Has it surged beyond its earnings and the market feels that the fundamentals are weak compared to current stock prices?

Technically, Tiger stock prices have risen dramatically in the last 3 months owing to a global equities rebound and some form of relief from its return to the skies in Australia. But it has reached a strong resistance line that clearly traces all the way back to Aug 2010. Never has the stock breached this levels convincingly and now, it seems equally unlikely to do so. Weekly volumes have been decreasing, a sign of waning interest in this stock. MACD histogram has diverged with the MACD signal line, pulling it downwards. RSI is not too indicative, staying around the 50 level.

In huge contrast to Yoma, Tiger seems set to have a reversal of fotunes and continue sinking into its malaise. Into the future, there does not seem to be respite. 

Surprising Correlation Between STI and Dow Jones Avg

Today, I finally got time to sit down and have a good look at STI and Dow Jones data. As I was fiddling with the data, I decided to take a look at its correlation. After all, we often chat up with each other excitedly in the morning if Dow went crazily up or slid frantically down the previous day, making exclamations and predictions about the current day's STI. So it would be indeed enlightening to find out how exactly is such a prediction based on Dow Jones performance.

Analysis 1 set-up 
Using the data from Yahoo Finance, I first weed out the different holidays to match the dates. This was quite tedious given the messy nature of the data available. What to do, it is still free and much better than nothing. And it seems pretty consistent and error free, at least. The date range for the data is from 24/1/2008 to 26/3/2012. I decided to chop off some data at the start of 2008 because there was quite a few missing dates in the Dow Jones data set. Well, 4 years of data should be good and clear enough for a correlation relationship, if any.

Then, I took only the closing day prices for comparison. Note that this is not the change of the day, and just purely the closing day prices.

Here are the results

1. Correlation between STI closing day price with previous day Dow closing day price (ie. the relationship between Dow's price last night and STI's price today)

r = 0.864

2. Correlation between STI closing day price with same day Dow closing day price (ie. the relationship between Dow's price tonight and STI's price today)

r = 0.866

From a statistical point of view, this correlation of around 0.86-0.87 is close to 1 and that suggests a positive relationship. To me however, even if r = 0.86, it does not make a very smart way to trade as it is not entirely close to 1 either. There must be something more to this correlation than this weakly positive value. I was not satisfied so I decided to take another approach to look at this 'correlation'.

Analysis 2 set-up 

Using another approach, I considered only the direction of move and not the magnitude. So it would be easier to sieve out the nuances of noise and volatility in the respective markets and identify if there was any directional correlation. 

Here is what I found

1. Average number of days where a loss or gain in Dow the night before will be matched with a similar direction of move in STI.

Average number of days = 0.617

2. Average number of days where a loss or gain in STI in the current day will be matched with a similar direction of move in Dow at night.

Average number of days = 0.304

Surprisingly, the correlation between Dow and STI is at best weak. Even though the simple linear regression analysis puts the figure at around 0.86 based on closing day prices of both indices, the impact is clearly even lesser when put to perspective in the direction of move of both indices compared. In fact, for every 10 days Dow increased/decreased, there would be 4 diverging days on the STI. That is really some news for short-term traders looking at strategies to employ. Definitely after looking at this, previous day's Dow prices is an inaccurate prediction of the direction of move STI will make in the current day! The opposite is worse. To use STI to predict Dow's price. Of course, this is not too unexpected given the economic impact Singapore exerts on the US - hardly.