Since I’ve taken a few large losses in a row since 5/4/10 I want to step back and take a close look at the mistakes I made. Since 5/4 I entered 8 trades, 5 of which were losses, and 4 of those losing trades lost big (> -100 points). Only one trade in those 8 was a winner, and I was lucky taking 190 points home on that trade thanks to a gap up opening on Sunday. Clearly my trading has been sub-optimal to put it mildly, and I need to take a closer look to figure out why. Below is a summary of my losing trades since 5/4/10 along with lessons learned and conclusions drawn:

Trade #1: 5/4/10 6AM – 5/4/10 6PM   -127 points

The losing streak started with what I labeled trade #1 in the first hourly chart below. I had set a long entry order into a falling market overnight, which was triggered on a sharp downmove. That alone was a big mistake and is the same as bottom-catching. I then failed to exit the trade and waited for a turn up instead, which never came. The result was a well deserved loss of 127 points. There was no confirmation at all that justified a long position at that point. RSI was bearish and downward momentum strong. I traded against the daily and against the hourly trend. I have no problem trading against previous trends, since that is part of my swing trading strategy, but I have to see a trend turn first, and that was not the case in this trade. Not waiting for confirmation was the main mistake in this case.

Trade #2: 5/5/10 9PM – 5/6/10 6AM    - 150 points

This trade was entered on a very marginal buy signal, that doesn’t even qualify as one when I take a closer look. One of my most reliable buy signals is when price crosses above the hourly EMA 10 with two blue (or bullish) candles in a row (the second blue candle is the one that crosses the EMA10), and the candle after that closes above the hourly EMA10 (this one can be red, or bearish). In this trade, the first candle below the EMA10 was red, which disqualifies this signal as a valid buy entry. Plus, price barely crept above the hourly EMA10 line, and RSI was still in bearish territory (<50). I partially entered this trade because I really wanted to be long, and make up for the previous loss, even though I didn’t want to admit that to myself at the time. And I set a stop that was too wide in retrospect, 40 points below a support level that wasn’t defined well. The stop on this trade should have been set 15 points below the day’s low at 1.2770, which would have limited the loss to 75 points. But more importantly, I shouldn’t have entered this trade in the first place. Lack of confirmation was the main problem on this one, stop set too wide a secondary issue, and trying to make up for a past loss was another one.

Trade #3: 5/10/10 11PM – 5/13/10 2PM   -162 points

Here I was essentially trying to buy a pullback in anticipation of a retest of the high, which could have manifested itself as a very sharp upswing. I was overly certain that this scenario would unfold. I had previously let a long run 300 points into profit only to see it stopped out at break even (the entry on that one was very good). If that wasn’t enough, I then entered long again at nearly the same level without any sign of confirmation of trend turn whatsoever. And on top of that I ignored a bearish RSI trendline break, which I even drew on the chart, but fully ignored. This may well have been one of the worst trades of those 4 big losing trades. There was nothing that was in favor of a long trade at that point, other than an anticipated turn. Trading anticipations and opinions is not the path to success. I had no buy signal, and bearish momentum was strong. And once again, I wanted to make up for the previous trade being stopped out, not wanting to stand the potential of missing out in case the market does turn in my favor. Here too the main problem was not waiting for confirmation and trading in anticipation of a move instead of waiting for one. Another problem was trying to make up for past losses. And I moved my stop down twice in the middle of the trade.

Hourly Chart for trades #1, #2, and #3:

Trade #4: 5/11/10 9AM – 5/11/10 3PM   -102 points

This trade was based on a similar analysis to the previous one, anticipation of an upswing. Once again, there was no clear buy signal, in fact the two blue candles crossing above the hourly EMA10 line were invalidated by the long red candle slicing below it right afterwards. I ignored this sign and saw what I wanted to see.  Stopped out as price collapsed and there was little I could do after I had entered. Main mistake was misreading the charts and not having a clear signal.

Trade #5: 5/12/10 8PM – 5/13/10 2AM   -40 points

This trade only produced a small loss, but I’m including it here since the entry was once again a reflection of lack of confirmation. Price had move above the hourly EMA10, but again it didn’t produce a clear buy signal, and price barely crept above the EMA10 line, momentum was weak. One of the main reasons my buy signal requires two blue candles in a row is that this reflects strong momentum, and the next candle after the crossing closing above the EMA10 line confirms the move. But in this case, price barely moved above the EMA10 line, and RSI was still bearish. In fact, it was capped by a declining TL which I ignored. So in this case, there was insufficient confirmation, and ignoring indicator signals advising against the trade.

Trade #6: 5/13/10 9AM – 5/13/10 12PM – break even

I actually broke even in this trade. But in retrospect, I shouldn’t have taken the trade since I ignored some important warning signs. I was trying to trade a butterfly pattern which is a good reversal pattern allowing a low-risk entry (marked in yellow). But the long red candle during European trading that stopped out my previous trade (#4) was a warning sign that the pattern may fail, or extend further than its typical 1.27 Fibo extension level.  At least I got out at break even and didn’t stay in the trade with my stop in place. Main mistake here was ignoring warning signs advising against the trade.

Hourly Chart for trades #4, #5, and #6:

Conclusions: The main mistake I made is clearly not waiting for confirmation. Just heeding this one alone would have avoided almost all of the past two week’s losses. I traded in anticipation of a move instead of waiting for a clear signal showing that the expected move is actually underway. The second most important conclusion is to heed bearish signs, to look for them, and not be too one-sided in my analysis. There were quite a few clear bearish indicators in almost every trade I entered that I simply ignored. I will pay special attention to both of these items in my trading from now on:

1. Wait for confirmation and a clear signal.

2. Look for warning signs, and heed them.

The quarterly-released Federal Reserve Flow of Funds Accounts report came out a few days ago, and ever since seeing Karl Denninger’s charts on total debt outstanding I keep my own data set and charts updated. Among other things I use them as a gauge of deflationary vs. inflationary forces, to predict the long term trend of the US Dollar. I believe that debt deflation is unavoidable, despite the Fed’s printing money, bailing out banks, and monetizing bad debt left and right. Those charts below confirm this point of view.

The table I’m using is D.3 – Debt Outstanding by Sector. Historical data was obtained from file gtabs.zip. (Starting June this year these files will be discontinued, but data will be available via the Fed’s Download Program.)

The charts are really pretty fascinating. They reflect the losing battle that the Fed is fighting against deflation. Federal debt continues to skyrocket, but all other sectors including total debt is contracting, for the first time in over 50 years! And look at where debt is contracting (households (home mortgages, consumer credit) and business overall) and where it’s expanding (Federal governement (look at that increase since summer ‘08!), state and local governments, and bailed-out corporations.) Those charts really tell the story of what’s going on in the US economy right now. Also notice in the first chart (”Debt Outstanding in All Sectors”) how tiny the Federal government’s efforts to inflate are compared to the overall size of the debt outstanding, which is contracting. The Fed’s injection of over 2 Trillion Dollars since June 2008 is dwarfed by the contraction of overall debt which is sitting at 50 Trillion Dollars. Most of the bad debt (mortgage, consumer and business) is still in the system, and it WILL be defaulted on eventually. I believe that total debt will shrink by several Trillions over the next 5-20 years, and there is no way the Federal government will be able to compensate for that. That’s why I believe we’re at the beginning of a long deflationary period of credit contraction, despite an inflation of money supply.

(Note: Click on a chart to get a larger version.)

Debt Outstanding – All Sectors:

Debt Oustanding – Total Household:

Debt Outstanding – Home Mortgage:

Debt Outstanding – Consumer Credit:

Debt Outstanding – Total Business Debt:

Debt Outstanding – Corporate Debt (a portion of Total Business Debt):

Debt Outstanding – State and Local Governments:

Debt Outstanding – Federal Goverment:

Debt Outstanding – Domestic Financial Sectors:

Debt Outstanding – Foreign:

Noticed that the time of my posts has been 1 hour off (in the future), I just corrected that.

We are still waiting for Q4/09 earnings reports to come in, only 71% have reported so far. But based on current estimates it is likely that we’re seeing P/E ratios return to normal after having spiked to levels over 100 for several months. As of now, annualized (12-month) earnings have rebounded back to about 50, which brought the P/E ratio back to about 22. Time will tell if those high earnings are sustainable, I personally believe they aren’t and we’ll see another increase in the P/E ratio, and eventually a fall in price balancing that rise. Below are the charts that incorporate the 4th quarter estimates.

Price and P/E Ratio Chart:

Price and Earnings Chart:

Found this great chart on Nathan’s Economic Edge (click on the chart to see the full size version). Even though it’s very funny, I’m certain that every trader has gone through any one of those emotions before.  

The S&P 500 P/E ratio remains at lofty levels above 130. I don’t see how it can go higher from here and believe a top is forming in the 130..150 range, followed by an inevitable sharp drop to historically reasonable values. P/E ratio, earnings, and price for the October 2009 have changed very little from September:

S&P 500 Price 10/31/09: 1036.19

S&P 500 P/E Ratio 10/09: 137.98

S&P 500 Earnings 10/09 (calculated from price and P/E): 7.51

Price and P/E Ratio Chart:

Price and Earnings Chart:

(Note: the latest version of these charts is from now on available on our charts page.)

The Price to Earnings ratio for the S&P 500 remains near record highs. Standard & Poor’s recently released the data for September, and reported a P/E ratio of 140.76. P/E levels of this magnitude simply cannot persist for long, and strongly call for an adjustment in price to match the low earnings. See updated charts for price, earnings, and P/E ratio of the S&P 500 below, and click here for more information on the source for this data in my post from last month.

I created the following charts after hearing about the insane S&P 500 P/E ratios of 143 in July and 129 in August. I needed to verify those numbers for myself, and came across several sources reporting the P/E ratio of the S&P 500 as only 18 in August. Which one is correct?

Using Standard & Poor’s own website, the P/E ratio for August is indeed 129.19. I also found historical data on the S&P 500 price, dividends, earnings, and P/E ratio on Robert J. Shiller’s website. He calculates the S&P 500 P/E ratio as the ratio of the S&P 500 price level and a 10-year moving average of the earnings data. The result is a P/E ratio of 18 for August. A 10-year moving average really smoothes out the P/E ratio and the last few months of 100+ P/E ratio values are lost in the average. For the purpose of evaluating present value of the S&P 500 a 10-year moving average really isn’t adequate, and instantaneous (monthly) values should be used as reported by Standard & Poor’s.

The charts below really speak for themselves. Looking at the wide gap between current S&P 500 price levels of about 1000 and earnings around 7 (these are earnings levels last seen in the ’70s!), there is no question that the markets are still heavily overvalued, and a second downleg is highly likely. The markets are still in denial, and P/E ratios of more than 100 simply cannot persist for much longer.

Historically, P/E ratios have always moved in long waves spanning several decades, and at the end of bear markets they always return to values below 10 (see the P/E ratio chart for 1900-1950 at the bottom of this post). It is unlikely that we’ll see a quick recovery of S&P 500 earnings, so the only logical conclusion left is a reduction of the S&P 500 price to levels in the 100..200’s. I don’t think this will happen within a year, but it could happen over the course of 10 or 20 years. We may see a gradual decline in price while earnings remain depressed.

(Note: I will post updates on these charts monthly: click here. Or you can find the most recent chart on our free charts page.)

I expanded my charts page. The following charts were added:

• USDJPY Hourly
• EURJPY Hourly
• US Dollar Index Hourly
• US Dollar Index Daily
• S&P 500 Hourly
• S&P 500 Daily
• Dow Jones Industrial Average Hourly
• Dow Jones Industrial Average Daily
• Gold Houry
• Gold Daily
• Silver Hourly
• Silver Daily
• GDX Hourly
• GDX Daily
• Federal Funds Rate Daily
• 10-Year Treasury Rate Daily
• 30-Year Conventional Mortgage Rate
• M1 Money Stock
• M2 Money Stock
• Reserve Balances with Federal Reserve Banks
• Federal Government Debt
• Total Consumer Credit Outstanding
• GDP
• CPI
• PPI
• Trade Balance
• Imports of Goods
• Exports of Goods
• Nonfarm Payrolls
• Unemployment Rate
• Business Inventory
• Retail and Food Services Sales
• University of Michigan Consumer Sentiment
• Spot Oil Price

I also added three dedicated chart pages for the currency pairs EURUSD, USDJPY, and EURJPY. They can be accessed by clicking on the title above each of those charts on the main chart page.

Go check it out: http://www.kangarootail.com/charts/

I’ve been looking at the big picture across all major markets lately, and have arrived at a turn of my long term view. I believe that we’ll remain in a deflationary environment for several years to come, at least two but likely more, and that inflation will only set in after the deflationary debt destruction has run its course. Credit is contracting faster than money supply is increasing, despite the efforts of the Fed to pump trillions into the system. The “financial holes” generated by credit that is marked-to-market (e.g. mortgages gone upside down by a 40% collapse of housing prices) are much larger and are growing much faster than the ability of the Fed to plug them. The trillions of dollars the Fed is pumping into banks is sorely needed to keep the banks alive, and even after several bailouts of mind boggling proportions the banks are in no position to lend, to direct the money where it’s needed to get us out of this mess (e.g. to pay down mortgages, credit card balances, etc.) Thanks to our fractional reserve fiat money system, the amount of credit in our economy dwarfs the amount of “real” money (cash and bank reserves), and it is the collapse of this giant credit bubble that soaks up any available cash out of the system as fast as it is printed or injected into the economy. The current state of our economy can be likened to a giant margin call hitting one over-leveraged investor, the Federal Reserve.

It is this situation coupled with recent economic events and developments and supported by economic data and chart patterns that have led me to the following conclusions of what I think will unfold over the next 3-6 months:

1. The dollar has made a major bottom and is turning up for a bull rally that may well last over a year. The pattern on the EURUSD dailies chart looks very similar to the pattern of last summer, just before the collapse of the Euro in August. The recent upleg does not look healthy at all, but tired and vulnerable to a break to the downside. The next few weeks will tell whether we’ve seen a top or not, it is possible we see an exhaustion rally first before the downside gathers momentum, but I believe it is more likely that this is it, that the dollar will move up from here.

2. The stock market is very close to a peak, and will turn down very soon to retest its March ‘09 low. Consumer sentiment came in lower than expected, banks keep failing (almost 80 banks have failed so far this year), the FDIC is almost out of money, banks keep lying about their balance sheets and refuse to mark their impaired loans to market just to stay alive, and the government is not very efficient in “trying to help”. Looking at a daily chart of the S&P500, we have hit major Fibonacci resistance near 1000, and the RSI has just turned down from overbought. The last leg of this rally looks weak and is running out of steam. The S&P500’s P/E ratio stands at a dizzying record high of 140. I believe we’re about to see a major collapse, possibly triggered by a big item of bad news, or the market will simply fall of its own weight.

3. Gold will not exceed $1000/oz and will turn down as the dollar goes up. Gold stocks will follow. I think gold will not do well in a continued deflationary environment. It has done well earlier this year in an enviroment of risk aversion, and in expectation of inflation when the government announced bailout after bailout, but I believe we’re headed into a market where the need for dollars will outstrip gold’s allure as a safe haven commodity. I think there’s a fair chance we’re seeing a return to $700/oz by the end of this year.

4. The real estate market has only made a seasonal high and will turn down. I live in California, and closely follow the California real estate market. The recent upturn in prices does not make the long term chart look like it has bottomed. It looks very much like a seasonal bump, and it is very likely that we have at least 2-3 years of falling prices ahead of us. Looking at the chart below it is clear that real estate markets don’t make V-bottoms, and I don’t see how this market can be any different. If anything, we’ll see a prolonged bottom since banks are unwilling or unable to cut their losses fast. Instead they put off foreclosures, NOD filings, and drag out short sales. I strongly believe that housing prices will stay depressed despite a record high affordability index. The bottom line is that people are simply out of money, cash strapped, and need every dollar they can get their hands on to deal with their debt. Very few have saved up the down payment needed to qualify for a loan today.

All of these events are coupled, and chances are that either all of them come true, or none. We’ll know very soon.