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In The Know Trader Identifying the Behavioral Influences that Move Markets

rick@intheknowtrader.com November 14, 2016

Macro Highlights • Our Bull Market Location Model has little good to say about US Treasury or Emerging Market

bonds, nor oil and gold stocks. See page 1. • We rightly targeted the SPX 2093 level as support. We suspect new all-time highs are coming

shortly and we define where to put on a new tactical long position. See pages 2 and 3. • A spectacular week was seen in US 10-year Treasury trading. We tell you what you really need

to know about if, when, and where the 36-year bull market comes to an end. See pages 3-4. • Our thoughts and trade ideas on the euro, yen, gold, and oil. See pages 4-7.

The Collective Appetite for Risk Our view: Last week, our Bull Market Location Model again saw significant change as several key markets did complete turnarounds. Most notably, US Treasury and Emerging Market bonds turned completely negative in all time frames, while emerging market equities lost bullish 26-week and cloud pictures to be mostly negative, too. The SPX went back to full bullish posture, with the Nasdaq close to doing the same. The current week’s table paints an unclear picture for wither an upcoming inflationary or deflationary period. We expect more clarity to show in coming weeks. (A predominantly green upper-third/red lower-two-thirds table would indicate a period of fear and likely deflationary concerns. A predominantly red upper-third and mostly green lower two-thirds table suggests a period of lagging fear and a generally more inflationary environment.)

The Week That Was Fourteen of 18 major global equity markets were higher last week, led by a 5.36% gain in the Dow Industrials (+5.36%) and Germany’s DAX Index (+3.98%). The four down markets were the Hang Seng, Spain’s IBEX, Mexico’s IPC, and the biggest laggard, Brazil’s Bovespa Index (-3.92%). The other major US equity benchmarks – the S&P 500 and Nasdaq Composite – were both up 3.8%, but we have to highlight the Russell 2000, which gained a whopping 10.22%. The US Dollar Index lifted a hefty 2.06%, it’s best weekly gain since November of last year. The greenback’s rally took its toll on gold, which lost almost 6% on the week. WTI oil lost only 1.5%, but that was after falling 9.5% the week before.

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Of the 11 S&P 500 macro sectors, seven of them gained, led by major surges in the Financials (+11.33%), Industrials (+7.95%), and Health Care (+5.82%). Interest rate sensitive and defensive sectors were all hit, with Utilities the worst performer (-4.08%), followed by Staples (-2.31%), Real Estate (-1.38%), and Telecom (-.10%).

Equity Markets US EQUITIES S&P 500 Index: We expected lots of volatility around last week’s elections, and surely we got it (especially if you were trading the overnight session on Election Night, itself). The dust has mostly settled – for now – and we are hard-pressed not to be enthused to see both the SPX bounce so close to our previously stated downside target of 2093, but also rebound so dramatically as it has. The daily chart shows a bottom right near the 200-day moving average – almost identical to what we saw on the Brexit low in late June. Moreover, the cloud’s lagging line (in orange) minimally breached the 2093 support level (at the bottom of the cloud directly beneath it) before sharply turning higher (in fact, now you see that the three daily closes since the elections have all stalled right as the cloud’s lagging line hit against the top of cloud directly above the lagging line (at 2174).

Chart courtesy of Bloomberg, LP

With elections now out of the way, the last major piece of the 2016 puzzle should be the Fed’s lifting rates – or not – at the December 14 meeting. Right now, investors are saying that it will occur, and with a new President-elect wanting rates to move higher (for a variety of reasons), Ms. Yellen and Co. may finally pull the trigger. With the SPX and Russell now but 1% or less from all-time highs, and the Dow making a new historical high last week, we believe that we once again want to find a tactical long position in the SPX. (And, of course, nothing has changed our long-term view (first stated publicly in June 2014) that we believe the SPX can rally to 5000 by 2024.) With last week’s SPX bottom also occurring on a TD Setup -9 count (a known potential inflection point) along with the aforementioned support near 2093 (see chart on top of page 3), we want to

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buy a pullback if we can get one. We will look to get long in the SPX 2055—2035 zone, with the belief that new highs are shortly coming. Moreover, we will plan on doing our buying at both of these two specific boundary levels, as I want to have some long exposure on if we only see a minor decline.

Credit Markets US 10-Yr. Treasury Yields: yields moved dramatically higher after election results came in, with this benchmark rate rallying an astonishing 21% last week to close out at 2.15% -- a 37 basis

point gain from the prior Friday. In doing so, yields closed at their best levels since January, and are much closer to getting some more upside breakouts. With rates running as they did last week, we were able to cover our remaining 50% TLT short position at an average price of $126 (when 10-year rates hit our 2.0% target). Thus, we closed

out the full short position, initiated at $138, with a partial cover at $132.81 and a partial at $126, for an average of $129.41 – just over an $8.5 profit per share shorted.

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Before anyone gets all giddy about the new bear market in bonds, we want to reiterate our long-term thesis about what it will take – in yield terms – to finally be able to say that the 36-year bond bull market is done with – FOR GOOD. As far back as December 2013, we put out a month-by-month closing rate level that we need see yields rally to for our model to finally call the death of one of the most spectacular multi-decade bull markets we’ve ever seen. As we’ve stated before, for the balance of this year (meaning on Nov. 30 and Dec. 31) we’d have to see month ending rates above 2.77%. And we can already tell you that by Dec. 31, 2017, that level only need move down slightly to 2.69%. In the future, the more we might see rates get above these mentioned levels, the greater we will believe that bonds will continue to fall, and that you will not likely have much time to materially reduce bond holdings, as we think that the thrust higher will be rather quick. Our confidence level on this call is HIGH, so act accordingly when and if we get this much-anticipated signal over the next 14 months. (We certainly will be monitoring the situation and make you aware as needed.)

Currencies Euro/US Dollar: The Trump victory gave the US greenback a strong lifting, with the DXY gaining over 2%. The euro fell to it’s lowest close since January, while also breaking the uptrend line from last December’s low. (See chart below.) Though some of you still had on our short recommendation – one we covered on Wednesday for a full point profit (but admittedly too soon, given the further declines the balance of last week), I am hesitant to re-short the euro on this trendline breach. The main reason for that is that today’s session (that started Sunday night) shows a TD Sequential -12 count (so long as Monday’s 5pm EST close is less than last Thursday’s low price of $1.0865), meaning that as early as tomorrow (Tuesday) we might see a -13 terminal downside exhaustion reading. (Please note on the chart how many times this year that a +13 reading has called an upside price exhaustion and a -13 reading has called for downside price exhaustion). Thus, I really don’t want to fight this potential signal that has worked so well all year.

We will watch from the sidelines before putting on a new euro position.

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US Dollar/ Japanese Yen: we’re going to start you off by looking at a long-term monthly chart, mostly to show you that the yen’s rally since summer 2015 (i.e. this chart showing price going downward) stopped not only at the 50% retracement level (just beneath 101) of the dollar’s major rally from ~75.5 to 126, but it also came back to backfill and bounce from the old downtrend line (shown in white) that it had broken out above near 107.50 in Fall 2015.

By now you know that we are very fond of the Ichimoku cloud charts, for we feel that they often give a very good sign of bullish and bearish structure of a security, as well as where prior bullish periods turn bearish, and prior bearish periods turn bullish. So now let’s take a look at the daily chart to the right. Notice that the cloud model has recently seen it’s first buy signal in 12 months (as Price > Conversion Line (pink) > Base Line (yellow) > the cloud (i.e. red and green lines creating the “cloud”, AND the Lagging Line (teal) is above the cloud directly beneath it. We’re going to want to get long on a pullback. As the

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dollar is already racing up again Sunday night as I write this, I don’t want to chase after the rally. So please make sure you are signed in and monitoring our Member’s Only chat room on Slack. (It’s our fastest way to communicate with you when we see something actionable.)

Commodities Gold: Last week was a very lousy one for those long gold, as the metal fell sharply on the post-election dollar rally. We see on the enclosed daily chart that gold is within striking distance of a 50% correction of this year’s rally from the cyclical low last December.

There will be some who buy the metal near that $1211 level (see the yellow horizontal line on the above chart), but we think that a better low may come later this week, should we see a Setup -9 count appear on Thursday. (A reminder: A Setup -9 count can occur when we see 9 consecutive price bars that the closing price is less than the closing price from four bars prior. This is often a near-term turning point, as evidenced on the chart already several times this year.) Should that -9 count occur in and around the $1172 Fibonacci 62% retracement level – all the better. We’ll watch and keep you informed of our next move. WTI Crude Oil: down some 11% in the past two weeks, bull’s inability to break above the major inverted head-and-shoulders neckline (shown on the chart in orange) has put some real pain into those that had positioned for an upside breakout. The chart now looks rather toppy, now with a two-month long regular head-and –shoulders top looking somewhat likely.

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We will use the closing price ($41.17) from the day that made the lowest low in August as our “line in the sand”. The more we breach that on multiple daily closes, the more likely that oil will head back into the mid-$30s. We have actually been leaning towards buying oil on this pullback, but never found the exact time and place to do it – and we were simply fortunate for that, given what the past few days have looked like. For now, we are standing on the sidelines, and we’ll let you know in the chat room if we’re going to play for a bounce against that $41.17 level.

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Explanation of Terms SIFs Not long ago, our reports were titled “Supposedly Irrelevant Factors”. SIFs is a term used by those of us in the behavioral finance and economic worlds that is associated with the introduction of human psychology and emotions into financially related decisions. Unfortunately, classic economic models simply ignore these important and academically proven influential elements within their models. (In fact, classic economic theory and its associated models assume that “perfect” and “rational” decisions will always be made after proper and thoughtful analysis has been completed.) Any one who has been around markets long enough knows that both perfect and rational decisions are, actually, atypical results. Humans make imperfect and irrational decisions all the time (most especially in the areas of finance and romance!) Therefore, we take a more intuitive approach to market analysis, and look at price movement much more from the vantage point of taking these SIFs into consideration. We aim to exploit the very real and constant irrational decisions made by all investors – professional and non-professionals alike. In doing so, we employ an array of indicators/models to take advantage of investment manager’s behavioral mistakes – along with employing market timing and non-textbook technical indicators – to get a much better sense of when and where trends will likely change – and to do so well before they are obvious to those using classic models (i.e. the bulk of the Street’s participants). At our core, we know that SIFs are very important to consider. As one very well-known economist wrote, “Supposedly irrelevant factors matter a lot, and if we economists recognize their importance, we can do our jobs better. Behavioral economics is, to a large extent, standard economics that has been modified to incorporate SIFs”. And that’s what we explore and share with you in each and every report you receive from us. Moving on, we often employ a counter-trend trading approach along with newer technical/behavioral models, most of which are not nearly as commonly utilized as are the more classic textbook studies (i.e. RSI, MACD, Stochastics, Bollinger Bands, etc.). A brief description of our favorite indicators that we most frequently use includes: Cloud Charts (a.k.a. “Ichimoku”) “Cloud” charting is a far-eastern technical model that was developed over 50 years ago, but is still not commonly used in the US (nor is there much reference material available on it, either). The calculations involved in the construction of each of the 5 lines that make up this model are simple math (see below). The proper understanding and use of cloud charts is still somewhat a mystery to many in the western world. We, however, have a deep understanding of this model, and use it as a core component to our market analysis. The names and calculations of the 5 lines are as follows: • Conversion Line: the arithmetic midpoint of the most recent 9 price bars (inclusive of the current bar). • Base Line: the arithmetic midpoint of the most recent 26 price bars (inclusive of the current bar). • Leading Span 1: the midpoint of the previously calculated Conversion and Base Lines, plotted forward 26 bars (including the

current bar). • Leading Span 2: the arithmetic midpoint of the most recent 52 price bars (including the current bar) plotted forward 26 bars

(including the current bar). • Lagging Span: the current price plotted backwards 26 bars (including the current bar). • The “Cloud” is the area on the chart bounded by the two Leading Spans. In any given time frame, it is our interpretation of the relationship of a security’s price to these five lines -- and the relative positions of these lines to each other -- that helps us decipher behavioral and/or structural shifts to the current bull or bear market environment at hand. DeMark Studies (a.k.a. TD models) DeMark Studies consist of models created by Tom DeMark, a noted market-timing indicator developer and consultant to many major Wall Street institutions. Two of these models that look for the timing of trend exhaustion include TD Sequential and TD Combo. A third, TD Propulsion, looks for a specific price exhaustion level after a trend momentum level has been properly identified and thrust through. Some key phrases we use in our writings include: • TD Setup: Nine consecutive price bars that the closing price is above the close from four bars prior (a.k.a. “Setup +9”). When

completed and “perfected” (i.e. the 8th or 9th bar’s high is higher than both bar 6’s and 7’s highs), a near-term top may be in place. Conversely, is a run of nine consecutive price bars that the closing price is beneath the close from four bars prior (a.k.a. “Setup -9”). When completed and “perfected” (i.e. the 8th or 9th bar’s low is lower than both bar 6’s and 7’s lows, a near-term price bottom may be in place.

• TD Sequential: After a completed Setup +9 count, if the security continues to move higher by a certain amount, a full trend has developed. This model looks to identify the exhaustion point of that trend, from a timing perspective. Here’s how: Subsequent

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to the Setup +9, the model then looks for 13 price bars (that needn’t be consecutive) that the closing price is greater than the high from two price bars back. When this happens, odds have increased that first buying within the current uptrend is much riskier than normal; some choose to actually lighten long exposure, too. Some aggressive traders even choose to initiate short exposure. Conversely, after a Setup -9 count, the model then looks for 13 price bars (that needn’t be consecutive) that the closing price is less than the low from two bars back. When this happens, odds have increased that first selling within the current downtrend is much riskier than normal; some choose to actually lighten short exposure, too. Some aggressive traders even choose to initiate long exposure. Thus, some aggressive-style accounts often use this model to take profits or even enter new counter-trend positions.

• TD Combo: This is a sister timing model to the above –mentioned Sequential model. It also reaches its trend exhaustion reading at a +13 or -13 reading. It counts to the 13th bar using a different calculation than Sequential. But it’s potential implications for an impending trend reversal are the same.

• TD Propulsion: This model looks to define the initiation of a momentum move (whether higher or lower). Once the identified Propulsion Momentum level is properly surpassed, it then pinpoints measured exhaustion levels for that same breakout or breakdown move (i.e. Propulsion Exhaustion and Full Propulsion Exhaustion).

• TD Trend Factors: This model looks to define important support or resistance levels from previous highs or lows of moves, measured in increments of 5.56%. (This particular number is a derivative of the Fibonacci sequence of numbers.)

• “Qualified and Confirmed” Breakouts: To qualify and confirm an upside breakout of some level we reference, the following need occur, in order:

1. A down close the price bar immediately before closing above the reference level 2. A gap up open the next price bar (that isn’t then the high of the bar), or, an equal or lower open that is the low of

the price bar. To qualify and confirm a downside breach of some level we reference, the following need occur, in order:

1. An up close the price bar immediately before closing beneath the reference level 2. A gap down open the next price bar (that isn’t then the low of the bar), or, an equal or higher open that is the high

of the price bar. Thus, the qualified and confirmed process takes 3 consecutive price bars to potentially occur.

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