Market Summary

Every cloud has a silver lining!

Breakouts performed spectacularly this week to gain 4.69% while the broader markets floundered. Although there were only seven, they were a prime crop that reached an average intraday gain of 10.32%.

While we usually discuss the markets first, the situation is so desultory that we wanted to lead with the good news. Now the bad.

The S&P 500 has fallen to a year-to-date gain of just 1% and we don't expect that to stay positive for long. The NASDAQ Composite fares better with a 4% gain to date and the DJI has gained 5.8%. The major reason for the discrepancy is the weighting of financial stocks and homebuilders in the S&P. The increasingly tight credit and still falling housing market will continue to hit hard companies that rely on the domestic economy while those with global reach will be best placed to ride out the storm.

Investors have concluded that the risk in being invested in equities has risen and this is reflected in increased volatility as measured by the VIX. This perceived increase in risk has forced a downward revaluation of the price of almost every stock in the market. It remains to be seen whether or not this is just a short-lived correction, such as we have seen several times since 2001 (examples: 9/11, Enron, recession scare, Chinese market crash), or if it is the start of a true bear market. The difference this time is that until now, the expansion has been fueled by cheap and available credit which is drying up as money-center banks withhold credit from, and force the collapse of, lenders like American Home Mortgage. The consumer can no longer withdraw capital from their appreciated home asset and this is already dragging the economy down.

Normally, we would expect the Fed to step in and inject money into the economy, particularly as a Presidential election year approaches, but with no incumbent running to put pressure on the Fed Chairman, and inflation still at the limits of the desired level, the timing of their intervention is questionable.

With volatility rising and markets seemingly on a downward trend, this is not an environment favorable to growth stocks. Instead, you may be interested in an alternative play that leverages volatility, which we introduce in this weeks Top Tip.

See below.

A New Tool for these Volatile Times - Unilateral Pairs Trading

I am grateful to a subscriber for sending me a copy of James Altucher's book "Trade Like a Hedge Fund" a couple or so years ago. I started to develop a tool to implement one the strategies suggested therein called "Unilateral Pairs Trading" but didn't complete the project due to other priorities. He rightly reminded me of the strategy recently because it works best in volatile markets such as we are experiencing now.

Today I'm releasing a very preliminary version of a tool to implement the strategy for ETF's. It's available to everyone who subscribes to our newsletter.

Put simply, the concept is to trade the most volatile side of a closely correlated pair of securities when the difference between the the two securities exceeds two standard deviations from their historical relationship. For example, trade QQQQ against SPY.

If the more volatile security exceeds the spread, then the security is shorted on the basis that it is overpriced and the spread will narrow. If the more volatile security is trading below the spread then the security is bought in the expectation that it is under priced and will rise.

A position is closed when the security reverts to within 0.5 standard deviations of the historical relationship.

The tool is accessed here. If you run it each day for your chosen pair(s) of securities, it will tell you whether to open or close a position in your chosen security at the next day's open. It will be enhanced in the coming days to add graphical representations of backtest results and for our subscribers, an alert service will be added.

If you run the tool for QQQQ/SPY (which was an example given by Altucher) since 1999, you will see the potential returns were quite impressive. (To closely approximate Altucher's results I used an initial capital of $1M). You will also see that the strategy said to go long QQQQ on August 1.

Any pair of highly correlated securities can be used. The tool lets you select the symbol you will trade from a list ordered by volatility, and its pair from symbols ranked by correlation with the first symbol.

Please tell us what you think of this tool and how you would like to see it improved.

Investment Advisors Using our Service

TradeRight Securities, located in a suburb of Chicago, is a full services investment management company and broker/dealer. They have been a subscriber, and user, of BreakoutWatch.com for some time now. They practice CANTATA and use Breakoutwatch.com as a “research analyst”. You can learn more about TradeRight Securities at: www.traderightsecurities.com. If you’re interested in speaking to a representative, simply call them toll-free at 1-800-308-3938 or e-mail gdragel@traderightsecurities.com.

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