Wednesday is the Critical Day for the Stockmarket

On Tuesday the S&P 500 made a strong advance and went beyond the upper trend line of a bearish wedge that bears have been following and hoping for since mid-July. This move is still legitimate in Elliott Wave Theory and is called a throwover. Any further rise though would call the pattern into question or negate it entirely.

As usual recently I have been rather confused about market direction as the NDX has chopped up and down in recent days. My models though also put Wednesday as a critical day - either up or down from here.

Here is a very interesting discussion of whether we have already seen the lows for the four year cycle.

Second Thoughts on Retirement Accounts?

As I begin to realize that maybe I can realize my dream of financial independence much faster than I ever thought possible, I am beginning to rethink the role of retirement accounts in my financial plans. Up till recently I have always contributed the minimum to retirement plans with my employers. The other side of the coin is that my main employers have had extreme levels of retirement contributions. In my first academic job in the UK contributing to the retirement plan was voluntary. It was defined benefit and I was only planning on staying a year or two. I thought reducing my debt was more important. The cost-benefit analysis I did at the time showed that the right choice was to opt out. In my next job (in the US) I didn't stay long enough to become eligible for the retirement plan. Then when I moved to Australia, participation was mandatory. Between employer and compulsory employee contributions, 24% of my nominal salary was going into my retirement account. I thought this was enough especially as it is almost impossible to get the money out in the Australian system before age 60. Then after a gap where I claimed to be "self-employed" :) I was back in the US and here we have to contribute a minimum of 1% and the employer 8%. My goal was to rebuild my savings from the 2002 drawdown and then head for the goal of financial independence. Then this year I opened a Roth IRA account when I learned that you can always withdraw the contributions without penalty and use up to $10,000 in earnings towards the first time purchase of a house. My plan was to save towards a potential downpayment using a Roth IRA. This summer, as I began to understand the tremendous profit potential of my trading model I began to rethink my Roth plan. I think I will hardly miss the $4000 annual contributions and the earnings on them. Therefore, I now plan to continue contributing as long as I can and not withdraw my contributions as soon as I hit $10,000 in profit (I am halfway there at the moment).

Now a new idea has struck me. If I maximized my 403(b) contributions to the $15,000 annual limit I could rollover my account into my Roth when I eventually leave my current employer (subject to paying the appropriate taxes). This would be a way of getting much more money into the tax-free Roth environment. I think I may do this as soon as my trading program has reached its full size and if I continue to be profitable money will then be flowing out of the trading program into long term investments (in order to minimize the potential of a catastrophic loss there is a maximum sensible leverage that should be used in a trading program relative to total net worth - in the long term probably 70% of net worth will be directed to long-term investment and 30% to margin for trading). At that stage I will no longer need my salary to expand the size of the trading program and can direct it to a more tax advantaged environment.

The bottom line is that if you are following a Kiyosakian path at first you want to maximize the assets you have to achieve immediate financial independence. But once that goal is achieved, it makes sense to take full advantage of tax sheltered retirement accounts.

Mayne Pharma to be Acquired

Mayne Pharma is to be acquired by Hospira. It has been in a trading halt for a couple of days pending a transaction. Yesterday most commentators were still thinking that Mayne would announce an acquisition. But in the last day all the speculation has been about a takeover of Mayne. The takeover price is $A4.10 which results in a $A1972 capital gain for me from a roughly breakeven position at the time of the trading halt. I am still carrying a loss of $A1055 on Symbion the other half of the Mayne Nickless company that demerged last year. It's been a long story since I first invested in Mayne Nickless :) The only question now is whether I should sell or hang on for a possibly higher price. I tend to get impatient during these merger arbitrage situations. This is nice news as the news on the U.S. trading front was not good today for me. The model is still however short but the picture is now a bit unclear.

PS 9:19pm After reading all the info about the proposed takeover I decided that a higher bid was unlikely. The stock opened an hour late at $4.21. I sold at $4.25.

Update from Croesus Administrators

Croesus Mining's administrators have provided an update on the state of negotiations to either sell Croesus' assets or recapitalize the company. In the latter case, the suspension of trading in Croesus' shares may be lifted. I guess that there is a 50/50 chance that my shares could be worth say 2 Aussie cents each (vs. 27.5 when the trading halt was called) or zero if the assets are sold. The latter would probably mean that there was only sufficient capital to partly pay the creditors (Mitsui Bank and Macquarie Bank are the main ones). Macquarie Bank has been really great through this whole process. Mitsui are the villains. I couldn't link the announcement but it gives a schedule for their meetings with interested parties and for due diligence to be carried out.

PS: 22 September - received a letter today from a fellow shareholder and her lawyers... the lawsuits over the Croesus debacle are beginning to fly. They want $A550 to represent each shareholder without even explaining what their strategy is apart from stating that we should have the same rights as creditors.

Trading Record for the Year So Far

It ain't pretty:

The chart shows the running total of profits from short term trades so far this year. As you can see I got a nice profit early in the year and then blew it all up. Particularly on 29 June. Then I started trading with "the model". I have slightly exceeded the previous maximum level of profits but went through two periods of bad and confused trading against the model. All of this is documented in this blog as it happened. I will need to see a decisive break to a new highwater mark for the year before I will really get convinced that trading this model is practically profitable in the real world. Both pre- and post-model there are some long streaks of mostly winning trades. These tend to engender overconfidence and consequent blowups. Psychology is the hardest part of trading for me.

This might look like irresponsible and reckless risktaking. But losing $4000 in a period of bad trading is a loss of only 1.25% of net worth. This is nothing compared to the reckless risktaking at Amaranth Advisors :). More on Amaranth Advisors.

What's Next for the Market?

This scenario has now played out. The model is switching to short at the close today. The S&P 500 index has now had 3 weeks of sell signals on my old model. Now maybe it is finally time for this much delayed longer term scenario to play out. Near today's highs I bought 20 put contracts in my Roth IRA account. So now I am effectively short 5000 QQQQ shares worth just over $200k. The short-term trend is going to be down from here. The stochastic will have to fall tomorrow unless there is a significant rise in prices. The McClellan Oscillator looks set up for a fall too. This isn't all the evidence to show that the "stars are aligned". So maybe now I will be surprised? :)

Business and Tax Planning

I am reading the two books on taxes for traders that I ordered. Green's book is not as well written, but his strategies are simpler and less aggressive. Tesser takes things to the next level. There may be some contradictions between their advice but I have only read part of each book so far. I am learning a lot. I am understanding more about what Kiyosaki was hinting about regarding business tax deductions. Deductions taken on a Schedule C for example have no effect on triggering the AMT. Traders have many special tax advantages. So if you think you could qualify as being in the business of trading rather than investing it is well worth reading these books. You don't have to set up a company to get business deductions but it allows you to take some other deductions - particularly deducting health insurance from income and making contributions to retirement plans (and social security). If you have another job or your partner has a job with health insurance this will be less important for traders and investors.

Tesser discusses a program I had never heard of: VEBA - a voluntary employee benefit association. Tesser claims that this program can be used as a retirement program. All the information I can find online though says that it is only for medical expenditures. I think his advice is relying on shutting down the program at some point and distributing the proceeds to the employees. The money in the program is tax deductible and tax deferred. The advantage is that none of the limitations that apply to regular retirement programs regarding contribution limits and age restrictions apply to VEBA. Seems that this is a rather aggressive strategy though he claims that none of the strategies in the book get anywhere near the legal limits.

The IRS has never stated what exactly allows one to qualify as a trader rather than investor but instead lays out some vague criteria in Publication 550. If trading isn't your major income source it seems unlikely you will qualify and instead you will trigger an IRS audit. Trading futures seems to make it easier to claim trader status than trading stocks as futures are prima facie trading instruments. Otherwise you will need to show that you do extensive, frequent, and continuous trading. That can be hard to prove if you have a full time job.

The good news is that I can take things step by step:

1. Planning stage - current: proving profitability of trading strategy - learning about tax law etc.
2. Switching to trading futures - which are taxed at lower rates than stocks.
3. Claiming trader tax status - only possible when income is sufficiently high or I quit my current job.
4. Setting up a management company
5. More advanced strategies for estate planning etc - Tesser recommends partnerships.

That Was a Bad Call

Why do I keep trying to trade against the model? It doesn't make sense. I don't understand why I am doing it. But for some reason it is very hard to stick with what the model says to do. Currently, it is long through Monday's close at least.

Back to the Short Side

Yup. The model is still long but probably Friday will turn out to be the last day of the uptrend in the stochastic. The stochastic can still rise as long as the index remains above 1582 (assuming a high higher than Thursday's 1629 or a low below 1558 do not occur). Friday is also options expiration day. After a strong rally one might expect a sell off on options expiration day as the "max-pain effect" comes into play. Many buyers of call options will have in the money positions. If they sell them to take the profits rather than exercising them the option sellers will then sell the stock they used to hedge their short options positions (delta hedging). This puts a downward pressure on stock prices. Well, just a theory. Futures also expire this time so a lot of stuff is happening - what is called a "quadruple witching". The Elliott Wave formation that began at Monday's low looks complete too. Also my weekly model's forecast for next week would make more sense if prices back off a bit on Friday. So that's my reasoning.

Can an Economist be a Trader?

Fin_Indie asked for me discuss how I reconcile being an economics professor and an active trader. I assume he is thinking about the efficient markets hypothesis (EMH) that states that all known information is incorporated in stock prices and prices only move when new information is revealed. This is also often taken to imply that stock prices move according to a pure random walk and changes in prices are unpredictable. Some take this idea further arguing that investors should simply invest in a diversified buy and hold portfolio as there is no way to profit from trading or even deviating from a market weighting of securities.

There are two parts to my response. One is to explain what I think EMH really implies and second to question whether the strong version of EMH holds. As a good economist I don't believe in too many free lunches. Financial markets are highly competitive markets and there should not be easy ways to make above average risk-adjusted returns (taking on more risk is a simple way to get above average returns). Otherwise, participants should simply get a standard return for their provision of investment capital to the market. That is, if that is all they provide. I argue that other inputs provided by investors should also receive returns in this market. These include returns on skill, returns on effort (time spent investing), and returns on special information. Of course if you don't have any of these then don't try to beat the market... It defies imagination that say Warren Buffett's track record is the result of pure chance. Rather, his excess returns reflect returns to these additional inputs. If you think you have these additional inputs you might have an edge, which you can test statistically and then it will allow you to beat the market.

Of course it helps that I am not a professor in the field of finance. I don't even have a PhD in economics (but another field instead). I do have a BA in economics (and the other field) and some graduate classes. I have been published in economics journals, I am a professor in an economics department, and I obviously teach economics. But my background is interdisciplinary and I think makes me much more open to alternative ideas than I might be if I had been indoctrinated in mainstream finance theory in grad school. Most of my research has been empirical and uses time series analysis.

The second part is to argue that while EMH is a good benchmark the strong form of the hypothesis does not hold. Countless anomalies have been documented. The most obvious is that stock prices fluctuate far more than do earnings or interest rates, which are their supposed determinants. A major issue that prevents the market from being perfectly competitive is as I have blogged before most participants in the market do not short-sell and many have mandates to remain fully invested in equities whatever happens. Active traders and hedge funds remain a minority of the participants, despite being very active. Even in among the active traders few are directional traders. Most are arbitrageurs, market-makers etc. Therefore, some forms of technical analysis do work. This is not a "belief" of mine but something I have now tested in the statistically validated trading model I am using. A lot of technical analysis out there makes no sense and a lot of the publicly available TA won't produce excess returns. This is not surprising. But a little digging will produce some useful approaches. Still, most participants have been persuaded that TA is nonsense. That is their problem not mine.

Fin_Indie also asked about my philosophy and inspiration. My basic approach is to trade my account like a global macro hedge fund, with a fairly conservative approach to adjusting the market exposure of my investment portfolio and an aggressive TA approach to trading the trading account. My biggest inspiration on how to trade and invest has been George Soros. But I have drawn elements of what I now do from all over and testing what works and what doesn't. Robert Kiyosaki's books were a big inspiration too.

Aligned with the Trend

The model has now been long for a day and I am again aligned with the model and up on the month a little. This feels better. The uptrend should run through Friday or Monday based on the current forecast. Spent the weekend in Vermont. Sunday went apple picking and other activities. Beautiful weather. Very relaxing.

Planning

A beautiful day here today - trying to appreciate it a little in between the things I have to do. The market has been making me nervous too as I've been confused lately about its direction. It's looking better this afternoon and I don't think I have to bail out (I'm long, though the model is short - go figure). So I can relax a little. The beginning of the Fall Semester is when we start planning for the Spring Semester. I requested to teach classes in the middle of the day most days of the week so I'm free from teaching at market closes and opens. As you can see I am getting addicted to trading :) Most profs try to concentrate all their classes into two days a week. But I have found that pretty tiring. Teaching is like acting or performing in some way. This way I spread my various activities across the week rather than concentrated. Not sure whether I've blogged about my longer term career plans? The downside of academia is immobility and I want to get out of that trap. I also am much less interested in the research part of the job than I was. In fact I enjoy more the management/adminstration aspects now! As long as something useful is getting done by doing them. I am trying to develop trading as a mobile do anywhere source of income that will give me much more flexibility. It won't neccessarily be my main activity. But I would be free to go where I like and do what I want. I am not planning on working in one job or career until I am 65 and then retiring. Why do the same thing your entire life? You only get one life to try out different things. But if I want to stay in the US I first need to get my green card and I am waiting and still waiting. The main driver is on the personal side. My girlfriend is also a potential immigrant and will be limited to visa-compatible jobs employment-wise. Total lottery where those potential jobs may be. The probability that they are close to where my current job is is infinitesimally small. Actually she was just talking about jobs in Sweden again... I won't rule it out, though am not really looking forward to another international move. Probably anyway it would be a 1-2 year position. OTOH I can travel to and live in Sweden with no problems as I have European citizenship.

On another planning front we are finally moving my mother's account from Citibank to two other financial management firms. I had high hopes from Citibank when we opened the account 4 years back and initially we got a decent guy assigned as our "relationship manager". But since then service has gone downhill. Don't think that if you have $1-2 million you will get any better service than a small investor. Many discount brokerage firms would put Citibank to shame. I was reading recently about why wealthy clients dumped managers. The number one reason was poor customer service, not poor investment performance. We just wanted no-hassle peace of mind and as long as we are making a little money we aren't concerned neccessarily about pursuing the highest returns. The last thing I wanted is for my mother to worry about what was happening with her money. One of the new providers is UBS. We will see if they live up to their image of better customer service. The other is a small local firm where she lives. Over time, we will probably place more money with the smaller firm if they are nice to us :) But we can't transfer some of our funds to their custody and don't want to sell them and therefore also need the big bank.

Confused

Yes, I am feeling very confused by the market today, even though so far I guess it is playing out the chart I posted in my last post. Just it went up one more day and then went down and so I ended up losing... Longer term NDX still looks like it is going up, though I still have that sell signal on the weekly SPX I posted about. Probably I should have just gotten out of the market if I was unclear about what was going to happen. Still learning!

New Weekly Model Says: "Get Long"

For the first time today I estimated a model with weekly data. Again, I was stunned by the results - the high correlation between the forecasts and the actual change in the stochastic oscillator in the following week. The R-Squared (a measure of the goodness of fit of the model) between the one step ahead forecasts and the actual data is above 0.9 (very high). This is the sort of number that got my girlfriend to say "whoa!" when I told her about it :) Anyway, to cut to the chase the model predicts the stochastic will increase next week. Therefore, one should be long. I intend to use this model when the daily model is ambiguous as seemed to be at the moment. Well actually my model has clearly been long the last two days but I was stubborn and thinking that the potential turning point on Tuesday after Labor Day would actually lead to a turn to the downside. A day or two down is possible before the market continues to the upside.

Of course all this goes against the fundamentals as I see them. But so be it. The bond market is forecasting recession, but the stockmarket is beginning to change its mind.

Here is a chart that points out the analogous point last November and a guess of the likely price action going forward:

Books on Tax for Traders

Just ordered a couple of books about tax for traders. The Tax Guide for Traders by Robert Green and The New Traders Tax Solution by Ted Tesser. This is definitely a topic I need to understand much better before taking my trading business to the next level. I know about several of the issues but am unclear how the following interact: 60/40 treatment of futures, mark-to-market accounting, trader tax status, self-employment tax. Well I know that mark-to-market accounting results in you not being allowed to use 60/40 treatment of futures. But I was reading that you still can claim trader tax status, and somewhere I read you can still avoid the self-employment tax. Need to get this all straight and also understand whether I should set up a business entity such as an LLC or S-Corporation.

August Report

August was another good month. Net worth increased by $14,000 to $330k, investment return was 3.61%, and total investment income $11380. Expenditure was $2062. I have now increased net worth by $60k year to date. So there is still $40k to go or $10000 per month to reach my goal of increasing net worth by $100k for the year. If I keep up the pace of the last two months I will be able to achieve it. The best investment performers in terms of dollars earned were: QQQQ $4712, Colonial First State Conservative Fund $A2731, and Challenger Infrastructure Fund $A1587. As something like one third of my net worth is in the QQQQ position and more than half in the CFS Conservative Fund those rankings aren't too surprising :).

My return on equity on my trading account was a little more than 15% - slightly more than in July. The goal is therefore to earn trading income of $5400 in September (15% more). My eventual goal is to earn at least as much from trading as from my salary ($6250 per month). So I am not too far from that as things are going now.

Trading Model Performance for August

Another month has gone by trading "the model". I have further improved my trading rules and produced a decent performance for both the model and my account in August. The results in percent terms look like this:

NASDAQ 100 Index: 4.66%
Model(Improved Version): 8.36%
Trading Account: 15.26%

This means I captured 182% of the model's performance using about 3 times leverage. Before the improvements were added the model would have only been up about 5% and my performance captured 300% of that lower rate of return. As a result I earned $4700 for the month from trading vs. $3900 in July when the account gained 14.57% on the back of a model performance of 9.57% and a decline in NDX of 4.80%. This chart compares the model performance and the market action to date:



Clearly if you were short in early July and long in mid-August you would capture most of the model's gains.

It is going to take about 3 months from now, therefore, to achieve my goal of regaining all past trading losses on this account. In the meantime I am also saving up cash in my HSBC Online Savings account to open a futures trading account which will be the next adventure. But first I want to prove I consistently trade QQQQ profitably using the model over several months.

At Midday the Rally is Looking Dead

This rally is looking pretty dead here.

Based on the prices earlier this morning my model would have switched to long, and I got close to pulling the plug/switch or whatever metaphor, but now in fact the spike up has extended the recent range and makes the model more likely to remain short at today's close.

Also I mentioned that my indicators were very similar to last November. Another difference is back then the full(5,5,3) stoch went above 80 on a 20 point up day. And the follow through day was another 20 points up and a runaway rally ensued. Here the breakthrough was a 3 point day and the follow through day was something like 9 points.

Of course things might look entirely different by 4pm. Tomorrow morning there is a bunch of very important economic news. This morning's economic news pretty much met expectations and so hasn't moved the market much either way.