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Surfing The Market Waves: The Nested Pullback

Patterns are important in trading; you might even say that trading is basically a game of recognizing the right patterns and doing the right thing when they happen. Most of you who have read my blog or my book, or have seen the research I write every day, know that I focus heavily on trading pullbacks in most market environments – pullbacks in trends, after breakouts, before breakouts, at the end of trends, at turning points in trends – even a simple pattern offers many ways to trade the market’s action. One of the more useful variations of the pullback theme is something I have called a “nested pullback.” As always, terminology can be confusing, so it’s important to realize that the “nested” part of the term means that the nested pullback is a smaller structure that is “nested” within the larger pullback’s drive to resolution. It is not nested within the larger pullback itself, but, rather, within the thrust that happens when the bigger pullback begins to turn into another trend leg. Another way to think about it is that it is a pause: the bigger pullback starts to go into another trend leg, and that move stalls into a small consolidation which is the nested pullback. (I wrote a longer post about a year ago here .) Take a look at this recent example in natural gas futures: Nested pullback in natural gas. Identifying the bigger pullback was easy if you were able to let go of preconceptions, concerns about sentiment/COT data, and other nonsense that always encourages us to fade trends. So many times, the right thing to do is to simply align ourselves with the dominant group in the market until the market makes it clear that something has changed. The market is in a downtrend so we want to short bear flags – that sentence is the essence of one pretty successful trading plan. The nested pullback provided additional confirmation. We obviously would prefer if every trade would move immediately and cleanly to its target, but things don’t often work like that. It’s more common for a move to stall or pause, but we can then often find additional information in the character of that pause. In this case, the nested pullback showed that there was a good probability that this market would break lower. (For instance, a pause that had a lot of sharp rallies would be more likely to suggest that factors were beginning to align against the trade.) This is a good pattern to add to your toolkit because it can do at least three things for you: 1) it gives you some insight into how to manage the trade and how to tighten stops, 2) it can provide a secondary entry if you miss the initial spot to get into the trade, and 3) it can be a good spot to add, if you do that within your trading plan. Spend some time looking for this pattern and see if it can enhance the way you view market trends. I’m very suspicious of “after the fact” analysis, and you should be too. Anyone can find any pattern on an old chart, but this is another example that we identified in real time: I signaled the initial short to my research clients and identified the nested pullback as it was developing. We took partial profits into the decline, and are still short for today’s meltdown. Obviously, not every trade works like this, but this is a clean example of the pattern, and a good example to commit to memory.

Highflier Airlines Earnings: Time For JETS ETF

The airline stocks, which were flying low at the start of the year on a stronger dollar and global growth worries, skyrocketed lately on improving industry fundamentals. Higher margin, lower debt, surging ancillary revenues from hotel accommodation, car rentals, onboard food, limited capacity growth and a host of modifications in operations helped the sector to gain altitude. As a result, the pure-play aviation ETF U.S. Global Jets ETF (NYSEARCA: JETS ), which has added just 4.5% so far this year, advanced about 5.8% in the last one month (as of October 22, 2015). In any case, cheap fuel has been a bonus for long. The swelling middle-income population in emerging markets is benefitting worldwide customer growth. Now, solid earnings results from top-notch companies are an icing on the cake. The sector is in the top 16% category of the Zacks Industry Rank at the time of writing, giving strong indications of the upcoming flight of the entire industry. Let’s take a look at some of the key third-quarter 2015 earnings in the sector: On October 14, Delta Air Lines (NYSE: DAL ) beat on earnings but missed on revenues. The top line was hurt by adverse foreign currency movements. In Q2 itself, Delta had planned to slash its international capacity by 3.5% in the fourth quarter of 2015 to lessen the unfavorable impact of foreign exchange on its international operations. Third-quarter adjusted earnings of $1.74 per share steered past the Zacks Consensus Estimate by 3 cents and improved 45% from the year-ago figure. Revenues dipped 0.6% year over year to $11.11 billion in the reported quarter, falling short of the Zacks Consensus Estimate of $11.12 billion. Delta expects volatile fuel prices going ahead. The estimated fuel price, including taxes and hedges, is expected in the range of $1.75 to $1.80 per gallon for the final quarter; the high end being in line with the average fuel price in Q3. The average price is even lower than what Delta had earlier expected for the second half of 2015 i.e.; in the band of $1.90 to $2.00 per gallon. This Zacks ETF Rank #2 (Buy) stock has a Zacks Momentum & Value style score of ‘A’ and a Growth score of ‘B’. Shares advanced about 4% in the last five trading sessions (as of October 22, 2015). United Continental Holdings Inc. (NYSE: UAL ) came up with mixed Q3 results with an earnings beat and a revenue miss. Earnings were up about 65% year over year on lower fuel costs and reduced operating expenses. Revenues declined 2.4% on lower passenger revenues. Cargo revenues were down 0.8% while other revenues improved 9.8% in the third quarter. Its indicators are also promising with a Zacks ETF Rank #2, and Growth, Value and Momentum scores of ‘A’. Shares were up about 2.8% in the key trading session of October 22, post earnings. Yet another leading U.S. carrier Southwest Airlines Co.’s (NYSE: LUV ) third-quarter 2015 earnings and revenues outpaced the respective Zacks Consensus Estimate. Revenues grew 2% year over year helped by 3.3% and 102.1% expansion in Passenger and Other revenues, respectively. Airline traffic was up 8.9% while passenger load factor inched up to 85.4% from 84.4% recorded in the year-ago quarter. LUV, with a Zacks ETF Rank #2, also boasts hopeful indicators of Growth score of ‘B’ and Value and Momentum score of ‘A’. Shares shot up over 7.4% to reflect the results on October 22. On October 23, American Airlines Group (NASDAQ: AAL ) reached a milestone when it came up with the ‘ highest quarterly profit in the company’s history’. This airline reported $2.77 per share of Q3 earnings breezing past the estimate of $2.72. Revenues came in at $10.71 billion, marginally short of the Zacks Consensus Estimate of $10.72 billion. This is also a Zacks ETF Rank #2 stock and its investing metrics were even more upbeat with all Growth, Value and Momentum criteria having a top-notch score of ‘A’. The company also bought back $1.56 billion of common stock. Not only these heavy-weight stocks, sturdy performances also were put up by other sector players. Alaska Air Group, Inc.’s (NYSE: ALK ) Q3 2015 earnings per share of $2.16 beat the Zacks Consensus Estimate of $2.06 and improved 47% from the year-ago earnings. Revenues grew 3% year over year and narrowly beat our estimate. This Zacks ETF Rank #2 stock can be a great pick for growth and value investors. ALK added 1.7% following earnings on October 22. By now, one must have realized that the mood in the airlines industry is upbeat. So investors might play the trend via basket approach to tap the entire potential of the space. And to do so, what could be a better option other than JETS ETF? The $46 million-fund holds over 30 stocks in its portfolio and is concentrated on a few individual securities, as it allocates about 70% to the top 10 holdings. Southwest Airlines (12.94%), American Airlines (12.78%), Delta Airlines (12.34%), United Continental (11.31%) are the top four elements in the basket, with a combined share of about 45%. Alaska Air holds a seventh position in the fund with 3.51% weight. The product charges 60 bps in fees. The fund added 3.5% in the last five trading sessions (as of October 22, 2015) which made the peak of airlines earnings releases. Original Post

When Picking Mutual Funds, Don’t Be The Dumb Money

For the typical retail investor, mutual fund research reveals an uncanny ability to pick the worst fund categories at the worst possible times. The reason has to do with the tendency to base these types of decisions on “gut feeling” or emotion, rather than careful analysis. Investors feel most comfortable climbing aboard overvalued sectors of the fund universe towards the tail end of bull markets, only to flee to safety when stock prices are closer to their lowest. First identified by researchers Andrea Frazzini from NYU and Owen Lamont from Harvard, the poor timing ability of fund investors has come to be referred to as the “dumb money” effect. Emotion, limited attention, misguided perceptions and inexperience lead retail investors to make questionable decisions. This tendency to invest more in funds with high positive sentiment (for example tech stocks in the 1990s), and to pull out of funds with high negative sentiment (for example liquidating stock funds in 2008 and moving to bond funds), has led retail investors to lose on average about 1.5% annually, according to a 2007 analysis by Geoffrey Friesen of the University of Nebraska and Travis Sapp of Iowa State. Understanding investor behavior provides insight into why retail investors underperform the market. It also reveals how an investor, with a modest amount of additional effort, can improve their performance by avoiding common decision mistakes. Recent performance is the force that drives dumb money losses for many retail investors. This isn’t surprising since mutual fund advertisements and fund prospectuses tend to emphasize how well the mutual fund has performed in the past. Most investors shop for mutual funds the way they would for a toaster or microwave oven. Instead of researching the quality and durability of the product, they use shortcuts – cues of quality such as brand name recognition, an appealing marketing campaign, or a recommendation from a friend or family member. Yale researcher James Choi and his co-authors David Laibson and Brigitte Madrian of Harvard investigated how an average investor uses information on a mutual fund prospectus using identical S&P 500 index funds with different fund initiation dates. In addition to the prospectus, they gave respondents in different groups a “cheat sheet” that summarized differences in fund fees, and another that spelled out how the objective of all funds was to mimic the S&P 500. Samples of both employees and Wharton MBA students (with average SAT score at the 98th percentile) consistently focused on the obviously irrelevant fund performance rather than on fund fees even when presented with information that should have helped them make better choices. Brad Barber of UC Davis and Terrance Odean of Berkeley blame return chasing on the limited attention span of individual investors. According to their investor attention hypothesis, most of us have limited time to devote to researching mutual funds. We can either invest a huge amount of time and effort into learning how to evaluate and select funds, or we can simply invest in ones that capture our attention. The fact that mutual fund investors are attracted by the shiny funds does not serve them well in a market where sentiment can drive the value of securities too high or too low. A simple way to break the cycle of mutual fund underperformance is to develop an investment policy in which the investor maintains a diversified portfolio that reallocates periodically as market values change. This naturally works against investor sentiment by increasing investment in bonds when stock prices are rising and reducing one’s bond allocation when stock prices have fallen. Azi Ben-Rephael of Indiana University and his co-authors estimate monthly shifts between bond and stock mutual funds and find that investors consistently do the opposite-they shift to bond funds when equity values drop and back toward stock funds when equities rise in value. I use the monthly calculated shift in equity funds during the two significant equity bear markets of 2001-2002 and 2007-2009. In both cases, mutual fund investors move sharply toward bonds after stock prices have fallen. Investors appear to be unwilling to follow a disciplined long-run investment strategy by maintaining their portfolio risk exposure in a down market. Since poorly timed mutual fund sales are more harmful than poorly timed purchases, these flights to safety can have a significant impact on long-run portfolio performance. Including an investment policy statement inevitably leads to a discussion of the importance of rebalancing during good times and bad, allowing a client to anticipate portfolio volatility and follow a smart money strategy. Friesen and Sapp found that sentiment-driven underperformance on load funds was twice as large (1.92% per year) as the performance gap on no-load funds (0.96%). Incubated funds are also significantly more likely to be load funds. This is consistent with other studies that suggest that the mutual fund universe can be split between funds that are sold through the broker channel and funds that are bought through a direct channel. It is far easier to sell a privately incubated fund with significant recent excess performance, than it is to sell a fund with average performance. This is so even if neither fund is actually more likely to outperform in the future. It would be tempting to conclude that bad investor timing is primarily the result of inexperienced investors making bad choices, but a recent study by Ilia Dichev of Emory University and Gwen Yu of Harvard found that dollar-weighted returns on hedge funds are between 3% and 7% lower than time weighted returns. This is more than twice the dumb money difference observed in mutual fund investments. Since hedge fund investors are primarily institutions and extremely wealthy individuals, apparently even the professionals can get caught up in the excitement of investing in hot funds. Whether novice or professional, it is easy for an investor to fall into the trap of chasing returns of attention-grabbing funds. The good news is that investors who avoid relying on their emotions are much more likely to succeed in the long run. And a skilled investment advisor can help a client tune out the noise.