The Big Picture

By Colin Twiggs
January 23, 2007 2:00 a.m. ET (6:00 p.m. AEDT)

These extracts from my daily trading diary are for educational purposes and should not be interpreted as investment advice. Full terms and conditions can be found at Terms of Use.

The Big Picture

Further support for my theory that the Fed is able to influence (manipulate?) the stock market by raising or lowering yields on long-term bonds. A plot of the S&P 500 price-earnings ratio against 10-year treasury yields shows a clear correlation between low bond yields and high PE ratios. Many thanks to Herb, a reader, for providing the link.

One of the biggest failures of the discounted cash flow model, used by many investment institutions to value future cash flows, is the use of long-term risk-free (treasury) yields instead of a stable bench-mark rate. When yields are low, valuations rise, and when yields rise, values decline. Institutional investors often fail to increase their risk premium when bond yields are low.

Ten-year treasury yields are rising, having respected the 3-year trendline. Expect another test of resistance at 5.25%. The latest rise is in part a response by OPEC oil producers to the fall in the price of crude, prompting them to liquidate some of the $97 billion in treasury bonds accumulated over the last 17 months.

10 year treasuries and yield differential

The yield differential (10-year minus 13-week treasury yields) remains negative, warning of long-term pressure on banking margins and a possible down-turn.

Equity Markets

The primary trend on the Dow Jones Industrial average is up, while a bearish divergence on Twiggs Money Flow warns of a secondary correction.

Gold

Spot gold is consolidating between $600 and $650. Breakout above $650 would be a bull signal, while a fall below $600 would be bearish, signaling a test of primary support at $560.

Falling crude oil prices are likely to reduce demand for gold, while a weaker dollar would increase demand; two opposing forces that may offset each other.

Source: Netdania

Crude Oil

Crude oil prices continue to fall after breaking through support at $55/barrel. The next major support level is $40. Prices are in a primary down-trend.

Currencies

The euro continues to test support at $1.29/$1.30. So long as the retracement respects the (green) upward trendline, the trend remains healthy. A fall below $1.25, though unlikely, would signal reversal.

Source: Netdania

The dollar has made a break above the long-term bearish descending triangle against the yen, rising marginally above the December 2005 high of 121 -- a bull signal for the dollar. I am wary of a false breakout and would rather wait for a pull-back to respect the new support level and confirm the up-trend. A fall below 115, on the other hand, though unlikely at this stage, would signal a test of long-term support at 100.

Source: Netdania

Wright Model

Probability of recession in the next four quarters remains at 45 per cent according to the Wright Model.

There is some evidence that the Wright model may understate the probability of recession in a low interest rate environment (as at present). The model emphasizes the nominal level of short-term interest rates and ignores whether these rates are rising or falling. It also does not adequately explain the behavior of the market during the 1966 and 2001 recessions, when interest rates were low.

In theory one is aware that the earth revolves, but in practice one does not perceive it, the ground upon which one treads seems not to move, and one can live undisturbed. So it is with Time in one's life.

~ Marcel Proust

Technical Analysis and Predictions

I believe that Technical Analysis should not be used to make predictions because we never know the outcome of a particular pattern or series of events with 100 per cent certainty. The best that we can hope to achieve is a probability of around 80 per cent for any particular outcome: something unexpected will occur at least one in five times.

My approach is to assign probabilities to each possible outcome. Assigning actual percentages would imply a degree of precision which, most of the time, is unachievable. Terms used are more general: "this is a strong signal"; "this is likely"; "expect this to follow"; "this is less likely to occur"; "this is unlikely"; and so on. Bear in mind that there are times, especially when the market is in equilibrium, when we may face several scenarios with fairly even probabilities.

Analysis is also separated into three time frames: short, medium and long-term. While one time frame may be clear, another could be uncertain. Obviously, we have the greatest chance of success when all three time frames are clear.

The market is a dynamic system. I often compare trading to a military operation, not because of its' oppositional nature, but because of the complexity, the continual uncertainty created by conflicting intelligence and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected. The formula is simple: trade when probabilities are in your favor; apply proper risk (money) management; and you will succeed.

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