Phil Erlanger is a rarity. A market seer who has been more right than wrong this year. The independent Boston-based technician and proprietor of www.ErlangerSqueezePlay.com, an institutional service with a retail offshoot of growing popularity, generously shared his thoughts. -KMW
Wednesday [10/9/02] was a fun day in the market – for bears. Reduced Maria to babbling about the sort of valuations that should excite investors with 10-15 year horizons. Then came Thursday's rally –
It is pretty interesting. Going down is good for me. But it seems to be doing so in measured steps. Definitely acting like a secular bear market.
You've been saying that perhaps the "big barf" bottom so many are looking for wouldn't happen – just because it's so fervently hoped for.
Well, I think we're actually getting a "big barf" now. It's just not going to be evidenced in the way we are used to seeing it in a bull market. I do ultimately think that there will be one day when the market just goes "Bleeeech" and then comes back. But by then, people will be so disgusted that they won't care. And that's the beauty of it. But this water-torture, 100, 200 points a day down, peppered with a couple of days that are up, is driving most people nuts. The clouds are rather dark and voluminous. But at the same time, we are starting to get some pretty serious numbers on the volatility indices again. Tuesday we definitely had a barf mode in some individual stocks. There are ebbs and flows. This is the ebb. We'll get past it, but there will be pain. My point is that if you are on the right side of this, you are loving it. I have lots of institutional clients – and 11,000 retail subscribers – who are loving it. Yet I'm still hearing on the TV-what's her name, the Money Honey, say, "You should be investing for the long term. 10-15 years. This one-year, two-year stuff is no good."
That's when I barfed.
That's a steaming pile of horse dung! I'm sorry, but that's like saying, "walk into the casino and keep betting on red, forever, and you'll do fine." It's insane. The stock market is a risk environment and you have to be very, very good to beat the odds. Or you have to put your money with people who are very, very good. Now, I have worked for the best and brightest in the business, and yet that is a level of trust that I could not transfer. There are more people in this game than should be in this game. You need to understand the playing field, and yet people don't have a clue. This ethic that you have to invest for the long term is totally wrong. Not that I am saying you should whip back and forth and day trade-that's totally wrong, too. My ethic is that you have to analyze the market for what it is. Position your portfolio to exploit factors as they unfold. Sometimes that means you have to trade quickly. Other times, it means you have to stay in there and give it a chance to work out. The factors that you look at have to be simple. You also have to be flexible. Sometimes the effectiveness of one indicator or another will go down. So I am always trying to second-guess. Sometimes you see that in my writing. Like the big barf.
If not that, what? More water torture?
I don't know. But you see what I am doing, don't you? I'm not pressing my bets here. I am taking my bets off the table as we go. The market is always an uncertainty; it's always a risk. You never know for sure. But I don't have to make every dime in a move. I am quite happy with my 30 percent gain in the Rydex fund, with my 20 percent gain in the Spyders and the 15 percent gain in the Diamonds. Even with my 10 percent gains in the QQQs, which are a big ripoff because they haven't reflected the decline in the Nasdaq. At bottom, my long-term outlook is more about process than about "buy a portfolio and forget about it." It is a distinction that most people don't understand, and it's why most people don't win in the long run.
Which explains why your model portfolio was almost entirely in cash in early October.
We've had tremendous action in our model portfolio from day 1. [A full recounting is kept up-to-date at www.ErlangerSqueezePlay.com]. We're ready for the next advance stage, if and when it begins. The next major play will be to the upside. But I don't expect anything greater than 20 percent perhaps. That's the max.
So just enough of an up-move to get everyone talking about a new "bull market?"
That's because they're wearing secular bull market eyeglasses. You have to look at the primary secular trend as a decline. In a long-term bull cycle, a 20 percent bear market is pretty much all you get. Well, that is going to be true in reverse now. Where the bear declines are much larger percentage moves and the bull markets are technically corrections to the primary bear trend. So that means that the "bull markets" could be anywhere from 10 percent-20 percent. What's interesting here is that if you look at the S&P 500, we're below 800 now. If you tack on 20 percent, where does that get you?
Not very high – 960 or so.
And do you remember what 960 is? That's the neckline, the heart of the neckline of the head and shoulders top pattern. So we have gone down enough to give us what I would consider to be the maximum potential for a bear secular trend corrective rally. You have to think of it in those terms. The big picture is that it's not all over. It's not going to be a brand new bull market, where you get the roaring '90s again. There are a lot of problems that aren't going to go away instantly. So you're only going to get a shift that corrects the primary bear trend. At least until proven otherwise – I'd love to see that neckline get violated; broken to the upside. That would change things quite dramatically.
But you're not holding out a lot of hope.
So far, everything has been precisely what one would expect, given my thesis that this is a long-term secular bear that will last probably through this decade.
Let's go back to square 1. What the heck is a squeezeometer?
Let me start with my investment philosophy, because that will trickle down into what I use – First of all, the effectiveness of a model is inversely related to the number of factors that are components of that model. The fewer factors you use, the more reliable the model becomes. This is the exact opposite of what most people think, but if you start with just one factor and then add another you now have 25 different possible outcomes-and it's possible to measure that accurately, if you have enough data. But if you add another factor, the potential outcomes go up to 300 or so. So my shtick on research is: "Find the one, two or maybe three factors that are the most effective." You had better be sure that what you are looking at is worth a damn and works because adding anything else not only wastes time but muddies up the process statistically. To my mind, the market is really governed by the laws of physics – stock market physics. Generally, when a majority has placed its bet, it is only a question of time before things start to happen that diverge from the expectations of that majority bet – and even if events go along with that bet, the money already has been placed. It is a supply and demand environment.
It is, after all, an auction market.
Exactly. So the trick is to make your big bets when you reach those juicy moments in time when the vast majority has gorged themselves on their expectations and the market starts to move the other way. So my main model is a two-factor model. It includes sentiment to measure what the majority is saying and price action to see whether moves are with or against that majority.
Sentiment can be measured at least a zillion ways.
True, but that's where short-selling comes in. Actual investment/trading commitments are more powerful measures of sentiment, to my way of thinking, than opinions. And short-selling is the quintessential sentiment indicator. It can be associated with specific stocks, industry groups, sectors, markets and index derivatives. Short sellers, because they must buy back the stock they've sold short to close their positions, represent future potential demand for a stock. And extremely heavy short selling is a sign of crowd bearishness. Conversely, we interpret times when short selling is light as periods when margin debt is most likely most extended – and so as a sign of crowd bullishness.
And that's what your "short rank" measures?
Yes, it tells you how intense the short selling is on a stock-specific basis. We look at the short selling of each equity issue on a weighted basis going back five years, if possible, then determine where the current amount of short selling ranks relative to each issue's history of short selling. So, a value of 100 percent indicates a new high in short selling, and 0 percent, a new low. Still, if I see too many bears, I don't automatically buy the stock. I wait until the market tells me that those bears are wrong.
What tells you when that tipping point is hit?
We wait until we actually see the price action confirmed by a variety of relative strength techniques. It essentially boils down to asking if the stock is relatively strong or relatively weak according to the way that I would read a chart. I measure that against how intense the short selling is to come up with one number we call our power rank-and that gives me my squeeze plays. Essentially, the higher the power rank, the stronger a stock relative's strength pattern is and the greater the short selling is, constituting a potential for a short squeeze. The implication, in other words, is that the short selling crowd is wrong. Often, when short sellers get caught in such a squeeze, the market moves against them until they capitulate-which we see as a decline in the stock's Erlanger short rank. On the other hand, the lower the power rank, the weaker a stock's relative price action is, and the scarcer its shorts (or, effectively, the more numerous the bulls)-meaning there's a potential for what I call a long squeeze.
Okay, if you concentrate on price action and sentiment, as reflected in short selling, why do I see a lot of options data on your web site?
That's another way of getting at my niche in the market. Short interest data is stock-specific. And there aren't a lot of other stock-specific ways to measure sentiment-except options trading. So I follow it, too. We use put/call ratios to measure the ebb and flow of bearish sentiment and call/put ratios to better see the bullish swings in sentiment. At extremes, they can be great setups for contrary trades.
Okay, so back to your squeezeometer-
Well, the concept of advancing and declining market phases is clearly at the core of our research. In both bull and bear phases there is a constant swing from an excess of bullish sentiment to an excess of bearish sentiment. And the market seems to wait for an excess to appear before shifting direction. Hence, each "phase" is a squeeze play. And these phases also tend to occur on short-term, intermediate-term, long-term and even mega-term bases-which we measure based on hourly, daily weekly and monthly data, respectively. The squeezeometer is simply a table designed to indicate which phase is underway for each of the four time periods-and further, by dividing each phase into four sections, to show where we are in that trend-at a turn in direction, early in its establishment, in the sweet spot, or on its last legs. So there are eight rows in every column-but only one cell is active in each one. An active cell is identified by colors and numbers. Mature trends are colored yellow, because conservative tactics are usually appropriate at such times. Other cells are colored either green or red.
And the numbers inside the active cells mean what?
They show the readings of our buy or sell confidence indexes-the buy confidence index in the four advance phase stages, and the sell confidence indexes in the declining ones. Typically, confidence is high as a move begins and then tapers off. Currently, for the mega trend, sell confidence is very high-because the short ratios are near multi-decade lows. As I said, despite what you hear on TV, there is relatively little short-selling in this market.
Which raises the question of just what all the hedge funds are using to hedge their positions?
Most of those hedge funds are not doing real hedging!
No kidding.
Hey, you would think that with this kind of action, the short interest ratios on the ETFs would be sky-high. They are not. We track them every month as the data comes out. There is a lot of stuff that doesn't add up right now, so it isn't easy.
That sounds like an old-fashioned textbook definition of a bear market again.
It is, of a secular bear market, like I said.
Yet haven't you heard? Bottom-calling is the new national pastime.
We have to get to a point where people hate stocks. Where you mention stocks to them and you walk away with a bloody nose. We are not at that point. There may be a lot of frustrated people and perhaps maybe even a certain level of disgust. But I don't see eight percent, 10 percent, 15 percent cash levels in Magellan-or any mutual fund.
Nope, I see bull market cash levels.
Exactly. They have essentially leveraged their equity exposure by meeting their redemptions with cash, instead of selling shares.
Your models have kept you pretty much on the profitable side of the market in a year that has been brutal to most investors-
It is painfully simple. I am not talking about some kind of wave theory that has so many different possible outcomes that a computer can't figure it out. Or some kind of black box that nobody can understand. The short selling stuff is just measuring the data. It is not more complicated than that. But you do have to do it the right way and get the historical stock-by-stock perspective, which is a lot of grunt work that most people are too lazy to do. Basically I am just trying to catch waves, trying to catch the opportunities when they arise. And the lowest risk, the easiest waves to catch occur at extremes. The July low, I pinned to the hour, just about. We went long. Because that was an extreme. I had 100 percent buy readings across the board and we saw the fear that we needed. But then that quickly reverted back to a whole bunch of optimism in August. Now here we are again. I would love to go bullish again but we have nowhere near enough fear this time.
You've talked a lot about the head and shoulders pattern in the S&P 500-
And when I mentioned it before it became activated by the break of the neckline, people were inclined to say, "bullshit. It's just technical."
Too simplistic to be believed.
Exactly. But I just said the pattern is developing. Then the pattern was validated. Then we bounced up and tested the neckline as resistance. We might do that again here. That is the only thing that could really screw me up somewhat-the next four to five months could just be spent getting back to the neckline and then we'd drop big next year. But if it happens that way, the big picture is very, very pernicious. Essentially anybody who has bought stocks since 1997 is a loser, as of last Monday. That is a hell of a tremendous overhead supply. Every mutual fund, every 401(k) guy, pretty much everybody has lost money and some have lost huge. Well, that tends to make it tough to automatically switch into an accumulation mode, especially if the mutual funds have used up all their cash. So I have had a nice scenario, especially from a seasonal standpoint where this month is a major low in the market. Which sets up for a nice bull phase next year. But I am starting to suspect we won't see it. If we had gone down to 740 or below, which is my target, then we could have a nice 30 percent rise back to the neckline next year-a nice bull market. But I would be surprised if we got above that neckline. And if we don't go that low between now and February, the upside to the neckline would be a pretty poor bull market and in fact wouldn't speak well for the large picture. Which would mean that my expectations for the next bull cycle become less hopeful.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
