Things used to be much simpler. In years past, the stock market was the best leading indicator for the U.S. Economy. If stocks went up, things were good, if stocks went down, things were bad. It's not so easy anymore. Now with a centrally "planned" banking system, good news is sometimes good news, bad news is sometimes good news and bad news is almost always good news. It's enough to get your head spinning. So, where do we turn to figure out what's really going in here in the U.S.? There are two main things I look at to see how/if we are working our way of the Great Recession. One is jobs and the second is Inventories. Inventories are a great indicator in that they paint a picture of both supply and demand. If inventories are rising that means there is either too much production or too little demand. If inventories are decreasing that means there is too little production or too much demand. We know that in our present situation production is not an issue. So, with yesterday's wholesale inventory number we learn that:
"Inventory growth stalled notably to just 0.1% MoM in December (missing the 0.2% rise expectations) from 0.8% growth in November to itslowest since May 2013. The other side of the spectrum was even worse with Wholesale Sales sliding a worse-than-expected 0.4% leaving theDecember inventories/sales ratio at 1.22 (up from 1.16 in December) to the worst level since Lehman."
The first part of this announcement can be seen as pretty good. Inventories grew less than expected so that must mean that goods are flying off the shelves! But when coupled with the sales component we see that the picture is as bleak as it was right before the Lehman Crisis. Is this something that I use to make broad assertions about the market? Not really. But I certainly file this away in my mind as a possible chink in the armor. Thinks are rarely black or white.
The major averages had a nice lift to the upside, as they have continued their push for the highs. With more action than the previous day, volume was still lighter than recent session. While the markets had a dip early on, we bounced and pushed for the highs of the session. Some stocks also broke out to the upside, led by AAPL making new all time highs. I am looking for a slight pullback today, but would not be surprised to see the markets float also. I think if we do press lower, it won't be by too much and we could be back to pushing for highs yet again this week. Looks as if the bulls are back in town everyone.
Risk is not in and of itself a bad thing. In fact, it is absolutely vital to trading. Without risk, there is no reward and thus no reason to ever make a trade. The important thing to identify is if you are being compensated commensurately for the risk you are taking. The way to determine this very important question involves two separate analyses, risk/reward ratio and expected value.
Risk/reward ratio is very straight forward. You take a given event, determine what the maximum amount of money you can make, determine the maximum amount you can lose and simply divide the two. That gives you your reward/risk ratio. What you do with this number is quite subjective. Is a risk ratio of 1.5:1 good? How about 5:1? That is nearly impossible to tell unless you put this reward/risk ratio in context. Enter the concept of expected value. Expected value is simply assigning a probability to a reward/risk ratio (or series of outcomes) to provide the necessary context to make a valid assessment of risk.
Let's take the very simple example of a game with a coin. Step right up! You pay me $1.00 to play, if heads comes up, you lose, I keep your dollar. If tails comes up, you win and I pay you $1.50! So, we can easily compute our reward to risk ratio. The most we can make is the $1.50 if tails comes up and the most we can lose is the price to play the game of $1.00 which yields a ratio of 1.50/1.00 or 1.5:1. Is this good? We can't know until we put the reward to risk ratio into context. We have two outcomes, heads or tails, each with an equal probability (50%). We employ the following equation:
Probability of Event "A" x Profit Effect of Event "A" + Probability of Event "B" x Profit Effect of Event "B"+ …
Event A = Heads
Event B = Tails
Using the above formula, we get: 0.50 x (-1.00) + 0.50 x (1.50) = -0.50 + 0.75 = 0.25.
Theoretically, anything with a positive expected value is a trade that you could make. You "expect" the outcome to be in your favor. The threshold for what is "enough" expected value is purely a personal one.
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