Calculating Pot-Odds For This Market

I recently had the chance to play in my first Texas Hold’em poker tournament at which I made it to the final table.  One of the basic skills in playing decent Texas Hold’em is being able to calculate pot odds.  Essentially, this means figuring out how much money it will cost to play a hand, how much you can win and what your chances of winning are.  Even with a seemingly poor hand, sometimes it’s worth betting because the pot-odds are in your favor – that is, you can win a lot for just a little.  For instance, if you have a poor starting hand, like a low pair (2-2), you would generally throw the hand away against a large bet.  However, if there are a ton of people in the pot already and there’s now lots of money to win, it’s worth calling to see if you can hit a miracle hand.   

Right now, the market is giving off tons of mixed signals so I’m going to go about trying to calculate the pot odds for this market to see which way we should bet, in a similar vein to Dan Harrington in Harrington on Hold’em (an excellent set of books if you’re trying to learn Texas Hold’em). 

Long-term Technicals – Mixed

After the strong rally of the past week, the technicals have gone from looking horrible to looking good.  First, the breadth indicators all remain strong.  I won’t take up space listing the Summation Index and the number of stocks above the 50 day moving average but will instead point you to my online chart room, if you’re interested. 

Second, the NYSE held support which was a big positive.   It was the only major index which didn’t break its long term trend line and thus gives some hope to the bulls that this move higher isn’t over yet.

The Russell 2000 was able to recapture its rising trend channel, although it didn’t do it very decisively. If the index pulls back this week, it could indicate that price is simply retesting the bottom of the trendline before heading lower.

The NASDAQ has rallied nicely but remains below the rising trend line.  That could indicate that it’s also simply rallying to test the bottom of the rising trend channel.

In the longer term, the market rally has helped the charts out a lot.  However, this rally could simply be a rally back to test overhead resistance.

Short-term Technicals – Unfavorable

The short term indicators have all formed some big divergences.  This lends credence to the argument that last weeks rally was simply the result of options expiration week.  Specifically, the TICK index has been making lower highs vs the higher highs of the NYSE.

In addition, several other short term indicators are now overbought and ready to correct.  The five day moving average of advancing volume to total volume is now at the top of the range. 

In the short term, I would bet for a correction.

Sectors – Mixed

Since May, defensive sectors like the Utilities and Consumer Staples led the market.  That’s a recipe for failure because those sectors usually don’t have enough oomph to get the market going higher.  However, last week two sectors that can lead the market, Semiconductors and Biotech, rallied strongly.  It’s vital that these sectors remain leaders for the market to regain it’s legs. 

While many sectors look ok, one of the more important ones doesn’t look all that hot.  The Dow Jones Transportation Average just broke through its long term trend line.  It is now testing the underside of that break. 

Fundamentals – Unfavorable

The most unfavorable aspect of the current market is the negative fundamentals.  Earnings estimates seem to have topped out for most stocks and, especially, for many consumer-oriented stocks. 

In addition, the economy has definitely begun to slow rather dramatically.  Whether this is simply a "mid-cycle" slowdown or whether it will turn into something worse is yet hard to determine.  However, the ERCI leading indicators are falling fairly rapidly.  If they stay negative for another two months, I’ll have to assume that the slowdown will last for a while.

   

Sentiment – Favorable 

The sentiment is one segment which argues for a continued rally.  It remains very favorable as the majority of investors and traders are pessimistic.  The sentiment surveys show the total number of bulls remains at the low end of the recent range.  This low level of bulls has marked lows in the recent bull market.  However, if this instead a resumption of the prior bear market, the sentiment can get worse. 

In addition, the put call ratios have reversed from very negative levels.   That usually indicates that the pessimistic sentiment is "unwinding" and fueling the rally higher. 

Finally, the consumer sentiment surveys also indicate that the market could be bottoming.  Usually, the Michigan consumer sentiment survey moves in line with the stock market.  When the Michigan survey stays under 80, it’s usually a sign of a market bottom and when it moves over 100, it signals a market top.

Pot Odds

According to my analysis, the odds are neutral at best that this rally will continue.  A 50:50 bet isn’t that enticing to me so I’m going to remain in my current position – invested but hedged.  I’m guessing that the market will continue to chop around until September.