The stock market held Friday’s big gains, all-be-it in lower volume. Lower volume will scare off a lot of investors because they think it shows lack of commitment by institutional buyers. But if people remember, we saw the same thing last fall and that lead to the phenomenal “light volume” rally. Like anything else in the stock market, the volume rule is only right about 1/2 the time.
The reason any stock market rule is only right 1/2 the time is because if it were more reliable than that, some savvy hedge fund manager would make an absolute killing arbitraging it. He would buy high-volume breakouts and short just as many low-volume ones. This means he is long just as much as he is short, so his net market exposure is zero. The market goes down he loses on his longs, but makes it back on his shorts. Same applies if the market goes up. In theory if his broad market exposure is zero, then his risk is zero. But where he makes his money is the performance difference between the high-volume breakouts and low-volume breakouts. If high volume breakouts really did perform better than low volume breakouts, then he would make lots of money with this strategy with very low risk. Now maybe it is just me, but trading breakouts with zero risk sounds too good to be true, and that’s because it is. Now don’t get me wrong, there are legitimate arbitrage opportunities in the market that have very little risk, but they are few and far between, and trading volume is not one of them.
That was a very long way of saying low-volume can be a warning sign some times and other times it can be encouraging. In today’s environment I actually find this low volume encouraging because indicates bearishness by big money. Their reluctance to buy at these levels is setting up a situation where money managers will yet again find themselves behind the curve if this market continues to rise. And just like last year, they will get panicked and start chasing the market higher if it doesn’t pullback like they are anticipating. Their pain becomes your gain.
Our most recent pullback did not come back to the lower channel line before rebounding, showing the bears losing even more control than they had in the previous failed attempts to push the market lower. The series of higher-lows and now the quicker reversal show the bulls clearly have the upper hand. Chances are this is indicating a move to a new character for the markets. I expect we’ll probably get away from this choppiness and that will make it easier to hold stocks without getting shaken out. We probably won’t see a powerful rally like we saw in Q1, but a gentle run up into the election will be nice.
The interesting thing to note is market is up over 10% for the year, not something you’d expect if you were simply reading headlines and sampling investor sentiment. As long as investors remain reluctant to buy this market, we’ll continue to have plenty of fuel to push this market higher.
Plan A: It should get easier to hold stocks for larger gains. Over the last few months the best trade was cashing in any gains as soon as you made them because they were likely to disappear within a few days. But this choppiness should be easing and holds of multiple weeks should be possible and profitable.
Many of the former leaders are struggling, so look for leadership in new names. Maybe those old names will come back a little further along in the rally, or maybe it is time for new leadership. Let the price action be your guide and buy what is hot, not what was hot.
Plan B: The market continues to be vulnerable to a major complication out of Europe since we are within 2% of a 52-week high. But don’t confuse major complication with the typical bickering and threats of doom-and-gloom that the market has grown immune to. Major complication would be something like a PIIGS nation actually refusing to service its debt. If something happens that is dramatically worse than what the market is expecting, that could crater prices in a hurry and we should be prepared to cut bait quickly. In a situation like that don’t be tempted to play that “lets see if stocks come back tomorrow” game.
Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.