Obvious correction or head fake?

Markets are lower, but seem to be finding a floor, preventing a wider cascade selloff.  Have we triggered enough automatic stop-losses to clear the deck and resume our rally?  Sticking with the trend remains the high probability trade, but the returning volatility is going to make for a bumpy ride.

S&P500 daily @ 3:05 EDT

MARKET BEHAVIOR

The selloff continues as we dipped to 1430 this morning.  It’s been a while without a material selloff and the ride was getting a bit too easy for the longs.  Everyone knows the market goes two-steps forward, one-step back, but each time the step-back happens, it catches everyone off guard and they panic.

Every rally must come to an end, and so will this one.  But the thing about trends is the high-probability trade is always sticking with the trend because it continues countless times, but reverses only once.  W could be at the start of this rally’s reversal, but that doesn’t change the higher probability that this rally will continue.  From a risk/reward perspective, I’ll gladly be wrong every once in a while if it means I can be right ‘countless’ times in-between.

And of course timeframe is everything when talking about the direction of the market.  What the market does in the next ten minutes could be different than what it does later today, this year, or the next ten years.  Bears could be right over the next two days, but bulls could be right over the next two weeks.  This is why it is so important to take profits when you are right because often if you wait too long, you end up becoming wrong.

MARKET SENTIMENT

Europe is crying wolf again and the market is spooked by the street riots.  As investors we have to ask ourselves if this unrest will affect the rate of economic recovery?  This isn’t the first protest and likely won’t be the last.  Ultimately this won’t have much impact, but the market is nervous and people by nature are 2.5x more risk adverse than greedy.  This is why the markets selloff at the first hint of risk.

The biggest headwind for US stocks right now is a strengthening dollar.  Since currencies are relative, a weakening euro translates directly to a strengthening dollar.  That doesn’t mean the dollar is in good shape, just that it is less bad than the euro right now.  How this affects the equities markets is through a strong inverse relationship between the USD and the US markets.  Just one of the many reasons explaining this correlation is a weak dollar boosts the stock prices of US companies with international exposure because it increases the relative value of their overseas sales and profits.  And of course the opposite applies when the dollar increases, like we are seeing right now with the unrest in Europe.

What will ultimately determine where this dip goes is if selling cascades, or if it climaxes and exhausts itself.  It all depends on the resolve of the larger group of holders.  Will the selloff persuade previously content longs that they need to bailout?  Or will the selling pressure from nervous holders, late buyers, and early shorts fail to trigger something bigger and the market will bounce after this smaller group is done selling?  It is impossible to gauge how contagious fear is in each situation, but under most instances cooler heads prevail and value buyers jump in when prices fall to attractive levels.

TRADING OPPORTUNITIES

The easy trade is coming to a close and making money is going to become more of a chore as the volatility returns.  There is lots of debate whether this is just a dip or the start of a correction, but the great thing about being a trader is we can cash in our profits and let the market figure this out while we watch other bulls and bears get turned into minced meat.  We don’t always need to be in the markets to make money, and in fact it is less stressful to capture profits by selling into strength and then waiting for the next great trading opportunity.

Some people want to hold big winners for their entire run, but that is no longer trading, it is investing.  And if you want to invest, then you need to be as thorough and disciplined as a Warren Buffet.  If you want to hold a stock through good times and bad, that is like getting married and you better know your stock as well as your spouse if you want to hold through each base and correction.  This includes reading annual reports, every article written about a company, talking with customers, suppliers, and anyone else who can give you an insight into the growth prospects of the company.  This is far easier to do with consumer product companies like CMG, AAPL, and NFLX.  If you are naturally an early adopter, look for the new companies and products you are most excited about.  Find the cult following and huge growth opportunity Wall Street doesn’t know about yet.  But remember, to hold through good times and bad, you are marrying the stock, so you better have a lot of conviction that a dip is just a dip and not something more.

Stay safe