Next greater fool

By Jani Ziedins | End of Day Analysis

Nov 21
S&P500 daily at end of day

S&P500 daily at end of day

MARKET BEHAVIOR
Stocks recovered the bulk of the last three days of selling and finished a few points shy of 1,800.  Volume was higher than the three prior down-days, but below average as we approach next week’s holiday shortened week.

MARKET SENTIMENT
Dip buyers jumped in and reversed this week’s modest selloff.  If buyers continue supporting these levels in coming days, that invalidates the thesis we are running out of buyers.  Markets often roll over quickly and holding up here for a couple more days prevents us from seeing that quick move lower.  Often that means the next is higher.

Markets roll over for one of two reasons, bad news but also paradoxically, good news.  The first one speaks for itself and there is no reason to cover it here.  The other is running out of buyers when the bull market wins over last of the fearful and finally convinces everyone to buy.  It successfully defeats every objection these pessimists have and they rush in as the final piece of good news falls into place.  From then on, it doesn’t matter how bullish follow-on stories are, the market cannot go any higher because everyone already bought in.  (Obviously terms like “everyone” are hyperbole, but you get the idea.)

Since the current market doesn’t have fearful headlines obsess over and by rule it is impossible to predict the next unexpected catastrophe, we are left deciding how many buyers are left to keep buying the good news.  Over the near-term there are a finite number of traders ready to put their money into the market.  While there are gigantic mountains of cash stashed in bonds and money markets earning negative real rates of return, they’ve been there for the last five years and are unlikely to flood into the market tomorrow or next week.  No doubt this is a major fundamental catalyst that will fuel our secular bull, but for this near-term analysis we can ignore them.

Markets move up and markets move down, driven largely by the shifting outlook of short-term traders.  They buy when they feel good and they sell when they get nervous.  Institutional money managers and buy-and-hold investors skip these gyrations as they hold for 12-months or longer.  If we ignore the money hiding in bonds and don’t count the buy-and-hold crowd, we are left with this smaller and more active swing trading crowd.  These guys pushed us up to recent highs, but they don’t have the deep pockets to keep moving us higher.  Some claim we will see a chase for performance into year-end, but to be honest, the chase started 9-months ago and anyone still sitting on their hands this long is unlikely to make a move now.  So the question is, where are the next round of buyers coming from?  I have a hard time answering that question and is why I am reluctant to own this market in the near-term.

TRADING OPPORTUNITIES
Expected Outcome:
While the market can continue higher, there is not a big weight hanging over it and we lack that explosive catalyst to launch us higher.  On the other hand, we are over 60-points from the 50dma and 160-points from the 200dma.  Limited upside combined with lots of open air underneath us don’t setup a favorable risk/reward.  The market likely has a date with the 50dma and either we dip down to meet it, or we grind sideways until it comes to us.  Given that setup there is not a lot of reason to own risk here if we are not getting paid for it.

Alternate Outcome:
While we are not currently in a bubble, we could easily continue higher without pausing and put ourselves in one.  Only price pays and it makes no difference why this market goes higher.  Breaking to new highs could set off another round of short-squeezes and that upside momentum could continue convincing new investors to volunteer to be the next greater fool.  If they are giving away money, we might as well take it.

Trading Plan:
We trade when the odds are in our favor.  That typically means buying when we don’t want to buy and selling when we don’t want to sell.  It is a little too easy and comfortable to own this market, so it is probably a good time to take profits and wait for the next trade.  If a long insists, they could move a trailing stop up to 1,775 and see where this goes.  A short could take a stab at this with a stop above recent highs.

Plan your trade; trade your plan

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About the Author

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.

Sam Fawaz November 22, 2013

Very well said as usual. Relating to money from bonds, do we really think that shell-shocked bond holders selling at the lows are really going to jump in and buy stocks at their highs? I’ve never understood this, but perhaps there are some not so smart investors out there that would do this.

    Jani Ziedins November 25, 2013

    It is all about herd psychology. When the market’s gone up and people feel safe, especially when their friends are making money, is when the risk averse lose some of that reluctance and start buying. Of course the market is often the most risky when it feels the safest.

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