Category Archives for "Free Content"

Testing Support

By Jani Ziedins | Intraday Analysis

S&P500 5-minute chart

The indexes are down just over a percent this morning in reaction to Friday’s jobs numbers.  This drops us down to previous support/resistance levels and slightly above the 50dma.  So far the sell-off has been fairly orderly and the indexes are trading in a tight range.  This is fairly constructive as the sell-off didn’t trigger a snowball of additional sell orders.  Volume is again fairly light, exhibiting a lack of concern by most security holders.

S&P500 daily chart

Technical and psychological support at these levels was inevitable.  Over the last 3-months, selling into any weakness has been a mistake and the best money was made from buying these dips.  And that is exactly what it appears people are doing as we find support at these levels and a cascading sell-off has been avoided to this point.

But the lack of fear in the markets and traders resolve to hold their securities and not get shaken out is what makes me cautious.  The best example of this is AAPL.  Again AAPL seems to be the hideout of choice for traders who want to weather the storm as AAPL is up on a big down day in the markets.  AAPL was a safe haven during last summer’s sell-off and it seems to be filling the same role this time around.

GLD daily

But in a lot of ways AAPL is reminding me of gold last year.  Gold bugs were saying  gold is good for inflation, deflation, slow economy, and hot economy.  Gold was the be-all, end-all, cure-all for anything that ailed your portfolio.  And this year, AAPL seems to be that same elixir.  Up-market?  Buy AAPL.  Down-market?  Buy AAPL.  Strong economy?  Buy AAPL.  Weak economy?  Buy AAPL.

AAPL daily

Since everyone is so bullish on AAPL, the real question is under what conditions should we sell AAPL?  When no one can answer that question is when you need to get nervous.  Right now the biggest liability I see for AAPL is the relative ease of buying a new iPad since its launch.  Did AAPL ramp up pre-launch production to avoid shortages and back-orders we’ve seen in the past?  Or was the demand for the new iPad less than what we’ve seen in the past and that explains the availability?  (Most likely a combination of those two factors.)

But as with gold last year, it was a great trade as long as you knew when it was time to get off.  No doubt AAPL can and will continue to ride higher, but remember what WON says, “All stocks are bad, unless they go up.”  Don’t fall in love with Apple and remember it is just a trade.  As always keep a lookout for a good time to lock in profits on a winning trade.

Bad Friday

By Jani Ziedins | Intraday Analysis

We’re somewhat lucky the markets are closed today with the monthly employment number coming in far under expectations.  The consensus estimate was for 210k new jobs, the actual number was just 120k.  No doubt that would have exacerbated the weakness we’ve already seen in the markets and most likely pushed us down to the lower end of the trading range and challenged support.  The one upshot for the market is this jobs report is so bad it could be good if it makes further quantitative easing by the Fed more likely.  It will be interesting to see how the market responds on Monday.

2011: Major market bottom or continuation of ’09 bull? rally

By Jani Ziedins | Intraday Analysis

Here are my thoughts on where we are in regard to the bull market cycle.  Remember, this and $3 will get you a cup of coffee.

Looking at a weekly chart dating back to 2009, visually it appears the most recent follow-through rally is simply a continuation of the 2009 bull market and not the start of a new bull.

1. We didn’t undercut the 2010 summer doldrums in 2011, so by that measure we didn’t reset the rally clock back to zero.
2. Given how powerful the 100%+ rally since the March ’09 bottom has been, a 20% decline in 2011 is kind of smallish given the scale of the rest of the move.
3. And lastly, the 2011 sell-off was a panic-driven, single-leg down that lasted just a couple weeks before finding a bottom.  In comparison, most major market bottoms are a reversal after prolonged declines comprised of multiple legs down.  In that context, it seems the recent rally is nothing more than a rebound from the panic induced selling last summer that turned out unjustified.

Using this context, if we were labeling things, we might call the Summer of 2011 an abrupt correction and not a full-on bear market.  It also appears to be a continuation pattern for the 2009 Bull.  But semantics are semantics and hopefully we don’t care nearly as much about labels as we do about anticipating future price action.

Now this is moving into soft science along the lines of reading tealeaves, but it looks like we could be in the 5th wave of an Elliott Wave.  (You can find good  information on Elliot Waves on Wikipedia.)

Why this is important is if we really are in wave five, that potentially means the next wave will be the start of the three-wave counter trend.  Paraphrasing W. O’Niel, if we get the direction of the market wrong, then most everything else we do will be wrong too.

Elliott Wave Theory is built on human psychology and shows up time and time again, but it is hard to use for timing trades because placing wave lines in real time is highly subjective.  In reality, it is a big picture tool to use occasionally to put market moves in perspective and it is most useful for reinforcing other ideas you are seeing.

Here is a second chart of the last few years with intermediate waves drawn on the chart showing the a smaller Elliott Wave pattern within each of the primary waves.  These patterns show up all the time, but the thing to be careful of is our natural tendencies to see patterns even when none exist.  But the intermediate waves seem to fit Elliot Wave Theory like a glove with their 5 waves up and 3 waves down.

Based on other signals in the market and economy, I don’t see a material corrective trend in our near future and this wave 5 still has a bit more room to run.  Maybe next year if economic growth pauses, that will provide the catalyst for a corrective trend.  But the two important things I do see happening due to the age of the bull is the rate of gains made in the markets will start to taper off as the bull gets older. And as part of this, we might see less correlation among stocks, making this the first time in years where stock picking has been important.  Over the past 4 years, you could have made a bunch of money (or lost a bunch of money) simply by owning any random stock.  Now we are getting to a place where simply holding random stocks will not give you the same bang for the buck and quality will start mattering again.  (recent gains in AAPL and other leaders are impressive, but pale in comparison to the 100% moves seen in broken names like SHLD, BAC and NFLX)

We just can’t keep up the pace of broad market gains we saw in 2009 and 2010.  After we reach a higher level of complacency, I expect we’ll see the corrective trend.  But this will still be part of a larger decade long secular bull market we started back in 2009, so view most pullbacks as buying opportunities.  And if you have a buy-and-hold portfolio, have the courage to hold through the dips.

Market showing weakness

By Jani Ziedins | Intraday Analysis

The indexes opened lower and have since retreated further on reports the Fed is less likely to pump more money into the system via QE3.  This strengthened the dollar and sent the US markets down. But that is just what the financial press is reporting.  The news is random, but the market’s reaction to it is not.  So it is somewhat telling that the market declines when the Fed say the economy is strong enough not to need another dose of quantitative easing.  In many ways that is far more bullish than an economy that requires additional intervention.  But the side effect of a less accommodating policy by the Fed is a stronger dollar, which recently has been inversely correlated to the US markets.  Anyway, headlines are headlines and price action is price action.  We make or lose money based upon price action, so that is what we need to watch.

While we are lower, we are still well within the consolidation range of ~1385 to ~1420 going back to early March, so directionally today’s price action is inconclusive and we are still waiting for a definitive signal one way or the other.  On the lower side we have a potential region of support at 1387, 1378, and 1370 from the recent the Mar 23 low, Feb 29 high, and 50dma.  Chances are we will fall closer to that region before the buy-the-dip folks come back in to support the market.  Then the real challenge will be seeing who has a larger following, the sellers or the buy-the-dip crowd.

So far buying the dip has been the smart move and I have no doubt we’ll see traders try it again.  But every with sell-off bounce, the probability the next one will bounce declines, if for no other reason than we are one bounce closer to the one that doesn’t bounce.  But either way I expect the market will throw a head fake at us with a breakout above or below the range before switching directions.  If the path is lower, then Monday’s new high was the head fake.  But if the trend is higher, we’ll probably see a head fake lower before heading higher, most likely by dropping through the 50dma before bouncing.

And the longer we can stay in this sideways range, the more supportive and bullish it becomes.  With major news events around the corner with the employment numbers this Friday and earnings starting soon, there are catalysts for launching the next move.  At the moment it feels like the market is a little extended due to the long run and without any external inputs, we’d probably drift lower.  But there are still enough skeptics sitting out this bull rally and they could push prices dramatically higher if the economy produces shockingly good employment numbers or companies continue to post record earnings.

As for how to trade this, there is nothing wrong with locking in some of the great profits from the first quarter.  Remember, it is much better to be out of the market wishing you were in, than in the market wishing you were out.  But with a couple key catalysts on the horizon, we could see another strong move higher if investors are caught flat footed again and have to start chasing this quarter too.

Stay safe.

New closing high

By Jani Ziedins | Intraday Analysis

The SPX made a new multi-year closing high Monday, recovering all of last week’s sell-off.  As encouraging as the price action was, the low volume is hinting at a lack of conviction among market participants. But, as we’ve seen over the last six-months, the market can rally substantially in the face of lackluster volume.

While Monday was not a definitive buy signal, it does indicate it is time to watch closely for convincing price action indicating there is substance to this rally and time to move back into the market.  Part of the goal of selling early is to move on and look for the next opportunity.  If that opportunity presents itself this week, then we need to jump back in when the original bear thesis is violated. In the market, it is okay to be wrong, but it is suicidal to stay wrong.

A close higher in strong volume Tuesday would send a strong bullish sign.  But on the other hand, lackluster volume and price action could signal the current bounce is running out of steam.  My inclination is to believe the last couple days have been a bounce preceding a move lower, and the buy-the-dip crowd is about to run out of gas, but I am not stuck on this position and will be ready to get long when the bulls show they have control.  But if we do move higher, I will still be cautious because we are on thin ice with such a long move behind us and a relatively high distribution count.

As always, stay safe and remember there will always be future profit opportunities, so don’t force a bad trade.

Chasing stocks

By Jani Ziedins | Intraday Analysis

The following describes how to buy extended stocks while staying within most of the key risk parameters set out by WON and CAN SLIM. I’m not recommending this, especially at this time, but I want share how to do it properly if a person cannot resist chasing a stock they missed.

An 8% stop-loss is a very unique tool that only applies at one specific place, a valid buy-point. Applying an 8% stop-loss any other time is overly restrictive and will inevitably lead to getting shaken out during normal and healthy stock movements. So if we must buy an extended stock, we need to adjust the 8% rule to accommodate the level we bought at to prevent an unnecessary shakeout. But at the same time, we also need to manage our risk and not expose ourselves to more losses than we would have had if we bought at the proper buy point.

The reason the 8% stop-loss works is because most successful breakouts will not retreat more than 4% below their proper buy-point. So with a hypothetical $100 pivot, almost all leading stocks will not dip below $96 dollars. And if you bought within the 5% buy region, or up to $105, you will be able to withstand a pullback to 4% under the pivot.

But if you instead buy 10% past the pivot, the 8% stop-loss is far more likely to get you shaken out during an ordinary pullback and you would be forced to sell at $102, far above the $96 level identified by WON and CAN SLIM as the intended shakeout protection and stop-loss level.

So if we want to use the same $96 level for a stop-loss on our $110 purchase, we now need to use a 14% stop-loss to have the same level of shakeout protection.

Since our adjusted stop-loss is nearly 2x as large as the standard stop-loss, we will then adjust our exposure by cutting our position size in half. Of course our upside is not nearly as great with half a position, but it does let us get in a stock we missed without affecting the risk of getting shaken out or increasing the potential loss to our portfolio.

If things work well in the stock, then you increase to a full position at a more traditional add-on point.

Always try to buy at traditional buy-points, but if you must chase, make sure to adjust your stop-loss and position size in order to maintain the same risk profile as laid out in CAN SLIM.

I hope this helps.

Is the sell-off real, or another headfake?

By Jani Ziedins | Intraday Analysis

The market rebounded nicely and recovered almost all of its losses from earlier in the day.  Many leading stocks also showed similar resilience and refrained from turning into a cascade of panicked selling.  In fact, much of this recent pullback has been far more controlled and orderly than anything we have seen in quite a while.

So now we need to figure  out what this means and how it affects where we are headed.  Is this stability a bullish sign that people are not rushing for the exits and supporting the market?  Or does it further reinforce the complacency argument and shows people are no longer afraid of a pullback?

By itself, this could go either way since on the surface it seems as bullish as it is bearish.  But when we start bringing in other factors, such as 14-weeks above the 50dma and the best first quarter in fourteen-years, it really starts to look like we have come a long way and the market often rests after such moves.  Also, the start of a new quarter often ushers in a new mindset among professional money managers who spent all of last quarter chasing a runaway market.  The aforementioned factors seem to tip the balance in favor of the bear camp, and if this is the case, any strength should be used as a selling opportunity.

Getting back to the prior discussion of nervous selling versus real selling, does the recent sell-off feel like nervous selling?  And if it isn’t nervous selling, then by default doesn’t that make it real selling?  And real selling is what we need to be most wary of.

And as always, I reserve the right to be 100% wrong on this.  The stock market is far from an exact science and anyone who claims to have a crystal ball is both a liar and a fool.  The market is largely random noise and it could go either way on any given day.  But by trying to understand the inner workings of the market and what drives its participants, the more it pushes the odds in your favor.  Any individual market call is largely luck, but the better you understand the market, the luckier you’ll tend to be.

Stay safe.

Follow up

By Jani Ziedins | Intraday Analysis

An important follow up on yesterday’s post, when I said “now is not the time to rush for the exits”, I’m not telling people to continue holding. If your plan calls for selling, then you need to sell. But what I was trying to convey is don’t rush into an emotional decision regarding your positions that contradicts your plan. Continue following the plan you set out for yourself.

As for a bounce, there is no grantee this next bounce will make a new high, so don’t hold out for that. And if you do sell, keep a close eye on the markets and watch how your favorite stocks hold up. Chances are the next sell-off will only last several weeks before finding support. That is the point when you want to start buying back into leading names showing the greatest potential.

And of course this recent price action doesn’t guarantee a larger sell-off. (there are no guarantees in the market) We’ve bounced many times before, so this could very well be another one of those times. If you sell, keep an eye out for strength and be ready to buy back in if the market holds up. But if this is the case, continue to stay on high alert because each successive bounce brings us closer to the one that doesn’t resume higher.

Rough morning

By Jani Ziedins | Intraday Analysis

S&P500 showing a very modest selloff.

The indexes opened the flat, but slid modestly as the day went along, losing about 1% by the afternoon.  But many of the leading, high-beta, small-cap names are faring far worse and seeing losses many times that.  This is far from the first time we’ve seen this phenomena recently, but we always managed to bounce back after those previous sell-offs.  So the question hanging in the air is this also going to bounce right back or is this the start of something more?

As I shared in my March 13th post, early in a move, sell-offs are more likely to be head fakes driven by nervous holders and premature bears, but the further along we get into this, the dynamic shifts as we have fewer nervous holders running for the exits and a greater portion of the sell-off is driven by real selling.

There is no reason to expect we won’t see a  bounce this time too, but like with a rubber ball, each bounce is often weaker than the one before it.  This is because we are shifting form nervous selling to real selling.  Nervous selling bounces like an elastic anti-gravity ball, real selling bounces like a brick. No doubt we’ll see what is left of the buy the dip crowd come in and support these discounted prices, but with every dip, that group grows smaller and weaker and the probability of a greater decline increases.  If we do bounce again, that might be a good opportunity to look at locking in some profits and waiting for the next good trading opportunity.  Remember, this is about balancing risk and reward.  Having come this far, the additional upside is more limited as compared to the air beneath us.    But this only applies to the traders out there.  Any home run hitters need to fasten their seat belt and mentally prepare themselves for some near term declines.

From a personal sense of well being, the trader who sold out when the getting was good and left some profits on the table is in a much more comfortable position as he is looking at the market for new buying opportunities.  Contrast this with the defensive trader who is nervously trying to decide if he should hold or sell.  Trading the markets is a head game and often the offensive trader has a psychological edge on the defensive trader in situations like these.  And perhaps this is why most of the great traders in history all claim they sell too early instead of waiting for the sell-off.

But this really gets back to the trading strategy that best fits a person’s personality, trading style, and understanding of the markets.  Each of us as an individual needs to decide what works best for us and then stick to that.  I’m sharing these ideas to show there are alternative ways to approaching the markets and I hope it is providing some incremental value to people.

And one last point, now is not the time for people to rush for the exits.  If you plan was to hold through a pullback, then stick to your plan.  There are two ways to do really well at this, the first is selling into strength, the second is finding great stocks and hold the dips.  The one that gets most inexperienced traders in trouble is holding through strength and then selling the dips.

Stay safe.

Near a turning point or ready to march higher?

By Jani Ziedins | Intraday Analysis

For the last few months we had countless pundits call for a pullback in the markets, yet the indices have continued to head higher in the face of this cynicism.  As I have pointed out earlier, it is this very cynicism that provided the fuel for a sustained move higher.  But that was then and this is now, so where do we stand today?

All good things come to an end and our current rally will be no exception, so the question is if the markets are ready to rest and refresh after one of the strongest first quarters in more than a decade?

I don’t have any quantitative data to back this up, but it sure feels like far fewer talking heads are claiming we are on the verge of a pullback.  The strong surge higher has humbled anyone who tried to stand in its way and the cynics are giving up after taking more than their fair share of lumps.  And for the individual investors, it seems like the small sample of other traders I’ve talked with are very excited about their portfolio and think selling and locking in profits at these levels is crazy because there is more upside left in this move.  Both of these are highly subjective measures, but it does hint that market participants are getting as bullish as they have been in a long time.

5-year chart of the CBOE Volatility Index

One way we can quantify this complacency is by the unusually low VIX, resting near 5-year lows.  The interesting thing from the chart is every time we got this low in the last 5-years, something happened to push the VIX much higher.  But countering this, we did see VIX levels far lower than this during the 2004-2007 bull market.  So like every other indicator in the markets, this one can go either way.   This might be the calm before the storm as it has been over the last several years, or it could be the start of a new market phase of low volatility and an appreciating market.  And of course this doesn’t have to be an either/or proposition.  We could very well see a bump in the VIX in the short term and then have it settle back down at these or lower levels once the anxiety passes.

But back to the complacency, how this affects the markets is all these bulls are already fully invested and are nothing more than spectators at this point.  From here it will take new money to continue pushing the markets higher.  So far a lot of that has come from former skeptics who changed their mind and started chasing the market.  But at some point we are going to run out of chasers and that is most likely when the upside move will peter out.

No doubt bad news could send us lower, but it feels like the market is no longer obsessing over headlines, so it will take something else to bring the market down and we stand a good chance of turning down on good news simply because we ran out of new buyers to push prices any higher.

There does seem to be a lot of money watching this rally from the outside, namely in the bond market, and that could easily push equities higher, but I think this is a longer term story.  Anyone still hiding out in bonds will need a bigger kick in the pants to move.  We might be seeing the start of this as bonds have been falling and stocks have been rising.  But, no doubt there is a lot more to come.

It is impossible to give a definitive answer about the timing of our next pullback, but the end of the quarter might just be that catalyst.  Currently many money managers are behind this rally and that has forced them to chase all the way into quarter’s end.  But with a new quarter, they will have more breathing room and that will allow them to shift strategy from chasing to something else.  What that something else will be is anyone’s guess, but it will probably involve more selling than we have seen so far.

Anyway, these are just my guesses on what other market participants are thinking and what that means for the market.  As always, only trade what you feel comfortable with.

Missed profits

By Jani Ziedins | Intraday Analysis

Nice open in the markets.  Pushing to new highs.  No doubt I wish I could have held for these extra gains and it just shows just how “disillusion” I was for selling early.  But, this makes for a great example highlighting the downside associated with selling on the way up.  No one can sell consistently at the top, so either you sell early or you sell late.  And depending on your trading strategy, you have to be okay with that otherwise the second guessing and regret will drive you crazy.  I like being proactive with the market because it makes me feel more in control and it lets me trade the market on my terms, rather than a more defensive approach where I get pushed around by the market’s twists and turns.

And this gets to a money management aspect of trading.  I’ve always found it fairly easy to pick winning stocks.  But in my experience the harder part is keeping those gains.  I’ve had more round trips than I care to remember, so that is why I try to be more proactive in harvesting profits.  But that is my approach to the markets.  Other people are swinging for the fence and they plan on holding for 12, 18, 24 months.  Both styles can be highly successful, so it really comes down to a trader’s personality and aptitude for determining which style suits them best.  For me, I know another winning trade is always just around the corner, so that is why I worry less about squeezing out all the profit from each trade and am more concerned about capturing and keeping profits when I am right.

No doubt people disagree with me and that is great.  This is what makes markets.  Without a diverse set of opinions, the markets wouldn’t work.  The more views there are, the more efficient the market is.

And this is also a great time to point out that a person also needs to follow their own plan and not trade blindly based upon what someone else is doing.

As for the market’s price action, this bounce is further placating nervous holders, showing them again that the best course of action is to hold through the dips.  But remember, if most of the nervous holders are not rushing for the exits the next time we sell off, then the selling we will be seeing is real selling.  When other people start getting complacent is when you need to become more alert.  In the markets it is often more profitable to be the fool standing out by yourself than it is to run with the pack.

Low volume; good, bad, or indifferent?

By Jani Ziedins | Intraday Analysis

I find the low volume declines over the last few days interesting. It potentially shows traders are no longer worried about a pullback and are sitting with their positions even in the face of a modest slide. Compare this with the March 6th slide that turned into a self-induced cascade due to heightened fears of a pullback.

Conventional wisdom says this calm during a sell-off is bullish. But a contrarian would suggest this newly found complacency toward a pullback is the exact ingredient necessary for a pullback.

In full disclosure, I closed out my positions today and was content with the profit I made. No doubt the market will head higher over the next few days, but personally I thought today was a good time to cash in and wait for the next buying opportunity. I can’t make all the money and it is a fools game to try.

I had some reservations about selling because it seems like highly rated stocks were holding up well while the index sank today. This shows strength and support for these names and no doubt I’ll probably buy some of them back higher. But I’m okay with that. I prefer selling into strength and that is just how it goes.

What I did makes sense for me and my trading style. Everyone needs to make their own plan and then follow it.

How about that AAPL

By Jani Ziedins | Intraday Analysis

The indexes traded in a very tight range around yesterday’s close and some will claim this shows support at this price level.  But in reality there were just as many willing sellers as willing buyers, so it is a wash from a directional standpoint and it would be more accurate to declare  today a draw.  Where we go from here largely depends on who has a bigger war chest, the bears or the bulls.

Of course the above analysis assumes we just consider buyers and sellers.  But maybe we can get a little more insight if we also include short-sellers.  Given yesterday was the largest index gain of the year and all sorts of professionals made the case this was a blow-off top, no doubt we had quite a few bears aggressively selling into this strengths.  In this regard, the buyers at least matched the best the bears could throw at them, which is moderately bullish.   And now all these new shorts are ready buyers if we move any higher and they get blow out of their positions in a short-squeeze.  Often the surge that makes the head of a head-and-shoulders is a fast upside move propelled by premature bears covering their shorts.  With the new short-sellers taken into consideration, the path of least resistance is probably still up for the moment.

Weekly log chart showing two different trend lines.

And how about that AAPL?  What a monster run!  Without a doubt this stock has changed its character from steady chugger to race car.  No matter what time-frame you chose and how you draw your trend lines, today’s price action has broken above them.  Even the slope of the 50-day moving average is the steepest it has been since the depths of the 2009 bear market bottom.

Does this mean AAPL will finally get the respect it deserves and can finally shake the pathetically low 12 P/E its been hanging on to?  This is one of the fastest growing, most profitable, and exciting companies in the entire world and it is trading at a valuation comparable to a boring dividend stock with no growth prospects.  Or alternately is this stock surging in a climax-top and today’s gap-up is the last gasps of this run?

A person could make a lot of money if they got this one right.  As a non-owner, I have been pretty vocal that owners of AAPL should lock in profits back at $525 and without a doubt I was wrong on that call.  Maybe I am early, but in the markets where timing is everything, early is the same thing as wrong.

Daily chart showing both a longer-term trend line and a shorter-term trend line since the recent breakout.

So do I continue to be wrong, or do I change sides on this trade and jump on bard this run?  As a trade, I just can’t do it.  This one clearly passed me by and I hope it keeps going up for all those who are still holding it, but the look of that chart just scares me.

Of course AAPL is more than just a single stock story.  AAPL represents more than 10% of the NASDAQ index and whichever way AAPL goes from here, it will also drag the market with it.  AAPL’s strength has almost single-handedly pulled the NASDAQ way ahead of the S&P500 since the beginning of the year.  And no doubt this is a double edged sword as a declining AAPL would also have the same outsized effect.

I wish I had a better answer for people than that.  But so far I have been wrong on this name and will probably continue for a few more days or weeks while AAPL continues its surge before finding a good level to base at.  But I do know that in the markets nothing goes up forever.  So keep an eye on this stock and if you own it, tighten up your stops and get ready to lock in those outstanding profits.  And if you end up selling too early, don’t fret, it is a fool’s game to try and top-tick the market.

Psychology of a Top

By Jani Ziedins | Intraday Analysis

Nice day in the markets, making new highs on both SPX and Nasdaq.  All is right in the world…..or is it?

For this discussion, I’ll define “real selling” as deliberate and rational selling done by large institutions.  And at the same time lets define “panic selling” as retail investors** who are easily spooked and allow their emotions to get the best of them.

Last week’s sell-off seemed almost entirely “panic selling” and that is evident by how quickly the market recovered.  But while short lived, this quick drop did a good job of humiliating nervous holders and almost all of them are kicking themselves this week for their momentary weakness of “panic selling”.  And on the other side, indecisive retail holders that didn’t sell were rewarded for sitting still.

But more important for our analysis is both of these groups had the idea reinforced that it is smarter to hold than it is to sell.  And this learned lesson will make it less likely we’ll have these same weak holders running for the exits next time.

What this really means for the next sell-off is there will be fewer “panicked sellers” and a greater proportion of the sell-off will be driven by “real selling”.  This is because the nervous traders “learned their lesson” last time and will not allow themselves to be part of the “panic selling” crowd this time.  Now this doesn’t mean the next drop will be the real thing, but it will have a higher probability of being the real thing simply because more of the selling will be “real selling”.  When a large number of the previously “panicked sellers” are patiently sitting on their hands, then more of the actual selling we see in the market will by default have to be “real selling”.

Now I’m going to start making up numbers purely for illustrative purposes so don’t quote me on this, but lets assume last week’s sell-off was 25% “real” and 75% “panic”.  Since there was no legitimate basis for the vast majority of selling, we rebounded in a matter of days.  But the next time we sell off, there will be fewer “panic sellers” because these people learned their lesson about selling into weakness on the first pullback.  So in this regard, the next sell-off will have a higher proportion of “real selling”.  So maybe it will be 50% real and 50% panic.

Because there is more “real selling” in this next sell-off, that dip will be a bit larger in size and duration than the one we just experienced.  But the buy-the-dip crowd will rush in and support the market because buying the dips has paid off really well recently.  You might even have some of the former “nervous sellers” buying the dip because they learned their lesson last time and want to profit this time.  And form this boundless optimism we find support and recover.

The steeper decline due to more “real selling” means we have further to go to make new highs, but now that we are 2-for-2 on bounces, almost no one is afraid of another slide because they “always” bounce.  And with this complacent attitude spreading, the next time stocks start to slide we will see very little “panic selling”.  But without any material “panic selling” this time around,  that means virtually all of the selling causing the dip is “real selling”!!!  Using my made up guesstimate, maybe 25% “panic selling” and 75% “real selling”.  And when most of the selling is “real selling”, it is finally the time to be nervous!

For those following along with a mental picture, they already know I just described the classic head-and-shoulders top.  Is this where we are headed?  I have no idea, but so far we are following the exact game plan necessary to form a head and shoulders, so it remains a real possibility and is something we need to be aware of.

One important note, this will be a smallish H&S, so the resulting correction will also be smallish.  This is because the only people who will actually see this price action are the obsessive types who follow the market daily.  And since this is a smaller portion of the people who are invested in the market, the downward swing also won’t be very large.  For a larger correction, we need to move beyond the daily-watchers and have sensational headlines drag in people who normally ignore their portfolio.  For example fear of European Financial Contagion did that last summer and we had people moving their entire 401k to cash.

As I stated in previous comments, this H&S is simply the way we are going to kick off the trading range we need to enter in order to digest these large gains since the start of the year.  Remember two steps forward, one back.

**For this argument I made retail investors out to be the stereotypical patsy, but the truth is professional investors are no more savvy and were also selling by the bucket load last week.  Anyone who puts professional money managers up on a pedestal will have a hard time explaining why the majority of them always manage to under perform the indexes.