Stocks are on the hunt for all-time highs resting just a few points away. The market is up an impressive 14 out of the last 17-weeks, covering nearly 220 points since the November lows. It’s been a good run, but how much longer can this last?
16% in four-months is quite remarkable and holding for more is getting a tad greedy. Markets made bigger moves in the past, but those were during periods of emotional extremes, either crushing depths of despair or widespread euphoria infecting the general public. It’s hard to compare current market sentiment to either the 2009 lows or the internet bubble, so chances are this is a normal rally and will behave more traditionally. Can we continue 1, 2, 3, 0r 4%? Of course, but we are much closer to the end of this rally than the start.
The challenge is knowing when to hold ’em and when to fold ’em. Often traders fold ’em too quickly when rallies are just getting started because they are still in shock from the previous correction. Later in the rally they continue holding ’em too long because time and distance makes them forget about pullbacks. As contrarians, we go the other way. We continue holding when everyone doubts the sustainability of the rally and we jump out early when everyone is finally feeling comfortable.
So far the market has a decent left-shoulder and left-side of a head in a H&S pattern or alternately the second high in a double-top. It’s always easy to spot these patterns months after the fact, but it is far more useful to see these formations develop in real-time. There is no guarantee we are building either of these topping patterns, but there is enough to warrant caution.
Patterns are more than just lines on a chart, they show up time and time again because the consistency of human nature and herd psychology. Markets rarely breakdown on the first attempt because too many people are still on the lookout for the correction. They are skeptical and cynical, claiming the bounce has gone too-far, too-fast and are waiting for the previous selloff to continue. At this stage many traders are still on the sidelines and the aggressive outright short the market, but the first dip rebounds quickly because so many people are already out of the market that there are few left to sell the weakness. The selling quickly dries up on lack of supply. Do this a couple of times and the cynical convert into believers. But by the time most of the former cynics join the rally bandwagon, demand is drying up and we finally top on a lack of buying.
One of the easy rules of thumb I use is “make the hard trade”. Most of us are normal, well-adjusted human beings, whatever that means, but more importantly what we feel is similar to other traders. If we are reluctant to buy the market, many others feel the same way. This means few are in the market and there is a large pool of buyers watching from the outside. When we are reluctant to sell, it reveals others are also holding on for more gains. If most people feel comfortable with the market, they are already invested and supply of new buyers is running out. This isn’t perfect, but more often than not the right trade is the hard trade.
It is impossible to know exactly when a market will top, but we can get a sense of when one is more likely to top. Obviously every rally must come to an end at some point and usually it goes further and longer than most expect, but it also tops while everyone is still holding out for higher prices. Somewhere in-between these extremes is the tipping point. Are we there yet? It sure feels like it. No doubt we can continue for a few percent higher, but is another 20-points of upside worth 100-points of risk?
The market closed above 1560 Thursday and Friday. Two more closes above 1560 shows support and the next move is likely a continuation for at least a few more points. Failing to hold 1560 and things get more interesting. 1550 is the next level of support and no doubt a large number of stop-losses lie under this level, expect selling to pick up and challenge 1525/1530. A lot of traders will be buying the dip because that has been the easy trade for the last several months, but in the markets things work until they don’t. Is buying the dip obvious to everyone? If so, expect the rebound to fail and form the right shoulder.
Everyone who called for a pullback the last few months has been humbled by the market’s resilience. No doubt it could run me over too and that is why this is a good time to lock-in profits, but it is premature to sell short into strength. Markets love to shred top-pickers, so we shouldn’t play that game. But if the market starts showing cracks, jump on it with both hands and go for the kill.
As for a continuation, if the market dips to 1550, yet holds support, that is building a solid base to launch an assault on 1575 and possibly even 1600. I don’t have a crystal ball and if someone is looking for definitive answers, there are plenty of snake-oil salesmen that will tell them what they want to hear. But if someone is looking to trade more intelligently, I think we laid out a decent plan.
-Take worthwhile profits
-Look for support between 1550 and 1560 to signal a continuation
-Short a break of 1550 with a stop at 1555