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Financial Literacy

Technical Tuesday: How to Avoid the Market’s Fake-out

When I played Little League baseball in the 1980s, one popular batting strategy was to “lay off” the first pitch.

The strategy was a fundamental tenet for some Hall of Famers and was said to increase batting averages.

This principle holds true when it comes to technical analysis, and I think the tenet applies to today’s market. I’m going to lay off the various “sell signals” we are seeing now or soon will.

Many technical indicators share the same rule: “Ignore the first sell signal in a new bull market.”

Why am I going out on a limb here and applying a rule that generally applies to a new bull market?

The key is to understand the true severity of the recent October sell-off.

While most people saw a sell-off in the S&P 500, down only 7.4%, internal market indicators showed much more severe damage. The type of damage we saw, in many respects, was akin to the market pullbacks in:

  • 2011 – The mini-crash as the U.S. credit rating was downgraded.
  • 2010 – The mid-year confluence of the “flash crash” and the BP oil spill, with the backdrop of the European sovereign bond crisis.
  • 2008 – The global credit crisis.
  • 2006 – Arguably unexplainable. Headlines called it fear of inflation, oil prices and interest rates, but to me it looked like institutions that saw the coming crisis dumped a ton of stock.
  • 2002/2003 – The bear market bottom after the dot-com bubble.

But damage is a good thing when it comes to the next leg up in a bull market, because the stock market is a place where, as long as the bull market stays intact, what doesn’t kill it makes it stronger. That’s why each of the above periods was followed by prolonged price moves higher.

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There are many types of stock market players, from conservative investors who would never sell a single share of stock to the traders who are in and out at the first sign of opportunity or trouble.

When a strong wave of selling and fear hits the market, those who are dating stocks and hoping for a one-night stand are quickly “washed out.” While they jump ship, investors who married their stocks are still in the game – many adding to their long-term positions.

With fewer scaredy-cats owning stocks, fewer traders are likely to sell at the first sign of trouble. That, in turn, means stock prices are more likely to have long uninterrupted moves higher.

So why do technicians tend to “take the first pitch” and ignore the first sell signal after a “washed out” market? Let’s take a look at history.

I circled the first Relative Strength Index (RSI) sell signal in the new bull market, after the 2002-2003 bear market bottom. (For a basic explanation of RSI sell signals, click here.) To paint a picture of why we ignore the first sell signal from most technical indicators, I must explain the market dynamics at a bottom.

At this point, the market was coming out of “washed out” territory. Convinced the stock market was far from bottoming out, individual investors capitulated, many cashing out of their 401(k)s and IRAs.

The large majority of speculators left were short sellers covering their positions.

Short sellers are people who sell first (hopefully at a high price), attempting to profit from downside moves by repurchasing the stock at a later date (hopefully at a lower price).

Many people think bullish heroes stepping in and buying the hell out of cheap stocks is what creates market bottoms. But in reality, investors just aren’t that brave. The buying pressure that creates that first bottom comes from short sellers buying back (“covering” or “closing out”) their short stock positions.

That’s why we see the ultra-sharp spike off an important low. It’s a function of short sellers covering their positions – some locking in profits and some limiting losses. But all are in panic mode as they know bottoms are formed three times faster than tops. Thus, the sharp spike created by short sellers is the final stage of an important bottom.

But because the nature of the trading dynamic causes such a sharp move higher, it sets up for conditions that appear to be “overbought” by many measures. This, in turn, easily causes technical indicators to trigger sell signals, like we see when the RSI moves from above to below 70 in the charts I’ve posted.

In 2006, internal indicators showed a larger number of stocks moving to sell signals than at any time since the 2002-2003 bear market bottom. This was a sign to ignore the first sell signal.

Because the speculators had been “washed out,” we then saw the biggest uninterrupted market advance in approximately 50 years.

Of course, after seeing the worst economy since the Great Depression, markets were washed out on a historically grand scale. After a short pause and many technical sell signals, prices moved much higher. Notice that after the strongest sell-off, this time there were two sell signals that were best to ignore.

Then we had the 2010 mid-year market sell-off. The S&P 500 moved about 150 points higher and, after a short pause and RSI sell signal, it moved another 150 points higher.

In a ferocious market panic, after the U.S. credit rating was downgraded, markets had been washed out again. The first sell signal was triggered when the S&P 500 was at a price level that would only be visited for two weeks later in the year, never to be seen again.

Finally, we have the October 2014 sell-off. While not seen in most major averages, severe damage was done, unless you managed to hold on. If you did, then you’re sitting in a stock market in good company. Investors like you remain while the weak have been shaken out.

The first RSI sell signal was triggered yesterday. Sell signals from other indicators will show up, but I say ignore them. Because you’ll never be able to hit that home run if you strike out early in the count.

Good investing,

Chris


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