Tuesday, January 28, 2014

Concise Trade Plan updated




The Trading Plan (revised and condensed)

3 signal strategy

Each signal accounts for 1/3 of the total position size
We enter each portion as each signal triggers individually 

Entering Position:
1. Price above rising 20 WMA, on a weekly closing basis (1/3 position)
2. RS trend breakout (1/3 position)
3. Active Pattern (1/3 position)

Exiting Positions
A position is exited in 1/3 increments as signals invalidate or achieve price targets
So when the 20 WMA fails, we exit 1/3 of the position. When the RS trend fails, we exit another 1/3. Also if the pattern invalidates you would sell that 1/3 position also.

-Profit Taking Opportunities
The other circumstance when to sell is based on profit targets of the pattern in play and/or a +13% extension above the 20 WMA. We would then sell that signal’s 1/3 position and continue with the remainder of the holding.
If you sell 1/3 on the 13% extension you then buy back the 1/3 position on a pullback to the 20 WMA.  

When new patterns setup, you can enter and trade the new pattern as a new signal.

Figure out how many holdings you can reasonably hold when they are all in full 3/3 positions based on your account capital. I like around 7 full holdings potential. You would divide your account balance by 7 and that will give you the full size for each position if all 3 signals triggered together. Then divide that full position size by 3 and that gives you your 1/3 position size for entry and exits. We then manage each position based on those position sizes and adjust as signals trigger/fail.

**I am trying to set up a rather automatic trading system that reduces risk, allows us to be positioned based on the current strength of the stock, not just based on one arbitrary stop level. This allows us flexibility to stay with positions that may be signaling indecision (say the 20 WMA is failing, but the RS is still holding with a pattern target above), we wouldn’t need to exit the entire holding, we would simply adjust our allocation to the actual strength in the holding at that particular time; in this particular case we would hold a 2/3 position (-1/3 for failing 20 WMA, but +1/3 for RS trend and +1/3 for the pattern).
I believe this will allow us to be shaken out less, have more flexibility when we buy and how much, and also provide an absolute signal for entry and exit. There will be no wishy-washy exits like, “well the RS is failing, but the 20 WMA is holding…what do we do? Sell the entire position? No. in that case we would just hold portion for the 20 WMA and sell the portion for the RS trend. Simple, takes risk changes into consideration without getting too antsy about when and how much to exit, and makes it so any one signal isn’t the end of the position. We simply flow from strong to weak as signals trigger and invalidate.  

Monday, January 27, 2014

When Things Are Complex Keep It Simple



Over the past year we have been following the markets together, and I will say I have been pleased with the results. While last year was spent getting everyone up to speed on managing their money and learning common market theory, we have built a nice foundation and it is time to evolve our process a little bit. I have been thinking about what I would want to change with our Blog Portfolio strategy and our watch list stocks for the last few weeks. What I have concluded is that I want to adjust some of what we follow and invest in, while also having a few concise rules we will need to trade by going forward.

Basically I want to continue to simplify our process while also continuing to post strong returns. Currently we are managing positions on our Top 10 Watch list and the 9 S&P sector ETFs.

First I have decided that this is a little too many holdings to currently invest in within our one Blog account. It simply stretches my funds too thin to adequately fund each position. So I am going to eliminate from the holdings in our portfolio the 9 sector funds (I will still track their progress and post monthly on their status) and I also am going to adjust the holdings of our 10 watch list stocks to fit one stock per sector group. Right now we have 10 stocks that we track:

Financials (WFC)
Consumer Discretionary  (HD and F)
Technology (AAPL)
Industrial (CMI)
Materials (PPG)
Energy (ENB and PBW)
Consumer Staple (HAIN)
Tech/industrial (DDD)

The thing I notice is that we don't have each sector equally represented. We do not track a Utility or a Health Care holding and we have a couple sectors where we track more than one position. My plan in the coming week will be to choose a Utility stock (I'm thinking AEP will be the choice), a Health Care stock, and I will need to consolidate our Energy exposure and Consumer Discretionary. I still only want to follow 10-12 positions for this account and intend on having one position as TLT, which is the long term treasury bond. We will want/need that exposure as a market hedge when the trend inevitably turns lower for stocks.

I didn't want to completely change our watch list as many have grown familiar with each holding and likely hold the positions in their accounts. However with the past week's market action a natural rebalance could be in the cards in the near future anyway. I think now will be a good time to get that ball rolling to create an even more balanced and targeted watch list.

--The second thing I want to work on is creating a VERY simple and clear method to follow for exactly what, when and how much to buy of each and any asset position; what I'm hoping to create is an effective plan that ANYONE can follow with a simple glance at any asset's price chart. The entry/exit methods we have used over the previous year will be more or less the same criteria going forward but we will make a slight adjustment to exactly how it's executed. Currently we track the 20 WMA, Relative Strength vs the SP500, and key support/resistance levels. There is no need to reinvent the wheel, but a few minor tweaks will allow us to maneuver around a position without an "all in, all out" mentality. This will help avoid being shaken out of an entire position right as it's about to turn and resume higher.

Here is what I'm proposing:

-each signal will represent 1/3 of a total position size for each holding.

-since we will likely track 12 stocks, divide our account size by 12 to know how much will be allocated to each holding. We then want to know what 1/3 of each position allocation is, that will be how much capital we deploy when a signal is triggered.
-When a signal triggers we will add 1/3 of a total position size, when a signal fails we will exit 1/3.
This allows us to manage a position based on several criteria of strength and therefore only the absolute strongest setups will warrant a full position size.
-Positions will be ranked 0/3, 1/3, 2/3, 3/3 depending on how many active signals are in play. We will then hold that amount of each total position.

3 Signal Plan
1. Price is above a RISING 20 WMA (1/3 position)

2. Relative Strength Breakout (1/3 position)

3. Price Pattern Breakout (1/3 position)

Each of these signals represent levels of strength and each is a proven winning strategy vs "Buy and Hold" investing. They do of course require attention and management however and that is what most people are unwilling to do. If you are willing to put the time in and enjoy the "game", you will come out ahead of the rest. 

The primary basis of the strategy alteration is to scale in and out of positions rather an an all in, all out method; you can also call this "trading around a core position". Basically we watch our 12 stocks, when a stock triggers one of our signals we make a buy. If that stock then moves ahead in the coming weeks and triggers another signal we buy more. What this creates is a situation where you are adding to winning positions as they grow stronger. Some people like to wait until thier stocks come down in price and they then add to it. But what this creates is a portfolio full of large losing positions and small winning positions. Think about it, if you only buy more of a stock when it is lower than your initial purchase, only your weakest holdings are large portions of your portfolio. Your winners are ignored and allowed to run on making a little bit, but nothing substantial. Meanwhile you are pouring money into losing holdings. You need to start thinking about portfolio management from the other perspective. 

You want to buy more of your best positions as they continue to strengthen. That doesn't mean buying every new high the stock makes; it means as your strong holdings move forward and higher in price, they will set up new positive risk/reward scenarios and you increase your size as those new setups emerge.  

At the same time if these signals begin to fail we reduce our exposure to the stock. As the stock weakens we sell off our positions as each signal fails 1/3 at a time. This again reiterates the previous theory, buy more of your best and get rid of the weak. 

Lets take a look at each signal individually, so everyone has a very clear idea of what our buy signals look like:

Price Above Rising 20 WMA
  
 We will look at prospect HAIN for how the Rising 20 WMA signal works. 
-Buy(green arrows) 1/3 total position when price closes the week above the 20 WMA while it is rising. We can reduce the "false signal" by waiting for price to make a new multi-week high confirmation.
-Sell(red arrows) 1/3 position when price closes the week BELOW the 20 WMA rising or falling. To reduce false signals we will use price support just below the moving average that will signify a real breakdown below the 20 WMA.

What this does is that it gets us into the stock when the intermediate trend is turning higher and gaining momentum, and it gets us out when any serious trouble presents itself. Trust me on this, you will never suffer through a bear market above the 20 WMA. This simple filter reduces your exposed risk significantly while positioning you for all potential upside moves. 

Occasionally you will get a false signal and be what is called "whip-sawed". A Whip-saw is a situation where you get shaken out of a good position only for the stock to reverse and go right back in the prior direction. So it will create some frustrating moments, but do know your amount of risk vs potential reward is strongly in your favor. If price goes above the 20 WMA but the average is declining week to week, that is a false signal and is to be ignored. We only buy when the stock is trading above the RISING average and making new multi-week highs, signifying a resumption of trend. 

*Note we do have an additional criteria for potential profit taking, if you are into that kind of thing. 
-When a stock moves a certain distance above its 20 WMA, it is deemed heavily overbought and generally leads to a corrective period. Typically I have found that for most large cap stocks that distance is about 12-13% above the 20 average. This depends on a few factors but in general it is prudent to take gains at these extreme levels. 
-Once a profit is taken, it is necessary to reenter the prior holding once price returns in line with the averages. 

Relative Strength Breakouts vs. SP500

Here is a rough example of how you would have used RS Breakouts to trade AAPL's stock over the past 4 years.
-Buy 1/3 total position when a downtrending RS trend is broken on a closing basis.
-Sell 1/3 position when RS uptrend or horizontal support fails to hold. 

Yes in hindsight its seems ridiculously easy, and it is. But in fairness and full disclosure I have traded this method in AAPL successfully beginning late 2012. I actually bought that surge right into the massive top when RS broke out of its 1-year sideways trend. I was stopped out rather quickly and for a small loss, but in hindsight this was my favorite trade I have ever made. And that trade was a sell after a small loss (I lost about 1.6%). AAPL was the coolest stock ever in late 2012, "you couldn't lose money by investing in it" was the thinking. This signal doesn't care about feelings and sentiment, it cares about rotating funds from strong to weak and vice versa. It signaled a sell and it was right. Everyone else who "thought" everything was fine lost 30% of their investment.

This position has since evolved into a fantastic winner for our Portfolio in the back half of last year and is still setup for continued positive risk/reward at this time. 

Price Patterns

 The final trading signal worth our while is a Price Pattern breakout. 
-Buy 1/3 position once an established chart formation is setup and a breakout occurs. 
-Sell 1/3 once price objective is acquired or pattern fails through protective stop. 
Price targets are derived from measuring the height of the pattern and adding that amount to the breakout area.  

Price Patterns are the most subjective of all the market signals, but they do have solid track records historically speaking. Being able to identify patterns in price action is a skill that is only gained from study of the markets. While as trivial as a price formations seem,  patterns signal sentiment and trader's emotions. Humans tend to act a certain way in a repeatable manner when it comes to dealing with the emotions associated with fear and greed. These little behavioral patterns tend to manifest themselves in the price action. Its seems like witchcraft, and maybe it is, but it continues to work for me. 

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That's it. That's how we are going to attack all entries and exits going forward. We will manage our open positions based on these signals and will track all progress to see how each signal performed over the course of the year. My study of the markets has led me to these conclusions: 
-you must have a plan
-your plan must be simple and unemotional
-your plan must skew risk/reward in your favor vs random events
-you must execute your plan...
-you must execute your plan!(this is really the hardest part of individual investing)

If you have a plan that puts your money in when the odds are in your favor more often than not, you are going to come out ahead. Your plan must be able to eliminate catastrophic loss to your accounts, it must also be able to minimize what losses you will face, and it must position you correctly when the market rallies strongly. If your plan can do most of that then you will come out better than most in the long run. I think we are very close to being at that level.

This week I will do my best to highlight each of our holdings (after i adjust our list to accommodate all groups) for the "signal score". Each holding will have a 0-3 out of 3 ranking. That will be based on how many active signals are currently in play. I will be using this coming week to prepare that list for you and position our Portfolio appropriately based on those signals.

Sunday, January 26, 2014

Weekend Update: Profit Taking Gathers Momentum

Our post last week highlighted some warning signals for the market...This week those concerns were in part put into motion. We saw heavy profit taking across the board and many setups are in jeopardy. It is typical in bull markets to see a slow grind higher followed by swift and violent counter trend moves. These moves usually stem from some sort of negative news event and itchy trades fall over one another heading for the exits. This sort of action results in a "whoosh" (a highly technical term) type sell-off, but then ends relatively quickly and the rally continues. We have seen this often over the past couple years.

Its hard to see on this chart but if you zoom in and look at these bars you will notice how most of the large sell-off days we have seen for the last couple years, end or are no more than 2 days from a bottom, before the market V-shape bounces to new highs. Will this happen again this time? Is everyone expecting it to? We will have to see, but also you can see that these kind of moves are fairly typical in bull market rallies to new highs. The buyers continue to come in on any weakness and the trend resumes. The question once again is, will the market snap back another time?

This would be a MAJOR change of character for the market should we see multi-day/week failure without a sharp recovery rally. It will give us a very clear picture of how dip buyers are currently feeling. If the buyers dry up for the sake of taking profits, that would not be a good sign for stocks near term and a visit to the long term uptrend support would be the likely result.

That being said, here is the weekly chart to put things into longer term perspective.

When you take a step back, things aren't that scary at all. If the market continues lower and breaks the 20 WMA, it will be important to see that it bounces back very quickly. Looking back at the last couple years, price has not stayed below the 20 WMA for long, and never set a lower low after the initial bounce back. Shorter term things are not perfect, but longer term no real damage has been done to the SP500.

We did lose 3 of our 8 sector holdings this week with XLY, XLE, and XLP failing to hold their key support levels; I will be a seller of those at Monday's open. However I will also be closing my other sector holdings completely. I have continued to do more year-end review for the blog and have decided to change a few things this coming year and beyond. I will discuss those changes in a post to follow soon...hopefully by Monday at the latest. There are no major changes coming in terms of what we do, but I have reviewed our trades from this year and Portfolio performance, and I feel we could do even better in the future should we adjust the ways we manage open positions. These adjustments will be meant to continue to reduce risk, while improving overall returns simultaneously. That is my hope at least. Look for the post to follow...

--One last thing to note heading into next week is that TLT (20+ year Treasury Bond) has signaled a "Buy" for a partial position entry (this is part of what I will discuss to follow). What is notable is that this is the first time since the large decline that we have gotten a signal to buy Bonds. That substantial decline also corresponded to the major rally for the SP500. I feel this is something not to be taken lightly; Bonds move inversely to Stocks, so the fact that Bonds say "buy" means the opposite is on the horizon for Stocks potentially. This is something to monitor front and center, and even an entry position in TLT is prudent at this time.

I have entered a 2/3 position size (again this will be explained very soon) for all accounts as a protective hedge. When the market suggests weakness, I like to protect my open positions with Bonds rather than shorting the market. Bonds react slower than a direct Short position against Stocks should I be wrong and they also currently pay nearly a 3.50% annual yield. You get protection from market declines, a 3.5% yield, and potential price appreciation. Whereas if you short Stocks, you had better be right because you will lose a bit of money if you are wrong. Bonds provide some protection (though its not 1-1 like shorting is) and allow you to make something on your cash holdings in your accounts while Stocks go through corrective periods.



--also to keep on your radar is that the Fed will have its January meeting this coming Wednesday. Participants widely expect them to continue to reduce their stimulus efforts by another $10B per month. Market participants expect this to be the case, and you know what the market likes to do to everyone's expectations...it likes to surprise the hell out of them. So be ready for a possible surprise to what the herd expects.

---Good luck out there this week. My follow-up post will be up soon explaining our strategy adjustments for the future.

Saturday, January 18, 2014

weekend update: Radars Up, Level 1 (the Double Take)

Now that we have 3 weeks of market action for 2014 to study, there are some things moving under the surface that demand some attention. While I have been flipping through my many charts of interest I am noticing myself having to do a double take with several of the key indicators I follow. We discussed a few specific groups that we will need to watch closely in our year end review posts. The two I give the most credence to are the leading sector of 2013, Consumer Discretionary (XLY), and Treasury Bonds (TLT) due to their inverse relationship to stocks. I said in the review that when the leading sector for last year breaks down it will likely be a leading indicator for a soft patch ahead for the market. I also believe that if Bonds issue a buy signal, that would put the current rally in jeopardy also.

What I have seen over the past couple weeks has gotten my Radar into a Level 1 warning stage which I will call "the Double Take". Going forward, just for fun, we will use 3 primary warning levels for the markets, this will simply give a quick summation to how I feel about stocks going forward.

The first Radar level is "the Double Take". At this level nothing is inherently wrong with the market yet, but some interesting indicators are suggesting change may be brewing. When I'm looking over charts and I have to go, "whoa, wait, what? Did I just see that?". And I have to dig a little deeper than a quick glance.

The second Radar level is "Getting Goosebumps". This level suggests that the concerns addressed in Level 1 are starting to come to pass and the market has likely begun to go through a shift in trend. Basically many leading stocks are failing and defensive groups are breaking out, the charts are literally giving me goosebumps. For some perspective of how a Radar Level 2 would come into play would be on a breakdown of that first support from our year end review. It means that things have started to turn and its time to make adjustments.

The final Radar level is what I would call "Look Out Below". This is a scenario where offensive stocks and sectors are breaking major support and the SP500 is failing its rally from the 2009 bear market lows. The bull market is in serious jeopardy, major portfolio risk is elevated, economic readings are signalling recession warnings, companies EPS are coming in consistently lower than prior years, etc. This would be the signal of a bear market (a multi month/year downtrend for stocks).

All that being said, I had to do some serious "Double Takes" this week when looking at some key indicator charts.

For starters, the SP500 year-long daily chart, while simply consolidating nicely over the past few weeks, on closer inspection has been accelerating rapidly and forming a multi-month rising wedge formation. Typically a rising wedge is a reversal pattern and resolves with a break to the downside. We would need to see a break and close below the swing low at 1,815 for this pattern to trigger.


For some larger perspective on the weekly chart, here is the current pattern (pink wedge) along with the prior, larger wedge from early in the year. You can clearly see from the chart that the prior rising wedge we saw (blue wedge), broke to the upside instead of downward. It certainly can be done that way, but the odds are lower for that outcome. All that being equal, when a rising wedge breaks out to the upside it typically is due to a parabolic move in nature and is largely unsustainable without a correction.

So what we have here is a longer term rising wedge that broke out to the upside. That move has now built an even steeper wedge pattern and therefore a higher likelihood of failure to the downside. It appears that in the near term prices have gotten ahead of themselves by breaking higher from the first wedge; price is "blowing off" a bit here. Nothing is confirmed yet as prices have held the prior lows, so we won't get cute and anticipate anything. But this will be something to watch as we go deeper into 4th quarter earnings in the next few weeks. Put these setups on your radar.

Along with the SP500, Treasury Bonds(TLT) will be the most important chart to watch for an impending trend shift.
This first view is a look back at the 5-year weekly chart. What you should focus on here is the inflection level at $110. This has been the most significant level for Bonds since the QE era. In 2010, $110 acted as a ceiling for the uptrend, it then took a year before the resistance was able to be broken. Once it was broken, volatile trading lead to two tests of the $110 level, but it held as strong support (this follows the primary theory that once broken, resistance becomes support and vice versa). Bonds then saw a huge surge that then marked the top for prices.

Once the downtrend began in full force, price was unable to hold the $110 level a third time and failed as support. In October of last year we saw another test of $110 and it rejected price, once again acting as resistance.
We now find Bonds below that key inflection level which suggests the down trend is still in place. However there is something that needs to be watched very closely. This look here is a zoomed in view of the current downtrend. The last "buy signal" that triggered was in the end of 2012 and ended up failing as a trade. I usually find that a failed buy signal (one that gets stopped out quickly after entry) is a strong indicator that a shift is likely. Its been over a year since the last signal for a long entry, but we are nearing a potential signal very soon should we see any more strength in the next few weeks.

Price seems to be putting in a Double Bottom over the past 6 months and appears to be attempting to breakout of the Relative downtrend vs. the SP500. When Bonds are outperforming stocks, its generally not a good thing for the market. We even saw a lower bar 3 weeks ago that broke the prior lows; that bar looks like a shakeout type move and now price is trying to gain some momentum. The last thing that is notable here is that for the entire down trend the 20 WMA has been declining sharply, however recently it has begun to flatten out indicating a slowing of the previous weakness. In fact this setup is eerily similar to what we have seen with AAPL recently, take a look at that post for how history could rhyme this time.

Consumer Discretionary Relative weakness
To start the year, last year's best performing sector group has been showing Relative weakness. The Relative Strength uptrend from the end of last year has been broken decisively, indicating some hot money is flowing out of the space. Price is still above its uptrend supports and is holding the prior swing low, so we don't need to go panicking just yet. $64 is still a fine stop placement and allows us to book solid gains if we do end up being stopped out.

Another positive is that while the shorter term RS trend has been broken, the long term uptrend off the 2009 lows is still well in place and still indicates a secular bull market for XLY.
 While there are still positive trends for XLY in place, many of the key holdings of the fund have been struggling and are failing their 20 WMA's. This will be one to watch very closely in the near term.

Again these are just things to watch for as we go ahead. There are some signs that a more cautious approach may be needed sooner rather than later. But as always we will wait until price confirms these signals and not act on them in an anticipatory way.

My Radar has been activated and we are in a Level 1 caution level. But there is still work to be done for the Bears if they plan on taking back control of the market over the intermediate term. Continue to watch those support levels in the SP500, keep a close eye on Bonds and also be aware of when previously winning groups begin to underperform.

Tuesday, January 14, 2014

A Position Rebalance (HAIN)

For the Longer-term focused Portfolio that I share here weekly, I like to manage each position on a fairly even risk level. How I do that is maintain a similar percentage of space for each holding within the account. When a stock has a prolonged rally, the size of the holding grows to a larger percentage than the other holdings.

What I like to do when managing a portfolio is to make sure one or two positions don't get disproportionately larger than the rest. I like to keep a fairly balanced list of holdings, therefore when a stock becomes too large in my account, I simply trim off some gain and bring it back in line with the majority of holdings.

HAIN has grown 30% larger than most of the other positions in our Portfolio over the past few months, culminating today in a very large spike in prices. I'm not just selling to sell either. It was brought to my attention yesterday by a friend that HAIN was becoming quite extended on an intermediate term basis. Today is finally the day that it has moved beyond my "extended" reading. For all accounts I am bringing HAIN back into balance with the rest of my holdings; I'm selling 1/3-1/2 of the holdings I have in HAIN depending on the aggressiveness of each account. Basically for my shorter term, more active accounts, I am selling 1/2 of my total position. For the longer term accounts I am selling down 1/3 of the holding.

We've seen a large breakout from the prior consolidation and today's action has blown the stock beyond the upper Bollinger Band and has extended the stock more than 13% above the 20 WMA. While selling when these conditions are in place isn't always perfect, it does tend (roughly 80% of the time) to cause the stock in question to at least consolidate sideways or pull back into longer term support.

Again, do know that there is nothing wrong with reducing a winning position into extreme strength. What you don't want to do is try to call an absolute top for the uptrend. Basically you can trim your winners, but you can not sell all of the position. We never know where the top is; the top might be today or it might continue to rally another 100%, who knows. But when a stock reaches an extreme level I think it is prudent to re balance the holding back in line with the rest of your portfolio.

Saturday, January 11, 2014

Looking Ahead to 2014

To wrap up our end of year/beginning of year analysis, I think its important to take a step back and look at the long term uptrend in the market and identify what is currently going on and what needs to be highlighted moving forward.

When we look at the SP500 on a long term view its important to realize where the true turning points could be, as well as where a potential correction is likely to find buying support. Being that the market is up so much over the last year, we could see a large correction of 15-20% and still be within the long term bull market uptrend. I have two primary support levels that I am watching very closely; the lines in the sand, if you will.

 The first "line in the sand" is the area we are most familiar with when reading over our weekly reviews.
 The intermediate term uptrend from November 2012 to our current date is the more aggressive trading support. Meaning that stocks can be heavily owned above these levels; the primary support of interest is the intersection of the uptrend support line, the rising 20 WMA and recent consolidation lows at 1,767-1,747. A clean break of that area of support that violates all of these levels of interest would be enough to seriously alter our current market exposure in the near term. The lower end of this support range will likely continue to rise as that currently corresponds to the rising trend support line and 20 WMA, those will likely be closer to the 1,767 swing low by the time any real threat to that area comes into play. So for now, focus shorter term positions against the 1,767 support low. If that low fails to hold on a pullback, we would likely need to play much more defense than our current allocation suggests.


The second key level for the market really is the BIG ONE. If this support zone fails then the entire validity of the bull market comes into question. To get the right view of the support we have to look at a Monthly bar chart going back to the 2000 highs.
 If we highlight the prior range highs, a "retest" of that inflection point would occur at the 1,570 area and even extend down to about 1,535. We then look to the rally support off the 2009 financial crisis lows which intersects our support band and nearly matches the 20 Month Moving Average. This confluence of support signals suggests that this "retest" scenario would present a fantastic risk/reward buying opportunity, but also is the long term line in the sand for stocks moving forward. We would want to be focused on equities above that support area and likely sell out completely from any Long exposure to stocks below it.

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Now that we have a very clear view of where our risk levels reside, we should also take a look at an interesting view of the SP500 that I have been noticing recently. This is a hypothetical scenario and should not be considered as a viable investment plan, but it does present an interesting outlook going forward for the market. If you want a prediction from me heading into the new year, this is as close as you will get...

It is commonly said that history repeats itself. I tend to feel that historical pattern recognition, whether it be financial markets, politics or general human interaction, tends to rhyme more than it repeats. Saying that something will occur exactly like it did before is a little silly, but understanding that a similar outcome could come to pass is reasonable. With that preface in mind here is a situation evolving right now that I feel could have a similar "rhyme" to it.

Looking at our recent market history, it is clear to see that after being sideways for the better part of the last decade, stocks seem to be attempting to push higher out of this sideways range. Many market participants feel that seeing that we have moved such a great distance off the bear market lows in 2009 that the market simply can't continue much higher without another "crash" situation. But if you use history as your guide and look for patterns in the price, its interesting to see that this recent 10-13 year range we have been in is strikingly similar to the market view from the mid 80's into the early 90's. Which was right before US stocks took off, climaxing in an amazing bull market peak in early 2000.

Lets take a closer look at these two periods.

First we look at our current environment. Within the past 13 years we have seen two quite similar  +50% declines for the SP500. They both took roughly 2 years from peak to trough and both declined a similar amount. We have recently seen a very solid breakout and follow through from this range suggesting higher prices to come...But how much higher is possible?

For that, we turn to the pattern from the 80's which I feel holds more information as to what is possible for us next in the stock market. While many "main street" folk are beginning to venture back into stocks, people still seem generally distrusting and disinterested with the market. This is one reason why I think we could possibly have lots of upside to come in the future. The financial media has grown incredibly short term in nature and are constantly fixated on the daily ups and downs in prices. I feel they lose the forest for the trees and are not considering the possibility just how much better things could become before this rally comes to an end.


The time period from about 1986 to 1991 seems very similar to where we are currently. The reason I say that history rhymes and doesn't exactly repeat can be seen by comparing these two charts. In our current environment the sideways trading has lasted more or less 10 years, while the comparison view only took 5 years to play out. Our current range had two roughly 50% declines and covered 2 years each. The previous range saw losses of 20-30% and lasted about 6 months peak to trough. While the decline amount and length of the moves was dramatically different, the same psychological effects of the price movements takes place. Prior to each decline prices rallied strongly and then went through a bear market decline (a bear market is usually defined by a correction of more than 20%). Investors were elated at the peaks and desolate at the lows. Yet each decline brought about a new, refreshed rally that made up for all the prior losses. We then see the cycle repeat. And we may be seeing it happen again in our current environment.

What the comparison is meant to show is that regardless of the dates attached to the bottom of the charts, investor (human) psychology does not change. During the bear markets in the 80's and into the 90's the US saw very high unemployment levels, was involved in the Gulf War and uncertainty was amok. Yet once the issues slowly resolved and the economy began to turn, markets rallied for 20 years to heights not imaginable except in hindsight...

  
Here you can see the remarkable rally and the prior consolidation base we have been looking at. To compare where we currently would find ourselves based on a rhyming scenario would likely be somewhere in the breakout surge in 1996. This prior pattern would suggest that dramatic upside could still be in store for stocks over the next decade or two.

The US will be going through a similar demographics phase beginning in the next 10 years that was very much like the Baby-Boomer's rise to power. We are the Boomer's kids, we happen to be larger in the number of people that were attempting to enter the workforce in the late 80's and could see a similar economic spike once we gain stable employment and reach our peak spending ages; this is typically defined as from our early 40's to mid 50's. That is the age where most of the age group is fully employed and looking to upgrade to their 2nd home as their children begin to head into teenage years. We have reached a higher income level at that stage and is typical that we buy new cars, new homes and continue to be spenders in a consumer based economy.

While that's quite an economic theory and based entirely on the past, so far the technical patterns we are seeing suggest more upside to come. It might just roll over and play dead in the next year or so and all of this is rendered worthless. Or we might just be entering a new chapter in the continued strength of the US economy and be setup for dramatic upside in the not so distant future.

Again I'm not one for predictions in general, I just thought this historical context was interesting for where we currently sit with so-called "elevated" stock prices. Am I basing my investment strategy on this theory? No I am not. I continue to defer to what price is actually doing and not what I think will happen. But this is an interesting nugget of information that we shouldn't just ignore and pretend the past doesn't matter.

This will wrap up our year in review/preview series and beginning next week we will get back to our standard format of following our watchlist stocks and continuing to use Relative Strength as our guide.