It Looks Different This Time

Which One Doesn't Belong?

SP500 Weekly Bars

Over the past 18-months we have seen 5 pullbacks in the market. Each one ended with a similar trading pattern called a Hammer. There have been 4 consecutive weekly Hammer confirmations to this point in the rally. For a Hammer pattern to trigger you need to see a follow-through green bar after the Hammer bar is present. The previous 4 tests of the 20 WMA have produced this, the most recent one however did not.

The pattern has changed and the market is telling us that it may have new intentions going forward. The playbook for more than a year now has been to buy the dip into the 20 WMA. We would see exhausted selling form the "Hammer" and off we would go to new highs. This time has given a very different signal, a signal of failure. When a pattern formation that everyone expects to play out all of a sudden does not, things can get very interesting. "From failed moves come fast moves" is the saying. When everyone is leaning the same way a little too far, the market does its best to give the herd a good jolt of reality. We may be seeing the beginning of that right now.

SP500 Wave3 weekly bars

This is also the first time since the Wave3 rally began in mid-2011 that we have seen a lower weekly closing swing low in the uptrend (1,925 was the prior higher closing low). The very definition of an uptrend is higher highs and higher lows. Once you make a lower low your uptrend begins to degrade and risk becomes elevated.

It appears that the SP500 Wave count has completed the Wave3 rally.

Now a Wave4 correction seems likely. Typically we would expect the Wave4 correction to be roughly similar to the size of Wave2. From peak to trough Wave2 lost approx. 21%. A similar correction would suggest a move to near 1,600, which if you would recall was within 25 points of the prior all-time highs from 2007. A move down to 1,600 would also retrace 50% of the Wave3 rally. This is not meant to be thought of as a prediction, it is simply a road-map using common patterns present in all markets.

The bright side of this whole mess is that typically patterns of this nature tend to move in 5-wave sequences. That would suggest that a potential Wave5 would follow and accelerate the market well beyond its current highs. The theory is that in a 5-wave move Waves 1, 3, and 5 are "with the trend" moves, and Waves 2 and 4 are "counter-trend" correction moves. Wave 3 should be the longest wave and Wave 5 should be the most powerful wave.

So its not all doom and gloom around here. The sun always shines after a storm...or something like that : )

So What's the Strategy Now?

Fortunately you all have not gotten to go through a corrective market with me since we began this blog in late 2012. But now we may be on the cusp of one and we need to understand how we deal with them to best protect our capital and maximize our returns. I have 3 general rules to deal with corrective markets:

1. Continue to run winning positions as long as individual uptrends are intact
2. Cut positions that signal lower lows and/or failed breakouts
3. Take no new Long signals while the SP500 is below its 20 WMA

On that note lets take a look at our Exits this week as the market gave everyone a good shake.

EXITS TAKEN

TWX

Time Warner was unable to handle the rejection from highs a few months ago and seems here that it at least wants to move back into the prior range for some time. Price violated the swing low from the failed Fox buyout offer and that was enough for me. It is now trading firmly below the 20 WMA and risk is too much for me right here.

Long-term I still like the setup. Provided the lows around $62 hold, the base formation seems intact. We will keep it firmly on the watchlist but for now we will wait on the sidelines.

ECL

I had my stop placed at the $108.25 swing lows but the failed breakout signal along with taking out last week's recovery lows AND slicing right through the 20 WMA was plenty evidence to protect capital and get out of the way.

The uptrend is still technically intact, but this is what we do in corrective markets. You weed out anything showing vulnerability first and ask questions later. We can always get back in, but now is not the time to try to be a hero.

IP

International Paper couldn't quite make the push and is now firmly back within the prior trading range. I have no interest in watching my money get chopped back and forth. We will take our exit here and wait to see if any actual resolution of the range can occur.

This is another longer-term play that I like the prospects of and as long as its above the range lows near $43, I still like the potential for upside in the future.

WFC

Wells is another one where my previous stop was not actually hit but the trading action dictated further action to protect gains. This has been my longest standing position in my personal accounts and in the blog Portfolio. WFC has displayed perfect uptrend action for almost 2 years now, but the recent action has me concerned about the near term prospects for the stock. Simply it looks like a failed breakout move from last month that sliced the 20 WMA and the 2-year uptrend support line. We have hefty gains across the board in WFC and I think it is time to harvest some of that profit.

If the lows can hold and the prior highs can be taken out I will gladly get back in. But for now we will take our gains and wait patiently.


Of our remaining 9 holdings, 5 were up on Friday's follow-through selloff. Those 5 were TLT, KO, BMY, UNH, and NKE. This is the reason we don't just dump our positions when the overall market fails. Theoretically if we have been listening to the market appropriately, some stocks were signaling strength and rotation while the market was beginning to correct. Those positions were telling us that they would hold up best should the market continue lower; money was being rotated into those "safer" names.
The only thing that determines whether a stock goes up or down is whether more shares are being bought or sold. If more shares are being purchased than being sold, the stock will go up.

This is how money rotates. It comes into the more "value" areas and leaves the more "expensive" areas. This flow continues in a mostly seamless action. Each individual stock should be held on its own merits and as long as they are holding their uptrends we will continue to own them.

For my portfolios I choose however to not take new entry signals while the SPX is in corrective mode (trading below its 20 WMA). The odds of trade success decreases dramatically when the market is undergoing a correction. This may sound a bit hypocritical to hold current positions based on their individual merits while at the same time deferring to the broad market for new entry signals. But I find trying to trade new positions against the tide of the major market indexes leads to more failures than successes. Like I said before though, you should have already received proper defensive trade signals prior to when the market ultimately fails it's uptrend. We saw this with new entry signals in NKE, KO, and BMY.

It comes back to the idea that you can be much more particular about choosing which new entries to take than you can be about current open positions (active risk). When it comes to active risk you need to defer to the price action of the individual name. But when you are choosing new investments you can be very selective and make sure all indicators are aligned to suggest the highest possibility of success. The broad market trading in an uptrend is my primary indicator for probable success. 4 out of 5 stocks trade with the overall market, so fighting that wave is very difficult to do. This I refer to as investing with the wind at your back vs blowing right in your face. You want to be adding risk when the wind is at your back-when the market is in a uptrend. Again we can continue to hold current positions until they fail, but adding more risk to our portfolio is not how I approach downtrends.

 We must continue to protect our capital AND run our winning trades. If those positions begin to fail we will exit and dial back our risk even further.

Oh And One More Thing

Russell 2000 (RUT) monthly bars

The Russell 2000 Small Caps Index is signalling my "crash" indicator currently and will need to recover back above the 20 month moving average in the next couple weeks to not confirm the signal. This signal has triggered 3 previous times in the last 15 years. Of those 3 signals, 2 lead to significant bear markets with losses of 35% and 50%. The 3rd signal turned out to be a false signal and bottomed shortly after and lead to a relentless 100% rally.

Which will this one turn out to be? Its impossible to say, but we do need to be aware that big problems don't arise until these conditions are in place. When the confluence of these indicators does not occur, the market remains on strong footing and in generally in "rally mode". When they do trigger however a couple different outcomes can occur. You could lose up to 50% of your investment OR it might be a failed signal and a new buy setup would form in the near future as occurred in 2012.

The bottom line here is that all pullbacks start out exactly the same and its impossible to know which is a true signal and which is false. But from my view the worst case scenario of acting on this pattern is you end up buying back in after a new buy signal is triggered and the market rallies significantly (there is that "failed move=fast move" only in reverse this time). And the best case is that you protect your account from a potentially life altering drawdown that forces you to rethink your future. To me its always better to protect your capital in high risk situations and this looks like one of those moments.