Rules Aren't Fun are They?

If you follow a rules based trading plan you likely have had your rules tested repeatedly in this market over the past couple years. This has been a market that makes a fool out of anyone who uses any form of risk management; if you have sold stock over the past few years, the market has laughed in your face and ripped higher. What this creates is a generation of investors (those of us bull market riders post Financial Crisis meltdown) who have been punished for selling any stock and not just mindlessly buying any and every dip. The mentality this creates is one of "why sell when the market just comes back higher every time". Investors begin to forget the risk of loss and only focus on the fear of missing the next rally higher. As the saying goes, the pattern works until it doesn't. Humans have an amazing ability to forget the past and constantly repeat the same mistakes over and over. We saw this behavior in 1999, 2007 and its building again currently; it has been happening throughout human history.

The market teaches all the wrong lessons at all the right times. The market is designed to set up emotional herding behavior and then blast them to oblivion when they least expect it. Following your rules will be frustrating at times, you will miss some moves, you will sell and have to buy back in higher, you will doubt your process and you will question your intentions. THIS IS NORMAL and is a necessary part of market cycles. Your strategy will not work all of the time but when it does finally come through it will save your biscuits, big time.

Around the time when you are about to throw in the towel on risk management is precisely when you will need it most. We are currently going through a period where the undisciplined and ignorant are reaping the rewards of their carelessness. But believe me when I say, that time will end and it will end badly, it always does.

I find it very difficult to be bearish as the market hits new all-time highs, there is no statistical precedent that suggests new highs are bearish, in fact its the opposite; new market highs lead to more highs. That being said I am personally seeing so many troubling signs that I am having a hard time getting more aggressively involved. I am trying to take an objective market view and frankly what I'm finding is a situation where the market is requiring me to stretch my risk management principles if I want to participate further.

Currently I am 50% invested and 50% cash. Despite the new market highs this week I was only able to find one compelling risk/reward opportunity. Here is what I'm seeing:

Stocks are Extended beyond Favorable Risk/Reward

Many normally favorable buy signals are requiring stops that are too far from the entry points to make them worth our capital. There are some excellent companies breaking to new highs but where the stops need to be placed, for trend invalidation, is beyond the rules I have in place. I don't like to enter a new position if the stop location is more than 10% from the entry. This is the rule the market is trying to convince me to bend, it wants me to chase. 

There are a few stocks that under normal conditions would have presented strong buy signals this week.

UNP

Union Pacific is showing its dominance but the stop location is more than $20 below the entry. This will need time to cool off before offering my kind of entry opportunity. 

AEP

AEP has held its long-term breakout level and is resuming to fresh highs. Unfortunately it too is running a bit hot and will need a more favorable setup to allow us to enter.   

DIS

Disney is closer to being an acceptable entry, but for my specific stop placement criteria it would take a break of the $79 low to invalidate the trend. Based on the entry price of 91.38 that leaves $12.38 as the distance between the entry and the stop. A 13.5% stop is simply outside my rules for solid risk/reward. 

These 3 examples are just a few of the potential signals the market is offering. Many names have not triggered entries, but the ones that have are all in runaway mode and currently will need more consolidation to set up more favorable trades.  

The only name that presented a strong enough case for entry and we will be taking is PCG. But it too is just extended enough to stretch my rules. 

Entering PCG

This week PCG broke through its long-term resistance level, finished at new monthly closing highs and signaled a strong trend resumption. 

Our stop location at the $44.30 swing low is just outside our 10% rule at 11%, but I felt the setup allowed just a tiny bit of leeway. That being said, this was the only favorable entry signal I could find among our watchlist. 

Monthly Chart Review Confirms Expanding Volatility

It is taught that markets experience volatility expansion near turning points in the prevailing trend. Volatility expansion is fantastic near the end of a downtrend as it signifies a possible change in trend direction that favors the bulls. However in a steadily uptrending environment that has been accompanied by very low volatility, a change in that volatility range is to be viewed with caution. Currently we are not seeing investors approach the market with caution. In fact bullishness among investors continues to remain elevated.  

The leading sector in the market right now is Biotech, and the leading stock in the group is Amgen (AMGN). AMGN is displaying symptoms of trend instability and volatility expansion. 

 Its slightly hard to see from this view but this month's bar is the largest trading range from highs to lows that AMGN has ever seen in any single month. After a 400% rally over the last 2 years, and then seeing the most monthly volatility in its history, AMGN has the look of "blow-off" type situation. 

Notice the other 3 times when monthly volatility was unusually high. The events occurred in late 1999, 2005, and 2008. Each of the monthly bars preceded multi-YEAR corrections in price. To suggest that this is a serious moment for shares of AMGN is a bit understated. Investors LOVE the biotech space here and based on the technical outlook of the stock, I believe risk is extremely high.  

We pointed out a similar situation back in June when Schlumberger (SLB) was exploding to new highs. The stock had rallied 100% off the lows in just over two years. 

Right before SLB underwent a 30% correction, volatility expanded significantly on its final surge. The chart we posted in June looked very similar to how many stocks, especially AMGN currently look. This doesn't automatically mean we will see significant corrections like occurred in SLB, but risk is now becoming alarmingly elevated. Caution is advised.  

SP500 Posts a Monthly "Hanging Man" Candle Formation

The Hanging Man formation is one we haven't seen much of in this market until this point. It has a similar structure as a Hammer, except that Hammers occur at the bottom of downtrends. They signify a change in sentiment as sellers become exhausted. A Hanging Man however occurs in an uptrend and suggests that buyers may be losing control of the uptrend. It can be an early indication that sellers are making headway and that a trend change may be developing. 

This formation can be seen across many of the SP500 component stocks and does signal some caution that we have not seen until recently in the uptrend. 

As of now this bearish theory has not been confirmed, but it does suggest that we remain highly vigilant for developing weakness.

Russell Small Caps Hold 20 MMA

A couple weeks ago we were concerned that the small caps were signalling a potentially ominous sign. I was concerned by the weakening trend indicators and most importantly the break of the 20 MMA. Since this is a monthly signal however we need the full monthly closing price to confirm the signal. As you can see above the Russell was able to regain its 20 MMA and postponed the signal breakdown. 

Currently the long-term RS and MACD still suggest caution, but until we get that confirmation from a break of the 20 MMA we have to still defer to the uptrend in price.

Following your preset rules is not always easy. At times it will feel as though the market has figured out your strategy and is now set to smash it to bits along with your account. But do understand that all strategies go through periods of underperformance, but those poor periods are then followed by extremely positive ones as long as your rules remain intact and observed.

Our set of rules have done a fine job at participating in the majority of this monster bull market, yet now we are seeing signs of a market change. When conditions begin to change you will notice the adjustment in how your strategy now interacts with the market. For the better part of the last 3 years our plan has wanted us invested heavily and that has been the correct positioning. It is only in the last month or two that conditions have begun to feel and appear different. It is also true that over the past two months our Portfolio has been moving decidedly more neutral. At a 50/50 stock to cash ratio my positioning is not particularly bearish, but also not fully bullish. It remains to be seen whether we do infact correct from here, but conditions are deteriorating noticeably from my view point.