By Gabe Velazquez, Online Trading Academy E-Minis Instructor
The current market rally has swung the sentiment pendulum from one of extreme angst, to that of an almost eerie complacency. The fears about housing, the banks, and all the bailouts throwing the US economy over the financial abyss have been replaced with a sanguine, and in some sectors, outright exuberant outlook - all in a mere nine weeks. This, after all the major averages have advanced roughly 35% off their early March lows, erasing their losses for the year. It's as if investors are suffering from bipolar disorder.
Evidence of this newfound giddiness can be found in a cross section of stocks. Over the last week or so, an inordinate number of equities have embarked on what technicians refer to as "parabolic" moves. For readers who may not be familiar with this term, a parabolic move is a chart pattern that looks very much like a rocket launching into space (a moon shot). The trajectory is at a 90-degree angle and is rarely sustainable as it usually indicates a blow-off, or speculative end to a move. Below are two visual examples.
Figure 1
Figure 2
By and large, when it comes to the study of trends, the steeper the angle of ascent, the more speculative the financial instrument becomes. If you're fortunate enough to get on board a move like this in the early stages, make sure you trail a stop (manually, or mechanically) snugly below the market, as the reversals from these types of moves can come quickly and are usually violent.
The reasoning for this phenomenon: As more and more buyers, drive prices higher and higher, they (the buyers) then have to be sellers. At the point where buyers are no longer interested in purchasing shares, the outsized imbalance of sellers that accumulated during the run-up has to take hold; resulting in a steep correction.
Surprisingly, if you were to cull through the entire universe of stocks that trade in the US, as of late, you would find this pattern often. Also noteworthy, and perhaps disturbing (if you happen to be bullish), is the fact that these patterns are appearing in the lower priced, lower quality stocks (under $10).
This type of price action is reminiscent of the tech-bubble days of the late nineties. Obviously, there are few, if any parallels to that period in the current environment. However, the speculative fervor going on in these issues may be a bad omen for the market in the short-term.
In my March 17th newsletter, I averred that the market was overdue for a tradable rally, and outlined the factors that led me to make that assertion. Some would call it forecasting, I just call it knowing probabilities based on many years of experience. So now that the "tradable rally” has come to pass, what's next?
New data has begun to mount that this rally is long in the teeth. Aside from the aforementioned chart patterns, most sentiment measures are registering extreme optimism, usually indicative of topping markets. Additionally, I've rarely seen new bull markets emerge with so many people fully on board. New bull markets frequently start by climbing the wall of worry, and plenty of skepticism about the newfound rally. Since every piece of bad news is being spun positively lately—that's not the case here.
In the chart of the ES (E-mini S&P) below, I've highlighted the open gap left back on January 7.
Figure 3
This gap is the likely resistance point that will stymie the recent advance, whether it will be a serious correction or just a brief pause is unknown. Nevertheless, the risk-to-reward calculus for investors being long here is less than favorable, and becoming more favorable for short selling. Thus, extra caution is warranted in the next few weeks (for those that are disproportionately long stocks) or are contemplating entering the market at this late stage.
Until next time, I hope everyone has a profitable week.
If you have questions or comments, please email me at gvelazquez@tradingacademy.com
- Gabe Velazquez
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