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Is This What Bear Market Behavior Looks Like?
You get up in the morning and tune into CNBC to check the pre-market. You see the S&P futures are up nicely, so you think to yourself… Okay, looks as though we're finally going to have an up day, no need to panic. You go off to work feeling somewhat relieved that your stocks will not be going down today, but you're still a bit nervous about your portfolio. You go about your business day, without giving much thought to how the market is doing. It's about time for you to head home, but before you leave, you log onto your computer to see how the market closed. Much to your chagrin, stocks finished sharply lower. You wonder, what happened? …Things looked so good this morning.
This narrative exemplifies what typical bear market behavior looks like. It's characterized by early rallies that fail and followed by downside acceleration into the final hour. Seems familiar doesn't it? This is pretty much how the market's been acting for the last two weeks. It may seem counterintuitive, but market bottoms usually start with a very scary decline in the morning. This decline is dramatically reversed by mid-day; the market then begins to build upside momentum on very heavy volume moving into the close. This momentum usually carries over for a few more days and when you look back at the charts, you'll see some type of reversal pattern (hammer, dragonfly doji, engulfing etc.) formed that day.
The other component of a market turn around is sentiment. I've written about this quite extensively in past newsletters, so I'm only going to touch on it briefly here. The bottom line on sentiment is that it needs to be extremely negative. Again, this is counterintuitive, but most market psychology is. Surprisingly, bearish sentiment is not as high as you would think. This leads me to believe we have some more work to do on the downside.
What I'm attempting to do here is share with readers the subtle hints the market reveals before it's ready to change its stripes, while at the same time showing you how to identify the different characteristics of bull and bear markets. They are quite different. First, in bear markets volatility is much higher, because of the "fear factor". As we know, fear is a much stronger emotion than greed and therefore its manifestation in the market is more acute. Thus, support levels are less likely to hold in downturns. When investors reach their maximum pain threshold, they are more prone to "sell first and ask questions later".
Since the market is obviously changing, traders and investors also need to change. Investors need to get into a "capital preservation mode", which essentially means - get defensive. Traders should also be super-vigilant about honoring stops, as the market is a lot less forgiving in this type of environment.
Now on to the charts, the first chart we will analyze is the weekly chart of ER2 below. Readers may be asking, "if we're day trading the Russell, why are we looking at such long-term charts?" The reason is very simple; you must go back as far as it takes to find the next level of support or resistance. In this case, we have to go back 18 months to the summer of 2006 to see that the ER2 broke the 706 support level. How important is this? I think it gains importance, if we are unable to regain these levels in coming days.
In the shorter-term, the hourly chart shown below yields insights on the utilization of moving averages as trend following guide posts. Note the 20 period EMA acting as resistance on the rally attempts. Even in Tuesday's trading this particular EMA presented tremendous low–risk, high-reward trades indicated by the "sell arrows".
The last chart we'll look at is the 5-minute intraday chart of Tuesday's trading session. This chart illustrates the bearish characteristics we covered earlier. Note the early failed rally and the subsequent attempt at a lift that was thwarted badly, resulting in a whopping 26-point drop in the final hour!
In summary: in last week's newsletter, I was unequivocal in my bearish position. This week, however, I'm going to have to temper that outlook. Since my last writing, the market has fallen precipitously (about 60 points in ER2), along with similar drops in most of the major averages. Indeed, I believe the market is ultimately going to work a lot lower for the reasons well known to most of you. Having said that, my sense is that unless we crash (which is a very low probability, but one nonetheless) we should see a tradable bounce of some manner in the coming days. This bounce should be used to lighten up long-term positions and raise more cash. E-mini traders are being presented great trading opportunities as volatility rises. But as always, risk management is paramount. I'm personally loving this action and I hope you are, too.
So until next time, I hope everyone has a profitable week.
If you have questions or comments, please e-mail me at gvelazquez@trading academy.com
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Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the
