Lessons from the Pros


The Market Always Looks Best Just Before A Drop

It seems as though every day that passes, the equities markets eclipse their prior highs and continue rising to uncharted levels. To some extent this is a positive, because to most individual investors it means that their “nest egg” (monies invested in retirement accounts) is once again starting to grow. On Wall Street when the market continuously rises, everyone is happy, and it’s good while it lasts, and believe  me,  I don’t want to be a party pooper, but what people tend to forget is that markets don’t go up in a straight line. There always comes a point when the market gets overheated ( all the buyers have bought) and that  eventually leads to the market  retracing  some, or in certain instances, all of the gains made in the bull market.  This is not a new revelation since it  has been  happening since the  US stock market opened in the late 1800’s.

History has shown us that when the market looks the best this typically precedes a major correction. That is, when all the economic data being released is favorable, and earnings for most companies are showing positive  growth.  This is also the time when the Wall Street analyst community is collectively raising their earnings estimates along with their projected price targets for many of the stocks they follow.

During these prosperous times, many private companies use the public’s growing appetite for risk to raise capital by selling stock to the public.  What better environment to sell stock , than when everyone’s in a buying mood. Along with those private companies, existing public companies ( those traded on the major exchanges )also seize this opportunity to raise money by issuing more stock (also called a secondary offering) to the same aforementioned individual investor.

In addition, the market technical’s — from a conventional point of view — also look great before a correction. If we look at some of the charts leading up to major declines, they all exhibit the same characteristics:  a strong uptrend, a series of higher highs, and higher lows, high upward momentum, and multiple buy signals being generated. In fact, most people would find absolutely zero reason to sell.

Below are three chart examples of various markets before they declined.  The first chart is of the Nasdaq Composite index on a weekly time frame, the last candle shown is January of 2000. As we can see all of the attributes that I mentioned earlier were in place at this time. For those of you not familiar with what happened in the ensuing months: the bubble in technology stocks finally burst in March of that year climaxing with the Nasdaq losing close to 80% of its value by the fall of 2002.

Nas Comp LFP  5-29-2013

 The next chart is of the S&P E-mini 7 months before the financial crisis produced the catalyst for a 55% decline in this index back in 2008.

ES weekly LFP 5-29-13

And last but not least, the chart below is that of the Dow Jones Industrial Average two months before “black Monday.”  On that day October 19, 1987 the market shed 23% in one day, and it took two years to regain highs reached that year.

Dow weekly LFP 5-28-2013

 If you look at the current chart of any of these three markets they closely resemble those from past corrections. If that’s the case, is the inference then that the markets are due for a big correction? The truth is that nobody knows for sure when this will happen, but it will at some point.  From a supply/demand standpoint we  have formed some new supply zones as of last week with the Bernanke testimony, and those will be selling zones in the near-term.

The point I’m trying to convey here  is that being complacent in this market will not be rewarded, but having an exit strategy and a rules based method will .  As a trader one must always remember that the toughest trade is usually the one that goes against every fiber of your being, and it doesn’t matter the direction, but more often than not,  it’s the one the pays the most  handsomely.

So until next time, trade safe everyone.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.