Update on the Markets
Update on the Markets
I thought it would be a good idea to take a little break from our normal coaches corner article and instead, take a look at the markets. The trading environment has been really difficult lately. The markets have been in decline and bad news is just everywhere. Sometimes, it’s just too easy to miss the forest through the trees.
First of all, let’s look at the trends of the market. I’ll be using the S&P 500 (SPX) to represent the broader market.
Below is a daily chart showing the last several months. I don’t need to tell you they’ve been mostly down, that’s been all over the news.
Let’s pull back a little bit. The chart below is a weekly chart of the SPX. It shows a large deal of volatility since July 2007.
I’ve drawn channels on the chart above. You can see the nice upward channel that was being followed only to have a new downward channel form since October. As of this writing, we are near the lower channel line. Often, when you are at the lower trendline, you bounce back to the upper trendline. However, you can stay near the lower trendline for quite some time before making the move to the opposite end.
I want to now zoom out even more. Let’s look at a longer time frame to get a different perspective.
This chart goes back to 1887. The crash of 1987 is just barely visible on the most left side of the chart. You can see how the S&P 500 followed a nice gradual trend until 1995, when it just took off at a much steeper angle. The tech bubble is clearly visible as is the popping of that bubble from 2000 to 2003. Notice the long bottoming process between 2002 and 2003. The bear market there didn’t just end abruptly, instead, a base was formed from which the market exploded out of. We just barely topped our 2000 highs in the SPX last year when our most recent bear market began. But you can see from this that there is an overall upward bias to the market. The market sometimes gets way over bought, but then it comes back down and proceeds to go higher. I don’t know if this bear market is going to be short or if we’ll retest the lows from 2003. What I do know is that we will one day have a great bull market again.
The point of showing this chart to you is to let you recognize that although the market can have some serious declines, it does have an overall upward bias. And although there is a general trend, it never just goes straight up or straight down. There are some reasons for this zig-zag type of motion to the markets, and understanding such market mechanics will help you to become a better trader.
Channels
The market, as well as stocks will move in channels. Some are major channels, some are minor or sub-channels. It’s important that you use longer-term charts, such as weekly charts, to identify many of the major channels. The chart below is a daily chart of the SPX since last October. You can see the major channel, but inside, you’ll see several sub-channels that are formed as the market goes from one end of its channel to the other end.
Let me just mention one thing here. Generally, in an uptrend, the lows are easier to connect than the highs. A good uptrend usually has the lows line up nicely, which is why it’s best to draw the support line connecting the lows first. The highs in an uptrend can be quite irregular and placing the resistance line at the peaks to form a channel can be challenging. The same goes for down trends, except it’s the highs that line up the best while the lows do not, making it often difficult to decide where to place that lower channel line. That is the case above, I honestly can’t find a place for that lower channel line that fits right, so I might move it at some point when more information is available. Remember, the lines are there to guide and help us, they are not magical and they don’t always hold prices.
The Extremes
While the market has been in a downward trend, several areas of the market have experienced strong bull markets. Of course I’m talking about oil and energy related stocks, as well as some mining stocks, steel, coal, railroad and agriculture stocks. These have been going up for quite some time. However, lately, there has been some signs of distribution in these areas, meaning big money is leaving. This doesn’t mean that these stocks are going to go straight down, they just might enter an area of consolidation. This often happens after large run-ups in price. If you start looking at longer-term charts, you’ll see that stocks often move in this surge-consolidate-serge fashion.
The chart below is a weekly chart of National Oilwell Varco (NOV). It goes back a couple of years. You’ll notice long periods of consolidation that could have been very frustrating for traders even though the overall trend remained strongly to the upside. Obviously, the most money is made in the surge areas. Unfortunately, they often don’t last as long as the consolidation areas.
It’s important to always look at longer-term charts to identify if you are in a surge mode or a consolidation mode. You can still trade a stock that is in a consolidation period, some of these ranges inside of a consolidation could be ten or even twenty dollars or more! You will however, need to be more careful of the resistance levels that will be present when consolidating.
Looking back at that chart of NOV, you may notice that the stock will get so far overbought, that it will pull back, often violently, even though it’s in a long term up-trend. This is why it is so important to use stop losses, you don’t want to hold through a $20 correction. Your indicators will alert you to when you’re over-bought. The chart below looks back in time a little on NOV to where that last consolidation period began.
There are some signs of being overbought at the top. The price is far above the 21-day EMA, in fact, it hasn’t tagged the 21-day EMA in quite some time. The MACD is at an extremely high area and now moving sideways. The Stochastic, which in strong trends generally stays at an extreme range, is starting to move slowly down. Now, all these signs don’t necessarily mean sell, because the stock could still go higher before it snaps back. What they do tell us though is that it isn’t the time to enter. It’s been too long and too far in price since the stock went 3 Green Arrow and gave us a good entry point. Yet, people were still buying. Why? Because they feel the stock is strong, it’s been going up for so long. They feel more comfortable buying a stock has been going up for 3 days in-a-row than one that has been going down for 3 days in-a-row.
I mention this because I see it too often. Traders who, having heard about a stock for weeks, and watching it go up endlessly higher, decide to jump in, then the stock pulls back. It is so important to have entry and exit rules written down and followed. If your entry rules say don’t enter when the MACD is at an extreme point and don’t enter if the price is far from the 21-day EMA, then you wouldn’t have entered this trade. Does this mean that you miss some trades? Yes, of course. But I’ll be willing to bet that if you look a little deeper, you’ll always find stocks that are meeting your criteria. If not, just wait, all stocks come back eventually.
I mention this because I’ve seen something similar the last few days. People entering the short side (selling stock short or buying put options) when the market was so obviously oversold. Stocks and indexes have been going down for so long, that the obvious thing to do is join in and go short. But you need to have your entry rules as well. Don’t enter a short when you’re near support, far below the 21-day EMA and your indicators aren’t giving you an entry point. Let’s look at an example. The chart below is of the Financial Select SPDR fund (XLF). This is an Exchange Traded Fund (ETF) that tracks the financial sector. Essentially, this is a fund that has bought a basket of financial stocks so it tracks that sector. Note the signs of extreme selling recently.
There is no doubt that this sector is in a down trend. But let me ask you, how much further do you think it could go? It’s already come down a long way. The best entry has come and gone and won’t come back unless the stock has a nice big bounce. Like the earlier chart of NOV, it was trading away from its 21-day EMA, but in this case it’s below the EMA. It also hadn’t touched the 21-day EMA for quite some time and it was moving further and further away from this moving average. It’s not the time to start entering a short sell.
Remember, stocks and markets don’t move in straight lines. They zig and zag their way to their destinations. If a stock is going to go from $50 to $100 in a 6 month period, it will rocket up, then fall back, move up a little, then move sideways and it will repeat this process over and over again until it reaches $100.
When a stock moves down, it will also have nice bounces only to move down again. A few days ago, it looked like the financials would never go up again. All the news stories were negative, everyone was telling you to stay away from them, yet, look at the bounce they had. Does this mean they are now going to rocket back up to new highs? Probably not, because this most recent bounce is just one of the zags in a down trend. Despite this most recent bounce, the trend is still down, if you buy, you will be going against the trend. When stocks have come down for such a long period of time, they usually form a base for several months or even years before their fundamentals are able to change enough to attract traders and investors again. So although the financials will one day stop going down, it doesn’t mean they will start an up-trend any time soon.
Zig-Zagging along
Why don’t stocks just go straight? Why do they zig and zag? Remember, people have different opinions, so they have different actions. Others have different styles and rules to their trading that make them buy when others are selling. If a stock is moving lower, more and more holders of that stock will sell because they can’t afford to lose any more money. Short sellers will come in, borrow shares and sell them in the market. There comes a time however, where bottom pickers come in, hoping to catch the bottom. Other longer-term investors and value investors accept the fact that they can’t pick bottoms, so they just buy when a stock has come down to certain price, knowing that the stock could still move lower in the near-term but that’s okay because they believe in a year or two or three that the stock will be higher and they are willing to hold and wait for that time to come. Eventually this buying slows the downward surge, the short sellers, sensing the downtrend is losing steam, begin to close their trades. They do this by buying back the stock that they shorted. This is buying and it puts buying pressure on the stock. This competition for stock can lead to very strong bounces.
After the stock bounces, if no new buyers come in, the stock will stall. Holders of the stock who hadn’t sold yet, are happy that they have a higher selling price than just a few days ago, so they sell. They are so disgusted and discouraged by the stock that they just want an out. As this selling pressure takes over, the new investors will often see early profits disappear and they too will exit and soon the stock is back at its lows, and maybe even lower. This process will repeat itself over and over until there are just no more people left to sell.
Let’s look at this in action by looking at the SPX during the bear market of 2000 to 2003.
I’ve pointed out the bear market rallies. Note how long they can last, but also look at how fast they move off of their bottoms. Shorting can be difficult because of this. Bottoms, even temporary and short-term bottoms, are much more violent than tops are. Look at the indicators. They move into extreme low areas before these bounces happen. You don’t want to buy, because that would be going against the trend, and just because your indicators say you are oversold, you can stay oversold for a long time and you can go broke trying to catch the bottom.
You also don’t want to short a stock when the indicators are at extremely low levels because the risk is higher that the stock is going to go against you.
Strong Sectors
Even in a bear market, there are stocks and sectors that move higher. We’ve seen this with oil, energy, steel, coal and agriculture stocks. However, as you go deeper into the bear market, all sectors will sell off. The strong sectors will bounce back sooner, but only after they have sold off. So just because a sector is moving higher while the market is moving lower doesn’t mean that you throw caution to the wind. You have to play defensively.
The chart below shows one of the strong stocks this year, US Steel Corp. (X). Recently, however, large-scale selling has taken place and large price destruction has taken place.
Does this mean the uptrend is over? Maybe not the long-term trend, but the near term trend is now bearish and the stock is yet to show signs of finding a support level.
Another hot sector has been oil and energy. However, that sector has also come down quite a bit. Here is a chart of a popular oil stock, Hess Corp. (HES), and as you can see, some trendlines have recently been broken.
The recent distribution is easy to see. The stock has broken through trendlines, which is not a good sign. Because perspective is important however, let’s look at a long term chart of the same stock.
The long term trend is still in-tact. It’s obvious that the stock got a little bit a head of itself. This chart suggests that in the near-term, it might be toxic to your portfolio. But there might be a day, sometime in the future that you’ll find this stock starting a new up-trend.
As you move out of a bear market, into a new bull market, you will have new leadership. New stocks leading you higher. This means that money will flow out of the stronger stocks that went against the trend of the market the longest, and then flow into sectors that investors believe will be benefiting the most from this new bull market. It’s important to track the sectors and look for signs of strengths in different sectors. Try to find out where that money is going.
Conclusion
The last thing you want to do is to get caught up in thinking that the market should be rational. It isn’t. It will eventually figure things out, but remember, the market is a forward looking mechanism. It doesn’t matter that a stock or sector is having the greatest growth or earnings in its history, if big institutional traders think that it’s time to take profits and put money somewhere else; they will. This is why the trend is always more important than everything else. Always go with the trend. Most oil and energy stocks have been showing signs of weakness the last month even though oil prices were going to new highs. Did this make sense? It does if you realize that it’s supply and demand for a stock that determines price, not news and fundamentals. Investors in these stocks, especially institutions will sell if they feel they’ve made enough profit. This means that there is more supply of the stock and the price is lowered to find willing buyers. Again, let the chart tell you what is going on; trade what you see. If a trade begins to go against you, get out. And always use a stop loss.
Remember, a stock can go down just because it went up too high too fast. A stock can also bounce just because it’s so oversold. These have nothing to do with news or fundamentals. It’s just the way the market works.
-Mark Jackman
Stock Investor Personal Coach