For this fourth installment of “Nerdvember,” we’re going to change gears from last week’s article on how to find strong investments.  This week, we’re going to discuss strategies on determining when to buy and when to sell.  The best part is, this market is freaking some people out, so I’m going to share some ideas and a few of the (many) red flags I look for when determining if the market is topping, or if we’re just in the midst of a normal, healthy correction.

Alright, in the interest of keeping this short, sweet, and easy to read, I’m going to share lots of pictures with annotations and brief descriptions for each, below.

First, here’s the NYSE Composite Index.  As you can see, as of Tuesday’s market close, it’s down -11.6% since the January high and -5.9% year-to-date.

Remember, the S&P500, NYSE, and the NASDAQ are all stock market indices that are heavily influenced by the largest companies on each index.  The Dow, for instance, is nothing but large companies!  So when small and mid-sized companies fall (and crash), we don’t see the indices crashing until the big companies start to crash.  While there are many, many more small-caps and mid-caps, the problem is, the large-caps still carry most of the weight.

For this reason, it’s helpful to look at the Advance-Decline Line (AD Line), which is an important sign of health in the market because it doesn’t look at how big or small the companies are – but instead, equally-weights all the companies so that each is treated as one “vote.”  To be specific, it’s calculated by subtracting the number of declining stocks from the number of those that advanced (rose) each day, and then plots them on a chart.

If the market is healthy, we want to see the AD Line going up when the market goes up.  This shows that a good portion of the stocks on the index are “participating” in the uptrend.  Conversely, if the AD Line is trending down while the NYSE index continues higher, this is a warning sign – an indication that, while the big companies are going up, there are fewer and fewer mid and small-sized companies participating in the uptrend.  Think of it like a war wherein the large-caps are the few generals in the battle and the mid and small-caps are the multitude of troops.  If the troops run away from the battle, chances aren’t so good for the generals as time passes!

So in the chart below, you can see that the NYSE index has printed lower-lows this year, but the AD Line is still moving right along with it (still higher, technically).  This is a good sign because every big market crash in history has been preceded by a negative divergence in the AD Line vs. the index.  Said another way, when markets crash, the AD Line tends to go down first, while the NYSE index continues sideways or higher until eventually, the buying enthusiasm dries up and sellers jump in… and the multi-month crash begins.

Another long-term warning sign I like to follow is a monthly chart of the S&P500 with a 10-month moving average (10MA).  This was made famous by Meb Faber and it’s pretty darn accurate, with some exceptions.  The rule goes like this:  If the market closes below the 10MA on the close of the last day of the month, the long-term trend has potentially ended.  But remember, you have to wait till the end of the month to get a signal.  Using intra-month prices for month-end charts makes no sense!

One of the things you’ll notice in the chart below is that sometimes, the S&P500 closes below the 10MA, it does so for a second month-in-a-row, and then it comes back and closes back above the 10MA.  This is what we call a “whipsaw,” “failed breakdown,” or my personal favorite, “head-fake.”  The first two circles on the chart below were pretty fast head-fakes that quickly came back on strong volume (heavy, positive buying enthusiasm). However, the other seven times this occurred, the enthusiasm wasn’t as positive and the long-term trend was seriously threatened.

Below, I zoomed in so you could see the failed breakdowns since the 2011 U.S. Treasury downgrade.  That year, the market closed below the 10MA for five straight months, but still managed to claw its way back.  In other words, the risk of a long-term market crash was very high.

Similarly speaking, 2015 saw two months of closing prices below the 10MA, followed by two months above it, which was then followed by another, second-round of two-months closing prices below the 10MA, all in context of lower-lows in the index, overall.  Talk about high-risk!  This was a time when you wanted to be very careful about owning any stocks, especially leading up to the election.  Today, you can see that October’s correction led to a close below the 10MA again.  This is one of the many reasons we’ve started to sell some of the investments in our models and raise cash – so as to protect against further downside in case this correction turns into something worse.

It’s never good to use just one or two indicators, signs, or “red flags” to determine the market’s trend, whether it’s topping, or whether you should get out.  Rather, a “weight of the evidence” approach should be used so that you’re not jumping in and out too quickly.

Two things I’ve been watching in the chart below are:

  1. The blue, diagonal trend channel. While the market “feels” scary it helps to step back, look at the big picture, and determine whether the trend is up or down.  This year has felt like a mess, and it hasn’t been fun, but one positive sign would be for the market to remain in/around that trend channel.
  2. The red, dashed lines, which compare the higher lows in momentum (lower-pane) to the lower-lows in the market index (upper). Momentum has a tendency to lead price… so it would be a good sign to continue to see higher lows in momentum as the market continues to shake impatient investors out.

Last, but certainly not least is this last chart (below), on which I’ve annotated some pretty important risk levels.  Tuesday, the market closed very close to the October 29th lows, which is good.  I’d rather not see it fall below that level… although if it does, there are surely a lot of stop-loss orders that will trigger, causing prices to initially drop, creating a scary, volatile day.  That being said, if it happens, I’d like to see it followed by a lot of buy-side orders to gobble up all the shares that the sellers are tossing out the window.

If that line in the sand doesn’t hold, then we’ll want to lighten up our risk and sell some of the investments we own, raising more cash.  The next important level we have to look forward to is the February/April lows, which lie only -2.3% below where we stand as of Tuesday’s close.  If the market falls to that level… again, I’d expect to see some stop-loss orders kick in, shaking out additional investors, but I’d also want to see buyers step in here, worst case, picking up those shares and sending the market higher, ending the current correction.

Worst case scenario, we want the market to hold above that last red line (Feb/Apr lows), and if it doesn’t, and after a few days cannot reclaim that line, it’s time to seriously re-evaluate how much risk we’re willing to take.

To be more specific, while we’ve already started to get defensive this past few weeks (and would get even more so if we fall through the October lows), a multi-day close below the bottom red-dashed line would mean we’d want to get aggressively defensive, as it would not only indicate a break through two important levels of support… but it would also mean that we’re probably seeing multi-month closes below the 10MA, as well as a negative cross between the 50-day moving average (blue line, above) and the 200-day moving average (red line, above), which is another long-term trend indicator.

I want to close with the most important lesson in this entire article.  If you take nothing else away from all of the information above, please soak up the following:

  • No matter what the trend looks like in the short, intermediate, or long-term
  • No matter how scary the market might “feel”
  • No matter what you “think” the market might do
  • No matter how much you “hope” it will go up or “worry” it will go down…

…there is no guessing in investing.  Anticipation is the enemy.  When building a strategy, you set your rules way in advance.  Then, once your parameters are in place, you follow those rules.  “If this happens, then we’ll do that… if that happens, then this is what we’ll do.”

You never, ever want to buy or sell in anticipation of the market doing what you “think” it will do, because the market will always find a way to disappoint you.  It doesn’t care what you think, which is why you have to watch, listen, and react to what it does.  Let it tell you what to do, not the other way around.

Am I worried about a market crash?  No… because:

  1. I know that right now, we’re still in a long-term uptrend with defined floors of risk in place, and
  2. If those floors are convincingly broken, I’ll take aggressive action to be defensive, and thus, I won’t participate in the market until risk:reward ratios are more favorable for taking such risk.

Lastly, always remember that market crashes don’t happen overnight.  The market correction is either going to end and we’re going to see new, all-time highs or it’s going to fail and continue downward.  If the former occurs, then there is still money to be made before the other shoe drops.  Even if the latter happens, there are other investments we can buy that can provide us with growth in our portfolios, but I’ll save that for the final installment of Nerdvember!

Meanwhile, may you all have a fun, relaxing, and FILLING Thanksgiving with your family and friends!

Till next time…

Adam

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