In this week’s issue:
Stockscores Market Minutes Video
To beat the market, you have to focus on Alpha. This week, Tyler explains the difference between Alpha and Beta and how to find them when trading. Plus, the regular market analysis. View the video by clicking here.
The Correction
Investors fear corrections.
Memories of the tech bubble bursting in 2000, the liquidity crisis in 2008 or the collapse of the mining market in 2011 have left many investors with a sort of post-traumatic stress disorder that causes them to be nervous any time the market falls like it did at the end of last week.
Rightfully so, the losses sustained by buy and hold investors during these major corrections were life changing. I have met many investors who tell me how their portfolios dropped by more than 80% through a correction, something that seriously hindered their retirement plans.
So, how should stock market investors deal with the potential for a market correction?
The traditional approach to risk management is to diversify holdings across sectors so that poor performance in one sector is offset by strong performance in another. This is referred to as Modern Portfolio Theory although I submit that it is hardly modern, having been devised over 50 years ago.
The great problem with this approach to risk management is major corrections, which seems to happen every few years, tend to drag down all sectors together. It did not matter if you had an automotive stock, a bank, an energy company, a technology company and a utility in your portfolio in 2007. By the start of 2009, they were all dramatically lower.
After the drop in the market last week, I think there are two things that all stock market investors need to take to heart so they can sleep better in the weeks ahead.
First, know the signs of a market correction. Second, apply a better method for managing risk.
The typical cycle for a correction is as follows. A steep upward trend is broken by some abnormal selling pressure. You can see this on a chart by drawing a line across the bottoms on a three year weekly chart (I do this in this week’s Market Minutes video). If that line is broken, step one in a correction has occurred.
Inevitably, buyers will come back to stocks with the thought that the selling pressure has created bargains. Most of the time, these buyers are correct and the long term upward trend continues.
Eventually, however, they are wrong and the brief bounce back rally fails to make a new high. This sets up a falling top, step two in a corrective phase.
The third and most telling in the corrective process is the break of the long term upward trend line from a falling top. All of the major corrections that I have witnessed have gone through this cycle. Take a look at the 5 year weekly chart of GLD and you can see it on Gold. Look at the chart of the Nasdaq (QQQ) in 2000 and you will see it there. Check the chart of the Dow (DIA) in 2008 and you will see it there too.
We do not have this 3 step chart pattern set up in the market today. The market is working on step 1 right now but even that is not complete because the trend line has not been broken. For now, this is only a pullback in an upward trend. That could change in the weeks ahead so don’t take your eyes off of the market but don’t panic either.
The second way to deal with the potential for a correction is to simply plan to exit any stock you own if it falls down through support. To find support, draw a horizontal line at the last low point on the chart. That is the last place where the buyers said “we don’t think the stock deserves to go below this price, we don’t think the fundamentals are worth less than this price”. If the price of your stock falls through this floor of support, it implies that the sellers have found a reason to accept a lower price. At that point, sell.
By doing this, you avoid taking big losses. Yes, you may take multiple losses at once when the market is correcting but they should be relatively minor. You will not endure the portfolio crushing losses that many have felt through the market’s corrective phases.
Corrections happen but you don’t have to suffer from them. Learn how to read the market index charts and know the steps in a market correction. Practice good risk management by limiting how far you will let your stock holdings fall before you hit the eject button. If you apply these practices you should only take small losses and be in a strong cash position for when the overall market makes its rebound.
Each day I look at the stocks and ETFs which have made abnormal price gains using the Abnormal Day Up filter in the Stockscores Market Scan. I add in some other filters to keep my list of charts to inspect manageable, usually setting a certain minimum number of trades to ensure that illiquid stocks do not come up in my results.
I like to see where money is chasing stocks and ETFs higher. Abnormal price gains are a sign that investors are focused on Alpha in that market, that there is something significant going on. We know that the great majority of market beating upward trends start with abnormal behavior.
Friday was a big sell off day for the market overall so it is quite telling to see what stocks and ETFs were making abnormal price gains. If a stock can go up on a day when the overall market was getting punished lower, there must be something significant happening. They key is to read the charts to ensure that the risk of the trade does not outweigh the potential reward.
Here are my comments on some of the standouts from this week’s Abnormal Gainer scan:
1. TBBK
TBBK managed a 7% gain and broke out of a pennant pattern on the daily chart. The stock has been trending higher since the middle of 2012 and looks likely to continue that upward trend after its recent three month rest period.
2. ARIA
ARIA was the most actively traded stock on Friday and managed a 20% gain for the day. The market is speculating that the company will be bought by a large Pharmaceutical company so consider this a very speculative trade and only suitable for an experienced trader. The market action on Friday is very convincing that there is some truth to the rumor.
3. SDS
There are now many ETFs that go up when the market goes down. SDS is perhaps the most liquid but the VXX and its derivatives, inverse ETFs specific to a sector and other market index ETFs all made big gains on Friday. If you believe the market has further to fall then these instruments are a way to profit. I caution however, as they are all rallying from new lows, just as the overall market is falling after making a high. Markets rarely correct from a high, there is typically a cycle of a break of trend, a bounce back rally that fails to make a new high and then a second break of trend. At this point, we are only at the first step making a bigger market correction a less probable outcome. Look for these inverse ETFs to pull back next week as the overall market bounces off of its upward trend line. If the bounce back for the market fails to make a new high before showing more weakness, consider the inverse ETFs and VXX for a buy.
References
- Get the Stockscore on any of over 20,000 North American stocks.
- Background on the theories used by Stockscores.
- Strategies that can help you find new opportunities.
- Scan the market using extensive filter criteria.
- Build a portfolio of stocks and view a slide show of their charts.
- See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligence.
