Lesson Learned: Price Cannot Deviate From Itself
Good Morning. Let's be honest; there are times when figuring out Ms. Market's game can be more than a little challenging. And in my humble opinion, this is one of those times. One minute tapering is a huge problem and interest rates are spiking. However, twelve days and 800 Dow points later, and despite the fact that rates are still sky high, apparently neither are a major concern. Oh and here's a good one; is good economic news good or bad for stocks these days?
The next question that traders and investors alike will need to answer is what is driving prices higher right now? In case you were out on the golf course or at the pool with the kids, the S&P 500, the DJIA, the Midcap 400, and the Russell 2000 all finished at new all-time highs yesterday while the NASDAQ powered to its best level since the middle of 2000. So, is it the idea that the economy is in "Goldilocks" mode (not hot enough to cause the Fed to pull back and not cold enough to cause concerns about deflation and/or recession)? Is it just a momentum trade? Is the public getting back in the game after a dip? Is the "great rotation" finally starting to roll for real? Is it a case of short-covering? (After all, the bears have once again been proved wrong, which is a theme that has been occurring with regularity over the last nine months.) Or is it the fancy shmancy carry trade that has been all the rage in hedgie land?
Regardless of your answer, the bottom line is stocks are at all-time highs. Sure, the indices are overbought. And yes, after moving higher for six straight days and eleven of the last thirteen, a pullback or a pause is to be expected. However, when stocks break to new all-time highs, it generally pays to buy the dips - not call a top and head for the hills.
Here's the deal. I don't know exactly why stocks are enjoying yet another joyride to the upside here. In fact, I don't know anyone who does (and these are the folks that manage other people's money for a living, not the media hounds that love to espouse their opinion to the camera whenever the red light is on). Further, I don't think we can know why this market is doing what it is doing. Sure, I've got an opinion. But as I've mentioned time and again in this space, we don't play the crystal ball game around here.
Now for the even bigger question. Will the recent jaunt up from the bottom of the corrective phase turn into one of those big, meaningful moves? Will this rally morph into one of those moves that you've got to catch if you plan on staying up with Ms. Market on a consistent basis?
While I hate to disappoint you and I hope I didn't lead you down the primrose path with the setup, once again my answer is "I don't know." But THIS is why there are times when I let my system lean on price as the final arbiter. You see, if the environment is "iffy" and yet you want to make sure that you catch the big moves - and catch them early - then playing a trend-following game is the only way to go.
One of my absolute favorite rules about the stock market is that "price cannot deviate from itself." Ned Davis taught me this back in the early 1990's and I've never forgotten it. The bottom line here is that unlike other indicators, price can't be "wrong." And while following a pure price-driven, trend following system exclusively has its problems, there are indeed times when this approach makes sense.
Think about it. The vast majority of market indicators can give false signals at times and then stay "out of whack" for long periods of time. One of the oldest market rules is "Don't fight the Fed." Except, history shows there have been times when this approach didn't work out so well. Then there are valuation indicators. The problem is that an "expensive" stock can, and usually does, get more expensive and vice versa. What about those mean reversion indicators the fast-money loves to yammer on about? If you've ever used them, you know that they work great in some environments and are horrible in a trending environment. However, with a price-based system, price moving up is always a good thing for long-only investors and price moving down is bad - it's that simple.
So, when things are iffy or I'm confused about what the heck is going on in this oftentimes silly game, I defer to price. Yes, I get whipsawed using this approach. And this means that I'm only "right" on a smidge over 50% of my trades when I'm using my trend-following system. But, I can also say (a) the losses tend to be on the small side and (b) we do tend to get on the right side of the big trends early.
So, will the current move be a big one or suddenly disappoint? Again, I simply don't know. And since my Market Environment Model (a model that, as the name implies, is designed to tell me what type of environment we're in) is neutral right now, my strategy is to simply follow the trend of the market. This is why we moved back to our long positions on June 26th. Not because I had decided that the reason for the decline had been proved false. Not because I got an oversold reading or that sentiment had gotten a little negative. Nope, we moved back to the long side because price "told us to."
Frankly, I don't know if this move will turn out to be profitable, but so far, so good on that front. And if the current rally does morph into a meaningful move - the type of move that makes or breaks your year - then we can enjoy the ride from here and not have to worry about whether or not it's too late to buy.
Is this a smart way to play? I'll let you be the judge, but I certainly think so. For when things are iffy, I want to stay in tune with what the market IS doing, not try to figure out what the indices "ought" to be doing. Remember, when things are confusing and unclear, you can always depend on price because... everybody now... price can't deviate from itself!
Turning to this morning... Concerns about Portugal hit the markets in the early going today. However, bank earnings and the state of the current rally appear to be the focal point at the moment on this summer Friday. Earnings reports from both JPMorgan Chase (JPM) and Wells Fargo (WFC) were above expectations, yet both stocks traded a bit lower after the release. At this stage, it looks like a mixed to modestly higher open on Wall Street.
Positions in stocks mentioned: none
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