chart of the day
- In Trading Articles
- Last Updated: 17 January 2015
- By LA Little
Roughly fifteen months ago my investment stance was unequivocal - you stay bullish until there is a reason not to (see Quit Worrying About a 1987-style crash and Do not worry about a crash until it's time). Those two articles outlined a fundamental axiom of neoclassical technical analysis thought - that there is a structure to market declines. Given this fact, rather than live in fear of a crash, informed investors and traders should instead focus on identifying the potentially devastating structure that must manifest before taking significant steps to protect their portfolios. Those thoughts were ridiculed by some - embraced by others. In the end, the theory has proved to be true keeping us bullish most of the past fifteen months while most other commentators had long since given up on the bullish trend.
Since those two theory articles first printed, there have been just a couple interceding calls to turn more cautious although nether resulted in any major market losses - until now. The two calls to get safer were in October of 2013 and late January of 2014 and both had the potential to take the market significantly lower but never actualized. This latest call for safety appeared three weeks ago on September 23, 2014 when the S&P 500 was still within 1% of it's all time highs and in subsequent articles the two weeks afterwards. Now that same neoclassical structure - the one that has appeared in all historical significant declines - has both appeared and has began to be realized. As has been stated before, the structure for a larger decline is not a necessary and sufficient condition - it only makes it possible for a larger decline to materialize and, most importantly, it always precedes such a decline. It is a necessary condition - just not sufficient in and of itself.
What has not been talked about in a clear and concise form is how to marry the neoclassical potential bear market signals with a workable investment strategy. In other words, how can an investor use the neoclassical theory to remain in a bull market up until the very end and to do so without significant risk? So let's consider that here and now for the benefit of all you investors out there.
It is important to conceptualize two important points initially to make sense of the neoclassical investment approach.
- There is an integral relationship between stocks, industry groups, sectors and markets/indexes where stocks move industry groups which move sectors which in turn move markets/indexes
- There is an integral relationship between time frames where short term time frames (daily charts) move intermediate term time frames (weekly charts) which eventually move long term time frames (monthly charts)
You cannot get a larger sustainable declines until enough stocks have weakened sufficiently. This has to occur in order for enough sectors to deteriorate to the point where larger index declines can occur. It cannot happen in any other fashion. It's a given.
Similarly, you cannot get a sustainable price decline until a sufficient amount of time has passed. Daily, weekly and monthly charts do not all rollover in tandem. They never have. Time is an important part of the structure and one which classical technical analysis either ignores or pays lip service to. Daily charts can flip around a lot with respect to trend but trend doesn't change all that often on the weekly charts and even more rarely on the monthly charts. There is a precedence in the order of actions.
Given the above, how and when should a neoclassical investor make portfolio changes based on neoclassical TA?
Assuming your portfolio consists of shorter term positions (let's call them trading positions) and longer term positions (let's call them core positions), then the following is a simple guideline that can be followed and one that TA Today investors are advised to follow:
- When the potential structure for a larger decline if first apparent, reduce or eliminate trading positions but do nothing with your core positions. This potential for a larger decline occurs when the structure for multiple swing point breaks on multiple time frames (daily and weekly charts) has developed which implies that enough stocks are trading in short and intermediate term bearish trends and that now sectors and potentially indexes are at risk of breaking down on the intermediate term time frame. Depending on your portfolio makeup, this should bring you down to maybe 30% to 60% invested. How much you remain invested is an individualized risk management issue.
- If the structure does not actualize then you go about adding back trading positions and potentially adding to core positions depending on what kind of a pullback occurred and how individual stocks or indexes performed
- If and when price rises to retest the prior breakdown areas (in neoclassical terms this is a bearish retest and regenerate formation) and rather than working higher instead starts to regenerate lower, then you continue to reduce risk letting some of your core positions go. An alternative strategy is to hedge your core positions to some degree with inverse market instrument. Note that you are using strength to reduce risk further and you remain in this mode of using strength to reduce exposure as long as the weakening technical picture remains in tact.
- In this worst case scenario, you should be out of, or almost out of the market or fully hedged. Investors that are willing to trade the market net short would be moving to that stance if the breakdown does occur
This three step neoclassical investing process will keep you on the right side of the market and bullishly invested as long as possible with minimal risk. Note that you don't have to predict in advance where the market will be in six months or even longer in order to profit from that knowledge. You simply follow a logical and methodological process based on neoclassical technical analysis.
Also note that following this process will necessarily result in some degree of underperformance if the gains you create during a bull market are roughly equal to that of the market because unlike the market you will not always be fully invested.
Finally, note that the real secret to outperforming the market over time, a secret that few will share with you, is not about making more money when the market is going up but instead losing a lot less money than the markets when they are going down. If you follow the above steps then you will be consistently profitable and will outperform over time.
This article originally published on MarketWatch at Oct 13, 2014 12:44 p.m. ET