How To Identify When a Bull Market Starts To Turn
Recently, I warned a couple of the subs to the SpreadBetPro website (via WhatsApp) of a potential turning point in the market, where they may want to consider moving predominantly to cash (i.e. having fewer open positions and less exposure to the market). As it happens, that tip-off saved them thousands of pounds in the space of a few days, it certainly saved my fund taking over a 7.5% drawdown in 3 days. I was then asked if I might consider doing a post about the warning signs that lead to me being able to issue this caution. So here it is!
NB: As with all my learnings over the years that I share on this blog, I don't expect you to take everything I say as the holy grail and copy me to the ends of the earth. I'd encourage you to do your own research and analysis and reach your own decisions. If my content provides any helpful insights or forms a part of that research then I'm happy to have helped partly inform your decision. I'm no oracle, and as with ALL traders/investors I'm not right 100% of the time. However, there are a few things we can learn and view objectively in the markets that statistically do give us an edge and are useful to be mindful of when managing risk.
When To Reduce Exposure in a Long Portfolio
1. Strange Stock Behaviour With Leading Stocks - Very Subtle
2. Indices Lag and Volume Contracts - Subtle
3. Leading Stocks Decline - People Take Note 4. Index Prices Follow Suit (Bearish Daily/Weekly Candle Formation) - Obvious To Market
1. Strange Stock Behaviour With Leading Stocks - Very Subtle
Without going too off-topic and discussing my personal stock screener criteria, one key element to my stock selection is to pick stocks with a high relative strength over the past 12-months. I look to take positions in companies that have outperformed 70% of the entire market in that period. One thing about all these companies is that as leading stocks, you'll notice on the charts that they are always the first to react to market movements. What's actually happening here that they're not necessarily always being acted upon by a fiscal force, but actually other stocks are slowly reacting to the price action of these leading stocks.
For example, let's say a monster company in the retail sector publishes dodgy sales figures for the quarter, people holding other smaller companies in the retail sector might look at these results and assume that the poor data is a result of the economic environment, and consequently they'll start to reduce their positions in retail stocks. Consequently what happens is that you get a ripple effect of stocks following-suit with the leading market movers.
So now we know why we're focusing on leading stocks, I'll explain how I notices they were behaving strangely. It's not too complex really. But I had 10 stock positions open, all of them premium leading stocks across a range of markets and sectors, and all of them with strong earnings reports or potential for beating estimates. I know that 60% of the time when I enter a long position I see a movement upwards on the next 2 candles. This is tested over hundreds, if not thousands of positions. However, near the end of April and beginning of May I was noticing that despite strong entry criteria with huge volume breakouts, the stocks were then just languishing in the same zones. In fact, in more cases than not, they were actually moving downwards, some even triggered my stop losses. I thought this was odd, and I went back over my trades to double check I hadn't overlooked something. But I hadn't, and it was just odd. Hence, the first VERY SUBTLE warning sign of the markets beginning to pull back. It took around 1-week to 10-days to notice this and make a note that it was strange behaviour.
2. Indices Lag and Volume Contracts - Subtle
After seeing this strange behaviour on the individual stocks I started to take notice of the fact that my index tracker robot which books profits in trending markets was putting in some strong trades. This contrasted with the behaviour of the aforementioned stocks. So I began to wonder, has the market not yet realised that things might be slowing down?
Sure enough the volume on the indices where beginning to contract, showing fewer major market orders being places, which signifies uncertainty or lack of interest in an asset - in this case the former.
At this stage I decided that I would move my stop losses up across the equities markets to mitigate any potential fall in prices, but still allowing for room to grow to the upside in case I'm wrong.
DOW VCP PATTERN + BEARISH PRICE DIVERGENCE BETWEEN US INDICES (SEE '3' NEXT CHAPTER)
Here you can see the Dow daily chart in the runup to the pullback. The price was still moving upwards despite the volume decreasing (this is known as a VCP - Volatility Cotraction/Compression Pattern). I moved to cash at the blue dotted line, read on for more details.
3. Leading Stocks Decline - People Take Note
The Nasdaq houses many of the world's leading stocks from a leading industry, tech. One look at the Nasdaq during this period would have told you a lot about what was on the cards. This index was face-planting compared to the more diversified S&P 500 that was still creeping forwards on lower volume.
NASDAQ DECLINES ON THE 29TH APRIL
S&P DECLINES FROM THE 10TH MAY
This divergence between indices was another example of things not adding up, and if in doubt as to which asset to listen to, look for the one with the highest concentration of stocks with an annual or TTM RSI of over 90. These are the stocks that are setting the tone for the rest.
All my stocks where I had moved the stop losses up had hit their stop-losses for very minimal hits or small profits. At this point I did not open any new positions. The risk would have been like trying to push a wave back out to see, it would have just made me look stupid.
4. Index Prices Follow Suit (Bearish Daily/Weekly Candle Formation) - Obvious To Market
The next day, the Dow and S&P both followed the Nasdaq in posting a down day.
Obviously in isolation a down day on an index should certainly not be a cause for concern. However, it was the combination of market behaviours shown above that make this a more pertinent down day to pay attention to.
The Dow had formed a bearish pin bar, for me that was the signal to stop my Trend Tracker robot for the time being as I could foresee the market potentially ripping through a good few losing trades before it starts to take trades to the downside. So I have 3 options here with the trend trading system, here are the 3 scenarios:
I could be wrong and it goes up (no worries, haven't lost anything from sitting out for now, the markets will still move in the future).
It goes down (pullback -5% which could turn into a bear market -20%) as I anticipate and I'd have lost quite a few trades before taking short positions. Because the Dow was relatively strong before this happened.
It chops about and I probably book a few small losses, but nothing too stressful.
If I were to weight the likelihood of these 3 scenarios occuring in neutral market conditions without any strange stock behaviour, I'd say that with the Dow it's: Scenario 1 - 55% - US indices tend to trend upwards most of the time due to the high level of innovation within the stocks that it comprises.
Scenario 2 - 5% - The chances of a market correction (not just a down day) are far less frequent with US indices.
Scenario 3 - 40% - We often get periods of sideways movement while the market takes 'stock' of fundamental factors. But for the most part US indices move upwards.
In this market environment described above though, these 3 options are weighted more like this:
Scenario 1 - 10% - Very unlikely it'd head back up again right away after many major stocks had dropped and the Dow had posted a bearish pin bar on the daily chart. This is a strong price action signal of negative market momentum.
Scenario 2 - 45% - All the signs are right for a continued drop in price, but it's not a certainty as it's not often that the indices do turn bearish.
Scenario 3 - 45% - It's certainly feasible to imagine that stocks could move sideways with the confusion, they may consolidate for a bit until it becomes clearer what institutional buying wants to happen lol.
So, my take on this situation was that there was around a 90% chance that I'd lose money if I kept running my system. In the event that I'm wrong and it does keep going up, I can totally live with that because I stand to lose more than I gain, and there will ALWAYS be other opportunities in the market.
I look for price action indicators such as a daily or weekly (daily obviously is quicker, and when markets turn they usually do it quite quickly) bearish candle formation. These are the ones that I pay most attention to: Pin bars
These candle formations show undeniable proof that, on that day (or week) there are more sellers applying more pressure than buyers. Nobody can deny that, and I'll fight them if they do!
It's just a fact, and if you see one of these formations occur at a key level (such as historic horizontal support or resistance) then pay VERY close attention as it's probably like 75% chance that price will continue in that direction over the next 5-10 candles at least.
When I saw a bearish pin bar on the daily Dow chart, I stopped my system, and decided to chill out and watch the show.
...Glad that I did, because the next 3 days did indeed drop, although only a pullback of 5.15% it was still a significant enough pullback to hit a long stock heavy portfolio right where it hurts. Rather than being down by, what would have amounted to around -7.5%, I ended up being up by +3.6% over the same period.
Of course, nobody can know the extent of such a move, but even a small pullback is worth being able to pre-empt, as it can really smooth out those returns by mitigating drawdowns.
Here's how to define a downwards market:
Pullback = 5-10%
Correction = 10-20%
Bear Market = 20-40%
Crash = > 40%
I hope that this method of anticipating a change in trend proves useful to you in determining your own methods. It's worked well for me on several occasions and has meant that thus far I've avoided any severe drawdowns that can scare off clients and test you psychologically.
I would like to finish this blog off by saying that I'm a firm believer that nobody can predict what will happen in the markets, but if you use price action to inform your decision making then you are giving yourself a better chance of controlling your edge in trading. Then it's down to you to do your own risk analysis based losely on all the factors your think might play out. Just as I did above with weighting the scenarios.
I'm always fully prepared to be wrong. As long as you can keep your losses small and let your winners run, then any extra risk analysis around that to improve your edge will go a long way towards keeping your equity curve on the up-and-up.
Happy trading guys.
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