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Analysis, Perspective, Trading Strategy

Don’t Trust the Bots: Stay Long but Keep Your Eyes Open

By Joe Duarte on July 8, 2018

In an episode of the Sci-Fi series “Babylon 5” which ran from 1994-1998 through syndication, and whose basic premise is not far from today’s Earth and over the top geopolitical situation, Kosh Naranek, a representative of a secretive alien race, the Vorlons, once said: “Understanding is a three-edged sword.”

It’s a frightening stock market where little seems to make sense these days and where understanding is indeed a three-edged sword. Moreover, it’s a market where as the news gets worse the market rallies to new highs. Consequently, every new outlandish development raises investors’ fear levels as no one knows what may be around the bend. As a result, if you trade, it’s hard to shake that nagging feeling in the pit of your stomach that keeps you on your toes but raises your blood pressure.

And why shouldn’t we all head for the antacids? Everything feels wrong. It’s no secret that the Fed will continue to raise interest rates for the foreseeable future and that eventually things will get very dicey for stocks as investors flee for the safety of higher interest rate deposits with lower risk than stocks. Geopolitical risk is high and rising with frequent and conflicting reports making facts difficult to process and often leaving investors with only the “better” of two bad choices as actionable alternatives. Furthermore, volatility is on the rise with 100 point price swings in the Dow Jones Industrial average occurring on a daily basis and sometimes on an hourly basis given the headlines of the day.

Of course, this volatility is due to the prevalence of robotic trading algorithms whose programs are designed to move money in and out of the stock market based on headlines and technical indicators such as support and resistance levels. What is also clear is that robot algorithms have clearly been programmed with strong digital stomachs along with heeding the words of J.P. Morgan: “Buy when there is blood in the streets.” Certainly we can complain and wish things were as they once might have been, but it’s not worth the trouble. Successful trading, at least for now calls for a new approach. Since robots rule the market, it’s important to understand how they “think” and to adjust to the reality of the trading moment.

As Martin Zweig famously said; “don’t fight the market’s momentum.”

The Trend Remains Bullish

Taken at face value we are in a scary place. Nearly a decade into what is clearly a secular bull market in stocks and nearly nineteen months into the rally that started in November 2016 after the election of Donald Trump, the New York Stock Exchange Advance Decline line (NYAD) has made yet another new high. Now while some may wonder as to what this could mean, I will again point out that the NYAD has been the most accurate indicator of the market’s trend since the November 2016 election. Furthermore, what that means to me, is that until NYAD is proven to be wrong, I will follow its lead and stay long stocks, albeit with one eye on the exit and one foot in the door.

As I noted last week, the NYAD had touched its lower Bollinger Band at the end of June, the eleventh time it had done so since November 2016. And as it had done eight previous times, this tag led to yet another reversal of the line to the up side. Furthermore, the upward thrust in NYAD was much stronger this time than in recent times during the post election rally, which suggests that before the market pulls back at some point, we may see some very dramatic gains.

Don’t Sweat the Lagging Indexes for Now

While NYAD has broken out to the upside, the Nasdaq 100 (NDX) and the S & P 500 (SPX) indexes have yet to deliver a new high. This is not necessarily bearish, especially if the indexes remain in trading ranges and NYAD keeps climbing.

Moreover, the fact that NYAD keeps climbing says that more stocks are participating in the rally than those that are falling in price. And when more stocks participate in any rally it raises the odds of individual stock pickers picking winners and making money. Thus, as long as NYAD keeps moving higher, the odds of making money favor active investors who can pick stocks with above average odds of moving up in price.

That said, there are still some points worth considering.

1) Volume remains a problem for the indexes

2) NDX and technology stocks are starting to lag

3) ROC, which measures momentum, remains below the zero line for both NDX and SPX

These indicators suggest that even though the trend remains up, volatility is likely to continue and that the market remains vulnerable to headlines.

Don’t Trust the Bots: Stay Long but Keep Your Eyes Open

Don’t trust the robots. But don’t ignore their influence on the markets and how you can use what you know about them to make money. Indeed, 2018 may go down in the books as a year in which cautious stock pickers whose focus remains on balancing profits and risk management beat the indexes. Therefore, the major focal points remain the same. Trade in small lots. Look outside the indexes for stocks with sound fundamentals and strong technicals. Consider using inverse ETFs as a portfolio hedge. Use options and option strategies such as Buy-Write and spreads to diversify holdings and decrease downside risk.

This is what’s working right now. Tomorrow may be a different day.

“Understanding is (indeed) a three edged sword.”



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