Monday, January 27, 2014

If the bear market has begun . . .

As every trader knows, no trend lasts forever. In our trader hearts, we know this.

We have, whether in denial or not, been waiting for the big one, the major bear market that will take back much of the market gains since Oct. 4, 2011, and indeed, since March 6, 2009, the Great Recession low.

Large trend changes break things. They break analytical systems. They break assumptions, habits and ways of thinking.

What worked yesterday no longer works today. The world is turned upside down.

And so it is with the systems that have served me well during the prior uptrend.

Trading tools break when trends change because they all, by their nature, have a built in lag time.

The shorter the lag time, the more prone the tool is to false positives, the dreaded whipsaws that can turn a trader's profits to losses in an instant. The longer the time lag, the more reliable the signals become.

Take the venerable moving average, one of the oldest technical tools for calling trades.

In its simplest form, the strategy is for the trader to open a bull position when the price moves above the moving average, and to close it and perhaps to open a bear position when the price moves below the average.

Click on chart to enlarge.
S&P 500 5 years daily bars with 200-day simple moving average
Long-term traders -- "investors" -- would use a 200-day moving average, which averages 200 days worth of closing prices. That works out to about a year, a bit less.

It's a fairly reliable signal. On the five year daily chart for SPY, which tracks the S&P 500, I see only three whipsaws, the last being in October 2012.

If the bear market has begun, however, it doesn't show yet on the 200-day moving average. SPY opened today at $179.06. The moving average stands at 170.31, 4.9% below the close, and is still rising at a steep angle, as it has been since early 2012.

The moving average is clueless to what has been happening in the past week.

Many popular analytical tools rely upon averages, such as the MACD or Bollinger bands.

Or take the major tool that I use in my first round of analysis. It doesn't use averages -- that is its attraction for me -- but it does have a lag time.

I calculate historical odds that a signal will be successful over a period of time. If a symbol has given a bear signal, then I look at former bear signals in calculating my odds.

Presently, I'm calculating odds for the past six months, from June 24, 2013.

Here's the problem. Out of 333 bear signals given in Friday's decline, 250 have no history of bear signals since last June. They've been in uptrends, like most of the market, and therefore have no historical odds of successful bear trades.

Under the new conditions historical odds are meaningless. Relying upon them is an invitation to miss good trades.

Case in point: The S&P 500, which I wrote up this morning in "The Market: Has the apocalypse arrived yet?", has no history of bear signals within the period I'm analyzing.

For the bull and bear signals themselves, I rely upon one of the most flexible analytical tools around: Price channel breakouts, a core component of the famed Turtle Trading strategy.

I use the 20-day price channel, which means that any signal I get reflects a trend that has been underway for 20 trading days or less.

Click on chart to enlarge.
S&P 500 3 months daily bars with 20-day price channel
The S&P 500 moved from the top of the 20-day price channel to the lower boundary, where it gave a bear signal, in only six days.

My motto as a trader is this: When conditions change, evolve. And if it becomes clear the the Great Bear Market of 2014 has begun, evolve I shall.

A characteristic of bear markets is that symbols with low liquidity are impossible to trade. I define high liquidity as stocks with market capitalization of $10 billion or more and average volume of 3 million shares a day or better.

Stocks that are liquid have sufficient open interest on their options for use in building bearish spreads, and many can even be borrowed for short sales of shares. Neither course is available for symbols of lower liquidity.

This week that works out to 174 stocks, plus around 78 exchange-traded funds that include some of lesser liquidity, for a total of 252 symbols, a huge step down from the 3,877 symbols in my present analytical universe.

Since under newly born bear-market conditions my odds analysis is no longer useful, my primary screening tool will be volume -- the higher the volume the more attractive the trade.

After the first round of screening, of course, the survivors would undergo my second round, which focuses heavily on the chart, sufficient liquidity and the absence of an earnings announcement within the next 30 days, as well as confirmation of the signal in the form of the stock continuing to trade beyond the 20-day price channel.

This week ought to provide a clear indication of where the market is going. In my analysis today I counted the S&P 500 as moving into a downtrend that will correct the rise from last August.

If the bear market has begun, then it will eventually amass enough history to allow me to resume using odds to assessing potential trades.


My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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