Extraordinary momentum conditions resolve in a correction

In the last 15 days or so the readings on short term momentum indicators like stocks up 50% or more in a month and stocks up 25% plus in a month were at elevated level. In many instances the readings were at highest levels seen in many years since the rally started in 2002. Such high momentum phases either resolve in orderly pullback or high volatility zone. Yesterday the high momentum phase resolved in to high volatility.

Based on previous experience I was expecting a 300 plus kind of down day for sometime. The thing with Market Monitor kind of anticipatory mechanism is it tells you a zone where it is likely to occur but precise date is difficult to pinpoint. This time the readings stayed elevated for longer time in this instance, in normal rallies there is backing and filling, where a high momentum phase is followed by quick shakeout of a day or two followed by more strength.Since 10 th October, I have been anticipating a dip of some magnitude. because the Market Monitor indicated such a dip.

Wednesday, October 10, 2007

Caution Time

The stocks up 50% in a month is at record, I have not seen reading like these for long time. What it means is many stocks which have run up a lot till date are prone to correction. Some of the shipping stocks look due for correction. The China stocks are just too difficult to game, but now lower quality stocks are breaking out. So even though for short term trading they are good, but holding them for long term is risky .

If you notice, IBD has turned cautious on market. For last couple of days it has been emphasizing not chasing strength and wait for pullback to 10 week average. It has also ben pointing out that now lower quality stocks are breaking out.

In the past many times at such elevated readings many stocks which have run up a lot 30% plus in a month, churn at their recent high on high volume and suddenly gap down or have a shakeout move of multiple points. If you look at many shipping stocks, you would see very high volume with no price gains.

If you look at scans also, most of the scans have few candidates with one month price growth below 10%. It is always difficult to nail such dips with precision. We are in such zone, based on my past experience. So from a trading perspective what it means in my book is moving stops closer and a bit cautious on buying new breaks till such dip takes place. Trades with shorter time horizon is currently my preferred option.

However the market since July- August has been in a different high volatility phase. So circumstances are not normal. With 65 days ratio still in positive, I would expect a bounce in a day or two. If the 65 days ratio starts deteriorating fast then we will have put in a top. At this stage my judgment is we will probably have a mixed market with some stocks going down and technology and commodity sector still holding on to gain and select stocks out of those sector rallying.

When such corrections happen , lot of people are caught by surprise, they get excited or confused. My mailbox is full of people anxiously asking what next. Having previously gone through similar bewilderment and anxiety, I developed Market Monitor as a filter for my kind of trading style.

If you have seen the behavior of market as indicated by Market Monitor , you know you can react to such things calmly and with a plan. Since the 50 % reading became elevated, I have had very light commitments and have been cautious in committing to ideas and as a result managed to keep almost all the profits accumulated previously. When trading momentum systems like Double Trouble, IBD 200 and Modified Double Trouble, it is more profitable to anticipate such periods.

If your trading horizons are longer, accordingly, you need to look at developing some sort of anticipatory mechanism. Markets, methods and mindset all the three need to be aligned to trade profitably.