No surprise in the dip

When market reach momentum extreme , traders and investors sometime get emotional and overconfident. But such parabolic straight up moves in large number of stocks are not sustainable for long period. Recognizing when market is entering such territory is important. Part of the move is very profitable, but if you don't get out in time or enter a momentum stock late in cycle, you have no safe exit.

There was no surprise in yesterdays action. The signs of something like this happening were everywhere:

1. By mid morning the Stocks up 50% in a month reading on Market Monitor reached 48, that is the highest reading in last 4 years I have seen. When momentum reaches extreme it always resolves in some dramatic action. It was in red territory for last 4 days .
2. Overconfidence. Signs were everywhere. When I start getting emails about windfall trading profits, I am always nervous. In addition when I start getting emails from those who missed out on rally, you know their pain is too much.
   
3. String of trades with 25% plus profits in few days or week .

The Market Monitor essentially gives you warning ahead of the time. Every time the Market Monitor readings reach extreme, the market looks easiest to trade. Most traders confidence is high due to number of successful trade and then if you are not prepared you end up giving up lot of built up profit.
This is what I wrote about in Members Only area on Wednesday .

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.

While the action was ugly, in number terms it was not such a bad day with downside breakouts below 300. Most probably today's action will resolve in to greater volatility period. Normally it takes 2-3 days to get clear picture. In most such sell offs I get back in to market after 2-3 days . All such dips are buy opportunities as long as 65 days ratio is positive. So while the action was ugly, it is good as it released the pressure in overheated market.