As I sit here at my home in S.W. Florida watching the arrival of the outskirts of Issac and occasionally checking the latest updates on the storm in order to take any last minute additional preparations, if needed, it reminds me of the similarities that violent weather forecasting has to the recent warnings that I’ve made in regards to the stock market.
Lately, I’ve been highlight numerous signs of non-confirmation and even many outright red flags that have developed on the rally off the early June lows. To put it bluntly, I believe that the odds of a significant correction are considerable higher than normal at this point. However, one must understand that increased odds of something happening does not mean that it MUST happen. To illustrate this point, let’s talk weather.
As per the National Weather Service: A Tornado Watch is issued when conditions are right for a tornado to form, while a Tornado Warning is an alert that warns that severe thunderstorms with tornadoes may be imminent. Does this mean that a tornado will definitely strike an area in which a tornado watch or even a warning has been issued? Of course not as many of these warnings prove to be false alarms. Does that mean that NWS jumped the gun or was wrong in issuing the warning? Absolutely not. All the conditions necessary for a potentially destructive tornado were in place and just because it did not happen, in no way means that the risk was not present. The fact is that those risks were very high, had those conditions come together at just the right time or place.
I believe this analogy holds true for the stock market. The majority of the time, the risk of a significant correction is low enough to not warrant high levels of caution. In other words, it is safe to be fully invested with minimal to no hedges in place. However, when multiple extreme conditions all happen to occur around the same time (as have been highlighted here and I’m sure elsewhere lately), you then have all the necessary ingredients for a sudden and sharp correction in stock prices. Again, there is a big difference between saying that a correction is going to happen (a prediction) vs. is likely to happen (a warning).
I’ve lived in Florida my entire 42 years and if I had a nickel for every hurricane that was forecasted to hit where I lived, but didn’t, then I’d be rich (or have quite a few nickels at least). Now, just because all but one of those storms actually hit my area, should I become complacent and just dismiss all those warning signs from here on out? Of course not. Ironically, the one hurricane that hit and did considerable damage to my house was forecasted to make landfall around Tampa, 150 miles north, until it took an unexpected turn and caught this area by surprise with very little advanced warning. Hurricane Charley turned out (at the time) to be the second costliest hurricane on record (behind Andrew..which has since been displaced to #2 behind Katrina).
Many homes and businesses in SW Florida were not fully prepared for a direct hit from Charley, as there had been many “false alarms” since the last direct hit by Hurricane Donna over 40 years earlier, which invariable led to complacency (a term being used very often recently regarding market participants). When I look at the stock market over the last couple of years, I see similarities: There have been a few periods where some of the conditions for a sharp correction existed. Some, like the flash-crash, played out while most just dissipated as the underlying negative technical and/or sentiment conditions (red flags) improved while stock prices held up or continued to advance.
Basically, where we stand today, at least by my analysis, is that one of two things will happen: As many of the necessary conditions are in place, either the current red flags will manifest via a correction in stock prices, quite possible a significant one, or those negative underlying conditions will dissipate while stock prices either hold up (relatively speaking, minor corrections aside) or continue to rise. As stated previously, which of these two scenario plays out will likely be largely dependent on how well, or not, the economic data comes in going forward (either stock prices or fundamentals reverting to the mean).
The bottom line is this; If bullish, do not become complacent with your longs, especially regarding your stops. Consider booking some profits if fully invested or at least trailing up your stops. If bearish/short, don’t fall victim to confirmation bias. The market can and will do whatever it wants, regardless of how “irrational” that may seem at times. Stay flexible and keep an eye out for signs of improving market technicals. Just because the odds of a sharp sell-off are elevated, does not mean that it must happen. Trade the best patterns and use stops that are in-line with your own risk-tolerance and trading style, regardless of what any other trader, including myself, might be doing. Finally, and probably most importantly, if you are not sure what to do, going to cash is as easy as a few clicks of the mouse nowadays. Although I believe that the risk/reward current favors the short side, that does not mean that it’s a no-brainier trade. The uptrend is still very much intact from a pure price perspective (although exhibiting potential signs of exhaustion) and until that changes, shorts remain counter-trend trades.
Regarding the R/R, one might make a case now that the market has a better chance of going up over the next few weeks vs. down, and I might even be somewhat inclined to agree with that statement, as the near-term trend remains solidly intact. However, when assessing the risk to reward ratio, I factor in not only the directional probabilities (how likely are we to go up vs. down) but more importantly, the probability of magnitude for both scenarios. Therefore, even if I were to give a slight edge to the market moving higher vs. lower over the next few weeks, my guess for the high-end of move up would be, say 5-8% while my best guestimation of a downside move from current levels (median percentage move) would be 10-20% over that time frame, hence, the R/R being skewed to the short side.