Stock Market Trend
The Smart Profits Report: Issue #397
Tuesday, February 20, 2007
Stock Market Trend: Stock Market Enters the Danger Zone with 4 Significant Trend Warning Signs
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
I was hiking on the Appalachian Trail in my native state of Virginia and heard a rapid rattle in the leaves. It was the unmistakable raspy sound of a rattlesnake’s tail. My friend and I froze. I slowly looked in the direction of the sound and saw the brown diamond pattern. A rattlesnake usually signals this way when it fears an attack and is warning that it will take action to protect itself. So while it didn’t definitely mean we were going to get hurt, it did mean that we needed to be on heightened alert before proceeding. But knowing we were a safe distance from snake, we gave it a wide berth and continued along the trail.
How does this relate to investing?
Well, if today’s stock market could rattle, it would. Just like that snake on the trail, it’s giving us some definite stock market trend warning signs that this relentless one-way run up is nearing a danger zone. Should we panic? No, not necessarily. But it does mean we should be very wary of making any sudden knee-jerk moves.
So let’s take a look at what stock market trend warning signs are in the air - and see what actions we can take to combat the situation…
Stock Market Trend Warning Signs
There’s no doubt that the stock market is overextended to the upside. After all, it’s moved almost straight up since September with no significant pullbacks. That in itself is a warning. But there are four other considerable stock market trend warning signs:
- Record Net Cash Inflows Into Equity Funds: When large amounts of capital flow into stock mutual funds and equity exchange-traded funds, that’s a reliable sign of a pending market top. (The same is true for market bottoms and large net outflow of funds). Last week, AMG Data Services said weekly net inflows totaled $10.8 billion. That’s an all-time high. This development could raise a major “red flag” for the markets.
- Volatility Index Has Hit All-Time Levels: The original CBOE Volatility Index (VXO) reached it’s all-time low on January 24 this year. While the VXO (and its re-mastered offspring, the VIX) can be overused and misused, many consider the volatility index to be a prime indicator of market fear or complacency. And all-time levels certainly grab my attention. When they’re at all-time low levels of fear, or high levels of market complacency (that is, investors don’t seem to be worried), it could signal a potential shift in trend.
- Dow Jones Industrials, Transportations, And Utilities Have All Set New Highs: When combined together, the various Dow indexes form a central part of Dow Theory, and their agreement on market direction is typically bullish. While all three heading up in tandem is usually a good sign, the fact that they all hit new highs in the same trading session for the first time since 1998 has traditionally been a sign of market topping activity.
- We’re In The Third-Longest Bull Market In U.S. Market History: According to the 2007 Stock Trader’s Almanac, the current bull market is now the third longest we’ve ever seen. The only longer ones occurred in the 1920s and the 1990s. And we all know how both of those stories ended…
The stock market is definitely showing signs of topping. But just like the rattlesnake’s warning signal, this is not a time to panic. Here’s what to do instead…
Assuming A Heightened State of Alertness
Even after markets become overbought, they can continue to drive upwards for long periods of time. But when they give off exceptionally important signals, it’s essential that you pay attention and assume a heightened state of alertness.
So depending on what kind of investor you are, here’s the plan for combating the stock market trend warning signs…
- If You Have Long-Term Trades That Are Performing Well: Great! Hang on to them and make sure your stops are set at the right places, in case a market pullback occurs.
- If You’re Considering Entering The Market For The Long-Term: Stand down, soldier. This is not a good time to jump into the market with new capital. With these many warning signals running around, prudent money will wait for a pullback or even correction before jumping in.
- If You’re A Shorter-Term Trader: Be wary with volatility contracting here. The market has a tendency to make “blow-off tops” (a rapid and strong upward surge, followed by an equally quick slump back down) at junctures like this. Be on guard and wait for better volatility to boost intra-day trading in order to add some pop to your swing trades.
Good Trading,
D. R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- At times like this, it can be extremely advantageous for you to keep a closer eye on market volatility. The VXO and VIX volatility indexes can provide time-tested, important clues as to whether investors are fearful or complacent about market conditions. For a crash course, check out my colleague Mark Whistler’s insightful article in Smart Profits #381, The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options.
- What ONE thing would make a huge change to improve your investing results? I delve into how to improve your own profits by making some small changes to your trading strategies in Smart Profits #389, Improve Your Investing Results: Your 8-Step Checklist To More Successful Investing.
- As a professional investor and someone who spent six years as a market maker on the floor of the New York Mercantile Exchange, there’s one question that Lee Lowell’s friends and associates seeking the ultimate investment ask him all the time, “What’s the best strategy you recommend for investing in options?” Get all the details in Smart Profits #377, Investing In Options: 3 Powerful Option Strategies That Make More Sense Than Stocks.
Related Articles:
- Dow Theory: The Most Important And Powerful Concept In Technical Analysis
- The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets
- Trailing Stops: How to Give Your Options Room to Grow
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