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Market Transitions
The Smart Profits Report: Issue #431
Wednesday, June 20, 2007
Market Transitions: The Three Main Market Conditions, and a Plan for Each
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
Today, I’m one of those proud dads whose son made the baseball Little League All Star team. The path he took to get there is an interesting one, with some good market lessons. Josh has always been a great defensive player - a good glove man, as they’d say in baseball. But he started the year hitting below his capabilities.
But then a funny thing happened when he started golf season - Josh’s baseball swing suddenly became a terror in the league. In fact, by season’s end he was cracking the ball all over the park and moved up to the “clean-up” position in the batting order (meaning he bats in the fourth spot). In the end, Josh’s golf practice really improved his baseball swing. It’s the same swing, but two different situations - baseball versus golf.
And therein lies the market parallel - one stock market, but many different situations for investors as the market transitions… We’ve been enjoying one type of market - a steady uptrend - the easiest type of market in which to invest. But savvy investors already have plans for when (not if) the market character changes.
What’s Your Plan for the Next Market Transition?
Investors get hurt the most in market transitions. Two weeks ago, I called this market the “Energizer Bunny” - it just keeps going and going. In fact the S&P 500 hasn’t had a 10% retracement since hitting lows in October of 2002. We’re coming up on five years without what market technicians would consider a correction.
And while this climb could continue for months, even years, all investors and traders need a plan for how to handle the next market change.
You see, three generally accepted market conditions exist: up, down and sideways. Some add a second variable - high versus low volatility - to the mix. But for this discussion, thinking in terms of three main market types will do…
Since no one knows for sure what the market’s next transition will be, let’s be prepared with a useful plan for each of the three market types:
- Up market: Since we’ve been in a steady up market for so long, it’s probably best described as “business as usual.” The two main dangers here are trying to pick a top and being overconfident. If you’re wrong when picking a top, you’re going to miss out on the longer-term gains. And overconfident investors often speculate on the most volatile performers - ones that are the quickest to fall off the cliff when a pullback comes. So be mindful of each.
- Down market: This is what most folks are not prepared for financially or emotionally. For instance, the little air pocket we hit on February 27th had people screaming about unbearable carnage. And it was only a 3.4% drop (in the S&P 500).
Preparation for an inevitable pullback is the area where most investors and traders need to spend some planning time. So make sure you have your stop loss points for all your investments. And also prepare a re-entry plan. You must strike a balance between getting back in too soon (and then getting caught in more down movement) and waiting too long for confirmation.
- Sideways market: The slow grind sideways isn’t that tough, unless it is accompanied with volatility. Non-volatile sideways markets are just boring. They rarely produce moves big enough to stop you out of positions. And they don’t make us much money either. A sideways market was last seen in 2004 - from December of ‘03 to December of ‘04, the market was stuck in a range of 100 S&P 500 points (for comparison sake, in the last three months, we’ve had almost double the range of that whole year).
The plan for a sideways market is patience. Finding the sectors that are outperforming is helpful, but this is typically a time when traders and investors must take what the market gives and not try to wring blood out of the proverbial turnip.
A periodic review of your trading and investing plan is always a good idea while the market transitions. And knowing that you have a plan to survive and even thrive in whatever conditions the market throws at you will help even the most jaded investor enjoy restful nights.
Great trading,
D. R. Barton, Jr.
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Related Articles:
- Financial Risk Management: Know Your Risk Tolerance Before You Trade
- Trading Lessons: Catching The Market Waves for Stress-Free Trades
- Trade Small… Save Big: The Single Best Piece of Trading Advice Ever
The Chart Of The Week
The U.S. and world markets have bounced back from their recent drop. But emerging markets have been stronger, making new highs versus early June numbers. Beware; the same volatility exists on the way down when we hit the next pullback!
