The Stock Market
The Smart Profits Report: Issue #419
Wednesday, May 9, 2007
The Stock Market: Fight The Froth And Battle The Blow-Off… Four Tips To Combat A Toppy Market
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
There’s one common denominator that shows up in most great stock market bull runs: They make everyone giddy.
When the stock market is roaring along - as it is now - the talking heads on television have an excited tone to their voice. Brokerage firms run more ads because people want to put more money into the market when assets are rising. And average investors finally stop procrastinating and pull the trigger so they don’t miss out on “the rest of the big move.”
Don’t be one of these “average” folks who follows everyone else like a sheep, and jumps blindly in at the height of the froth.
Yes, the stock markets are exciting right now. Yes, you can’t turn around without the Dow hitting a new all-time high. But no… you shouldn’t be piling in now for fear of missing all the excitement and the promise of gains.
There are better ways to play this market right now. Let’s look at some of the telltale “froth signs” and see how prudent investors should combat the current situation.
Four Signs Of A Frothy Stock Market Climate
- Dangerously Fast Dow: Through Monday (May 7), the Dow Jones Industrial Average had risen in 24 out of the past 27 trading sessions. The stock market has not powered up consistently like that since July-August 1927. While this looks like a very strong market to some, there is a warning sign here that you must heed. The markets are a complex mix of give-and-take. Nature, it is said, abhors a vacuum. And markets abhor one-way streets.
- Tight Trading Range On S&P 500: Monday also marked the lowest trading range day that we’ve seen in the last five years. The S&P Futures had a range of just 3.75 - a number so low that it’s only happened twice before in the last five years (July 2004 and November 2006). Low volatility is always a sign of stock market indecision. Right now, the market has two big central bank announcements to deal with this week - the U.S. Federal Reserve and the European Central Bank. Both will let the world know their rate policies in the next couple of days. And this basically has the market holding its breath and waiting to exhale.
- China Concerned About Stock Market Froth: Top-level banking officials in China are concerned about the frothy state of the market. Deeply concerned. As renowned analyst Dennis Gartman reported in his letter on Monday:”Mr. Zhou Xiaochuan, the Governor of the People’s Bank of China, is in Basel, Switzerland, for a meeting of the Bank for International Settlements. The press assembled there is hovering on every statement that Mr. Zhou has to make. One has our interest here, for Zhou said that he is indeed worried about what seems to him to be a ‘bubble’ in China’s stock market. He said that the Bank is ‘monitoring’ the market on a regular basis. Mr. Zhou is not given to wayward comments, and he knows how seriously the world shall take his use of the term ‘Bubble.’ Mr. Zhou is not naive. He is a seasoned operator on the international scene, and we suspect he used the term ‘Bubble’ only after careful consideration. He knows that all bubbles end in tears. But he, like we, has no idea when the bubble shall burst. He knows only that it shall.“
- Goldman Sachs Momentum Looking Weaker: Stock market bellwether Goldman Sachs is showing momentum divergence. This means that while the stock is making new highs, it’s doing so with less “push” and less strength than the previous highs. I’ve illustrated this in the “Chart of the Week” section below.
What’s An Investor To Do?
When the market is showing these key signs of “frothiness,” the bottom line is this: Don’t jump in with both feet.
If you’re fully invested, by all means keep riding the wave. Just make sure that as you do, you have your stop-losses in place, and keep adjusting them as long as the stock market keeps moving in your direction.
If you have money to invest, the most prudent decision is to hold some of it back until the market has had a chance to relieve its overbought condition.
But be aware that frothy stock markets can have blow-off tops that have rapid gains before any correction comes into play. And a Fed announcement is the type of trigger event that can cause a blow-off top, or kick the stock market over the edge toward corrective activity.
Great trading,
D R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- Here are some more thoughts on dealing with stock markets that have hit extremes. Make sure you: Spread your risk by having a diversified, balanced portfolio… “position size” (i.e. allocate the same amount for each investment, so no one losing position cripples your portfolio)… and employ stop-losses. The latter is one of the best risk management strategies you can use, because it ensures that you stay disciplined with your investments by never taking a heavy loss, but also grabbing profits when your positions rise. Find out more in Smart Profits #193: Position Sizing: The Most Powerful Investment Concept.
- The Stochastic Oscillator indicator, mentioned with regard to Goldman Sachs today, is a technical tool developed by George C. Lane in the late 1950s. The Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods. Closing levels that are consistently near the top of the range indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure).
- If you’d like to harness the power of short-term momentum investing to your advantage, check out the Momentum Alert. Run by Oxford Club Investment Director Alex Green, you’ll find out how to profit from stocks that are in significant uptrends and enjoying heavy institutional buying right now, as well as companies whose earnings growth is accelerating and market share is increasing. Visit this link for more details on the Momentum Alert.
Related Articles:
- The DJIA Index: As The Dow Goes 14 For 16, Beware The Momentum Indicator Warning Signs
- Stock Market Trend: Stock Market Enters the Danger Zone with 4 Significant Trend Warning Signs
- Technical Analysis Indicators: Harness The Power Of Leading Indicators And Bollinger Bands
The Chart Of The Week
Goldman Sachs (NYSE: GS) is truly one of the great success stories of the last decade or so. The firm is simply a profit machine - and the share price reflects this. However, if the stock is any indication of the underlying market fundamentals (and many think it is), the divergence between the recent highs made and the stock’s momentum are a reason for caution.
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