Sunday, January 31, 2016

State of the US equity market

Let's get to it. Today's first chart is the weekly chart of the NYSE index:

I see a possible massive Head & Shoulders top forming in the major U.S. equity indexes. Does this mean that a 25%, 40%, 50%, or even larger drop in stocks is inevitable? No, charts do not predict, let alone guarantee, financial or economic developments. Charts - and our interpretation of them - only inform us of possibilities. It is possible for stocks to rally and negate this topping interpretation.

Still, the possibility of a serious drop is real. Remember, recessions happen (and it seems we always know only in hindsight), and stocks drop quite a bit during an average recession. If we experience a more serious global financial trauma, then a 50% or even 60% or greater decline is possible. Stocks lost 90% of their value during the Great Depression. Anything is possible. We can only try to control our emotions and limit our risk as traders.

The next chart is a daily NYSE chart for a closer view of the set-up:

After declining more than 10% from late December, stocks have rebounded in the last 2 weeks and seem to be in the middle of a rally. Nobody knows how much higher this rally will go.

As noted, we can only control our entries, exits, and risk. Positioning and staying patient are vital. We can be "right" about the market and lose money. Say that we expected the market to break down. If we shorted heavily after the indexes broke below the neckline, then we may be surprised and dismayed by the market's recent rally. And such panic is understandable. After all, the market may continue to rally for weeks or even months as it not only negates the H&S top but also starts another uptrend. Nobody knows. So positioning is vital. If we have not shorted yet, then the current rally (if it continues) may give us a chance to short at a spot (higher) that better controls our risk.

If we piled into short positions just before the market rallied, then covering them may be appropriate. If the market resumes its downturn, then we'll have conserved enough financial and mental capital to re-short at an appropriate place. If the market continues  higher, then we'll also have conserved our capital as we wait to see a potential inflection point before the market turns down again.

Remember to stay flexible. If the market doesn't decline but instead starts an uptrend, then we can trade accordingly. Or not. No one forces us to be in the market. Don't trade if you don't want to trade. The key is preserving our capital so we have a choice.

There are no certainties in trading except risk. Always remember that there will always be more set-ups to trade.