[dc]L[/dc]et’s take a quick look at some developing market structure in the US stock market. First of all, consider the broad context: we are firmly ensconced in summertime trading conditions. This means low volume and, usually, low volatility. In fact, volatility is extremely low by historical standards. (Note that low VIX does not, statistically speaking, portend any horrible market crash, contrary to the fearmongering going on right now in some circles.) Second, stocks are really strong. We’re somewhere in a historic bull market for stocks, but whether at the beginning, middle, or end… that question is more difficult. (Smart money is on “the middle”.) Stocks have been making new highs, and this is the first piece of quantitative context. What happens after stocks make new highs?
Historically, there is an extremely strong tendency for stocks to make significant new highs (e.g., 52 week highs) and then to reverse or pull back significantly. If you know this, you can be prepared. Buying stocks that break to 52 week highs is a losing strategy because they tend to lag by about a percent over the next month. (However, buying stocks that make 52 week highs and then hold together in good pullbacks does make good sense.) This is an extremely clear and strong statistical tendency—a solid example of mean reversion in action. If you know that stocks (individual and indexes) tend to make highs and pull back, there’s no need to wring our hands over pullbacks at new highs.
The chart above shows the S&P 500 futures, and highlights an unconventional failure test pattern at the highs. The failure test is a pattern that has served me well through the years, and allows trades to sometimes pick off precise turning points at the highs and lows of trends. (I covered it in detail both in my book and in my free trading course. This is an excellent pattern to add to your analytical toolset, even if you decide to not trade it.) The failure test usually occurs when a market makes a new high and reverses on the same or the following bar; perhaps the market has simply cleared stops, found to conviction beyond the pivot, and then collapses back into the vacuum. This is not a textbook failure test: the market did not quite clear the previous high with conviction. (It’s summertime. Nothing is happening with conviction.) The market did not quickly reverse, but lingered at the highs. (Also typical of complacent summer markets.) The reversal back below was a fairly moderate selloff, and came a few days after the high was made. (Though the DJIA did register a -2.2? collapse on this day. Volatility-adjusted measures matter.) Regardless of these arguments and counter-arguments, traders looking to fade this market could initiate shorts under yesterday’s low with a stop above the week’s highs, as the typical failure test dynamics could be in play, at least conceptually, around these pivots.
Once you are in the trade, trade management matters. You’ll have to be proactive taking profits, and there’s always a substantial chance the market will simply turn higher, so you’ll have to be prepared to exit at your stop if the market goes there. This is often the best we can do with trading: find a setup, don’t agonize over it, put on the appropriate position with appropriate risk, and then manage that risk with perfect discipline. I do not know if stocks are going to go down or up over the next few days, but I do know that this little pattern provides a good entry point for nimble, short-term traders and that there is a slight edge for short-term downside. If you are going to take a trade like this, spend some time thinking about all the ways it could play out, both for and against the intended trade direction.
It is also important, I think, for traders to be aware of reports and events that might drive markets. US GDP is released early tomorrow morning. Though it’s unlikely GDP will be a huge catalyst for this market, we do know a lot of attention has been focused on growth lately, economic reports have been broadly positive but growth forecasts have been revised downward. We don’t need to focus on the details of those reports, but it’s helpful to know when major reports might bring some volatility into markets.
One more quick point: the chart above has a few indicators you have not seen before. This week, Waverly Advisors has launched a new quantitative equity trading model in our research that provides both stop points (red and orange dots), entry and profit taking levels, and trend assessment (the colored bar at the bottom of the chart) for actively traded equities. Stay tuned for more information, but we are excited to put this tool to work for our clients as it offers a statistically significant edge for both idea generation and risk management. I’ll cover general trailing stop ideas in a future post, as this is something all traders, regardless of style or timeframe, can incorporate into their process in one way or another.