The Three E’s Are Back

It's Time To Be Careful And To Rely On Your Trading Plan

The up side momentum that had been present in the stock market for the last few months seems to be stalling. That means that volatility is likely to return, and that having a few short positions, whether to hedge long term positions, or to try to make money on the down side is now a good strategy.

Yes, stocks could get some kind of bounce from the situation in Greece. But past experience suggests that unless the S & P 500 can make a new convincing high over the next few days, the rally may be over for now. If we're wrong, we'll pick back up on the bullish side and follow the prevailing trend. That's what trading is all about anyway, following the major trend.

So as the market is starting to show signs of a potential stall, this is a good time to re-examine the major theme for 2012, The Three E's: the U.S. economy, the 2012 election, and the situation in Europe, you can see why the market rally is likely done.

Europe is clearly on the ropes again. Every time Germany gets a victory, Greece riots, and everyone else cringes. That's not success. That's another reason to bet on the collapse of the Euro and the Eurozone. It's no suprise to us, but it seems to be surprising to many. Greece is just the tip of the iceberg, but it's what people see. And riots in the street, a government that won't face reality, and people that don't want to pay taxes are not a recipe for success. What is mind boggling is that the E.U. wants to give Greece more money. The Wall Street Journal, over the weekend reported: "the Greek finance minister told his party's deputies Saturday that troika of Greece's lenders--the European Union, the European Central Bank and the International Monetary Fund--proposed that Greece receive an additional €15 billion ($19.9 billion) on top of the agreed but not yet secured €130 billion ($172 billion) bailout to keep the country funded over the next three years." It's that kind of strange behavior that riles the market and anyone in the world who has an ounce of common sense, which the EU clearly does not.

The U.S. election is also turning more bizarre by the minute. The GOP continues to destroy itself, looking for some kind of miracle candidate to oppose Mr. Obama. Guys, there isn't one. No one in their right mind wants to run for president and have to face a $15 trillion debt with a bunch of people in Congress who are only interested in their own skins. Wake up! There is no savior. There is only what you have. Make the best of it. Roll the dice. That's what we the people do on a regular basis. Come down here and breathe our air for a while.

On the other side of the fence, Mr. Obama, steady as can be, continues his assault on success and traditional American values by wanting to tax anyone who has enough to live fairly well, but not the people that have taken the system off balance, the large corporations and their Congressional helpers. $250,000 is too low a bar for being considered "wealthy." It's not poverty. And it's not an unreasonable amount of money. But it's not wealthy. Warren Buffett, Bill Gates, Donald Trump, are wealthy guys. The rest of us are just working stiffs. Raise corporate taxes, close the offshore loopholes, restore financial borders, and stop penalizing working people.

And if Mr. Obama and Congress, both the GOP and the Democrats, continue to target the medical industry as the cash cow for their own pet projects, the health care system will collapse and billions of dollars of purchasing power and job creation will dry up. That's pretty scary. And no, it's not an opinion. This is what we see in the trenches. This is what we hear from physicians. This is the fear of the very ill. This is what people talk about to their doctors now behind closed doors. What will we do when you shut your door? But no one in power seems to care.

Two years ago, this scribe was speaking to a well connected, politically active physician who had just come back from a CMS sponsored forum in Austin. What the doc told us was spellbinding, frightening, and impossible to forget. He pulled aside one of the main speakers, a high level CMS official in the Bush administration and point blank asked him why physicians were being targeted with such large reimbursement cuts in Medicare. The answer was basically, because "you guys" don't fight back. As long as you don't "fight back," we'll continue to get you. It's that simple. The health care system, in a political sense, is a sheep for plundering by the government. It's the major source of blood for the Vampire kings in charge.

That leaves us with the economy. We think that it has turned the corner and will be stable. It may even grow a little faster than many expect. And that, in and of itself, will make the election interesting. Every day when we drive to work, the Dallas streets and freeways are starting to fill up. The same routes that three months ago were empty are now full of cars. Our favorite economic pulse taking indicator, the number of cars at the drive through window for a well positioned Starbucks in Dallas, is now regularly spilling onto the street. That means that people need their morning java on their way to work. And that's usually a sign that the economy is improving.

The market, on the other hand seems to be running out of steam. Our most reliable indicators over the last few months have begun to soften, suggesting to us that, the intermediate term action in stocks will be much softer than what it has been over the last few months.

Chart Courtesy of StockCharts.com

The S & P 500 (SPX) barely budged on Friday, on a percentage basis. But that small loss hides several important things. First, the index never moved convincingly above 1350 a key resistance level. Second, the rest of the market, as we point out below, took a much bigger hit than the S & P 500. This is the technical divergence that we have been describing over the last few days as a possible turn of events. We think it has started and are changing our stance to bearish for the long term.

Chart Courtesy of StockCharts.com

The Russell 2000 Index of small stocks (RUT) is a better barometer of the broad market. Comparing its loss to that of the S & P 500 is a much clearer picture of what's happening internally in the market. Think of the market at this point as a person who may be in the early stages of developing a major disease. The outside may still look good, but the inside is starting to become ill. That's what we mean when we talk about the market's "internal health."

Chart Courtesy of StockCharts.com

An even better view of the "internal health" of the market is the Nasdaq Advance Decline line (NAAD). This is graph of the number of stocks that are advancing versus the number of stocks that are declining. We use the Nasdaq A-D line instead of the New York Stock Exchange A-D line, which is a more popular indicator, because the NAAD has fewer distortions, such as preferred stocks, ETFs, bond funds, and other instruments that trade on the NYSE.

In other words, NAAD is a better view of how stocks are doing in this market. As the chart shows, they were doing just fine until three days ago when NAAD topped out, failed to rally back to its top, and finally broke down on Friday. This signals that investors are becoming bearish and are starting to sell more stocks than they are buying. When there is more selling than buying, not only does the market tend to fall, but our chances, as investors of picking winning stocks decline. That means that our chances of making money by buying stocks are less now than they were a few days ago, unless this is reversed.

During these times, a good trading plan has provisions aimed at protecting our gains. First, we don't buy stocks during these times. Second, we pay attention to our sell stops. And third, we monitor each position individually. If something is working, we are vigilant, but we stick with it. If it's not working, we sell it.

A good trading plan always includes some kind of hedging strategy. That's why we have recommendation in place in our S & P timing section for buying ETFs that sell stocks short. Because we plan ahead, those recommendations have been in place for some time and will trigger their entry point when the market reaches a certain point to the down side.

Chart Courtesy of StockCharts.com

Next, we look at the Nasdaq Hi-Lo line (NAHL). This is a measure of the market's momentum. As with the Nasdaq A-D line, this line is less distorted by ETFs, etc. than the NYSE AD line. So it's a better indicator of stocks.

Right now, the slope of the rising trend in momentum is starting to roll over. This indicator usually lags the NAAD. Thus it's a confirmation mechanism. If NAAD continues to falter, we expect NAHL to follow. If NAHL breaks down it will signal that up side momentum has been broken and the odds of decline have increased to the point where we have to start thinking of being in a down trend.

Unless something changes, it looks as if we are now within a few days of such a development.

On Friday, in this space, we wrote: "The stock market's rally is suddenly running into trouble. The reason mostly cited is Greece. And that makes sense. But also important is the fact that we are now in February, a month that isn't always bullish for stocks and that the market has had quite a run for the last few months, so it's bound to be tired."

Now we have a fragile stock market to deal with, despite the jump in prices in the early going on Monday after Greece's austerity vote. But dealing with a tough market doesn't have to be a big deal, if you have a trading plan, which we do. We're not saying that this will be an easy market to navigate or that we won't be affected by volatility. What we're saying is that a trading plan will help us to navigate difficult periods.

And the way to play this market is to stick to our trading plan. Monitor each position individually. If it's working monitor it. Pay attention to sell stops. If it's not working you will either be stopped out, or be forced to sell based on your own time frame.

Our S & P timing section has recommendations for when to enter ETFs that sell the market short. Review those entry points and consider following those directions in order to hedge your portfolio. Stay tuned.

When you understand the big picture, the next step is how to survive and profit from what lies ahead. That's why we recommend: "Market Timing For Dummies." and "Trading Futures For Dummies." The Trading Manuals for All Seasons. Also Available As Kindle Books.