By: Chris Rowe — June 14, 2015
How to Avoid The Coming Bear Trap
I'm writing to warn you about a very dangerous trap being set up in the stock market.
I, for one, fell for a very similar trap just two and a half years ago, and lost a few dollar in the process. And I'm the guy who created multiple investing and market analysis courses, written over 1,000 articles and held seminars on how to avoid traps like this one. I don't claim to be perfect.
One concept I drive home in my teachings is that even the most seasoned veterans and successful investors make mistakes where they absolutely know better. The mistakes are crystal clear, in hindsight. But the following article is to point out a devastating trap, ahead of time.
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The Bear Trap
We've just seen an important technical sign of weakness in this stock market. This time around, the signal can be tricky because it's the type of signal that implies weakness, but where the stock market can rip higher in your face. And if you get bearish, it can be painful. Instead, exercise more caution than usual and be ready to buy quality on the dips.
We have seen several signs of weakness over the past two months but now "the grand daddy of stock market risk indicators" is telling us to start playing defense instead of offense.
I'll tell you what the bearish signal is in a moment.
But it's extremely important that you not make the mistake that I made in early 2013 when I took bearish positions on what appeared to be a very toppy market.
Any successful technical trader won't soon forget the massive bear trap of early 2013. A "bear trap" is a Wall Street term describing when a long-term uptrend appears to be reversing lower, showing many signs you'd typically see at a market top, only to continue higher again.
Short-sellers pile on the bearish positions and then they get smoked when prices actually reverse higher again, especially if they're not limiting their downside risk.
Thank goodness I did have my stop-loss orders in place. The losses were limited. But the point is there were a plethora of bearish signals that the Technical Analysis community absolutely had to heed so as to not stray from an approach that had done well by them over the long-term. And I stand by this concept, where investors should stick with one proven approach and just endure the losses that come with investing.
But there was one overwhelming piece of evidence that should have told me that, instead of taking my bearish positions, I should have simply been less bullish and more cautious. The stock market in the fist half of 2013 turned out to be strong and that may very well turn out to be the case in the coming months. But the stock market is vulnerable to a dip at this point so it's important to have a solid perspective on the market risk and how to play it.
Market Internals vs. Relative Strength
The stock market approach that I've been using for most of my 20 year investing career and teaching for 7 years focuses on two aspects of the market: Market Internals and Relative Strength.
Shockingly, most investors don't focus much on either or they spend a small fraction of their time thinking about these concepts. But the majority of people underperform the stock market and are distracted by stock market noise.
Market internals and relative strength reveal the "True Market".
The trap I want you to avoid today, considering my readers probably have a better understanding of market internals than most other investors, is losing sight of the powerful relative strength position the U.S. equity market remains in, today.
Market internals are telling us we should definitely take a defensive stance on the stock market at this point but that's different from taking bearish positions. One important relative strength relationship is telling us we should remember the long-term strength in U.S. stocks.
Market Internals - The NYSE Bullish Percent Index
You may know that the New York Stock Exchange is the worlds largest stock exchange listing 1,869 stocks with a total of over $16 Trillion in market-cap (the market-based valuation, or number of shares outstanding X market price).
But do you know what size stocks the NYSE composite mainly consists of?
Most people would guess large-cap. After all, the Russell 2000 index has 1,993 components - a larger number than the NYSE has - and the Russell 2000 is specifically focused on small-caps.
The NYSE mostly consists of mid-cap stocks (stocks of companies valued between $2billion and $10 billion). The average market-cap is actually $1.9 billion, which is small-cap territory (below $2 billion) and the smallest company in terms of market-cap is valued at only $2.5 million!
The two specific U.S. stock styles, recently bouncing between first and second place in terms of strength, have been mid-cap growth and small-cap growth. Mid-cap value has also been very strong and small-cap value, not so much.
With this in mind, you'll have a better understanding of an important change in the stock market.
The grand daddy of stock market risk indicators, the NYSE Bullish Percent Index recently signaled increased risk to bulls. This is important because, while the Bullish Percent Indexes of other groups of stocks (S&P 500, Nasdaq etc.) have already signaled increased risk, the NYSE BPI is a mix of two especially strong groups: Mid-Caps and Small-Caps. When the strongest groups finally succumb, it's cause for a bit more concern.
Quick Review of the BPI
The most effective way to view market internals is by checking the "Bullish Percent Indexes" of various groups of stocks. You can create a "BPI" out of any group of stocks whether it be the stocks listed on the NYSE or even just stocks in the same industry/sector.
The "Bullish Percent Index" tells us what percentage of stocks, within a particular group, are on buy signals. This tool gives us a great understanding of the level of risk in a certain group of stocks as well as which force is currently stronger; supply (likely to push stocks lower) or demand (likely to push stocks higher).
The New York Stock Exchange Bullish Percent Index (NYSE BPI) recently completed a significant reversal lower. This means a large number of stocks in the NYSE composite recently moved from buy signals to sell signals.
The indicator is telling us that supply is in charge, for the time being or until further notice. When the NYSE BPI is at a relatively high level the implication is higher risk. That isn't the case thus far.
The U.S. stock market has been trading in a historically tight range. The number of stocks on the NYSE have only gradually been moving from buy signals to sell signals so its' not some ferocious move that causes us to spring into action.
When the indicator has a significant reversal lower, it creates a new down-column or "O-column", as it has in the chart, above (red arrow). This reversal happens when a large number (over 6% of stocks in the group) break below key support levels. When a stock breaks below a key support level it's typically more likely to experience weakness. So this change in the NYSE BPI shows another sign of the supply-side taking control of the stock market.
The higher the reading is when we get a new downward reversal to an O-column, the higher the level of risk. This O-column occurred in the mid-50s so we don't see a heck of a lot of downside thus far, but that doesn't mean it won't happen. We will become a bit more defensive because we would have to see more signs of deterioration before we would actually become bearish.
Just as there are many different types of market internal indicators (like the NYSE BPI), there are many different types of relative strength. Relative strength, as the name suggests, reveals the strength of one security (or asset class) verses another. It might be the "RS" of one stock verses the stock market, the RS of one stock verses its peer group (sector), the RS of the sector verses the stock market, a sector verses other sectors or an asset class verses other asset classes.
What we must focus on today and what I should have focused on more in the beginning of 2013 is the RS of the U.S. equity market verses the other 5 major asset classes.
Major Asset Classes
- U.S. equity
- Non-U.S. equity (can be broken down into developed and non-developed)
- Fixed Income
Without diving into an entire lesson on relative strength I'll tell you that a huge number of relative strength studies, comparing several hundred different funds representing the 6 asset classes revealed, above, show the U.S. stock market having enormous relative strength. The asset classes, above, are listed in order from strongest to weakest on a long-term basis.
On a historical basis, the distribution of strength is overwhelmingly weighted toward U.S. equities. In fact, when compared to the confusing time frame in early 2013, when many technicians took losses by following their time tested indicators, the relative strength position of these six asset classes was just about as heavily weighted toward U.S. equities as it is today. The main difference today is instead the Fixed Income asset class moved to second place and non-U.S. equities moved up to second place. U.S. equities has barely budged from being ranked #1, by far.
So again - we follow market internals and relative strength in order to see the current stock market clearly. We don't forecast or predict. Instead we are trend followers because trends in motion tend to stay in motion until acted upon and reversed by an opposing force. Our strength, at Rowe Wealth Management, is having an especially clear understanding of the current market environment and quickly adjusting to that environment. We focus on intermediate-term and long-term trends.
Don't view today's situation as two indicators giving opposite signals. That's one simplification that tends to hurt investors who are new to this approach. Instead, take both signals seriously. One is shorter-term in nature (market internals suggesting weakness) and the other is a long-term picture (U.S. equity relative strength). These signals are no guarantee of anything but understanding the dynamics of how financial markets typically work allows us to draw reasonable conclusions based on the current environment.
The longer-term picture tends to be the stronger and more valid picture while the shorter-term picture speaks to just that - our shorter-term stock market posture. Long-term the relative strength of the U.S. stock market looks to stay in place for the foreseeable future while the intermediate-term picture shows a vulnerable market.
Know that volatility may be coming, especially in a quadruple witching week like the one we are entering along with the Fed speaking on Wednesday.
Join me Tuesday on my "Quick Dip 20/20" live webinar presentation with a live Q&A to discuss two ways to take advantage of a short-term dip within a strong long-term uptrend. There is no cost to you for attending. It's 20 minutes of presentation and 20 minutes of my answering your questions.
Register here. I hope you can make it!
You can also learn more about relative strength investing with these free articles:
***Disclaimer: Rowe Wealth Management is NOT a part of True Market Insiders. They are two separate companies, in different locations, with different management and employees. Rowe Wealth can't answer any questions about True Market Insiders or its programs, and True Market Insiders can't answer any questions about Rowe Wealth Management. True Market Insiders is not a registered investment advisor.