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By: Chris Rowe — January 11, 2011

Top 2011 Stocks? SELL THEM NOW, Buy 'em Back Cheaper!

Every Tuesday (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the week:

Which momentum indicator am I describing?

This indicator compares the strength of the price action of a security to its own historic price action.  This indicator gives overbought Sell and oversold Buy signals, oscillating between 0 & 100.  As is the case with nearly all indicators, you can use any number of time periods to adjust the indicator to work with the time frame that you are studying.  Below is the calculation: 

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NOW HEAR THIS:  If you are fully invested in bullish positions in the stock market, then you absolutely should either hedge a large percentage of those positions (instead of selling at least half -- perhaps due to tax reasons), or you should reduce your bullish exposure and wait for a pullback to reenter at better prices!

Sure, the general market might decline by only 5% or 10%.  But what if your individual positions don't do what your favorite weighted market average does?  What if the averages decline by more?  What if the market trades down or sideways?  Wouldn't you rather be in a CD collecting a bit of interest with no volatility, a currency that is on the rise, a short-term bond, or even the king of all securities:  Cash?

Heck, it might even be fun to take the family to Disney.  The bottom line is you should act the way the smartest, savviest and wealthiest traders are acting right now and sell into the strength (perhaps not at the exact top).

Below I will give you some compelling reasons (statistics) that may convince you to take this warning seriously.

I'm not saying it's time, yet, to be aggressively bearish.  But in strong bull markets, the corrections we see are often half complete by the time we have seen enough confirmation to take bearish positions.  That's dangerous.  And if your bearish positions are being taken as a HEDGE, then they should be taken a bit earlier than that.

To be a total bear would be "contrarian". 

To make sure everyone in the car has fastened their seat belts when it starts snowing and the driver is, perhaps, a bit too aggressive, is called "prudent". 

BEING A "CONTRARIAN" CAN BE PROFITABLE -- Just not my style.

One of the most painful things to do is to be a contrarian. 

*  Painful to your trading account if you are a contrarian TOO early and can't maintain the position. 

*  Painful to your stomach if you are TOO early and don't have any Pepto Bismol nearby.

(Both, listed above, can either result in a market that declines 1,000 points, but only after gaining 1,200, or in a market that ultimately moves lower than where you originally became a contrarian -- and vice versa.)

*  Painful in a circle of friends who are traders in the camp who's currently on the RIGHT side of the trade -- especially if the friendship is strong enough to sustain multiple friendly jabs here and there.

As they say, "don't dish it if you can't take it".  I'm all for friendly jabs.

Your style might be to have all bullish positions, but to now tighten stop loss orders as risk is elevated. 

Your style might be to just move away from equities and trade futures or bonds -- or just ETFs that track securities other than stocks. 

Maybe it's a combination of both. 

I choose to play most financial markets, including stocks.  When trading stocks, I maintain both bullish as well as bearish positions at the same time.  And based on the stock market's trend and condition, I adjust the "bull position to bear position ratio" accordingly. 


TOPPING SIGNALS

There are too many to list here, and I reserve most of the specific info for my paying members.  But I'll tell you some of the compelling things to pay attention to, and remind you that most good traders won't act until they see confirmation -- which means price action and lagging indicators' signals. 

The idea is that it's best to not try to call tops or bottoms, which I wholeheartedly agree with.  Again, my style is to hedge as my market stance needle sways from the bullish extreme to the bearish extreme and back to the middle.

When we look for signs of a top, what we are often looking at are leading indicators.  By definition, these are signals seen "early" -- or, before the reversal.    

Sentiment indicators are leading indicators that can flash red 30 - 60 days before a sell off.  The question is how far the market can move up before that sell off happens, and the answer is almost always:  Not very far at all.  There are always exceptions.

Mutual Fund Cash Levels is a leading indicator that can flash red 3 - 9 months before a sell off.  It works similarly to sentiment indicators, but sentiment indicators are often derived from surveys of people who don't have much skin in the game (if any at all).  Mutual funds are known for being wrong all the time, but actually putting their money where their mouth is.  When they have little cash on hand, it shows that they are super confident in the bull market (a warning to the savvy) and that they have little money to buy more stock from the coming sellers. 

Buying climaxes (when stocks hit 52-week highs but close down for the week) is a leading and a lagging indicator, and usually gives signals very close to tops.  It's a reading that occurs due to price action, but you usually see it happening before the majority of stocks start to decline.  It shows that selling is happening, and coming from those who are strong enough to knock the stocks down and savvy enough to do so near highs.  Savvy "whale" investors are forced to sell into strength (often because selling into a decline can seriously damage their profitability and the stock they are selling).

All three of these indicators are flashing red, and have been for months.  And as I said:

Mutual fund cash levels:  3 - 9 months lag time (and we saw alert in July - now).
Sentiment indicators:  30 - 60 days lag time (and we saw alert in November - now.)
Buying climaxes:  Usually only weeks of lag time, if that (and we saw alert in November AND now).

MORE SPECIFICALLY ...

Mutual fund cash levels are at around 3.6%.  Over the last two quarters they hit record lows not seen since 1968 (the oldest records I have).

Sentiment readings of several different types have flashed red like we haven't seen since stock market's all time highs in July and then October, 2007.  AAII bullish readings well over 50 on a number of weekly readings ... Investors Intelligence's bullish readings close to 60 and above 55 for several weeks ... and the ISEE's various sentiment readings showed a number of overly bullish signals over the last couple of months.  About 90% of the time, when we see these readings we get a sell off. 

So where is it?

Data compiled from Investors Intelligence (shown below) have been showing a huge number of buying climaxes.  Over the last 5 years, we got the third highest number of buying climaxes seen (604) in November 2010.  We got 610 near the 2006 May high (before the sell off) and 1056 at the April, 2010 high.  Feel free to study the top 24 buying climaxes since 2006 below ...

(Click on image to enlarge)

It pays to be a contrarian, as long as you don't get aggressively bearish too early.  To be a contrarian has another meaning: "To not make the same mistake everyone else is making".  That means you don't have to be a bear and step in front of a train, but instead, you can get out of some of the bullish positions you have to hedge them.

In mid May, 2008 I wrote to you telling you to get out of commodities when everyone loved them.  I was called a fool.  That was the top.  

I told you from mid 2007 right up to the 2008 crash to be bearish on Wall Street stocks.  Same thing.

I gave you over 10 Chinese stocks to take long-term positions in that traded up hundreds or thousands of percentage points in October and November, 2008, and I got some very nasty feedback, which further solidified my conviction.

I made the same kind of comments on the market in late December, 2008 through early January 2009, and similar comments to members of The Trend Rider in the first few days of 2008, and there are many more I can list.  But they were all at times where I seemed to be going against the grain and against what I practice and teach -- that the trend is your friend -- but that's not what it was at all.  It was more of a warning.

Of course, I have made incorrect calls, but as long as we go with what odds favor every time, we will come out on top over the long haul. 

ANALYSTS ARE USUALLY WRONG

All you hear about nowadays are the brilliant analysts talking about the notion that the market will move higher form here.  Don't listen to these experts.

I just read an interesting article in The Wall Street Journal by Brett Arends, who compiled data from Thompson Reuters.  In this great article, he compared the performance of the top 10 stocks most recommended by analysts to the top stocks most hated by analysts. 

Here are the results he found (before trading costs and tax):

In 2010 -

The S&P 500 overall gained just 13%.

The top 10 stocks most recommended by analysts showed an impressive 24% return.

The 10 stocks that the Wall Street analysts liked the least a year ago gained 32%!

2009 -

The S&P 500 gained 26%.

The top 10 stocks most recommended by analysts made a 22% profit.

The 10 stocks that Wall Street analysts liked the least made a 70% profit.

2008 -

The S&P 500 plummeted by 39%.

The top 10 stocks most recommended by analysts lost 48%.

The most-hated stocks (that are still in the S&P 500 today) lost 51%

He combined data going back to 2006.  From the beginning of 2006 to the first week of 2011 ...

$10,000 invested in S&P 500 SPDR ETF (SPY) becomes $11,190.

$10,000 invested in the top 10 most loved by analysts becomes $10,950.

$10,000 invested in the top 10 (still in today's SPX) most hated by analysts becomes $16,430!

Finally, my favorite quote from the article for personal reasons...

"Lehman Brothers?  At the start of 2008, 17 analysts covered the stock.  Of them nine had it as a 'hold,' five as a 'buy' and two -- amazingly -- had it as a 'strong buy.'  Given that one of the smartest things anyone could have done with their money, ever, was to sell Lehman stock at the start of 2008, how many analysts actually issued that recommendation?

"One.  Out of 17."

Here are the articles I wrote to you about getting bearish on Lehman in the first half of 2008 ...

Telling you in June of 2008 to be bearish on Lehman instead of bullish:
This Falling Dagger Can Bleed Your Portfolio

Telling you to to stay away from or be bearish on Lehman in April, 2008:
How to make sure YOU don't own the next Bear Stearns

Showing you how to create a pairs trade using Lehman as a bearish example in June, 2008:
Profit Like a Hedge Fund From This Article

Being a "contrarian" is frowned upon in the technical analyst community.  But here, we are using contrary technical indicators to do what most people aren't doing, which is the smart thing and the prudent thing:  Reducing bullish exposure, not getting aggressively bearish just yet, and taking some bearish positions here to either reduce the pain the bullish positions are extremely likely to experience or to start making money on the down side.

Your comments are welcomed, especially if you want to call me crazy for writing this to you.

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Answer (to TA question from above the article):

The "RSI", or Relative Strength Index (not to be confused with comparative relative strength, which compares one security to another), measures the relative strength of a security against itself. 

In other words, it compares the current price action of a security to its historic (usually recent) price action, indicating whether the momentum is strengthening or weakening. 

Here is a link to a Tycoon Report article I wrote on the indicator: "How to Sell at the Right Time"

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