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By: Chris Rowe — January 23, 2017

Odds Favor More Downside

This Week's Market Stance:  Long-term we are very bullish on U.S. stocks.  Not only are they the strongest asset class, but when we check the other 5 asset classes, we see an appetite for risk.  Commodities and International stocks (especially emerging markets) are in demand.  Safe havens are out of favor across the board.  Short-term we expect a continued price dip.  (Perfect!)

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On January 4th I wrote an article titled: "The Coming Dip - Too Much Bull in This Market".

Today's article is an important update to that, as now there's even more "Bull" in this market.

I'll give a couple of examples of how I'd play it...2017-01-05_17-24-191

Let's reiterate the simple principle:

When too many investors agree on something, it's almost always best to go the other way.

And while that principle might be sound... it would be a dangerously oversimplified way to approach what's happening in the stock market at this very moment.

Too many investors are bullish for the odds to favor a sharp move higher.

Rather, odds strongly favor a short-term dip, prior to the next surge of strength.

Now, the stock market can be very tricky. It can appear to investors that strength is continuing, while in reality more and more stocks are showing weakness.  That's a different discussion about "The True Market" - and you can find more on that here.

But when the market is near a high, you'd better be ready to react.  It tends to hit investors with a "one-two punch."

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PUNCH 1 - Bullish sentiment evolves into overwhelmingly powerful bullish hype, which lures investors in (to buy) near the top.

PUNCH 2 - The True Market (the stock market that actually affects investors' account values) weakens right under their noses, while the major market averages appear strong.  The first part of the decline is masked by the major averages.

By the time investors recover from these jabs, the stock market has sold off and investors find themselves wishing they had sold off some stock to raise  cash for new stock positions.  Only the well-informed investors have a fresh shopping list on hand and are ready to rebalance themselves.

Now, let me clear up a misconception right now. What I just described isn't about "market timing".  That's not to say that market timing has no value.

There are three keys to investing and you really only need the first two to be a success.  But, in order of importance, it goes:

  1.  Risk management...
  2. Allocation...
  3. Market timing.

When we talk about some key indicator that is flashing "overbought", what we're saying, is: "Now is probably a great time for investors to plan out the next allocation of their portfolio."

It's a great time to plan or even implement phase-1 of how our portfolio will be rebalanced.

We're not suggesting it's time to sell out of your position in the S&P 500 and buy it back when it declines 5%.  Most investors have a stock portfolio that doesn't match "the market".

When the stock market is overbought and due for a decline, it makes sense to think about #1 and #2, above.

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Think About These Two Investing Keys:

#1)  Risk management -

Odds favor a short-term dip on the horizon.  Why not hedge off some of that risk (a mere hedge still allows for more upside if the dip doesn't happen!

Savvy investors are selling covered calls to collect income on positions that are overbought.  If these positions decline, the collected premium offsets a portion of the loss.

Some are buying cheap, out-of-the-money, put options that expire in 6 months or more.  They'll go up a bit if the underlying position declines.

But more importantly:  Smart investors are selling out of whatever positions are underperforming the stock market averages.

Why not sell out of the bottom 20% worst-performing positions?  If they didn't do well when the market was strong, they're likely to be among the worst performers, on a risk adjusted basis, when the market does dip next.

This pruning of weak positions is also a great way to raise money for the coming dip.

#2) Allocations -

When markets dip lower, those covered calls can be bought back at a lower price for a nice profit.  The out-of-the-money put options can be sold at a higher price.

The money collected from those hedged positions and from the sale/exit of weak stock positions (or ETFs) can be used to buy, on the cheap, what we know are today's strong performers.

"But Chris, today's strongest performers are not necessarily tomorrow's strongest performers".

True.  "Not necessarily".  But hundreds of market-studies over the last several decades prove it's highly likely that the vast majority of them will be.

Instead, we want to check out the positions that had enormous strength in the recent rally and we will lick our chops awaiting their return to lower prices.

The key point of all this is, of course, to...

Have a plan.

So why am I writing bringing this up today?

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Because...

The Investors Intelligence Advisor Sentiment indicator is showing overly bullish levels to a larger degree than they were showing back on January 4th, when I first wrote about it.

Keep in mind, this is one of the only leading technical indicators out there.  Markets can and likely will continue a bit higher before the move.

But HEADS UP!

The following is a 10-year chart showing the stock market (S&P 500) on the top and the percentage of advisors polled that were bullish or bearish (on the bottom).

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When bullish advisors are above 55% it's a red flag, and in the rare instances when bullish advisors are over 60% it's a huge warning.  But it doesn't mean the market will crash or even "correct" (defined as 10%+ decline from high).

It does mean: You should look out for a dip.

To simplify it further, the following chart will show the spread between bullish advisors and bearish advisors.  60.6% of advisors are bullish and 17.3% are bearish, for a spread of 43.3%.

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I've only marked some of the historic highs.  And the chart is so long (10-years) that the large emotional declines that followed seem small.  But consider the moods, if you can remember:

In August 2015, we saw this same indicator showing overly bullish sentiment.  Too many bulls.  It was an overcrowded trade because everyone was bullish. But as we wrote in the August 2015 article "85% of all sectors look bearish", the True Market was already in decline.  I told you we were reserving a chunk of cash for the likely coming dip.  Be prepared!

In the first half of 2011, the stock market was euphoric and hit a new high in May.  What followed was the S&P downgrade of the United States credit rating. Look at the decline on the chart and think about how crazy everyone was going.  Talks of a government shut-down during arguments about the debt-ceiling.  Markets around the world were getting crushed.

Some people had their shopping list ready. Some people had their cash on hand from hedged positions or from exiting their underperformers.  Most did not.

Be prepared with a list of what's been strong lately.  Those should be the focus when everyone is running around with their hair on fire.

I hope to see you on today's webinar, at 11:am eastern, where I'll reveal three sub-sectors likely to be among the strongest over the next few months (or more!)

Best,

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