Lessons from the Pros

Runaway Bull Market or Irrational Exuberance?

In the days since the last newsletter, the Dow Jones Industrials briefly touched the all-time 14000 mark, before falling back. Additionally, the S&P flirted with 1552 – its 2000 high watermark. Being left out of the party was the small cap (Russell 2000) index, which failed to surpass its prior highs and has been lagging all week. [More on this later]

As you might imagine the media (CNBC) is having a field day with these latest developments. They are once again providing the cheerleading, as they do any time the markets hit a new milestone.

"Irrational exuberance" was the now infamous phrase used by former Fed chairman Alan Greenspan in a speech given back in December 1996. At that time, the market had been rising steadily without as much as a 3% pause (very similar to current conditions). Readers may recall the reaction that followed – a sell-off directly attributed to those two words.

Is today’s market environment irrational? The bears would argue, yes, and as corroborating evidence, would point out the litany of reasons the market "should" move lower. By now we’re all very familiar with these, so there’s no sense in listing them here. The bulls on the other hand, will be quick to disabuse you of all the negatives; they’ll go on to paint a much rosier picture of market fundamentals and the economy. They will also tell you the Dow is on its way to 15000. Presently, they are still the dominant force in the market, but this could change at any time. Both are cogent arguments that should be taken seriously.

However, traders should never become wedded to any single point of view. We’ve covered this topic in prior newsletters, but I think it bears covering again.

As a case in point, readers may recall in last week’s newsletter I wrote that I thought the ER2 would probably trade down to the lower end of its recent range. This would have taken the ER2 down about 20 points or so from last Tuesday’s close. I based that call on the facts that were before me at the time of the writing. (See chart below)

Obviously, that was the wrong call. The point to stress here is, although technically it looked like the market was poised to continue its downward path, by the end of Wednesday’s trading session it became clear that the selling had abated and that the buyers had gained the upper hand (as seen in the chart below). When this change became apparent, my thinking had to change.

The market is no place to be rigid in one’s thinking. If the market’s not acting the way you thought it would, then you should get out. Don’t rationalize or add to your position in the hopes that it will come back and make you whole. By doing this, you’re putting yourself in a position whereby one trade may completely obliterate your account. It’s best to be humble, admit you’re wrong, and move on. Part of being a successful trader requires a steady diet of humble pie.

If we look at a daily chart of the ER2 below, we find little has changed. We’ve come up to the top of the range, as the Dow and some of the other major indices have powered ahead to new highs. We see from the stochastic reading that we are still in overbought territory.

On another technical note: the recent market highs are coming on weaker market internals. The small caps have been lagging badly and money flow (institutional money) is waning. These are important components of the market and will be worth watching for further clues in the near-term.

To Summarize: The market has a lot of information to digest this week. Earnings season is in full swing and unlike previous quarters, expectations are much higher then they’ve been in the recent past. Ben Bernanke will be delivering his semi-annual monetary policy report to both the House and Senate on Wednesday and Thursday. Market participants will be closely scrutinizing the language for any hints of an imminent rate cut. What’s more, there’s a whole host of economic reports to sift through and assess. And let’s not forget, it’s option expiration week. We’ll just have to see if the market has the Mojo to continue this rally.

So until next time, I hope everyone has a profitable week.