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Sunday, January 23, 2005
Market Recap
A reoccurring theme on Friday as the sellers once again controlled the markets to the downside. The markets did open higher, but as I had mentioned in my market update, the volume to the upside was weak and sure enough the early gains ended up being a short-term tease for the bulls. The Nasdaq finished the day lower by –11 points, the Dow closed down by –78 points, and the S&P finished lower by –7 points. The volume was, once again, above average and the indices all closed near their lows of the day.
Needless to say it was a rough week for the bulls. Every bit of strength that seemed to give them any hope was sold off in a hurry. Repetitive action like this will certainly take its toll on the average investor. I think many of them are finally throwing in the towel and selling stocks that they have held since the beginning of the year. I also believe that weakness on a Friday of a rough week also scares many investors into selling because it gives them 2 days to forget about their losing trades. It is amazing what 2 days can do for a trader's short-term memory. Our lack of strong participation in the markets during this time certainly has paid off. I also believe that our patience and planning is going to reward us with some nice profits very soon.
Psychology of the Trade
The #1 indicator that we use for trading at TWPD is the chart. If the chart stinks, we do not buy the stock. However, there are a few things charts cannot measure; emotion and the psychology of the investor. While difficult to do, we always try to keep our emotions out of our trades. I would be lying if I said that emotions never affect any of my trades. The key is managing those emotions and always going back to the reason you bought the stock in the first place, the chart. The average investor/trader fails simply because of their need to be right and their failure to admit they were wrong. Every stock we buy we expect to go up, or we would not buy it. We use data and opinions to create those expectations. So it is very easy to understand why many people have difficulty selling a stock that is not doing what they thought it would do. It is an admission of being wrong. No one ever wants to be or ever have to admit they were wrong. It is human nature. Remember, the chart could care less what you want the stock to do.
Psychology of the Bounce
Now let's look at the recent action in the markets and I will explain why I think the markets are going to bounce from a psychological standpoint. Most average investors buy near the top and sell near the bottom. As I said already, I think many average investors threw in the towel on Friday and finally admitted they were wrong. I also believe many of those same investors, out of frustration, shorted the weakness into the bell. The average investor does not control the direction of the markets, so I am not suggesting that the herd created the weakness. The down volume has been strong so there have certainly been some heavy hitters taking money off the table. I am suggesting, though, that when the herd finally “throws in the towel” that a bounce is due. The psychological aspect of trading is exactly that, psychological. I will never base any trades on these theories or opinions. All of the stocks I bought on Friday were based on the charts of the individual stocks and the support levels in the charts of the indices that I showed on Thursday. If we end up being correct on the psychological piece then it is simply a bonus. It just so happened that the chart support coincided with a negative and frustrating sentiment amongst the average investors. Without the chart support, we would not have played for the bounce.
Looking Ahead
It is no secret that I believe a bounce is coming. The pullback in the markets that I was hoping for came to fruition late in the day on Friday and I took advantage of this weakness by putting quite a bit of cash to work to the long side. We now have 12 open positions that should do very well if our bounce strategy works out as planned. We still need to be very aware that more downside is possible. Tight stops will be in place as we should not be afraid to close out these positions if a bounce does not materialize. As much as I want to be right about this bounce, if we are wrong we must respect the charts so that we can live to trade another day. The confirmation of a bounce will be a high volume move and close back above at least 2050 on the Nasdaq. We will then evaluate the charts to determine if we should sell for quick gains or hold for a possible continuation of the bounce.
The second piece of the bounce strategy is deciding if and when to short. Many members are calling for shorts and I certainly agree that the current weakness suggests we should start looking at shorts. The problem we have had since the beginning of the year is that the markets have gone almost straight down, making it difficult and risky to short because any bounce would stop you out in a heartbeat. Shorting is most profitable and the least risky when positions are entered on strength below resistance, just as longs are most profitable when entered on pullbacks to support. I have added some shorts to the bulletin to give us some options if and when we do get a bounce. If we do get a bounce, we will be sitting in the drivers' seat because we will have longs sitting profitable and we will also have the option to short the strength.
Do not forget to check your short-term holdings and know when those companies are reporting earnings. Holding a stock through earnings is risky and I do not recommend it. You can always buy the stock back after the dust settles.
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