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Follow These Patterns, Not the 'Experts'

Written By Briton Ryle

Posted May 28, 2014

If you’re feeling a little confused about stock market activity lately, you are not alone. Even professional money managers disagree about what’s going on.

When key markets drifted lower during March and April, almost everyone was betting on the imminent arrival of the long-anticipated correction. Small caps, technology, biotechnology, and momentum stocks dropped like stones in water, while large caps and bonds gained. The flight to safety was in full swing, and managers were entrenching themselves for a sell-off.

But when May rolled in, all that defensive posturing came to an abrupt halt like the scratching of a needle on a vinyl record album. All that once went down was now heading back up.

“Hedge funds have done an about-face on a group of crowded stock bets,” reports CNBC.

“Stop looking for that big correction because it’s not coming,” advised famed market forecaster Denis Gartman.

In yesterday’s letter to subscribers, Gartman admitted that he and his team got it “wrong…badly…to have expected the market to correct.” Having started April in the “scared” camp, Gartman announced halfway through the month that he had switched to “pleasantly long.” Yet by the end of April, he was “neutral.”

Meanwhile, money manager Marc Faber is sticking to his call for a correction, while manager Ralph Acampora described a “sick feeling” he has about stocks right now, as he expects a 25% plunge on the NASDAQ.

Is there a way to make any money from this market churning even if the experts can’t agree on a direction? Yes, there is. But first we need to look at a pattern that keeps repeating itself.

Pattern A: From Risk to Safety

As depicted in the graph below, the tech-heavy NASDAQ index (blue), the small-cap populated Russell 2000 index (RUT) (beige), and the iShares MSCI USA Momentum Factor (NYSE: MTUM) ETF of momentum stocks (orange) were all down some 6 to 8% from the top of March to the middle of April.

During those six weeks, the large cap-populated Dow Jones Industrial Average (brown) and the broader market S&P 500 (black) managed to hold their heads near the waterline, falling by only 2%. The flight to safety continued for the last two weeks of April, as the risk trades remained decidedly negative, while the large caps rose back into positive territory. The gap between the two groups is clearly evident.

NASDAQ%2C RUT%2C MTUM  Spring 2014


What was going on? Because tech, small caps, and the momentum stocks (or “mo-mos”) tend to lead the market in a new direction, the pattern that developed over March and April heightened the expectation of the “sell in May and go away” event.

Money thus flowed into the safety of large caps and bonds, pushing the 10-Year Treasury bond up, its yield falling to 2.6% by the end of April — its low for the year at the time.

Only, it appears May didn’t get the memo, and she simply stormed onto the scene completely clueless as to what was expected of her. On her arrival, everything came to a screeching halt with the sound of a needle screeching across a vinyl record.

Pattern B: From Safety to Risk

As noted in the lower portion of the graph above, from the end of April until just yesterday, the month of May reversed everything that had developed in March and April. All that once was down came back with a vengeance, as the small cap Russell 2000 index climbed over 2%, the NASDAQ surged 4%, and the mo-mos shot some 5.4% — beating the large-cap Dow Jones and the broader S&P.

For the month of May, then, money seems to have been flowing from the safer stocks back to the risky. Hedge fund managers were reported to have switched out of leisure facilities and the auto sector, while jumping into trucking, financial services, and specialty stores. In fact, the Dow Jones transportation index clobbered even the momentum stocks, rising nearly 6% over the past four weeks.

The transportation and financial sectors are what you might expect to grow during economic expansions. The gains in these sectors confirm the reports of a few weeks back which forecast 3% GDP growth by the end of 2014.

Adding the Two Together

So let’s put these two patterns together and see what we come up with.

First, we note that the equity markets are nervous and jittery. Being rather overheated from having repeatedly set new highs without a meaningful correction since 2011, the slightest bit of bad news easily triggers a flight to safety.

Second, we note that each pullback is quickly bought up. Economic forecasts calling for GDP expansion in the second half of 2014 and into 2015 are providing the markets with enough lift to keep setting new highs well into the future and to keep its upward trajectory intact — which is reflected in the relentless climb of the transports.

Conclusion? The markets will continue to climb for the rest of this year and deep into 2015… but with some pretty sharp pull-backs every few weeks or months. These will not be full-blown corrections, however — just something in the magnitude of 5% per dip.

How can we be sure these dips won’t turn into severe corrections? Because every time we get one, the dips keep getting bought. Just look at the follow graph of the S&P 500 since the last correction of 2011.

S%26P since 2011 correction


Now there is one solid line of support. Even when the trend line was punctured at the end of 2012 during the last Presidential election, the market quickly regained its footing and hasn’t looked back. Even if the S&P 500 were to pull back 5% or 100 points back down to 1,800, the uptrend would still remain intact.

The economy recovery is proving itself strong enough to withstand U.S. Federal Reserve bond purchasing reductions, so don’t look for a bond tapering-induced correction. The Fed has also reiterated it is prepared to keep interest rates low for a considerable period after its bond purchases are terminated by the end of this year.

The Fed is supporting the market and will continue to do so for years.

How to Trade this Market

So how do we make money going forward? Note the pattern:

1) The market sets a new high,

2) traders get defensive,

3) the market pulls back about 5%,

4) traders get aggressive again,

5) the market climbs to another new high.

Just follow the bouncing ball. When the market reaches a new high or close to it, take some profit and reduce your positions. When it has pulled back about 4 or 5%, jump back in again.

You might also do some relative value trading between the small-cap Russell 2000 index and the large-cap Russell 1000 index. When the market has reached a new high, you would switch from the small cap-populated iShares Russell 2000 ETF (NYSE: IWM) and into the large cap-populated iShares Russell 1000 ETF (NYSE: IWB). Then, after a pullback has leveled off, you would switch from the large cap IWB back to the small cap IWM.

Notice how the two funds keep criss-crossing each other in the graph below?

IWB and IWM etfs


This is what the pros are doing. Many of them never short the market, which Gartman warns against, given such a relentless rising market. They just switch back and forth from defensive to speculative and back again as the market ebbs and flows.

This is the kind of market we must stay long in. Even amidst the heightened expectations of a correction? Yes, even now, since all pullbacks are quickly bought, readily positioning traders for the next leg up. Just make sure you take some profit or switch to something more defensive when a new top is reached — such as right about now, for instance.

With the S&P posting a new all-time high close of 1,911.91 yesterday, stick with the large caps for now. But get ready to buy those small caps, techs, and momentums when the next pullback runs its course and flattens out. We should get a 5% dip this summer, but like Gartman emphasises, “Stop looking for that big correction because it’s not coming.”

Joseph Cafariello