In our shop, trend-following is at the core of our investing beliefs. We buy stocks when prices are trending up and sell or sell short when prices are trending down. We also closely weigh the overall balance between risk and reward in the market. Even though the last few weeks have been the strongest short-term uptrend the market has had this year, my optimism is guarded. The reason is risk.

 

Since the beginning of the year, the risk factors have been piling up. When coupled with the beginnings of a new downtrend back in May, we felt comfortable calling the market top. At that time, we also expected to see a short-term bounce as a result of all the heavy selling and the recent increase in bearish sentiment. Since then, the market has rallied, and a handful of leaders have recently re-asserted themselves. A few of these have notched new highs.

 

This kind of situation gives investors hope, and that hope can make them myopic. A strong two weeks does not erase the persistent risk factors hanging over the market. Aside from the factors discussed in previous blogs, here are a few new developments:

 

  • The market is trading near the upper end of overhead resistance levels. For the uptrend to continue, we’d have to clear this upper area of resistance, consolidate, and resume the uptrend in a meaningful way. As we come out of that consolidation, it would be very positive to see true conviction (volume) returning to the indexes.
  • After studying the recovery phase of the last seven major bear markets (those down 45% or more, peak to trough), the average gain in year three was 3%. As we are now in year three, the best case scenario is probably a choppy, volatile market going forward.  
  • The only positive catalyst on the horizon is earnings season. Earnings are projected to be, once again, very strong, but remember, last quarter’s earnings were excellent (by and large), and the market was unable to lift and move higher.
  • There is a lack of conviction on behalf of stock buyers. The last eight up days in a row, with closes at the top of the range on the NASDAQ, have been positive, but all of the up days have been on volume less than the 50-day average volume.
  • Several leading stocks have broken out of chart patterns on lower volume. Results from these breakouts have been mixed, and to me, the breakout failures cast doubt on a sustained uptrend.
  • Many leading stocks are around their 52-week highs, but they got there on mediocre volume. This underscores a lack of conviction within this market environment.
  • Significant market uptrends normally don’t start in July (the peak of the summer doldrums).
  • The market is still very sensitive to the news of the day.

 

Trend-followers never fight the market direction, which is always right - regardless of opinions. So although I am still mostly negative on the market (long term), I did initiate some conservative long positions last week. My thinking was that most of the very best leading stocks of the last two and a half years were still acting strong. Over the last two weeks they received renewed institutional support, and at the time of this writing, most are at or near 52-week highs, which is a positive sign for the bulls. However, today’s break (7/11/2011) confirms my original risk assessment and has me wondering why I have any long positions on the books.

 

Investors participating in this rally should be wary of the risks that are still very real in this environment. If you notice more and more of your decisions turning into losses, your batting average is telling you you’re on the wrong side of the market. Although my buy rules had me initiating a few positions on the long side, my interpretation of the risk-reward ratio is keeping my exposure to a minimum and my position sizes small. By addressing risk, sticking closely to rules, cutting losses quickly, and investing lightly, we will survive this difficult market and somewhere down the road we will see another true bull market. Capital preservation is rule #1.