Remember, Selling Into Strength Is How You Make Money In The Stock Market

This post was originally published on this site

Buy low, sell high. It sounds so simple, right?

Selling “high” (whatever that means exactly) is tricky to execute, though.

Recently, the stock market has been on a tear. The S&P 500 index rose 5% in April with record-setting breadth. Over the course of 18 trading sessions this month, 95% or more of the S&P 500’s members traded above their 200-day moving average. According to Bloomberg, that’s double the previous monthly record set in September 2009.

Broad-based participation in a rally is normally a bullish signal. It signifies a healthy advance with broad momentum. But when a market becomes one-directional, smart investors have a risk radar that sounds an alarm bell.

“The fact that 95% of the S&P 500 is now above its 200-day moving average is NOT a bullish sign,” wrote chief market strategist for Miller Tabak, Matt Maley, in an April 26th note. “Yes, a high number of stocks above their 200 DMA’s is usually positive, BUT it is NOT bullish when the number becomes extreme (like it is now… at 95%).

From March 23, 2020 through April 30, 2021, the S&P 500 has gained 90% on a total return basis. The torrid pace of gains foreshadowed the current state of positive earnings and economics reports. Investors should not ignore such positive fundamentals. But it’s also wise to remember a lot of the current positive data we’re seeing now is what the market has already been discounting over the last year.

MORE FOR YOU

This week, I decided to book some meaningful profits in my firm’s managed portfolios for the first time in a long time. Why?

Here are some ‘risk-off’ signals that make me a little more cautious heading into May.

#1: Seasonality Shift

“Sell in May and go away” is one of those market adages that resurfaces every year.

The saying relates to a Stock Trader’s Almanac finding that shows the best 6-month rolling period for stock returns has historically been November through April. Since 1945, the S&P 500 has gained an average of approximately 2% from May through October. That compares to an average return of about 6% from November through April, according to Fidelity.

So, seasonality favors de-risking around now, independent of the fact US stocks are up 90% over the last 13 months.

#2: Sector Rotation

Investors are starting to rotate toward lower risk sectors. One way to see how this trend is evolving is the Relative Rotation Graph. In the graph below, the vertical y-axis measures momentum and the horizontal x-axis measures relative strength. Momentum trend changes happen before relative strength shifts, which results in the weekly tails evolving in a clockwork-like pattern.

When investors start rotating more into a sector, its tail trends up and to the right. Up and to the right is good. Conversely, when a sector is underperforming, the tail moves down and to the left.

Currently, the defensive pockets of the S&P 500 are seeing relative inflows, including Consumer Staples, Utilities and REITs. Previous outperformers will declining momentum include Energy, Financials, and Technology.

The last time I flagged a bearish development in the RRG graph was February of 2020 in this Forbes post. Back then I wrote, “The S&P 500 is trading about 11% above the 200-day moving average, and there may be a correction soon.”

Little did I know at the time, the Coronavirus was weeks away from walloping the global economy. The severity of the economic shutdowns was a big surprise to me and I think most investors. But it’s interesting looking back at how the sector rotation trend provided an early warning that risk was around the corner.

It’s not always the case, but defensive sector rotations often foreshadow broader market corrections.

#3: Bullish Sentiment

One of Warren Buffett’s most famous sayings is, “Be greedy when others are fearful, be fearful when others are greedy.”

One way to track investor greed and fear is the AAII Investor Sentiment survey. Yardeni Research tracks the weekly ratio of bulls to bears, noting that when the reading is over 3 or under 1, sentiment is lopsided in a statistically significant way.

Before the 90% rally in the S&P started last year, the Bull/Bear spread shown above dipped just under 1. Currently, bulls outnumber bears by over a 3-to-1 ratio.

#4: Prices Paid Index

Inflation is a hot topic lately. Supply constraints and unprecedented levels of monetary stimulus have created a mismatch between supply and demand around the world. With more money chasing fewer goods, prices are bound to go up.

A broad range of commodities have soared in price over the last year. Consequently, many firms are reporting higher input cost pressure this earnings season.

One way to track input costs is the ISM Prices Paid Index. The index recently climbed above 85, recording the second highest reading since 2000. The previous high was in June 2008.

Per the Leuthold Group, the prices paid index has only been higher than 75 about 22% of the time since 1948. The S&P 500 has historically delivered below-average returns when the index goes above 75.

#5: Technical Exhaustion Signals

On March 31, 2020, I wrote a piece advising investors to “Stay Agile Investing In the Ides of March.”

At the time, sentiment was heavily bearish. It was hard to see how things could get better anytime soon.

Technical indicators are most useful when they are both counterintuitive and accurate. Like the DeMark Indicators.

Last March, I wrote, “If you incorporate technical analysis into your decision-making, use trend exhaustion signals. They are the best tactical guide for a climate like this, where the greatest risk is getting whipsawed. Don’t get whipsawed… One tool that is excellent at spotting potential trend inflections is called TD Combo.”

As I profiled in that note, in March 2020, several broad equity indices printed daily Demark TD Combo buy signals. That turned out to be an excellent time to buy low.

Since then, numerous equity indices have recorded several TD Combo sell signals. For example, below is a daily chart of the New York Stock Exchange, which shows several 13 upside exhaustion signals, which were followed by shallow corrections ranging 4% to 8%.

On April 28th, 2021, the NYSE Composite Index recorded another 13 combo sell.

Maybe an important inflection is coming.

Maybe just another shallow consolidation.

Maybe nothing can stop this bull market from charging higher.

Whatever your overall market view is, I think it’s worth at least considering downshifting a gear here.

Related Posts