Ready to Run?

By Brad Thomason, CPA

 

Is the stock market ready to run to even newer heights?  Or should you be making ready to run for the door?  Those are the questions on a lot of minds tonight.  We may get some indication as early as tomorrow morning’s open.  But the complete answer is likely to be at least several days in coming.

I’m not going to tell you what’s about to happen.  ‘Cause, you know… I don’t know what’s going to happen.  But I will point out a couple of things you might want to watch over the next few days.

First of all, we are in new territory.  Or in trader speak, we’ve moved through a resistance level.  Moves through resistance are generally considered bullish indicators.  However, not all resistance points are created equal.  Moving through a point somewhere within an established trading range is one thing.  Moving into a completely new range is something altogether different.  There is no past context in which to try to gauge what’s going on when prices move into new territory.

Every time in history that the market has moved dramatically higher (not just regained previous losses), the run necessarily started with a push into a new range.  Can’t have one without the other.  So if the market is about to soar, it has now accomplished the first important prerequisite.

But before you switch off your computer and head to the Caribbean for a month of celebration, there are a couple of little nuggets you might want to keep an eye on.  Because they could very well hold the seeds for this latest up-leg’s collapse.

High-level, there is the matter that the market has jumped about 8% in value in the last 10 weeks.  If markets were in the habit of jumping 8% every quarter, and then staying there, there would be no need for a financial industry.  Everyone with a 401(k) account would be wealthy to the gills and no one would much care about this stuff.  You of course know that’s not the way it works.  At a horse-sense level, we know: that which goeth up, cometh down too, y’all.

More specifically, it’s never a bad idea to try to get a sense of how the traders are looking at things.  Trader activity will drive where the range is over the next few days; and the places where high, lows, opens and closes occur will influence how the automated systems react, and in turn how the institutional money will flow.

I can guarantee you that when a trader looks at the present chart, two things are going to immediately pop off the screen.  Back at the beginning of the year, the market opened one morning substantially higher than where it had closed the night before.  In fact it jumped up into a new trading range: the following day doesn’t overlap the previous days at all (set your chart package to candlestick or OHLC and this will be very easy to see).  Two days ago it did it again.

Traders refer to these as “gaps.”  Traders love gaps.  Why?  Because they have an extremely high historical tendency to “close,” that is, the prices move back through the area where the gap occurs prior to moving on.  Closure of the two gaps that are currently in the chart will require that the market fall back to December levels.  Or to state that differently, if the gaps close it will erase all of this year’s gains.

Do gaps always close?  Nope.  There aren’t any always-es in the market.  But they usually do.  Why?  Because the thing that usually causes them is some sort of short-term joy (or despair; gaps come in a downward variety, too) that dissipates after a while.  Professionals look at what happens immediately after a gaps and ask, “Is this a real move?”  And a lot of the time they take a wait-and-see approach, looking for new support levels to form above the gap level before they move in.  Very often, such support levels never form.  Prices reverse, and they are happy they waited.  History morphs into prophesy and back again, and the practice becomes self confirming.

I am alternately amused and infuriated by people who tell me, usually with a condescending tone, that finance isn’t based on little lines and smudges on price charts.  I have learned not to argue, in the same way that I would not accept a pig’s invitation to wrestle in the mud.  I am well aware that finance is controlled by the actions of people.  But here’s the thing: a lot of the people who move the biggest pots of money around are looking at those squiggly little lines every time they make a decision.  Price charts may not be responsible for direct causation, but I wouldn’t want to have to defend the position that they don’t matter.

So will the gaps close and destroy the run?  Again, I don’t know.  And if the gaps do close, does that indicate that the market won’t run some more afterward?  Certainly not.  The reason that any of this makes a difference?  This is a heads-up moment for those who employ some degree of active management with their stock holdings.  Stock investors have had a nice run here lately.  Maybe it will continue.  But to account for the possibility that it won’t , now is an especially important time to be vigilant.  If the market starts showing signs that it is hell bent on retracing, I for one would not want to hang around and let my gain get wiped out.  It’s not like sitting out precludes you from getting back in when/if the run resumes.  But sitting out gets you double points on what is perhaps the most foundational notion of running a successful portfolio: buy low and sell high.  Or maybe in this case, sell high and then buy back in again when it gets lower.

Tomorrow may be a good day to wait for more data.  Or maybe we’ll see drama and fireworks.  But either way, just keep in mind the data that the traders are going to be looking for.  And don’t under-estimate their power to exert short-term pressure which makes their gap-bets a reality.  A win for them is going to be a loss for anyone who is long stocks when it happens.  If it happens.

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