But selecting investments with strong relative performance potential is only part of what it takes to be consistently successful. In fact, I've found that more consistent personal profits have come with an improved understanding of market conditions and by then matching trading strategies to market environment, sometimes BEFORE it shows up in the price action.
Chaikin Analytics' Power Gauge helps predict relative stock price movement before it occurs because it rooted heavily in the same financial metrics and fundamental factors that prompt Big Money trading desks to value and then accumulate what's cheap or distribute what's expensive. That's why my trading partner AA and I place so much emphasis on The Power Gauge and have created and track aggregate Bull:Bear power gauge ratios (the relationships between between bullish and bearish stocks) within markets, sectors and industry groups. It's the key to our trading life.
By comparing these ratios to each other and the market, we believe we have a roadmap of future relative strength, one that gives us an edge over traders who simply trade relative strength strategies on past performance alone. It's working for us.
For the past year and a half, market conditions have been favorable for longer term trend following strategies, and Chaikin Analytics has provided us with a steady stream of "Classic Bulls" - Stocks with Very Bullish ratings, strong technical ratings, rising Chaikin trend-lines and strong industry group ratings. We have restricted our bullish trade entries to sectors which have Bull:Bear ratios superior to the S&P. We've just waited for the appropriate buying signal, pulled the trigger and simply managed stop loss protection as each stock made a series of higher highs and higher lows. We cut our losses quickly when we were wrong. While the market delivered 30% returns, our portfolio generated better than 45% ROI annualized.
The old saying goes: "Everyone's a Genius in a Bull Market." Thanks to Chaikin Analytics, we've simply been geniuser.
But the Power Gauge is a reliable predictor of future relative performance, not absolute performance. Fine when the market is screaming up. When the market is screaming down, initiating trend following strategies likely to deliver "less worse" performance than the market is something we'd rather avoid.
There is a way to use Chaikin Analytics to help us formulate rules for different market conditions, then trade appropriately whether the likely direction is up, down or sideways. Better still, Chaikin Analytics has the data we need to help us figure out likely future market conditions.
AA and I have been writing for the past few weeks about how the market has taken on a more defensive posture even while it's been hitting new highs. While the S&P has been range bound on the surface, a lot of churning has taken place underneath. Some of this is simple sector rotation. In the graphic above, look at how the Bull-Bear ratio for the beaten down energy (XLE) sector has spiked in the past few weeks. Now is a great time to be looking for great industry groups and stocks in that sector. It's why we bought oil refiner VLO last week.
But, we set a price target and an exit date, because our rules no longer allow us to take open ended trend trades until market conditions are more favorable.
Other market trends are more concerning. The consumer is 70% of the US economy and both consumer centric ETF's (XLY and XLP) have bearish Power Gauge ratios and have been lagging the S&P for months. The bull bear ratios of cyclical sectors like Industrials, Basic Materials have waned (though they have certainly not fallen off a cliff), while a more traditionally defensive sector Utilities (XLU) is flashing green. Look at the bull:bear ratio trend above over the past 3 weeks! Price action has started to follow.
Divergences are a powerful early warning system. While the market itself hit a new high this week before reversing rather violently Friday, we note the SPY bull bear ratio made its high for the year on March 10th. And the ratio hasn't been above 3 since November. There are still a healthy 119 stocks with a bullish or very bullish Power Gauge rating in the S&P 500 index, and the bull bear ratio remains solidly above 1. We are watching for a divergence on the SPY, QQQ and IWM Overbought/Oversold oscillators. If any roll over before making it into overbought territory, while the ETFs make another high, that will be a VERY bearish development.
The price action on QQQ, the ETF which tracks that Nasdaq's biggest names has diverged so much from the S&P that Chaikin Analytics fired a relative strength breakdown sell signal over the weekend. The same holds true in the Russell 2000 small cap index ETF, IWM. The major indexes never diverge from one another for long. The Russell and the Q's were the leaders on the way up, and it's quite possible they'll lead a downward correction. Only time will tell.
Are we selling everything? Are we net short? No. We're in a bull market and the trend of higher highs and lows remains in tact in most sectors. However there are plenty of signs that the market could enter a corrective phase soon, so here's our game plan
- Cut our risk. Trade 1/2 positions.
- Look for Overbought Sell signals in sectors with bull:bear ratios below the market. Buy puts or option spreads on VERY BEARISH rated stocks in weak industry groups
- Reduce our time frame and set specific price targets. No new bullish stock trend trades for now.
- Sell any stock with a Power Gauge that turns bearish.
- Hedge 1/3 to 1/2 of our bullish exposure with short option trades as opportunities present themselves.
- Sell covered call option premium or buy collars to protect profits in stock positions that have run up substantially.
- Tighten stops.
- Don't be emotional. Be systematic. We're not bearish. We're simply anticipating a possible market correction.
- As we stop out of positions, we'll considering not replacing with new trades. Cash is a position.
- Pay attention to earnings. Actual company Q1 earnings performance relative to consensus estimates may not be as important since trading desks will be writing off some earnings misses as weather related. Forward guidance will be VERY meaningful. If enough companies with Bullish Power Gauges warn about earnings falling short in the coming quarters, we could see a market sell off -- a dramatic one at that given how long we've run without a meaningful correction.