Ask any NFL coach and he'll tell you unequivocably that defense wins championships. If you're looking for market-beating returns, then you'd better improve your defense first, then your offense. Plain and simple, Invested Central did everything possible to prepare defensively for last week's massacre. Two weeks ago, we acknowledged that the banking sector was showing marked improvement, especially relative to the S&P 500, and that could bode well for later in 2010. And it still might. But at the same time, red flags were being raised and, as a result, we put our members on high alert in the very near-term. In fact, we issued cautious short-term comments beginning around January 10th and we haven't strayed since. The "clouds on the horizon", as we like to call them, exploded into a Category 4 storm, leaving most investors wondering whether the storm will be upgraded to a Category 5 next week. No one can predict with any certainty the timing of a stock market selloff. However, we do have tools to at least know when we should be more defensive. Those tools begged us for two weeks to bring our "A" game when it comes to defense. We've constructed a defensive timeline page to provide details of how we approached the market as this newest of storms emerged, CLICK HERE for more details.
What causes the stock market to drop like it did last week? There are many reasons, but one that always gets our attention is the emotional element that leads to market swings. Fear and greed are present at most pivot points on longer-term index charts. It's just how the market works. When markets bottom, investors and traders usually feel despair and vow to never again place a trade in the stock market. It takes weeks, months, or even years sometimes to create the type of confidence that fuels the opposite emotion of greed. At the height of greed, no risk is too great to take. To me, greed and fear are simply by products of the stock market. Any time the potential of financial reward or threat of financial loss is present, so too will greed and fear. You can ignore it or profit from it. We've chosen the latter and believe you should too.
I've discussed in prior articles the necessity of watching the equity only put call ratio ("EOPCR"). By following the "equity only" put call ratio, you can delve into the true psyche of the retail trader. Many experts follow other sentiment components such as the weekly survey from Investors Intelligence that details the ratio of newsletter writers that are bullish vs. bearish. While I recognize this as being somewhat valuable, it doesn't tell me what folks are doing with their money. Rather, it tells me what they're doing with their lips. Fundamentally, that's a big difference. Not every market period is exactly the same, however. So a high "equity only" put call ratio one period may not necessarily carry the same weight in a different period and different environment. Therefore, I've created what I refer to as a "relative complacency" ratio when the market turns greedy and a "relative pessimism" ratio to identify the periods of extreme fear. In order to measure the "relativity" component of this ratio, I compare a short-term moving average of the EOPCR vs. a longer-term moving average of the EOPCR. Two weeks ago, this ratio touched levels that marked tops twice in August and once in September. Take a look at the chart below:
For a thorough explanation about this chart, you can CLICK HERE for the video version, which will also serve as our Chart of the Day for Monday, January 25th. We are now awaiting signs that the market is safe to step back in on the long side. Historically, a reason may be right around the corner as we enter a bullish historical period for the market in the middle part of next week.
Until signs emerge that suggest it's safer to trade on the long side, play solid defense.
Happy trading!
