The most difficult decision a trader/investor can make is determining when to go from speculation to protection. Doing so too early can result in the loss of significant gains while doing so too late can cost one all those gains and more. Markets travel north a larger percentage of the time than they do south -- it's just that when heading down, they do so in a much more frantic fashion.
This week is a big one. With Friday's market spanking, the importance of earnings reports and the Federal Reserve are magnified. Short-term trades/buys (like those made Friday into the heat of the selling
), have to be flipped and profits garnered or losses cut when the dynamics signal a change in the supply and demand for stocks.
A fundamental premise of neoclassical technical analysis is that tests are how the market reveals information to the trading community. It is through the testing process that known and suspected areas of supply and demand are forced to reveal themselves. If one can identify those areas, then a subsequent test of that area should provide clues to the current dynamics in the supply-and-demand equation. Friday was a test failure on the demand side of the equation. Buyers should have stepped up at the first test of a retest and regenerate zone, but they didn't.
To be clear, the test failure tells us that the supply-and-demand equation has shifted for now on this time frame. Thus, one should expect that a trip back to where demand should have presented itself is highly likely to find supply now. That supply is a result of all the buyers since the middle of December 2013 who are now upside down in their trades.
For an investor, simply having upside down trades on the short-term time frame isn't sufficient to cause one to turn and run. There has to be an increased probability that a larger decline is soon to come -- a decline that will wipe 15% or 20% off of one's portfolio value, not 3% or 4%. Three percent or 4% is common and natural, but 20% is not. The latter has to be protected against if it looks like a possibility.
This is where neoclassical technical analysis truly separates itself from classical technical analysis. Neoclassical analysis maintains the premise that there is a structure to the market, and that unless the structure for a large decline is within reach, then a decline of size is extremely unlikely. That structure was outlined in Trend Trading Set-Ups
and is now present in the Dow Jones Industrial Index
The potential for a larger decline has to do with the alignment of swing points and the potential break of those swing points on multiple time frames. When this alignment happens on multiple time frames (the low shown here is also a swing point low on the intermediate-term time frame), then the potential exists for a much larger break to the downside.
Again, what we know is that the supply-and-demand equation has shifted on the short-term time frame. We also know that one of the five major indices now has the structure needed for a larger decline. The other four do not, but a failed bounce this week would likely set up that structure on two more of the major indices as well.
This is an early warning sign that a larger decline may be in the offing. How much you protect your portfolio is a function of how much risk you are willing to take at this particular time. Personally I had already moved to short-term trades only to start the year and now am moving more to safety as a result of the technical and fundamental indicators as shared in a 35+ minute update issued over the weekend
On top of the technical signals, we have many fundamental issues front and center this week: large currency fluctuations and a Federal Reserve tapering decision; unrest in Thailand, Ukraine, and Turkey; significant earnings reports starting with Apple Inc.
(NASDAQ:AAPL) after the bell today, and much more.
Bull markets always die hard, and I doubt seriously that this one will be any different. They are usually marked by long periods of distribution before the bottom drops out of them. Whether we are now entering into such a period or are simply going to see the trees shaken significantly before a further advance is not known. What is known is that a failed bounce creates the potential for a larger move down, and that the structure needed for that move will form as a result of the failed bounce. That's enough to say risk is greater and the focus should turn from speculation to capital preservation near term until more information is revealed.
Editor's note: L.A. Little is a professional trader, author, and money manager who has written several books and contributed material to many financial sites in addition to authoring his own: Technical Analysis Today. He brings a unique perspective to technical analysis, incorporating his extensive engineering and modeling skills when analyzing the markets.
No positions in stocks mentioned.