6/6/06 Notes

THE RALLY IS DEAD, LONG LIVE THE RALLY

Using the criteria set forth by Mr. William O’Neil, the founder and publisher of the daily IBD newspaper, and author of How To Make Money In Stocks, the latest rally attempt has officially failed. Mr. O’Neil’s criteria changes somewhat from time to time, so I am not sure what the exact parameters are nowadays, but I don’t imagine they are much different than formerly, i.e., when the market rallies off a new low on at least one percent higher volume, that marks the beginning of a new rally attempt. As long as any subsequent session does not undercut the low of the rally attempt, the rally lives. Sometime in the first ten market sessions in the new rally, a follow through day must occur to demonstrate that the rally has legs and has a chance to succeed. A follow through day, the last I recall, was another up day on higher than normal volume. The best ones occur between the 4^th and 7^th market sessions from the start of the new rally.

Mr. O’Neil is fond of pointing out that rallies may fail even after a valid follow through day, but all true rallies have always had a follow through day. In the last version of his book How To Make Money In Stocks that I own, he mentioned that occasionally deep pocketed institutions can paint a picture of a rally by forcing a follow through day, only to have the rally subsequently fail. I do not recall if he mentions the intent of the institution that does this. Are they doing it to try and get a new rally started, in the hope of inviting others to join them? Or are they luring in the small fry money that is attracted to momentum in the markets much as a bass is to a shiny lure?

I also have to debate whether ‘occasionally’ is the correct word in bear markets. I did a study back in the 2000-2002 bear market. I checked each occurrence of rally days and follow through days. During that prolonged bear market, you would expect to see that almost all of the rallies failed at some point. But it was still surprising to see how many ‘follow through’ days occurred like clockwork four to five trading sessions into the latest rally attempt, only to fail miserably shortly thereafter.

Yesterday’s big selloff undercut the latest rally attempts on all the major exchanges. So we start counting again, waiting for a brighter day – unless you are short the markets. But shorting is a game that most of us small fry do not like to play.

If you do not go short the markets or individual stocks, then there are periods of time when the best thing to do is sit on your hands and do nothing. This is one of those times. The most important single rule of trading is to cut your losses. If you limit your losses you can survive rough periods and live to trade again when the storm has passed. In my own trading I once had twelve losing trades in a row, and twenty out of twenty two. As devastating as that was psychologically, because I put strict loss limits on my trades, I was able to survive that slump relatively intact.

One of the books in my trading library is How I Trade For A Living by Gary Smith. In that book, Mr. Smith recounts how he was unsuccessful as a trader for about 19 years, basically treading water. But then he found his system and has been consistently profitable since, at least as of the date of the book’s publication. Amazingly, AFTER he has his epiphany, Mr. Smith went through a string of 23 consecutive losses. I cannot imagine how he felt he was finally on the right track while going through that many losses in a row.

My system of trading incurs a lot of losses. My best trades are trend trades. I never know going into a trade whether that trade will work or not. The best that I can do is wait for the criteria I use to line up, put the trade on, and then use money management strategies while in the trade. Sometimes trades work and sometimes they do not. Looking for trends, I know that statistically I am going to lose at least 50% of the time. That is why money management is crucial.

Mr. O’Neil points out why avoiding major losses is so important. If you do not cut your losses, the mathematics of trading start working against you in a big way. For instance, if you allow a trade to move against you by 50%, then you have to double your money from there just to get back to even. That’s a difficult chore and not something you want to be forced to do very often. If you lose 25% of your capital, you will need a 33% return from then on just to get back to even. Mr. O’Neil recommends setting your initial loss limit on a trade at no more than 8%.

The longer I trade the less attention I pay to technical indicators. I have concluded that big players often paint the charts to lure other traders to jump, then pull the rug out from under them. I have seen that over and over through the years, perfect chart patterns, where all the indicators were lined up in almost certain can’t miss alignment, only to immediately reverse and trap everyone who fell for the bait.

There is an old trading axiom that there are no rich chartists. I doubt that is true, but I certainly understand the sentiment. Most of the traders on the stock bulletin board I frequent are dedicated chartists and they continually get blown whatever direction the market wants to move them.

Having said all that, I do think it is worth mentioning that Dow averages failed at their 50 day exponential moving averages (ema) last week and again yesterday, and that the Nasdaq composite has not been able to penetrate its 200 day ema to the upside. The 50 day and 200 day averages are significant because they are yardsticks used by many major institutions. The 200 day average is often referred to as the bull/bear line.

There are many things lining up all around the planet that have at least the potential to create the financial equivalent of a perfect storm. I believe that we have entered the last days before the return of Jesus Christ. I write more about that on my other blogs if you are interested in checking them out. I am not pessimistic, because I have read the ending in the Book, and the good guys win. But there will be a lot of stuff happening in the meantime.