As I showed you last Friday, the typical action following a sudden and swift correction like we saw earlier this month is for stocks to chop back and forth in a very wide trading range for several weeks. During that time, the market often retests its low point at least a couple of times before we get any sort of sustainable move higher.
Of course, it’s possible that stocks will continue straight up from here in a V-shaped pattern. It’s possible the S&P 500 will be trading at new highs within a month, as so many talking heads on the financial television stations are predicting.
So, as I went through my normal chart review on Saturday morning, I intentionally looked for reasons to be bullish – reasons to believe the stock market’s bounce last week would continue this week. I tried hard – really hard – to be bullish this past weekend. But I failed.
Instead of finding a pattern that supports the case of “new highs within a month,” I noticed another pattern that suggests we could get another bearish move starting this week. Let me explain…
My favorite pattern for trading in a bearish environment is something I call the “busted momentum” trade, followed by the “kiss of death.”
Momentum for a stock is often defined by where it trades relative to its 50-day moving average line (MA). If a stock is trading above the 50-day MA, it has bullish momentum. If it’s below the line, the momentum is bearish.
A busted momentum pattern exists when a stock that was trading above the 50-day MA sells off enough to drop below the line. It usually takes a good deal of selling pressure to force that to happen. So much so that, by the time a stock drops below its 50-day MA, it’s already quite oversold. And the odds of a bounce are quite high.
The 50-day MA line, however, now serves as resistance. So any bounce back up to “kiss” the line from below is an ideal short-selling setup.
Here’s a good example in the energy sector from a few years ago…
The energy sector started to lose momentum in July 2014. XLE dropped below its 50-day MA, which shifted the immediate trend from bullish to bearish. The stock then rallied just enough to come back up and kiss its 50-day MA line from below.
Traders who used that “kiss” as an opportunity to short XLE saw a 20% gain on the position in a matter of weeks.
Here’s another example using the chart of Yahoo! (YHOO) around the same time…
It took only about five months in 2014 for Yahoo! (YHOO) to rally from $33 to $52 per share. That’s a gain of almost 60% – making YHOO a clear favorite among momentum traders.
But when the stock broke below its 50-day MA in the early days of 2015, it signaled the momentum was gone. The first bounce back up to kiss the line from below was an excellent short-selling opportunity. Then, about three weeks later, traders got a second kiss of the 50-day MA and a second chance to take a short position on YHOO. The stock then fell about 14% over the next two weeks.
There is one important thing to note about this “busted momentum” pattern… It works best on stocks that have enjoyed large rallies.
You’ll note, for example, that the chart of YHOO shows the stock breaking below its 50-day MA in October 2014. At that point, though, the stock hadn’t rallied much off of its mid-July bottom. So, there really wasn’t much momentum for it to bust.
But the break of the 50-day MA in January, following a 60% rally in four months, led to a very nice busted momentum trade.
We haven’t seen this pattern very much over the past two years. The stock market has been on a one-way path higher. And most sectors and major indexes have held above their 50-day MA lines.
That changed earlier this month when the S&P 500 broke down from a parabolic rise and sliced right through its 50-day MA. Last week’s rally pushed the index back up to “kiss” the line from below. Take a look…
It’s hard to view this as a bullish setup. It seems to me the odds favor a lower stock market this week.
Best regards and good trading,
Jeff Clark
Reader Mailbag
Thanks for the brilliant service. Jeff is top-notch at what he does and the education he shares is invaluable. I really appreciate the chance of the year with the Delta Report.
– Geoff
I too watch gold. I have not found this depressing. Instead, it presents an opportunity.
A look back in history will show this cyclical pattern over and over. It is difficult to profit from this, unless the longer-term picture is seen. When gold and silver hits this sawtooth pattern at a bottom, it will rise. But it is difficult to predict when. What I have done successfully is to create true synthetics far out in time (LEAPS).
With a sold put and bought call or bull put vertical + call for healthy gold stocks or royalty companies who help fund mining companies. In this way, a great deal of money can be made with little or nothing invested. The biggest challenge is knowing when to sell these, after closing the put side and converting bought calls to at least a bull call or covered call. I realize your style of trading is much more short-term, but I believe this is a valuable means to take advantage of the eventual rise in gold and silver without worrying about timing. Thanks for your valuable insights.
– Jack
I am inclined to go with the historical retests. It just occurred to me that there are a ton of people that have been flying high till the downturn and are now piling in to get back on top again.
Just curious as to what you think of the human element that is involved here? You hit the nail on the head!
– Gary
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