Short-Term Caution Warranted

A short-term downtrend began on Thursday, June 11. I mentioned last week that I think there may have been a short-term downtrend that started mid-April and ended mid-May, and I base this on the stochastic shown in the chart below. I'm hesitant to abandon the PMO index which has worked so well for me over the past several years but I need to be open-minded about market outcomes and that indicators don't work 100% of the time.

It doesn't really matter that much though because for me the stochastic shown below isn't a tool that indicates exactly when to buy or sell but instead is used to indicate when to start thinking about trimming holdings (at the top of the range) or adding to holdings (at the bottom of the range).

So, with this in mind, the stochastic was suggesting that we should have been trimming last week, and, most likely, in about two weeks when the stochastic moves to the bottom of its range, it will be suggesting that it is time to start adding to positions. 

The same is true for the PMO index shown in the previous chart. The stochastic is a bit more sensitive than the PMO, but I expect the two indexes are now back in sync. One last thing, in mid-May, when the PMO was still at the top of its range, and when the stochastic was at the bottom of its range, it suggested a very bullish divergence and was an excellent buying opportunity.

Now with both the stochastic and the PMO pointing lower, it means that it is time for a bit of short-term market caution until the indicators start to reverse. Looking at the chart below, it suggests that there are about six or seven short-term buying opportunities in a year, so this means that we'll probably get the next short-term buying opportunity late-June or early-July.

This chart shows a MACD with settings that allow you to see how far stretched the index is above or below its 50-day EMA. In March the indicator suggested a rally back up to the 50-day, and recently it suggested a correction back down to the 50-day. 

Based on the short-term corrections in August and October, the index will dip under the 50-day for a few weeks. This will the opportunity to redeploy the cash we have in our accounts that was raised during this past week.

Sell at the top, buy at the bottom... sounds simple? Yes, it sounds simple but much harder to do. Over the next two weeks, we'll be hearing lots of scary news about all sorts of issues that will make us wonder if we just reached the top of a counter-trend that marks the beginning of the next major leg down.

I am one of those people who believe that this recent market rally is too good to be true which means we could see much lower prices. However, my opinions don't matter, my instincts are always negative, and therefore I am not going to give in to my fear. Instead, I am going to be following my favorite indicators and let them and the market guide me. 

The 10-day Call/Put ratio (put/call inverted) shown below is one of my favorite indicators. This chart confirms my suggestion that we had a short-term downtrend that ended in mid-May, and now it is pointing lower again. Over the next couple of weeks, I'll be looking for some white candles and a shift in the parabolic SAR similar to what occurred in mid-March and mid-May. It will be the signal to start to buy stocks again.

This ETF is important because its holdings are the best-of-the-best small-cap growth stocks, and this rally up to and failure at the 200-day is negative at the moment. Let's keep an eye on this chart. If it starts to point lower then it is an important bear signal, but if it moves mostly sideways and builds a base, then it is probably getting ready to break above the 200-day which would be bullish for the overall market.

At the moment, my accounts are about 90% invested in stocks meaning I have about 10% cash available to redeploy. Considering how crazy the world is right now, I'm a little worried that this is not enough cash. Generally, I like to have at least 20% cash near the top of a short-term cycle.

The reason I have more stock holdings than I should is that the stock price pattern setups in the best growth stocks have been so favorable. The cyclical stocks were bouncing off the bottom and doing well early last week, but many of the growth stocks were at new highs for the year and this is where I like to be invested. Also, even after such a huge drop in the indexes on Thursday, the growth stocks held up well. Prices were definitely lower on Thursday for growth stocks, but I didn't see sell signals.

That could change next week and growth stocks might start to drop under support levels and moving averages, but I have no choice now but to let the market take me out of positions instead of trying to take partial profits. The market has already skimmed the top off of the best returns on these stocks.

Another of my favorite indicators is the number of new 52-week lows, and there are so few new lows that it indicates a healthy stock market.Mike Burk is my blog-mentor regarding new 52-week lows, and he used to often state that nothing really bad ever happens to the stock market without an elevated number of new 52-week lows. Keep in mind, though, that the number of new lows can increase suddenly, so you need to look every day to make sure the number of new lows remains at safe levels.

One last thing, I haven't had my best year in the market, by far. Early this year, I was too casual and wasn't following my own trading plan with the discipline required. Then, in April, I was too worried and defensive, and therefore wasn't ready (or in denial) when the market quickly turned around and started to head higher again in May.

So after having a rough five months, and with 90% of my holdings in stocks, I am now at risk if the market really does start to head south again similar to late February. I will need to protect my capital, and I feel as though I need a little bit more help to follow this market than I usually do. So I am turning to the IBD Big Picture column for assistance.

In Friday's commentary, the column acknowledges the very bad price action and volatility on Thursday and Friday, but that they believe the market remains in a "confirmed uptrend" with only a few distribution days (2 NASDAQ, 3 SPX). They suggest that if the market is going to come under pressure, then we'll see a cluster of distribution days develop. Here is how they word it, and it is very good advice I think.

"Be on the lookout for clusters of distribution days, which are consecutive distribution days or several in a short period of time. Often, clustering can quickly cause a shift in the stock market trend.", IBD June-13

Outlook Summary

I do my best trading when I am patient and disciplined.

The medium-term trend is down as of Feb. 26.

The short-term trend is down as of June 11.

The economy is in recession as of March 28.

Contrarian Sentiment favors lower prices as of June 6.

The medium-term trend for Treasury bonds is up as of Jan. 25 (prices higher, yields lower) .

Strategy During a Bull Market

• Buy large-cap stocks and ETFs at the lows of the medium or short-term market trends
• Buy small-cap growth-stocks on breaks to new highs in the early stages of market trends
• Reduce buying when the market trend is at the top of the range
• Take partial profits when the market uptrend starts to struggle at the highs

Trader Discipline

• Never invest based on personal politics
• Take pride in sticking to the trading plan
• Don't give in to fear, greed or anger