Friday, December 5, 2014

Remaining Patient in a Challenging Market

The recent market choppiness has us uttering certain words over and over around the office.  While some aren't fit for print, one that stands out is patience.

Here's why:

Stock market gains in 2014 have been made on narrowing leadership.  While the major indices like the S&P and Nasdaq continue to set new all-time highs, a different story is being told when we look at stocks individually.  For instance, the Nasdaq is up 14% on the year however much of those gains can be attributed to the index's largest components. Apple makes up more than 9% of the index and its share price has risen 47% YTD.  Microsoft, the next largest weighting at 6%, is up 32%. Other heavily weighted stocks like Intel, Facebook, Gilead and Amgen are all up significantly more than the overall index.

This sparks a number of observations.  First, yes, there remain opportunities to capitalize upon individual names.  However, the abundance of those names has dwindled as the year has worn on. Many of the stocks in the Nasdaq remain well below their early 2014 highs.  Looked at individually, the average stock in the index is up less than 3% on the year.  This means that bigger cap names, like the companies mentioned above, have pulled a considerable amount of weight in order to drag the index higher over the last several months.  That's perfectly OK for shorter periods of time but if things remain narrow over the longer term the chances of the index collapsing under its own weight likely increases.

Further, breadth measurements on the Nasdaq, as well as the S&P and Russell 2k, are all showing signs of exhaustion as the % of stocks above 10 and 20 day moving averages are all making lower highs as price continues to make higher highs.  Couple that with the longer term A/D Lines on both the S&P 500 and Nasdaq, we can see this is a market making progress on less and less participation and momentum.  Again, these are secondary indicators but they are waving the caution flag nonetheless. (Yellow is A/D Line, Blue is Index).

More data?  On Monday, we observed that the number of stocks making a 4% or greater move lower on higher volume was the second biggest reading all year.  *Note* we caveat the higher volume reading because of the holiday shortened session on the Friday before.  We didn't put much stock in that figure but coupled with other data we track, our risk meters started to perk up.  The number of stocks making new 20 day lows across all listed equities was in the top decile for all of 2014.  Also, the declining volume on the Nasdaq was 83% of total volume.  These aren't necessarily extreme readings but certainly high enough to turn our heads.

Observations like these suggest this bull market is showing signs of fatigue and may be in need of a rest.  However, it does not mean that the market will correct in short order.  It very well could just consolidate before resuming its plod higher.  That brings us to the point of this entry: PATIENCE. Six years into this bull market, we know better than to be calling tops. However, we will readily admit that this has not been an easy year for active management and stock picking.  Environments like this serve as important reminders for investors/traders to acknowledge that their system and edge will not align with every market.  For "Buy and Hold" market participants this is likely nothing more than noise but for active investors it's a call for heightened awareness.  Having the ability to appreciate that fact is critical to long term success.  What do we do when the market is not giving us the risk/reward scenarios we prefer?  Well, we like to raise lots of cash, sit on our hands and do even more research. Really boring stuff but also the best course of action.  What we don't do is over-trade, violate our rules or lose sight of the larger goal.

If you find yourself falling victim to impatience when your strategy is not in tune with the market, you must address this ASAP.  It's every bit as important, and then some, as uncovering your next great trade idea.

For further commentary, one of our favorite resources, Dr. Brett Steenbarger, touched on similar topics yesterday over at his site.

-Ryan Worch

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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