Wednesday, April 11, 2012

Trading Strategy in an Inflated Market

Let's admit it that the market has gone too far. Valuations (P) have outstripped earnings (E) far too quickly and for the market to move further ahead, it needs to seek a breather. Well, basically either the P decreases, or the E has to increase to match a 'worthy' evaluation.

The first quarter of 2012 was basically brought about by a couple of changes.
1. Greece unlocking itself from the debt abyss; hopefully.
2. Improving US economic health
3. China seemingly avoiding a hard landing
If it is not clear enough, 2 out of 3 of the main factors contributing to the market's rise has been based on speculations and psychological perception of the future. Only the improving US economic health is real and based on truth.

We know the market is forward looking so there is some sort of an element that this is what we all expect. But there comes a time when evaluations are too high than what we should expect. And we have seen it in recent times. But on the other hand, there will be ones with evaluations too low that we miss in this euphoria chasing the rallying stocks. One huge example is the knowledge we all have that the big cap stocks tend to move first followed by the mid and small cap ones in a bull market. This is no special ingredient. As the big cap fulfills its valuation, people feel they are pricier and re-look at the mid and small cap ones that have yet been fully valuated.

Today, everything seems inflated.
So what can we do?
Look and relook.

One tendency that I find myself often doing is being fixated at a certain set of stocks that have participated in the rally. Even though their prices have ran far away from their 55d, 100d and even 200d averages, it is still tempting to buy. That is now, to me, trying to pick the peak. It will never happen and when it does, all it takes is a couple of days to return to square one or even much below.

So instead of trying to go heavy on these stocks that have already moved, my aim now is to look at stocks that have yet moved. Of course, this is not easy as a hard search is necessary but with some stock filters, doing so should not be too difficult.
Focus on a select few and monitor them for a couple of days or weeks if necessary and enter only when a huge move is possible. Things to look out for include a large white candlestick together with a larger than average volume that signifies a possible interest from the broad market. This bodes well with their low valuations that are lower than their moving averages whichever you decide to use.

Nonetheless, there are downside risks to this play since an unattractive stock may remain unattractive for long periods or even experience a whipsaw that leads us buying into the stock and getting ripped. These risks are real but they can be mitigated by some simple checks on analyst reports and annual reports gauging the fundamental performance of the company. Once satisfied, this method is definitely much more relevant and less risky in the inflated market of today.

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