It's tough to buy the market when everything seems to be falling apart.
Humans are emotional creatures with often irrational wants. I've written about this extensively and it matters a great deal when it comes to investing. Understanding the psychology of need is every bit as important as knowing how GDP is calculated or what the heck a moving average is.
Especially in markets like this. This is the kind of market where emotion becomes a huge factor and knowing how to tame it is a mandatory skill to have success. Our rational brains understand that we're supposed to buy when it looks scary out there and sell when everyone is going bananas. But our emotional brains want to hide during weeks like this one and want to go party alongside all the yo-yos at bubble tops.
I know it cuts against the emotional grain, but I think the market could be setting up for a move back upward. We usually get only two or three shots at a trade like this per year. And I think this is a quick trade you can believe in whether you're inherently bullish or bearish. It just requires temporary abandonment of our pre-established opinion paradigms and recognition of a few factors.
Let's weave together a bit of both fundamental and technical analysis and outline a very specific trade.
Regardless of your own bias, we all know the long-term economic fundamentals are weak. We all know that the U.S. is going to grow through the next decade at a rate slower than what we all got used to in the last couple of decades. For the most part, market bulls and bears both tend to agree on this point. So let's just ignore all that talk about the new normal.
The short-term fundamentals -- which had been rather good -- are changing. There's no way to spin it: the latest economic data hasn't been as good as it was a few quarters ago. Whether a recovery or a continued deterioration in economic fundamentals is ahead is anyone's guess. We all know Europe is in disarray. The point is that a lot of this has been priced into the market. Things like unemployment aren't getting much better and they aren't doing it as quickly as we need them to. Bulls and bears can agree on this.
On a technical basis the market is oversold. This isn't opinion, it's fact. Feel free to debate about the degree to which it's oversold or the best tools to use to measure the degree of "oversold-ness". Feel free to debate whether or not that even means anything for the future or whether it'll get worse or better. Just agree -- bull or bear -- that the technical indicators say oversold.
Here are a few popular measures of buying/selling pressure:
click to enlarge
Now, erase all your biases and take a look at the risk/reward setup.
How to play it
It's easier than you'd think to put on a trade like this. Consult with your financial advisor to figure out the best method to execute it. Here's a really basic way to do it:
Buy something like the SPDRs (NYSEARCA:SPY) or Diamonds (NYSEARCA:DIA) right now. Like, today. I'm not a huge fan of the leveraged ETFs, but if you know what you're doing then those can sometimes make sense for short-term trades like this. Feel free to write some puts, too, so long as they are cash-secured.
If the market sells off further and violates the 200-day moving average or the lows of March -- a little more than 2% from here -- then pull the plug and walk away. Don't be one of those irrational, emotional, investors who cling to hope all the way to the panic bottom. Be objective and surgical with the trade. Be a professional.
I think the upside is worth it. In the event that this is just another test of the cyclical bull trend, you could see the S&P move back towards a new high above 1370. That could be +10% or more. Even if the trend is changing and the market is about to flatten out or settle into a cyclical bear trend, this trade still could work out as it clears the current oversold condition. You could see a move back towards the low 1300s at which point you'd probably want to think about getting out.
I'll leave the exit up to you. If you're inherently bullish, ride the trade for a little while. If you're inherently bearish, keep your finger snugly wrapped around that exit trigger. Either way, the important factor here is to be disciplined about your stop-loss. Make sure you're already long gone if the market makes a decisive new yearly-low or dips too far below its 200-day moving average.
When you look at it this way, I think the risk/reward characteristics of a quick trade like this is very attractive. With downside risk of about -2-3% or so and a legitimate shot at 10% gains over the next few months if it turns out that the medium-term bull trend is intact and the oversold condition clears.
And best, it doesn't require you to be bullish or bearish. This trade works for either paradigm.
Before I sign off, you should probably understand my own perspective. I think the market is troublesome on both a medium- and long-term basis. I don't think "buy-and-hold" will get investors the same results it generated before the financial crisis. It's a volatile world and investors need to be really cautious about the road ahead. If you want to call that bearish, go ahead.
Here at Seeking Alpha I wrote a long article about whether long-term investors should buy or sell this market, which requires a totally different way of looking at the market than what we discussed today. Longer-term, I'm much more optimistic about investments other than straight equities, one of which is real estate. I know. I can hear you laughing. That's cool.
It's not easy to go against the grain.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours.
Additional disclosure: See additional firm disclosure at TheDraconian.com/legal-notice/