How (Not to) Short a Market Melt-up

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Feb 6th, 2013 | By | Category: Markets, Trend Playbook

“Never short a dull market” is an important bit of wisdom many traders tend to ignore…

Now that we’re experiencing some sideways action in stocks for the first time this year, I thought it would be a good idea to dive into just why you should exercise caution on the short side — even when the markets become overbought.

First, a quick history lesson for you. Here’s 2013 (so far) in a nutshell:

A huge, unexpected rally…

The ensuing low-volatility market melt-up…

Now indecision has crept into the picture:

After a few whipsaw days, the bears have emerged from their dens. They’re looking for opportunities to short this market. Unfortunately for them, Monday’s 1%-plus drop did not stick — stocks promptly moved higher Tuesday morning, recapturing most of their losses.

For some traders, it’s tempting to short a red-hot market at the first signs of weakness. However, I have to caution you: This can be a very dangerous proposition. Look no further than the market action from one year ago.

2012 began just like this year: a big New Year’s rally followed by a market melt-up. But then in early March, the market started to wheeze. For three straight days, stocks moved lower. Short-minded traders lined up for the kill…

However, the very next days, the market carved out a base. Stocks moved higher. And again, in just three days, the rally was back on track. A strong signal that a pullback was in the works didn’t appear until early May when a lower high around 1,400 formed in the S&P.

Now, I’m not saying the market has to follow this script letter for letter. But the similarities are too striking to ignore.

Jonas and I have written about how time periods can line up to offer you additional insight into the potential direction of stocks. In fact, to show you just how effective these techniques can be, I’ve pulled up some predictions from late 2012…

“It’s not uncommon to see price action from two completely different time periods line up,” Jonas commented back in November 2012. “Especially in the very short term… But when price action syncs up over the long term, it’s worth paying attention.”

Here’s his chart comparing the debt ceiling deadline in 2011 with the price action we experienced in the weeks leading up to the fiscal cliff:

This chart is broken up into two sections. Up top, there’s the S&P 500 index over the last year. Below it, there’s the S&P 500 again, but it’s shifted back by 450 days. At a quick glance, it’s clear that the key inflection points in both charts line up uncannily well.

Not only did the charts line up very closely — Jonas was also spot on with his prediction that the market would jet higher after the fiscal cliff deadline. As he explained at the time, the big turning points for both of these charts matched up. Both started out in a downtrend. They consolidated for the next month, and then moved into an uptrend. The uptrend then topped for both charts at the same point. And both charts consolidated sideways at the end.

Of course, there were some differences. But the main takeaway here is that you can use similar patterns from the past as general road maps for developing trends — especially when the economic climate lines up so well.

In the coming days and weeks, we’ll see just how well 2012’s winter rally lines up with what’s shaping up in today’s market. In the meantime, don’t get caught leaning into shorts too early. That’s a good way to get burned.

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Author Image for Greg Guenthner

Greg Guenthner

Greg Guenthner, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes. He is also the editor of Agora Financial’s Trend Playbook, a free resource for trend followers and technical traders. For close to a decade, Greg has led Agora Financial’s small-cap division, where he founded one of one of the only independent OTC research advisories in the industry. Greg specializes is classical trading techniques and combines timing strategies with his fundamental analysis of small-cap stocks.

He is a member of the Market Technicians Association and hold the Chartered Market Technician designation. 

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