Time to Revamp Your Strategy

 | Feb 26, 2013 | 9:13 AM EST  | Comments
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If you don't like something change it; if you can't change it, change the way you think about it. -- Mary Engelbreit

After the very ugly action Monday, the big question Tuesday morning is whether this marks the beginning of a downtrend, or if it's just a temporary hiccup that will be quickly overcome. As is their tendency, the bulls are already talking about how this is a "buying opportunity" and that we should hurry up and scoop up all the great bargains while we can.

During a correction, the hardcore bulls tend to make the same mistake that the bears make when the market is trending upward: They keep trying to anticipate a market turn and aren't patient as the action plays out.

After a day like yesterday, there is a very high likelihood of downside follow-through. An oversold bounce may come first, but the kind of action we've seen over the past week causes a change in the character of the market. Instead of rushing to buy the dips so they can catch more of an uptrend, market players are inclined to sell the strength so they aren't caught in further downside. The mindset switches from trying to rack up gains to avoiding losses. There is far less focus on putting money to work and far more on letting go of poorly acting stocks.

When the market starts to downtrend, almost all traders who are wiped out make the same mistake -- they try to average too big and too fast, attempting to catch a bottom. They build a big position and then end up panic-selling when the downtrend continues.  

It is understandable why. The folks in the media will go on and on about that "buying opportunity" a weak market supposedly presents. I complain about anticipatory bears in an uptrend, but they are nothing compared to the anticipatory bulls in a downtrend. When the market is acting poorly, you hear endlessly how we have to hurry up and buy.

My view now is that, with this downtrend now in play, the bears have the benefit of the doubt. The market has to regain its pose and prove itself before we can do any major buying. What makes downtrends particularly tricky is that they generate the biggest and fastest bounces. You can do quite well trading to the upside within a downtrend, but it is all about timing and proper position management.

It is certainly possible that the market will regain its footing and head straight back up; we've seen V-shaped moves more often than not. But don't be too quick to trust strength at this point. When we see weak action similar to Tuesday's, it emboldens the bears, who will now short more aggressively. That, in turn, frightens the bulls, who will look for ways to cut losses and exit positions. The "buy-the-dip" mindset, therefore, no longer operates in the same way.

Fed chief Ben Bernanke will be giving congressional testimony later this morning, and he can move the market with even the slightest comment. In fact, I wouldn't be surprised if he triggers a bounce with comments about how the quantitative-easing program is likely to continue. But I wouldn't count on that being enough to repair the damage done this past week.

To reiterate, given this new trend in the market, we need to adjust our thinking and our strategy accordingly.

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