Put Away Your Crystal Ball

 | Oct 03, 2011 | 8:57 AM EDT  | Comments
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"When things are bad, we take comfort in the thought that they could always get worse. And when they are, we find hope in the thought that things are so bad they have to get better." --Malcolm S Forbes

If you spent any time looking at charts this weekend, you probably don't feel very optimistic this morning. The S&P 500 dropped more than 14% in the third quarter and that has left us with no leading stocks and few strong charts. Finding a stock in an uptrend, other than an inverse exchange-traded fund, is nearly impossible.

Some market players view this sort of market action as a buying opportunity. They look to snap up bargains and then wait for the market turn that they are sure is coming at any moment. Their goal is to be heavily invested just as the market turns so they don't miss a penny of possible profit.

You can be sure that with poor action overseas and another weak open in the U.S. this morning there will be another chorus of calls that the turning point is nigh. It may in fact turn out that this morning is ideal to load up for a major reversal, but I see no reason to believe that the selling is about to come to a sudden end. In fact, downside momentum appears to be building as a default by Greece is becoming more certain and investors embrace the idea that the U.S. is falling back into recession.

The optimists and bottom callers argue that sentiment is extremely negative. The thinking is that when it is this bad, those who are inclined to sell have already done so and that will keep further downside contained. We all know what the bearish arguments are and they have to be priced in to the market.

Unfortunately, timing the market by measuring the mood is extremely difficult. There are sentiment surveys that have been negative for a while, but there are few precise measurements of mood. Generally, the folks who try to use sentiment as a contrary indicator have already made up their minds about the market and are hoping that their view that things can't get much worse turns out to be right.

I am a trend follower, so my approach to the market is to ignore all the folks who try to predict a market turn and, instead, wait for the price action to demonstrate that conditions are really changing. If bad news no longer has any impact and we start to see stocks holding support levels, that will be my cue to become positive about the market.  

The comments about sentiment being so negative that a low has to be near are just guesses until there actually is some sort of price action to back it up. If we really have reached an extreme in negativity, then stocks should start acting differently and it will be time to be more aggressive in putting money to work.

What many market players dislike about a trend-following approach is that you don't spend much time engaging in that great market pastime of trying to call turns. For many on Wall Street, that is their primary focus, and we will hear it all day long in the media when the market is in a downtrend. Usually, the folks making these calls made up their minds long ago and are already heavily invested. Their advice tends to be more hopeful than objective, but they can be very loud and receive a lot of attention. Most of us want to believe that this misery will end soon, and the media is always happy feed us what we want to hear even if it doesn't have real support.

A trend-following approach requires staying patient until the price action changes. That doesn't mean you can't play bounces, average into longer-term positions or do some shorting, but it does mean you don't spend a lot of time trying to predict when things might change.

It is very rough going and it's easy to lose money if you are anxious to fight the poor action. There will be plenty of great opportunities if you forego the fortune telling and let the price action be your guide.

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