After the biggest two-day Nasdaq decline since December, after the light switch was turned off at Friday's open, many investors are worried, and rightly so, that they might be too long (and too wrong) in the stock market, especially technology's "Fab Five" (Facebook (FB) , Apple (AAPL) , Amazon (AMZN) , Microsoft (MSFT) and Alphabet (GOOGL) ).
Yet, just because everyone is focusing on a particular asset class like stocks, and sector like tech, doesn't mean there aren't less crowded opportunities that are inherently less risky. What is the definition of risky? That depends on your investment/trading style, wealth, time horizon, and liquidity requirements while your funds are invested.
Since many of us don't have any training in investment analysis, let alone risk analysis, let's consider defining risk as the amount of points (not percent) a security can fall before becoming worthless. Then, we can assume that a security at all-time highs is more risky than one well off its all-time highs. In other words, a stock at a price of $100 has 100 points of risk, while a stock at $20 has 20 points of risk. True, they both can fall 100%, however, let's also assume neither will go to zero for the purposes of this illustration.
If we then use an objective decision support tool to inform us when securities are overbought vs. oversold, and agree to only buy when objectively oversold, and always sell when objectively overbought, we can combine objective buy/sell decisions with "risk of ruin" (potential for a stock to go to zero) to get an overly simple, but effective, decision support model. We call ours the DSE (decision support engine), and post many of its buy/sell signals in these pages within a few days of alerting members of our Trading Room and DSE Alerts services.
Next, so we don't get caught in the debate of valuations on tech stocks vs. value stocks, etc., let's look at a security off the beaten path that almost everyone comes in contact with on a daily basis. This is the iPath Bloomberg Coffee Subindex Total Return ETN, known as (JO) , which tracks the price of coffee (as in cup 'o Joe).
Most investors think of Starbucks (SBUX) when considering a bet on coffee prices, which is misled, as that company hedges away swings in the price of coffee in order to remain in business. However, JO can either be used to hedge coffee holdings, or speculate on the price of coffee itself.
This is the monthly bar chart of JO, showing price behavior that closely, but not perfectly, tracks coffee prices back to 2009. As can be seen here, it has fallen from a high near $80 in 2011 to the current level near $17; a 79% decline.
On a risk analysis basis, unless the price of coffee goes to zero, JO is now 79% less risky as it was when trading at $80. While the theoretical risk from here is still 100% (if the security declines 17 more of the 17 points it now trades at), the practical risk is much smaller than it was when trading at $80. Compared to those that have ridden JO all the way down, and there are always those folks, most of the risk has been wiped out with their equity.
Next, look at the objective stochastics study in the lower pane of the chart. This indicator identifies times of high relative risk when the stochastics reach toward the 90% extreme overbought threshold (red dashed line), and low relative risk when they reach toward the 10% extreme oversold threshold. Currently, the stochastics are around the 10% oversold extreme. This doesn't mean price can't decline further. It means that an objective selling condition is not indicated, like it was when up around the 90% overbought extreme.
Another objective indicator is the olive/gold lines that are seen above and below the black price bars. These are the two-standard deviation bands, which control 95% of normality. As you can see, price rarely gets above or below these statistically significant levels. Currently, price is finding support from the lower two-standard deviation band.
Finally, our DSE's algorithms are constantly reviewing historical chart patterns for highly correlated "if/then" conditions. In other works, if this pattern is seen, then what price behavior has historically followed. As you can see from the bright green buy box within the light green buy box, we are very close to where the DSE is targeting JO to end, at least temporarily, the declining trend and begin a multi-month rising trend.
Combining these objective indicators, the conclusion regarding the ideal action to apply to JO is that of buying actions only. Therefore, our DSE warns investors that are enjoying winning short positions to use buying actions to exit those shorts, and/or use protective buy stops to protect profits before the eventual rise in price. Specifically, $13 +/-$2 is the ideal landing zone for shares of JO, and the next few days, weeks at the longest, is the ideal time window.
Any move above $18 should hint that the decline has completed, while closing above $20.50 should confirm it. The conservative speculator could play JO as follows: buy one-quarter of your intended exposure in the $16s, add one-quarter in the $13 +/-$2 zone, and add the rest on a close above $20.50. This is called laddering or legging into a position, and releases you from the need to be exactly perfect on your entry price. Then, stop loss protection can be used in the $9s, or wherever else you deem appropriate.
For illustration purposes, though, let's say this laddering plan was filled. An average price of around $17 is possible. If the pattern recognition forecast is correct, JO could reach into the high $30s in the coming two years. This would offer a potential reward of 20 points for a risk of around 7 points, or nearly 3:1 in favor of those buying into this zone.
For updates on this analysis, as well as other trading opportunities, try Ken Goldberg's DSE Alerts service for free for a couple of weeks, or contact him at firstname.lastname@example.org
Facebook, Apple, Alphabet and Starbucks are holdings in Jim Cramer's Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells FB, AAPL, GOOGL and SBUX? Learn more now.