One of the key tenants of my approach to the market is to react to changes in price action rather than try to anticipate or predict what might happen.
It simply isn't possible to guess what is going to happen in the future. Therefore, it is more effective to stay with a trending market as long as possible and then shift as the character of the market action shifts.
Like most things in trading, this is not nearly as easy as it sounds. 'Get out when the market starts act poorly' is great advice, but there are many obstacles that must be overcome to do that in an effective way. The market often has a few days of poor action that will cause us to believe that a significant change is starting to occur, but then things bounce back and the worries are quickly forgotten. If you reacted too quickly to the temporary weakness, you will find yourself trying to chase the market as it resumes its uptrend.
However, the key to superior market performance is to be standing on the sidelines when significant weakness starts to occur. Keeping your portfolio as close to highs as possible is what will lead to exceptional returns. If you outperform in bad markets you will be far ahead of the game.
With that in mind, the question we should ponder is what are the warning signs the market is starting to undergo a change in trend? What are the signs that we should react to?
1. Focus on Price Action not Arguments: The first thing to keep in mind is there are always very compelling arguments for why the market is about to reverse and go in the other direction. Never in my career in trading has there not been some very smart bears telling us why disaster awaits.
It is good to contemplate these theories, but don't be tempted by the glory of being the genius that calls the exact market turn. That is a nice goal for pundits, but it extremely unproductive from a trading standpoint.
If you understand what the bearish thesis is, then you can appreciate it when the price action starts to change, but wait for hard evidence. Don't just sit and hope the market is going to suddenly recognize the genius of the bears.
2. Action in Individual Stocks: The best clue that market conditions are changing is the action in the individual stocks you are holding. Even if they are not reflective of poor action in the overall market, it is still important to take action when stocks you are holding are breaking down. It may just be a sector issue or some negative themes, but there really is no better clue the market has issues than the fact that you are losing money. When the profit and loss statement erodes--don't just sit there, do something.3. Leadership: Another clue there is a shift in market action is when leadership narrows of shifts. All strong markets tend to have good leadership. There are usually themes that work well like semiconductors or financials. In a poor market, the leadership quickly narrows. In the best markets there is always a good theme that is working, such as small cap oils, solar energy, biotechnology, etc. That sort of speculation dries up very fast when the market shifts
4. Technical Action: One of the key clues that market conditions are changing is the technical action. Some things are obvious like the breaking of key support levels, but the best early clues tend to be intraday reversals or poor closes. The indices can hold up quite well in the early stages of market deterioration. It is necessary to look under the surface and measure things like breadth and the willingness to chase strength.
5. Reaction to News: Market health can also be gauged by the reaction to news events. Market players will often say 'all news is good news' in an uptrend. When the trend is strong the market has an inclination to ignore all the negatives the bears have seen in the headlines. Once market conditions shift, then there is a tendency to use good news for selling. The good news, such as a headline about China trade, no longer leads to sustained upside. It becomes an opportunity for market players to reposition. When that happens, we know that market conditions are shifting.
6. Stay open minded: It is very easy to overact to early signs of weakness. If we have been worried about the market and think it is ready to correct, then we will be very quick to embrace any weakness as the start of something significant. There are going to be some poor days just due to the normal ebb and flow of the market. You won't know right away if the initial weakness is just a routine pullback or something significant.
7. You will incur losses: If you are a reactive trader, then you will incur losses before you fully react to a shift in market conditions. Hopefully you will have incurred a substantial cushion of gains by staying with the uptrend as long as possible so the losses will not be too severe.
Market players that try to anticipate turns incur large opportunity costs. The cost of not being in the market as it continues higher is not an actual loss of money, but it is just as costly. Staying with the trend to the bitter end can produce a very big cushion of gains that makes dealing with downtrends much easier.
8. Think of selling as insurance: Just because you sell a position, that doesn't mean you can't buy it back very quickly. Market players often think of the selling decision as being something that can't be reversed. It is simply a form of temporary insurance. When you no longer feel like you need protection, then you can buy back your position. If you pay a lower price then you are in better shape. If you pay a higher price, then think of it as an insurance premium.
One of the great advantages of this approach to the market is that it frees you from trying to predict the future. Institutional Wall Street likes to pretend that it helps investors by providing them with special insight into where the market is heading. They have an abysmal record of doing that, but market players tend to believe it. Rather that waste time on hopes and dreams, stay focused on what is happening right now and react accordingly.