Market Review:
The rally in smaller, more speculative stocks isn’t going very well.
The ARK Innovation ETF was initially looking promising with a gap higher to a new 52-week-high. From a Trend-Following point of view, you had to give the bulls the benefit of the doubt. You can’t be bearish at new 52-week-highs.
However, as is almost always the case recently, these new highs never amounted to anything. ARKK never ventured far into new-high-territory before getting nailed by a series of black candles on above average volume (distribution):
These distribution bars brought price below the 20ema, which is my line in the sand for determining short-term momentum. This dip also means that the previous bullish gap up failed to hold. On Friday, price continued to languish below the 20ema, closing near the low of the day with another black candle.
All in all, it’s difficult to view this price action as some sort of fantastic new bull market. More like a tricky trading range mixed with some frantic short-covering in November.
Ideally, this tricky trading range would end and the market would trend higher. One clear sign of a new bull-market in small stocks would be for the RSI to become overbought and then stay overbought.
The trouble with the Russell 2000 is that it does have the ability to become overbought, but never the strength to hold it.
Like clockwork, each overbought reading leads to a sharp reversal:
Though the RSI indicator looks great in the chart above, it should be noted that there’s zero evidence that it works in the long-run. You simply cannot perform a back-test on a wide variety of markets using the RSI and have it come out profitable.
This is because the RSI falls apart during strong trends. For instance, in January of 1995, the S&P 500 became overbought. Yet notice the difference between the chart above and this chart below: the market back then kept on trending, plowing higher without any concern:
By comparing and contrasting the previous 2 charts, it should be clear that the market environments are radically different. The first is a high-volatility trading range and the second is a real bull-market.
My particular strategy works well in bull-markets and even bear markets, but struggles when thousands of stocks are in a trading range such as is the case today.
In order to deal with difficult market environments, one can develop a “market barometer” to determine when you should trade aggressively and when you should trade conservatively.
For example, you could trade your full-sized position when the S&P 500 is trading above its 200 day-moving-average and cut your position size in half when it’s trading below. That’s not what I do, but it is a simple example of a market barometer.
In his book Unholy Grails, Nick Radge examines a few market filters and provides backtesting results that are better than just using the 200dma.
The market barometer that I’ve been using for over a decade looks at the long-term trend (100 & 150dma) and short-term trend (20 & 50dma) of three important ETFs.
For instance, looking at SPY, we know that both trends are currently up, so this turns a switch up to the ON position.
The same is true for QQQ and IWM.
Based on this barometer, the overall market is in its most bullish position possible.
One advantage is that this method is objective. At this moment, for instance, the 100dma is above the 150dma for each ETF. There is no grey area, no room for any subjectivity.
Although this filter is simple and clear, and although it has served me well over the years, it has slowly dawned on me that it is flawed.
Yes, it is true that technically IWM is in an uptrend, yet it fails to recognize the drastic differences between the 2 aforementioned charts. It treats the choppy mess of today exactly equally as the S&P 500 in the 1995.
What is the key difference between something like ARKK or IWM today versus a real bull-market such as those seen in 1995, or 2021?
A simple, objective and factual difference.
Please take some time to meditate on this question.
Okay, welcome back.
There is something that happens over and over again in any strong bull-market. It happened thousands of times with Bitcoin. It has also happened thousands of times with MSFT or AAPL.