Weekly newsletter of Danny Merkel - Issue #75
Market Review:
With this week’s bounce in the market, the key question is whether it will last. I’ll be keeping a close eye on QQQ to see if the previous gap down acts as resistance:
If the bears are still in control, then this rally should peter out in this highlighted area. But if the bulls are in control, price should plow through this area and, ideally, form a new higher higher, surpassing the high reached on June 2nd.
In my opinion, this is a poor risk/reward area to begin buying, with QQQ up five days in a row and facing gap resistance.
Growth stocks, shown below, are now in the process of forming bear market rally #15. Even though rallies 1 - 14 have completely failed each and every time, it still amazes me how quickly growth stock traders are able to dust themselves off and step up to the plate again and again.
Also, the dashed grey line represents February 16th, 2021 - the day I started this newsletter. It’s almost comical to me that I wrote the first issue literally at the very top of a massive speculative mania.
Although the market has been very challenging since the top, it has also proven the validity of Trend Following principals. One such principle that I can’t stress enough is to always be aware of the long-term trend.
For example, the S&P 500’s candle on Friday is indeed bullish, but a single candle is never enough to change the long-term trend.
Since the long-term trend hasn’t changed, I’m sitting this rally out. But this is something that new traders really struggle with; for them the market is up 800 points, things are moving, the market is oversold, stocks are cheap, let’s go!
Remember, professional traders have the ability to stop trading when their rules tell them to stop. Amateur traders have no rules and will never stop pulling that slot machine lever.
Individual Stocks:
It appears to me that the market has really entered a “dead zone” this summer with very few opportunities. For instance, Commodities, which I’ll discuss in the next section, were previously the only game in town, but even they have fallen apart.
In terms of shorting, many growth stocks have been so bombed out that they no longer represent a good risk to reward trade. Zoom Video, as an example, has just transitioned from a short-term downtrend to a short-term uptrend.
ZM with short-term trend (20 & 50 ema)
Given that the trend has changed, it might be tempting to get on board now, but that’s not how my system works. I buy stocks that are making new 52-week-highs, and ZM isn’t even close to doing that.
So, the bottom line is that I can’t short ZM, and I also can’t buy it. It’s in a dead zone where I can’t do anything. That’s not very interesting to the new trader who wants constant action, but it is what it is.
Commodities:
In issue #70, I discussed the reasons why the breakouts in Crude Oil and Wheat were likely to fail, and I will expand on that theme now.
The largest Crude Oil ETF - USO - did breakout from a nice consolidation pattern which, in theory, should have been bullish, but let’s look at a few nuances.
Firstly, there was very little volume on the breakout. Specifically, almost every volume bar in late May was below average. The one and only volume bar that was above average (red arrow) occurred when price formed a big black candle, indicating distribution.
From there, the chart eventually petered out and later gapped down. To me, the gap down is a clear sign that the trade is busted.
Another red flag was that most oil-related stocks were not confirming the uptrend in Crude. In my own trading account, I bought Chevron as it approached its 52-week-high, but the stock never really took off. As oil was climbing higher, CVX basically just ground sideways.
Following the rules of my trading system, I exited CVX after it had closed below the 20ema, taking a small loss.
Because my trading account is linked to a website called Collective2, you can actually see documentation of all of my trades, which are based on real money and real executions.
The table below shows me locking in a loss with CVX:
In fact, you can see all of my closed trades - going back almost 10 years - on Collective2 and you can do so absolutely for free.
If I was a new trader, I’d be spending a lot more time on Collective2 trying to reverse engineer how successful traders trade than on social media, where track records don’t exist.
Anyway, the Wheat chart also appears totally busted with price slicing through the 20ema and the gap down.
It’s possible that commodities setup again in the months ahead, but for the time being, I’m putting this entire asset class on the back burner.
Sports:
I know what you’re thinking - why is this nerd going to talk about sports.
While it’s true that I don’t understand sports and with my distressingly thin physique, I certainly don’t play them, but nonetheless I’m going to point out an interesting parallel with Trend Following.
People like me will never make money playing sports, but they can make money betting on them, and the best way to do that is to think like a trader.
The chart below shows the odds of two different hockey teams winning a game. The chart begins with a 65% chance of the stronger team winning. That’s an important distinction, especially with a sport like hockey which contains an element of luck - there are never any certainties - only probabilities.
Now as time progresses, that edge erodes slowly, just like an option decays, since there is less time for that edge to materialize. After a penalty, which temporarily changes the odds only slightly, Carolina scores a goal, which increases the odds.
Half way through the game, Carolina scores another goal, causing the odds of winning to hit new 52-week-high and the trend is now up. The trend continues until the final goal is scored and the odds of victory close in at 100%.
Now the Trend Following take away here is that you start each trade with the idea that you have a small edge, but that anything can happen. From there, you need to be open-minded to re-adjusting that view as new evidence comes is. In this case, the new evidence that came in confirmed the original hypothesis, but you also always need to be on the look out for evidence that disconfirms your point of view.
Contrast this mindset with the Bitcoin Hodler. Here, there are no probabilities, only certainties - Bitcoin is going up, and that’s that.
And as the the fundamentals or technicals change, there is absolutely no re-adjustment. Their mentality is something like this:
Bitcoin fails as a currency - it’s still 100% going up
Bitcoin breaks the 50dma- it’s still 100% going up
Bitcoin fails as an inflation hedge - it’s still 100% going up
Bitcoin breaks the 200dma - it’s still 100% going up
Bitcoin fails as a store of value - it’s still 100% going up
Bitcoin is down 75% from its high - it’s still 100% going up
Bottom line is that Trend Following involves constant re-adjustment and being flexible to new information.
"Observe that the blade of grass that resists the lawnmower gets cut down, while the blade that bends remains uncut"
- Paul Tudor Jones
Portfolio Review:
Here are my holdings going into next week:
Not a great week for my portfolio given that I’m basically 100% short, but the positions are small and the losses have been mild.
Remember that any position that violates the 20dma will be cut, so that’s always a guaranteed way to remain flexible and it is this simple rule that has really done so much to avoid massive pain this year.
Quote of the Week:
From Richard Weissman's book "Trade Like a Casino".