Best Trading Strategy For August

¹²The Best Trading Strategy For August

By Jeff Clark | 3 August 2010

The bulls got it. The monthly chart of the S&P 500 closed above its 20-month exponential moving average (EMA) on Friday. That's bullish action. And it negates the bear-market signal that occurred on June 30— when the S&P closed below its 20-month EMA.

Here's the chart… This marks the first time since late 1990, when the U.S. was preparing to kick Iraq out of Kuwait, that the bear was forced back into hibernation in just one month. The bear market signals in late 2000 and early 2008 led to dramatic declines in stock prices. I expected we were in for something similar this time around, too. Based on yesterday's action, it appears that won't be the case.

At least, not yet.

It's hard to give up on the bear case. After all, global economies are a mess. Unemployment is high [[…with no real end in sight— see Beware The Move In Durable Goods: normxxx]]. Government, corporate, and individual debt burdens are out of control. And everything just seems, well, bearish.

But when it comes to the stock market, price action trumps everything else. And right now, the price action is bullish. Yes, it's possible the chart will flop back into bear-market territory by the end of August. The S&P 500 only needs to lose about 2% from yesterday's closing price to do so.

Whippy moves like that are unusual, though not out of the question when most of the volume in the market comes from high-frequency trading and algorithm-based computer programs. Nonetheless, if you trade on the basis of technical analysis, you have to respect the current signal. Of course, that doesn't mean we abandon all common sense and jump into the market with both feet.

Stocks are extended here. They're overbought. The S&P 500 is up 10% in one month, and it can use a break.

It didn't make sense to sell or short stocks into oversold conditions early last month when the above chart first flashed a "sell" signal. It also doesn't seem too wise to be aggressively buying stocks right now. Perhaps the best strategy for August is to take a cue from the "big time" Wall Street traders, who took off for the Hamptons last weekend.

Relax. Take some time off to get away from the pressure. And come back in September.

How To Trade A Bear Market

You cannot ride a bear. Rodeo cowboys score points by staying on the bull as long as possible. Investors profit by doing the same.

But a bear is a completely different animal. No cowboy is crazy enough to saddle up and try to ride a grizzly. Yet investors try it all the time— and they get killed.

Bear markets are not for riding. They're for trading. That means you wait for severely oversold conditions before you buy anything. Then you sell when conditions become less oversold.

And you wait for severely overbought conditions before selling stocks short. Then you cover those trades when the market turns neutral. It's not a "buy-and-hold" environment. It's a "scalping" environment— you play only the best setups and take profits quickly.

[ Normxxx Here:  Stocks are still in a secular bear market (that started in cy2000) and are likely still in a cyclical bear market (that probably started in May).  ]

Short-term conditions were wickedly oversold by 1 July, and the intermediate-term indicators pointed to a strong bounce. But rather than sell into violent downside moves, it's smarter to wait for the inevitable bounce and use that strength to cash out of long trades and enter a few short trades. [[Maybe by the end of this month, but anyways probably during the September-October-November time frame. Still, I would hold off on any attempt to swing trade here: the market is too risky/volatile for that. It's OK for short term trades only.: normxxx]]. As you can see from the nearby chart, stocks usually do bounce hard at the beginning of a bear market

The bear markets that began in late 2000 and early 2008 both experienced bounces where the S&P 500 rallied back up to test the breakdown level of the 20-month EMA. I expected something similar to happen this time as well— before a much more serious decline took hold. But the upmove overshot and morphed into a buy signal. Stocks may still be headed much lower by the end of the year; but right now, it is too risky to short any. Don't be surprised if they work still higher over the next month or so. [[SPX 1200?: normxxx]]

The Right Time To Short Stocks

It's dangerous to be short stocks right now.

Yes, we may have entered a bear market in May. And yes, stock prices will likely end the year far below where they are today. But stocks were so oversold and investor sentiment was so pessimistic, a huge bounce was inevitable.

We got the first stage of that bounce in July. And it was so strong that it cleared the 20-month EMA hurdle and 'signaled' an 'end' to the (1-2 month?) cyclical bear! [[Or, did it!?! In any case, that severely oversold condition is long gone, but we are still far from severely overbought.: normxxx]]

[ Normxxx Here:  In fact, the parallels to 2008 are eerily similar. In 2008, stocks rose from a March low to a May peak then tumbled in June to a July low and an August peak. This year, stocks rose from a February low to an April peak then tumbled in May to a June low. However it recovered strongly in July and is still on an upswing. In other words, the 2010 move (so far) is advanced one month from the 2008 move. Nevertheless, historically, August has been the month in which the markets have "rolled-over" into a Fall selloff. The markets can deal a crushing blow to prematurely and overly aggressive bears who hope to make some 'easy' money betting on the downside. That's what bear markets do. That's why you should wait for a strong bounce and a strongly overbought market (which this isn't yet) to try any shorts.  ]

Of course, bear markets are usually even more brutal to long-term investors who insist on holding stocks in a declining environment. But bear markets also crush traders who try to sell short into oversold [[or even 'neutral': normxxx]] conditions. The biggest "one-day wonder" rallies always seem to occur in the midst of a bear market. They serve to shake out the traders who got a little too aggressive betting on the downside.

There will be plenty of opportunities to make money shorting stocks in the midst of this bear market, if that's what it still is. There's not much to be gained, though, by shorting stocks when the market is this strong, short term. Be patient. Give this rally another few weeks, or maybe even more, to run its course. You might even put out a few longs here. Start nibbling on short positions when the S&P stalls (or obviously turns over), investor sentiment soars again, but most stocks are already short term positive or definitely overbought. Pay close attention to the talking heads over at CNBC. If they once more eagerly declare the 'return' of the bull market— for as far as the eye can see— then get out your songbook and sing-a-long with the fat lady.

[[I am holding my breath and keeping my powder dry; in a market like this, it is better to be too late than too early. But in any case; it is not a time to take big risks— either way.: normxxx]]

Best regards and good trading,