Barry Ritholtz
Timing Market Turns
 By Barry Ritholtz
Special to RealMoney.com

5/17/2004 11:59 AM EDT
URL: http://www.thestreet.com/p/rmoney/barryritholtz/10160440.html
 Trading Strategies
  • Be patient and scale in slowly.
  • Adhere to stop-loss discipline.
  • A low-volume retest makes sense.
    		•

    Updated from 8:00 a.m. EDT

    Early in my career, I learned that the markets do only a few things: Go up, go down or go sideways. While being on the right side of the trend is crucial, temptation always exists. Can you catch the shift from one trend to the other? Can you time the reversal?

    I believe -- with a few caveats -- that you can time markets and anticipate key turns. But before going into specifics, here are some ground rules:

    1. You should expect to be wrong.

    This concept should guide all of your purchases, but it's especially true when it comes to catching reversals. Before stepping into the fray, you must know at what point your expectations are false. That's your line in the sand, and when it's violated, you are out. No fuss, no emotions -- just some capital preservation.

    For example, a close below last Wednesday's reversal day would mean that my thesis -- seller's exhaustion -- is wrong. If that level is penetrated, I'm out. I can always get back in, but I want to avoid getting caught in a cascading waterfall move down.

    2. Reversals are processes, not a single point.

    V-bottoms are relatively rare, especially after long selloffs. Human nature tends to be tempted too soon, so it's prudent to be patient and slowly scale into positions over time. (Rev Shark mentions the importance of patience constantly.) At this point, market-timers should be about 60% invested and should expect to be almost fully invested (95%) over the next few weeks. I'd also expect to see part of the reversal day retraced, as the rest of the weak hands get shaken out.

    3. Without discipline, all is lost.

    Gary B. Smith has mentioned several times that every time some hedge fund full of Nobel laureates blows up, it's always because they failed to follow their model. Without a stop-loss discipline that you follow religiously, you shouldn't even think of playing in these waters.

    With that out of the way, let's get to the nitty-gritty.

    On Wednesday, Barton Biggs announced on CNBC that the market was "as oversold as anytime as it's been in 20 years." Whether or not that's true -- and by some measures, it's not -- is that the reason you should've been buying into the selloff? What's so magical about the 20-year mark?

    Nothing. Oversold markets can always get more oversold -- just as overbought markets can get more overbought. But this doesn't mean you should merely step aside when the markets plunge. If you are a trader, you can find opportunities for fast profits. Key reversal days like last Wednesday can also offer advantageous entry points to longer-term investors.

    But like all opportunities, these come with especially serious risks. Trying to catch the proverbial falling knife isn't for the faint of heart or the undisciplined.

    Various Methodologies

    Einstein discovered that the universe is essentially mass, space and time -- and even those are relative. Likewise, technical analysis is nothing more than price, volume and time. An entire market discipline has been derived from these three variables, and everything else is simply a variation on a theme.

    On RealMoney alone, I counted no fewer than six different methodologies for buying market turns. Each uses a different measure of individual stocks or the entire market, and not one is foolproof. However, they offer quite a compelling argument that turns can be successfully timed, if you have the nerve -- and the trading discipline -- to step into the fray.

    For example, Gary B. Smith tracks the T2108, which shows the percentage of NYSE common stocks above their 40-day moving average. That seems to give a fairly reliable signal some 30 days ahead of market turns.

    James Altucher uses a tick count, an excellent intraday tool for seeing exactly when things get silly.

    Longtime readers might remember Aaron Task discussing the Wyckoff Spring in 2001. That's another technical approach to determine the difference between a retest and a new cascade down.

    One favorite indicator of my friend Kevin Lane, chief market strategist for Redwood Technimentals, is the Nasdaq Composite net 52-week highs-lows 50-day moving average. On its chart below, net 52-week highs are below the zero line and have similar readings to March 2003. This certainly qualifies as a short-term oversold condition. Kevin also observes that "as of Wednesday's close, only 22% of issues on the Nasdaq Composite were above their respective 50-day MA." This is a similar reading to Gary's T2108 measure.

    Clearly Oversold
    Nasdaq Composite net 52-week highs-lows 50-day MA
    Source: Redwood Technimentals Research Group LLC
    Click here for larger image.

    An early mentor of mine, Guy Ortmann, technical analyst at Capital Growth Financial, combines candlestick charting with McClellan Oscillators, along with several other oversold indicators. By his measure, we put in a double-hammer bottom Wednesday and last Friday. He says Hammer #2 makes him want to "sit down and strap in," so you could say he's a little bullish lately.

    My own methodology involves several other measures. After a long downturn, I like to see a big down-volume day, and Wednesday certainly qualified. One share traded up for every 10 down intraday, which suggests to me that sellers are becoming exhausted.

    I like when several other indicators confirm this. A key reversal day happens when the markets trade down very low, only to reverse and close at the day's highs. This is yet another piece of the puzzle, suggesting that sellers are running out of supply or losing conviction.

    The Arms Index, or TRIN, is another item I watch. I prefer to see the TRIN's 10-day moving average above 1.5, but an intraday spike to 3.8 was enough to get my attention. When the put/call ratio moves above 0.90, that's another early sign of panic, and it happened earlier last week.

    I also want to see secondary signs confirm an attitude shift. It may be that money supply is rising, as it did early in the first quarter. Or it could be that insider selling is tailing off, as Vickers recently reported. These are merely confirming factors that help -- but do not clinch -- the deal.

    Time and Patience

    Sometimes the market doesn't exactly cooperate with your timing. It helps to understand what may be affecting the exact turn in sentiment.

    The recent action reminds me of the prewar activity in the first quarter of 2003. After making a capitulation low in October 2002, the market came in for a retest on lighter volume -- right up to the "exquisite moment," as Jim Cramer called it.

    October 2002's selloff was characterized by heavy distribution; stock dumping was rampant. To date, that marked the bear market low. As we approached the March 2003 retest, the market exhibited a different character. Those queasy few months were more of a buyer's strike than a selling crescendo. Duct-tape alerts frayed nerves to the point where investors were distracted by other, more important geopolitical matters.

    We're now in a somewhat parallel process. After peaking on Jan. 26, the markets made a new low two months later, on March 23. The indices then got ahead of themselves, as the Dow Jones Industrial Average gained more than 500 points in eight days, while the Nasdaq tacked on a cool 10%.

    Of the 900 points the Dow has lost from its April highs, the majority has happened since the Iraqi prison photos were released two weeks ago. Combine these geopolitical factors with the latest wait for the Fed to hike rates. A low-volume retest then makes some sense.

    As we wait, the spring coils ever tighter.

    Update, 5/17/04 11:59 a.m.

    This piece was written before the most recent horrific headlines out of Iraq. In light of the latest news, I'd like to add a few additional thoughts regarding the market:

  • My stop losses are not intraday, but based on closing prices. Therefore, any action today before the close will not violate my discipline.

  • Watch the intraday up/down volume for a climax. At one point earlier this morning, the up/down volume was 15-to-1 on the OTC and 12-to-1 on the NYSE. That is a very extreme level of selling.

  • In light of the recent attacks in Iraq, I considered moving my "line in the sand" to the March lows in the QQQ (QQQ:Amex) at $34 and the May lows for the Semiconductor HOLDRs (SMH:Amex) . Most people are better off sticking with their original stop-losses. I normally don't like to violate my own discipline, but when an external factor impacts the markets, I'm willing to consider being a little flexible. That said, discipline trumps flexibility in the long run.

  • I have long considered whether terrorists plan attacks around market pivot points for maximum economic damage. Today's assault raises that issue again.

    Consider the coordinated assault on various oil installations as an attack on the lifeblood of global capitalism. With oil prices above $41 a barrel, the global economy is hugely vulnerable to a major oil disruption. That might explain the attacks on pipelines, on foreign oil engineers living in Saudi Arabia and on shipping lanes. I wouldn't be surprised to see an attempt made on big tankers or on oil installations in a less-guarded part of the world.

    It isn't unthinkable that terrorists are targeting perceived vulnerabilities in the global economy.
    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to barry.ritholtz@thestreet.com.