Pull back likely

With markets severely overbought now, you have entered in the area where the return is likely to be less going forward and the risk is likely to be higher. The reason being that the more people that buy, the less on the sideline and elsewhere available to fuel the rally. Of course in the US, the money supply can certainly be expanded, but it is unlikely or at least less likely for a rally to continue for a significant length of time without a pull back.

Although over a short time period, bears are prone to getting squeezed out, providing potentially additional upside for those looking to make a quick trade, over the intermediate term, stocks will likely present a lower reward at these levels at higher risk, and the buying power is more likely to fizzle.

Stocks will be running into resistance based on volume profiles. There is a lot of transactions that may occur in this range, but not a lot higher. We can perhaps support maybe SPY 133 before the buying power fizzles. It will take a significant amount of buying pressure to push above these spikes in volume. We also will be in the upper range of price

We are quickly approaching levels where the transactions pick up. The number of transactions puts a ceiling on pries for the time being because it would require a lot more buying demand to overpower it and is more likely to take time.

More importantly, going into these levels we are overbought on both a weekly and a daily chart, while a monthly chart remains in a downtrend with a bearish divergence (but is testing it’s limits). This is additional evidence that there will not be enough buying power to drive much farther past these levels.

And the daily chart is egregiously overbought as well.

Not only the slow stochastics which is more common, but we are overbought in the RSI and nearing the upper bollinger band. The Dow and Nasdaq aren’t looking much better.

Yes stocks can remain overbought longer than many people anticipate, however, it just doesn’t tend to be sustainable. At a bare minimum you simply have to consider reducing into this strength. You may be able to get away with it, but it only will take that one 1929/1987/flashcrash type day to ruin years worth of returns if you are aggressive into that. One of those days can wipe out all of the days in your trading career in which you pushed the envelope and got ahead of everyone else. If you are managing other people’s money professionally, it’s a different story. People freak out if you only make 5% when the market is up 7% and when you are only up 3% but everyone else is up 1% they love it. That’s just how it is. But as an individual investor, you should recognize the luxury that you have of not having to beat any particular benchmark on a regular basis and if the market proceeds to throw you out in front of a freeway picking up nickles you are not forced to play. This is the insanity that goes on that leads to conditions being at such extremes. The money flows into the fund manager’s hands and they have to put it to work before the other guys do and then they have to put it to work to keep up with those around them. They flock together and crash together.Have fun playing that game with them if you like, I will use the extremes as opportunities to do the opposite, even if it means underperforming into a hot rally.

Of course, as mentioned in the trend reports, mutual fund cash levels have still yet to raise significant cash, and that makes the stock market vulnerable on a longer term basis as it lacks the mutual fund buying power. We have not been at levels this high since before the November crash that took place followed by the S&P downgrading the US credit rating.

Additionally QE2 effect is perhaps going to be wearing out soon, and Europe’s crisis will eventually come to a head. Nevertheless the question “what if it doesn’t” and “what if all the negative stuff has been priced in for quite awhile now” is relevant and valid.

Nevertheless, if you are ever to consider to initiate a short position, I would begin to build a position at these levels. 133 on the S&P may be a bit more ideal if we get there. Certainly a reduction of risk and an increase in plays that do well in a bear market makes sense here. If there’s ever a time to take some profits, it is now. If you want to play with the odds in your favor, you have to reduce positions when stocks are higher and the trend is stale to the upside. Right now the weekly and daily trends are stale, and the transactions are on the high end or the range. I can’t imagine getting a better opportunity. It may be a bit more prudent to wait and if SPY hits 133 until you can then start to short. As we saw before the flash crash as an example, or before the May top in 2011 stocks certainly can stay overbought for awhile. Trend following only works until the trend has played out, then you must leave the pack if you want to avoid becoming a lemming and falling off a cliff. That doesn’t mean you have to go against them and short, but it becomes a possibility.

At some point, you have to recognize the advantage from following the trend is gone if the people you follow lack the buying power to push it higher. You don’t have to be a hero and lead the bearish crusade against the bulls, but you should at a minimum scale back. In the post trend trader I talked about a contingency plan for if the weekly uptrend continued and we got into significantly overbought territory across the board, and to have plans to potentially get more “aggressively conservative”. I believe it is a good time to do just that and begin to shift into an even more conservative portfolio, and possibly consider dipping into bearish territory if this continues for much longer. I don’t know how long this “aggressively conservative” period of time will last but it potentially could be short lived if we get drastically overbought on a weekly and daily timeframe and continue the charge upward, closing the month high enough to result in reversing the monthly trend from bearish to bullish, or if we pull back sharply and no longer have such extreme conditions, and then we may build a more sustainable rally. With everything overbought, the dollar could pull back and the market rallying for even longer would not be out of the ordinary before it has perhaps a healthy correction and maintains an uptrend.

Despite the overbought nature, capital is seemingly concentrating into stocks right now and flowing into stocks strongly enough where the monthly trend is likely to shift to bullish if we do not get a pull back very soon. It is unfortunate that it had to become so overbought on a daily and weekly timeframe to do that, but if we get a close around these levels or higher, it will signal a change in the monthly trend.  The monthly trend provides both a sense of direction on whether liquidity is increasing or decreasing and whether growth expectations and longer term capital movements are going into stocks which further helps productivity. All the capital in stocks could further provide opportunity for companies to invest that capital, which could lead to increased production and growth (to a degree for awhile) until the market becomes over-saturated with capital. It is only after a significant monthly rally that this occurs and it then lacks the opportunity to continue to put it to work at a high return and growth becomes impeded by the market itself as competition grows and gets in the way of itself and too much capital becomes a problem for companies and too few places for that capital to go and too high of expectations of growth and an inability to meet those expectations or continue to support such sentiment. It is a delicate process handling an increasingly overbought weekly and monthly chart if the trend changes bullish. Ideally we will pull back strongly and be closer to oversold on a weekly and daily timeframe as we finish just strong enough to change the trend on a monthly chart if we are to rally. However, even if that happens there is still a bearish divergence in the monthly chart as stocks made higher lows as the slow stochastic and RSI made a lower low. So there is a higher probability than not of a change in trend, if it occurs to be a false move.

I wouldn’t be too concerned about the monthly trend changing on us just yet though, for now you still should be expecting a pull back to be a high probability event and this very well could turn out to b an excellent selling opportunity, particularly if the downtrend continues on the monthly chart and we get another wave down.

In my personal account I bought a TZA position today. I couldn’t resist speculating here.

Mock portfolio using principals I have discussed on here is up nearly 14% since October when I started due to some arbitrage gains, and some adding and reducing at the right times with different assets. Considering the bearishness I have tended towards, I consider this an impressive feat. If I played the weekly uptrend a little more aggressively to the bullish side it would have been more impressive.

Higher risk and lower reward does not automatically mean betting against the market will be profitable, it just means that you should be able to find other assets that support a better reward with lower risk, that aren’t so vulnerable, and that reducing position may be a good idea. Also, shorting as a hedge to reduce position size if you aren’t really willing to sell individual names may be one way of reducing your risk. There is most likely a higher probability than usual of a pullback right now, or at least a pause in the action. If you aren’t using this price run up as an opportunity to take profits and reduce positions, when are we ever going to be overbought enough where you are? Personally, I do think betting on the pull back is likely to be profitable, but I am not willing to do so too aggressively, other than just to reduce the risk exposure of my portfolio. I do not feel comfortable buying many currencies or treasuries in large quantities, so shorting to reduce exposure seems prudent.

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