An ominous pattern has occurred in the U.S. stock market. Investors definitely felt it Tuesday, when stocks cratered after rising earlier in the day.
What is the best strategy for investors at this time? Letâs explore, starting with a chart, which can show us this pattern.
Please click here for an annotated chart of S&P 500 ETF
Similar conclusions can be drawn from charts of the Dow Jones Industrial Average
Nasdaq 100 ETF
and small-cap ETF
Please observe the following from the chart:
â¢ The ominous pattern is the âoutside day,â as shown on the chart. In an outside day, the high is higher than the previous day and the low is lower than the previous day. The chart does not include pre-market data. In the pre-market, S&P 500 futures
were much higher than the ETF SPY shown on the chart for regular hours.
â¢ The point of the outside day is that it started with a lot of optimism over good earnings and ended with a lot of pessimism on the theory that company earnings may have peaked.
â¢ Many gurus are attributing the outside day to the 10-year Treasury yield reaching 3%. However, yields were approaching 3% the day before and in the morning when futures were much higher. The trigger for the selloff was a comment on the Caterpillar
conference call and lower-than-expected earnings from 3M
â¢ The outside day, like the one that was traced, is a bearish pattern.
â¢ As the chart shows, the selling occurred on relatively low volume. This indicates that the necessary cleansing is not yet done. Please see: âBe careful, a necessary âcleansingâ in the stock market is still under way.â
â¢ The outside day has occurred in the context of a broader consolidation pattern shown on the chart. The consolidation pattern is forming a triangle. In the present context, the probability of the market breaking outside of the consolidation pattern to the upside is only slightly less than the probability of the market breaking to the downside.
â¢ The relative strength index (RSI) is neither overbought nor oversold.
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Read: âBig bear marketâ for stocks lasting several months appears to have begun
Caterpillar is a very important stock. It makes earth-moving, mining and construction machinery. The theory is that Caterpillar earnings reflect the global economy.
Caterpillar reported earnings better than the consensus and the whisper numbers. The stock ran up to about $161. During the conference call, Caterpillar management raised the possibility of this quarterâs earnings to be the high-water mark. The stock subsequently fell to under $144. In plain English, Caterpillarâs management was lowering the expectation for next quarterâs earnings. This is a commonly used technique by company executives. First they lower expectations, then they beat them. This typically drives the stock higher. However, this time they raised concern that earnings might be peaking. This was the real trigger for the selloff.
A big negative is weakness in popular FAANG stocks, which have been leaders. At this time, FAANG stocks have entered the fifth stage. To learn about the fifth stage, please click here. However, when overcrowding in FAANG stocks is removed, some of the FAANG stocks can start another up leg with five new stages. When this happens, it will be a big positive for the stock market.
What to do now
For market timing and allocations, at The Arora Report we follow the ZYX Global Multi Asset Allocation Model that has proven itself in both bull and bear markets over a long period. This model takes into account macro, fundamental and technical inputs in 10 categories. Please click here to see the 10 categories. In general, this is the time to be neither overly aggressive nor panicking. Consider holding a fair amount of cash, hedging part of the portfolio and making sure that your portfolio is properly diversified with highly selective positions suitable for this market environment.
If you panic and sell, you have to make another decision to get back in. As described above, the market can easily go up from here. Many people have panicked over the past decade and sold, and now regret that decision. On the flip side, until the probability of the stock market going higher improves, there is too much risk in being aggressive in your investing.
Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.