“Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of euphoria.”
That timeless quote of Sir John Templeton appeared to be valid again at the beginning of the new year: The CBOE Volatility Index (VIX), the so-called “fear index,” recorded a six month high on December 28, but collapsed in the following weeks. The crowd was truly skeptical four weeks ago – and is not euphoric yet in my opinion.
Even though program trading managed to push the Dow Jones Industrial Average (DJIA) above the critical 14,000 level on the last day of the month, sentiment still does not seem overly bullish. The low VIX itself is not a reason for concern in my opinion. Goldman Sachs published a report in late January in which the analyst argued that the VIX is entering a new low regime over the longer term.
Breadth appears to be extremely strong: 777 NYSE stocks recorded new 52-week highs on a monthly basis, according to Stockcharts.com. That’s a 20 year record. With such a strong participation, I believe this rally has more potential.
Bearish investors refer to high AAII sentiment survey readings in January. However, my research shows that a high number of bullish investors are in no way an argument against higher prices. In fact, I believe individuals acted quite smartly in the last three years: bullish sentiment declined prior to intermediate-term market tops. We haven’t seen a similar decline in January.
The current environment is not an easy one for short-term traders since volatility is almost absent. Entry and stop points are hard to nail down and staying on the side lines is not an unreasonable move, although it’s always emotionally difficult.
In my opinion, a good compromise is to trade with limited risk and operate with high cash levels and moderate position sizes. Throughout January, I almost constantly ran with 40-70 percent of cash in the Technical Swing Covestor model portfolio. Still, the model slightly outperformed the S&P 500, net of fees.
We believe a focus on leading stocks and trading on simple price swings helped out our January performance. Other setups just didn’t work. For example, trades in Walter Energy (WLT), a met coal company, were closed with a loss because the anticipated breakout didn’t occur.
Certain of our other investments, such as Arm Holdings (ARMH), Cypress Semiconductor (CY), Foster Wheeler (FWLT) and International Paper (IP), ride the “global recovery” theme. It appears that most trading setups had been quite simple: stocks started to exit low volatility short-term consolidations during strong intermediate-term momentum moves.
As always, the environment can change fast. But unless I see signs, I stay bullish.
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Investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.