“Some days you go long, some days you go short, and some days you go fishing.”- An old Wall Street saying.

Countertrend trading is risky, but reversion to the mean trading is known to work in multiple time frames. Knowing when to execute and how to manage the risk is critical because one is going against an established trend.

As seasoned traders know, the most bullish thing a market can do is get overbought and stay that way, and conversely, the most bearish thing a market can do is get oversold and stay that way. On a sentiment level, the market has been in an oversold psychological state since April 26 (Using the CNN Fear & Greed Index). That is a significant period with no real bounce to speak of. Is it time to go fishing or make a countertrend trade? The trend is down so countertrend trading may be too risky given the above.

In an environment like today’s equity market, we have found that higher volatility is best handled by trading smaller sizes and with broader stop-loss order levels. It is a matter of risk. If we go long or sell short, we do so in smaller increments and adjust our stop-loss orders to reflect the potential for broader trading ranges.
Online trading software can help design and execute reversion to the mean trading strategies. Most good packages can calculate and draw the mean line and trading bands around the line. The longer the period under observation, the more stable the mean line is. The shorter the time under observation allows for a steeper incline or decline of the mean line average and the bands above and below.

Let us look at the current market character and what we have seen over the last few days/weeks. Portfolio and mutual fund managers are not paid to sit on cash generally, and they will adjust the volatility of their portfolios to express their individual market views. When bullish, portfolio managers will overweight higher growth, higher beta (volatility), and as a result, higher PE stocks, and when bearish, they overweight lower PE, lower beta names that have stable characteristics. Think Technology Services vs. Consumer Staples.

Growth names have been decimated in many cases over the last six to nine months, while stable lower growth names have held up the best. Until recently, Walmart was a consistent outperformer as institutional money sought out a safe place to weather what has been a bear market for many stocks. Even though the company had warned in the prior earnings release that it would do its best to maintain lower prices to benefit customers, resulting in lower margins, the stock collapsed on the most recent earnings release. The drop had the character of a too crowded trade. Kraft Heinz, a defensive consumer staples name, had a similar pattern. In general, the market takes down the last remaining refuge stocks towards the end of a selling campaign.

Let us now look at some prior years and significant time periods. 1932 (90 years ago), the market (DJIA) had a final down move from about 88 in early March to about 41 in early July. A devastating move. In 1962 (60 Years back), the S&P 500 declined from 71 in March to 61 in May (not the final low, which was the end of June). In 2002 (20 Years back in time), the S&P 500 fell from 1176 in January to 775 by late July. Our master cycle of 60 years has a potential low on Sunday, May 29, Labor Day weekend. In 1962 there was a short but significant move upward between May 29 and May 31 (There was no Labor Day Holiday until 1967). If the cycle is still operative and the current psychology stays in place, might a significant reversion to the mean occur in the S&P 500? Or is it just time to go fishing?

Trade well and stay safe. JHS

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