Trader’s Narrative

In poker, you have to know and watch for “tells”. These are habitual behaviours or reflexive actions of opponents. By watching for them you can know whether they are bluffing (or not). The same type of “tells” exist in the stock market.

As can be seen in the relative strength chart (see below) Apple (AAPL) has been one of the strongest stocks throughout this bull market. It shrugged off the March 2007 correction and kept on barrelling ahead. For me, AAPL is a “tell” for the current market.

All the smart and “hot” money has been trading it and riding it higher. And you can bet they will run for the exit at the first sign that the party is over. Which is why I watch Apple so closely. I’m seeing a confluence of things which gives me reason to believe that the ride may be over.

For one, the sentiment picture is just too bright. Take a look at this recent Economist magazine cover page. Although I’d prefer to see such a glowing cover story on a more general magazine like, say, Business Week, it still is a cover page. The last time I pointed out an Economist coverpage was the one they did for Goldman Sachs (GS). That one did a fine job of alerting GS longs to take profits and go home.

The other reason is the upcoming launch of the iPhone. As the old adage goes on Wall Street, Buy the rumour, sell the news. The closer we come to the June 29th launch of the much hyped iPhone, the higher the expectations. And the easier to fall short of them.

Also a bunch of technical indicators are signalling caution. For one, look at the lofty heights that Apple is trading relative to its long term (200 day) moving average. The last time it was at this level was in January 2006. And you know what happened then.

As well, if you draw trendlines on its chart, you’ll notice that for its latest upleg it has basically gone parabolic. Such a steep rise is simply not sustainable for more than a few weeks to a few months maximum.

Now, some may be looking at the relative strength and thinking that you should always buy strength. But its not that easy. It never is. The last time it peaked, relative strength also looked good. But that didn’t last. And if you notice, during that upleg it was also going parabolic.

Finally, today’s action seems ominous. It was a a wide range engulfing candlestick which took price down 3.5%. I had been meaning to write this post during the weekend but forgot. But even if you missed today’s move, there’s ample room to tighten stops on Apple.

I don’t think it is an automatic short here since it could very well go into a protracted range and work out its overbought condition. But if you’re long, I’d be very careful here.

Have you noticed that often at inflection points in the market, before a new trend is started, we see a sort of ‘thrashing’ about in the breadth figures?

You can see what I mean in this chart of the daily advancers and decliners for the Nasdaq index:

Notice that before the recent market top, there was a contraction in the market breadth. The trendlines I’ve drawn by the way, are not 100% accurate, they’re just guideposts. But see how the internal workings of the market were getting squeezed? Becoming less volatile and smoother. Until it went plop!

It might seem imperceptible to you, especially if you’re new to charts in general and especially to the crazy looking advance decline charts. But depending on your natural visual abilities and the amount of time that you spend training your visual acuity, you will find the subtle contraction and expansion taking place.

Another example was in the summer of last year when we had another expansion (in June and July 2006). To see a closer look at the breadth at that time, take a look at my previous mention of the advance decline numbers.

So why do does the market exhibit this characteristic?

I think it is because at times of panic we see extreme herding take place. The market rushes towards one direction: sell!

But then, paradoxically, it immediately turns on its heals and goes the other way within a short time frame. This is exactly the sort of behaviour that studies like Lowry’s 90-90 day or Marty Zweig’s 9-to-1 pin point. If you are in the market at these times it can be jarring. You see wild swings in your portfolio and it seems almost random. But it isn’t.

The market is simply doing what it must to flush out the weak hands, to throw the maximum number of people into the wrong positions, so that when the new trend is established, it has fuel to propell it. Unfortunately for those who are on the wrong side of the emerging trend, the fuel is their capital going up in smoke.

As the incorrectly positioned player slowly realizes their mistake, they begin to close out their positions. As they do, the trend is given fuel to continue and intensify. Of course, there is also a lot of money that simply stands aside and waits this out. Their contribution as mo-mo (or momentum players) is to jump on the trend once it is established and to squeeze the losing side for all they’ve got.

So which do you want to be? The one that gambles or the one that stands aside and lets the dust settle before riding a trend?

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