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Market review 23.06.04
Three types of trade entries, and on the lookout for a rotation
I promised back in March (when this blog went behind a paywall) that I would occasionally write a public post. Today is the first one. If you find it useful, please share it with others.
I’ll begin with a discussion on trading strategy (expanding on previous ones). I’ll then apply this to the current market and how I’m thinking about the big picture.
Types of Trading Entries
Using only horizontal lines on price charts, there are three main types of trade entries I like:
Buying a breakout in a leading area of the market.
Buying on a major support level with confirming positioning data.
Buying a failed breakdown.
Breakouts do well when the market is trending. You are aligned with the market and have the wind in your sails. These trades are easy to identify and are what I spend most of my analysis on. The downside is that you could be buying after a sizeable move, and the breakout can fail.
As an example, tech is currently a leading part of the market. And many tech ETFs are breaking out of clean bases such as FDN.
As a market hits a major support level, you might be getting a great entry price at a turning point. However, there are many challenges to doing this: You’re fighting the trend, prices can pierce through your identified support, there may be a more significant support level on a different ticker at lower prices, and even if the market does bottom where you think, it can spend a long time basing there before it turns.
An excellent example of this is the home construction sector. In April last year, I tweeted when the Dow Jones US Home Construction Index was hitting 17-year support. At the same time, sentiment was poor (interest rates were ripping higher, and nobody thought homebuilders could thrive).
While this index is now up 46% since my tweet, it didn’t bottom until two months later, in June. And there was zero price progress in the first seven months after my tweet! That’s frustrating. One could’ve bought the breakout on the weekly chart in late November and still made 32%!
These setups are more rare, but they give you the best of both worlds. After a market recovers a major support level, you’re getting in relatively early in a potential new uptrend. But, at the same time, you have a little wind in your sails too.
C3.ai Inc (ticker AI) gives us a great recent example with not one but two failed breakdowns in just this year alone.
The first came on Jan 11th, when the stock recovered support and closed around $12. It then reached over $30 less than a month later. Of course, while the chart looked good on Jan 11th, few knew about the new AI trend, and even fewer knew this stock would be the biggest beneficiary. So let’s not talk about the initial move.
From Feb to April, this stock saw enormous volatility as the trade became crowded. By early May, the stock was down to $17, and the AI theme was left for dead.
But on May 15th, we got the second failed breakdown. The stock opened a little above the $20.20 resistance level. From there, it gained another 16% that day and 93% by the close on May 31st (before the company’s earnings release).
These three trade entry types can help you in different market environments. It’s amazing what you can do with just a horizontal line!
The above serves as a tutorial and helps with how I’m currently thinking about this market.
For months, I’ve been discussing the leadership in growth stocks but saying that we could see a rotation back into value and resource sectors later.
I want to discuss three things today:
Seeds for a rotation.
Reasons this may be already occurring.
Reasons to be patient before jumping in.
The big picture: Seeds for a rotation
We know that US stocks, particularly growth stocks, have been the place to be during the 2010s. Over that same period, value, global equities, and commodities fared poorly.
The chart below shows the S&P 500 (“SPX”) vs. the Producer’s Price Index (“PPI”, a commodity index) over the past 100 years. These two indices are on different scales for illustration (SPX vastly outperformed commodities over time). What we can see is that when one index trended higher, the other generally went sideways:
So far this decade, there’s been a tug-of-war between these two markets. Which one emerges as the long-term winner? There are many reasons for the latter group.
First, the above chart shows that commodities have come out of a major long-term base. We can see the same thing in many resource stocks and global regions. While many resource stocks are in shorter-term downtrends, they are at or approaching those significant breakout levels.
Meanwhile, commercial hedgers have been increasing their net exposure to oil to a 10-year high.
Reasons the rotation may already be occurring:
This week ushered in a new month, and so far, June has been interesting. In these past two days, beaten-up areas like KRE, COPX, and XOP were up 8.5%, 7.8%, and 4.9%, respectively. Many are already talking about this rotation.
We can see some “Type 2” setups in materials, energy, and closely related markets.
The Gulf region, which is highly correlated with oil prices, is sitting on 7yr support:
SQM (a diversified chemical company and the world’s largest lithium producer) is on 12-year support.
SQM is the largest holding in the Chile ETF (ECH) at 20%. In fact, many emerging markets have heavy exposure to commodity producers and financials. It’s striking how closely the total-return performance of EEM has tracked copper over the past 25 years:
Earlier this year, we saw Argentina make a 6-year breakout. In addition, we have a growing list of emerging markets on the verge of breakouts from bases ranging from 2-10 years. This includes EWW, EWZ, ECH, ASEA, and India’s Nifty 50 Index.
Reasons to be patient before jumping in:
With the above said, I still believe this gap between QQQ and DBC (which I first tweeted back in late March) can widen further in the short term:
I say this for several reasons:
Recent “Type 1” breakouts in several tech ETFs (e.g., FDN, ROBT).
Charts for many banks, commodities, and resource stocks still look horrendous.
Energy ETFs hit significant resistance levels in recent quarters, and some major supports I’m watching in this sector haven’t been reached yet.
While this week’s volatility hints at a potential change in the market, the actual inflection can take months of chop, just like we saw with homebuilders above.
Commercial hedgers have kept increasing their net long exposure to oil and copper. This may continue until positioning gets to a more historical extreme.
Because I’m entertaining the idea of buying volatile sectors with very weak market leadership, I prefer seeing “Type 3” setups (failed breakdowns) before taking positions.
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That’s all for this week. Thanks for reading, and have a great rest of your weekend.
Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.