…That You Need to Recognize to Make Money
Legendary trader Dan Zanger and host of ChartPattern.com, who holds the stock-trading record with an annualized return of more than 29,000%, makes no bones about which type of market he prefers.
“What motivates me to be at my trading desk no matter what the market is doing, is because you never know when the next big rally will arrive,” he says. “Unless you’re sitting at your desk everyday, you risk missing the next big run as it develops. Every big bull market can trace its origins to a bear market rally.”
Much of his success is due to his uncanny ability to measure the pulse of the market. He can tell when trader sentiment is shifting and market players are becoming more bullish. The real trick is in gauging whether the next move is real or a fake-out. An important factor in gauging markets is in understanding the difference between a secular and a cyclical market.
Figure 1 shows the four secular bull markets (blue) and four secular bear markets (red) that have occurred over the last 130 years. Secular markets last decades and indicate the primary or dominant trend.
Figure 1 – Long-term chart of the S&P500 after adjusting for inflation showing the percentage gains during secular bull markets (blue) and losses in secular bear markets (red). Cyclical markets are much shorter and there have so far been two cyclical bulls since the beginning of the latest secular bear market in 2000. Note that the shortest secular market lasted 14 years. The current secular bear market is now nearing 11 years old. Chart courtesy of Advisorperspectives.com
A new secular bull market is confirmed when the stock or index puts in a new all-time high and a secular bull ends (and a secular bear begins) when the issue fails to put in a new all-time high and instead puts in a series of lower highs over a period of years, as the red sections on figure 1 show.
But as figure 1 also shows, new secular bull markets often begin in the depths of a secular bear. This is an important distinction because the trader never knows for sure when a new secular bull has begun until a year or more after the fact which is why it’s so important to be watching the market daily.
Figure 2 – The next two charts from the Zanger Report newsletter show the difference between a powerful cyclical bull and bear market. In this chart from 2005, Google experienced strong, sustained rallies with modest corrections. Flag and pennant patterns continually succeeded providing great buying opportunities and any weakness was short-lived after which the stock broke to new highs. Chart courtesy ChartPattern.com and The Zanger Report.
Cyclical trends, on the other hand are shorter-term, typically lasting from a few weeks to a few years. Cyclical trends occur within the larger secular trend. A counter trend rally occurs when a stock or index moves in the opposite direction to the secular trend. Recent examples of counter-trend cyclical bulls are the rallies from 2003-7 and 2009-11 in the S&P 500.
At the short-end of the scale are moves such as the one-day rally on November 30, 2011 that led many to believe that the bear market might finally be over. Only those who have studied such rallies through history can appreciate what’s really going on and act accordingly, Zanger says.
Figure 3 – This chart from 2011 shows Google struggling after peaking in late 2007. Even before the market peaked in May, this long-term stock market leader had begun to exhibit weakness as it entered a cyclical bear market in late 2007, warning that overall market conditions had changed. This chart also shows what can happen after a powerful relief rally in a bear market. Note the strong gap up in July that is quickly filled before GOOG continues to fall in August. Chart courtesy ChartPattern.com and The Zanger Report.
Zanger doesn’t consider himself a day-trader. He prefers moves that last from a few days to a few months and like a champion surfer will ride the rally wave as long he’s making money. And as soon as it begins to weaken, he starts feathering out, gradually selling his position into strength.
Another big reason for his success is his skill in identifying different types of rallies – learning to separate a real money-making rally from a brief relief or sucker’s rally that will eat the portfolios of those who jump in too early.
Here he shares his list of the top 10 key considerations when analyzing trend moves.
1. Learn to instantly recognize cyclical versus secular trends on any stock chart. Cyclical bulls and bears are much shorter-term compared to a secular market bull or bear. At the other end of the scale are the powerful but brief one-day sucker’s rallies. Those with short investment time horizons can still make money buying stocks during a cyclical bull within a secular bear market. However, cyclical bulls can be very expensive for those without clearly defined exit strategies. No matter what your time horizon, it’s important to be aware of the prevailing secular and cyclical trends and trade accordingly. Overstaying your welcome in a trade during a cyclical trend can be very costly for those who get it wrong when the secular trend resumes.
2. Short-term bear market rallies are much more powerful than shorter-term bull rallies. Relief rallies are extremely powerful and why selling short can be so dangerous. This is one big reason why traders such as Dan Zanger prefer long trades.
“You can make money in both bull and bear rallies, but it’s a lot tougher in bear markets. It’s important to remember that the max you can make shorting a stock is 100% and that is only if the stock goes to zero. You have a limited upside but unlimited risk if the trade goes against you,” opines Zanger. “But you can make thousands of percent during a strong bull rally and unless you’re trading on margin, the max you can lose is what you paid for the stock in the unlikely event that it goes bust.”
The next table shows the 12 biggest daily rallies in the Dow Jones Industrial Average during the last decade with cyclical bear rallies in red and cyclical bull rallies in green.
12 Biggest One-Day Rallies Since 2001
Note that with the exception of two cyclical bull rallies at the very beginning of the 2009-11 bull market; the biggest one-day rallies occurred during bear markets.
Since stocks have been in a secular bear market since 2000, we also examined the 12 biggest one-day rallies since 1900 in the next table. Cyclical bull markets are shown in green and cyclical bear markets in red. Secular bull and secular bear markets are identified in the right-hand column.
12 Biggest One-Day Rallies Since 1900
Of the 12 biggest one-day rallies, only one (March 23, 2009) occurred during a cyclical bull market; the rest occurred during cyclical bear markets. With the exception of a single rally which occurred during the secular bull in 1987, all of the biggest one-day rallies over the last 111 years occurred during secular bear markets! It is also interesting to note that 4 of the 12 biggest one-day rallies in the last century occurred in the wake of the 2007-9 financial crisis.
In other words, odds are extremely high that a huge one-day rally (greater than a 4% gain) is a sucker’s rally.
This clearly demonstrates the risks of being too optimistic when it comes to markets, a trait that can be very expensive during bear markets. To be successful long-term, traders and investors must learn to kill the urge to buy into powerful relief rallies. There is a good reason they’re called sucker’s rallies.
3. Relief rallies in bear markets generally lack follow through. This point is a subset of point 2. Unlike bull market rallies, powerful bear rallies are often followed by ugly down days. In other words, buying into a big bear rally can be even more expensive than trying to catch a falling knife, the dangerous habit of buying during a big correction. So even if you do make money initially buying a bear rally, the gain can become a loss in short order.
4. Buying volume is higher on up days in a bull rally. In a bear rally volume is higher on the down days. This is one way that a trader who’s been away from the market can quickly tell which kind of market he is in. Stock rises tend to occur on falling volume in a bear rally. If volume falls during an up move, it often signals that the rise is nearing an end. Don’t get caught.
5. Bullish pattern failures are more frequent in bear rallies. According to Zanger, a pattern failure can often be a powerful signal to reverse direction. He provides a detailed description of the most powerful chart patterns such as cup & handles, head & shoulders, flag and pennants and parabolic curves at http://www.chartpattern.com/understanding_chart_patterns.html If you are in a long trade and there is a pattern failure, it is an exit warning. Cyclical chart patterns also tend to have a shorter duration than the same patterns occurring in a secular market.
Figure 4 – Chinese internet stocks like Sina Corp and Sohu.com soared in 2010 and 2011 but have since become laggards in another sign that conditions have clearly changed. Chart courtesy ChartPattern.com and The Zanger Report.
6. Market sentiment responds differently in bull and bear markets. Bull markets climb the proverbial wall of worry. Both bullish and bearish sentiment tends to be more muted with euphoria usually only occurring near the end of the move. Bear markets on the other hand, slide down the slope of hope and are generally accompanied by extreme highs in sentiment followed by extreme lows (highs in bearish sentiment) which is another reason why volatility is higher during bear markets. Hope is one big reason why relief rallies can be so powerful. Pent-up investor optimism causes investors to pile into stocks on positive news, whether it is real or perceived.
7. Volatility is higher during bear rallies. Large shifts in sentiment aren’t the only reason for increased volatility during bear markets. As we have witnessed in the last four years, there are a number of other factors. Institutional traders must quickly react to big swings by unloading large positions. Governments also get involved in markets, especially around election time, making changes in monetary policy that can have a large impact on stock prices like we saw on November 30, 2011 when central banks led by the Federal Reserve announced that it was opening the discount window to European banks. This was perceived as good news and caused the huge spike in stock prices.
8. Short squeezes occur more often and are more powerful during bear markets. This is one big reason that shorting can be so dangerous. A short squeeze occurs when those who have borrowed a stock to sell short get caught when unexpectedly good news temporarily propels the price higher. Those with short positions scramble to cover (buy back) their short positions and in the process help propel the stock price even higher. Unfortunately for these shorts, the price usually hits their selling target but only after they have been forced out of the trade.
Figure 5 – Amazon.com, another long-term market leader experienced three strong rallies since it was launched in 1998, put in a new all-time high in October 2011. It has struggled afterwards. Spikes in volume are followed by falling volume and a subsequent correction. Also note that bullish chart patterns like the flags in this chart either failed altogether or experienced breakouts that were short-lived. We also see that the most recent flag on the far right-side of the chart broke down in a move that was accompanied by rising volume, which is bearish. Chart courtesy ChartPattern.com and The Zanger Report.
Figure 6 – Goldman Sachs, a strong market leader in the rally of 2003-7 has struggled since then. Recently breaking below $100 per share, it is well off its all-time high of $250 of October 31, 2007. Chart courtesy ChartPattern.com and The Zanger Report.
9. Leadership isn’t clear during a bear market rally. Different stocks generally lead the next bull market than did during the last bull. During the tech bubble in the 1990s, Internet stocks were the dominant leaders but financials led the next bull rally in 2003. Changing leadership is further confirmation that a new bull rally has begun according to Zanger. However, if leaders are defensive stocks such as utilities, it usually indicates a countertrend rally, which is a shorter-term rally in the opposite direction of the larger trend.
10. If a rally is occurring below a previous high, it’s either a bear rally or cyclical bull until proven otherwise. A new secular bull trend in U.S. stocks in real terms won’t be confirmed until the S&P500 breaks well above the 2000 high of 1527 and the longer that takes to occur, the higher the confirmation threshold will be. Until that time, any rally will simply be a cyclical bull rally.
Putting It All Together
It is a key requirement that to be successful traders must learn to differentiate between moves that are potentially profitable and those that aren’t. Zanger relies on his stock market leaders to help him decide when the time is right to buy. He then uses chart patterns and volume to help him confirm the trade and then tell him when it’s time to get out. Assessing the strength and duration of the current rally is an essential requirement.
About the author:
Matt Blackman, CMT is the host of TradeSystemGuru.com. Matt’s articles have appeared in publications such as Technical Analysis of Stocks & Commodities magazine, SFO (Stocks, Futures & Options) Magazine, Trader Monthly Working Money, Physicians Money Digest, Laffer Economics, The Wellington Letter, Traders.com Advantage, Traders Mag (Europe), Active Trader and Investopedia.com. Matt is a member of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA). He earned the Chartered Market Technician (CMT) designation and a B.Sc. (Honors) degree from Simon Fraser University.
Get Matt’s latest trading ideas and market comments on Twitter at http://www.twitter.com/MattBlackmanCMT