Morning Market Thoughts
Good morning. Let’s take stock of the current market through the lens of one of the biggest questions related to performance. When do you sell? This applies to both individual positions and the overall state of the market.Ignore for a moment your unrealized profit or loss on the current trade and instead just look at the current price. When you opened the trade, you took into account the potential for loss. You have your stop loss in place. Your position size takes into account your maximum acceptable loss in the event that your stop is hit. As such, your original entry and current P/L on the trade isn’t relevant to the conversation here.
So assume you just opened the trade. Based on the current price of the stock, what’s the potential for profit on the trade? What is the risk and magnitude off the potential loss? When you have considered these questions, you’ll have a pretty good idea whether it’s time to sell…or whether it’s time to add to the position.
This strikes at the very heart of today’s market.
Say the stock (or the market) is making all time highs. You know that there are no unhappy bulls overhead, looking to just get their money back on their losing trade. Everybody’s a winner. Look at the chart. The only unhappy traders are those who wished they had bought the stock at lower levels. Now, some of them will buy now. This happens on every tick on every stock; every day that the market is open for business. Somebody wants to own the stock, so they look for supply.
And where is the supply coming from when a stock hits an all time high? Traders who are taking profits. This is a “blue sky” situation, where the stock can just keep moving higher. But at some point, traders begin to see the stock as having moved too high. Perhaps valuation is an issue, where the stock is perceived as having “gotten ahead of itself.” It’s out kicked the coverage. When traders perceive the stock as being too expensive to own, the demand drops off. At that point, all those blue sky bulls will start taking profits.
At what point this happens is unknown. And that’s the nature of the current market. The mass of traders that make up the equity market (i.e., Institutional traders down to small retail traders) see stocks moving higher and higher. But the “smart money” sees little upside potential because stocks have “gone up too much”, and are expensive. So they temper their appetite for stocks. They raise some cash by selling positions. After all, they’ve had a good year and don’t see much potential for even greater gains.
But the market keeps going higher…and higher. These same money managers who previously saw little potential for future profit are now stuck. They now see the potential that they’ll get left behind. So they begin getting back into the market. They’re a bit worried about the situation and are waiting for the big correction…that never seems to come. Their buying pushes the market even higher, exacerbating the overbought situation in the market. Indeed, it’s a blue sky market where the potential for future profits is truly unknown.
I’m describing the “Wall of Worry.”
The interesting, and frustrating, thing about the current market environment is the notion of risk. How much risk, versus unknown potential for future profits, is in the market? Because of the lack of options in other asset classes due to the Fed’s grand experiment, traders actually see little risk. That’s why the VIX is so low. There’s just no appetite for portfolio insurance.
This is actually a pretty complex topic that goes beyond the scope of this note. But just keep this in mind. No one truly knows how much potential for future gains exists. Breadth is narrowing, major divergences are everywhere, but stocks keep moving higher. Sellers soon become new buyers…and the market moves higher still. No one seems to be wondering when to buy stocks. The prevalent question is when to sell.
And until there is consensus on the answer, the market will keep moving higher.
Always be aware of the current market conditions, but focus on your individual stocks. Some will be in sync with the broader market, and some will not. But if you contain your question of when to sell to each specific situation, you’ll find that your ability to balance the risk of missing out on future profits against the risk of loss improves.
Have a great day.
–Dan
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