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Risk on

When reading financial headlines one could easily think the markets are selling off, we’re in a in severe downtrend where panic is just about to hit the main street. It’s really hard to find anything positive, and even if we get to read something that could sound a bit optimistic it’s accompanied by a word of caution, caution ahead of the next recession. Everyone’s obsessed about it.

I don’t know about you guys, but I like to stay open minded and being optimistic is a viable option too. It helps spending some time with family and friends during the Summer, and having the Adriatic sea at our fingertips is just a bonus.

Since the beginning of the year we’ve been bullish the stocks (Is it over?), bitcoin (Are cryptos trying to bottom?) as well as gold (Will gold bugs finally have their day?). It’s a ‘risk on’ environment, you know. However, is that about to change?

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How will the dollar affect stocks?

I guess everyone knows the saying ‘fool me once…’. The market tries to fool us not once or twice, but much more often. If it was straight forward, risk management wouldn’t be as important as it is. In fact, it’s the most important aspect of trading in my opinion. I believe finding the best opportunities and making the most money out of them starts with great risk management and not other way around.

In a recent post Dollar about to rally? I was exploring the dollar bull thesis. Frequent readers know that I’ve been a dollar bear for a long time now, and exploring the opposite side of an investment thesis is a must if you want to manage risk effectively. While the dollar is still in a sideways trend, last week turned the table in favor of dollar bears once again, which is my preferred stance. But why is this important and how could this affect the stock market and economy?

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New all time highs is not a downtrend

The S&P 500 index is back at new and fresh all time highs. Maybe this is not the best time to be writing a bullish post, it could backfire and we could see a 2015-16 bottom style retest. We have just seen an incredible 25% bounce in about 4 months, volatility is depressed and just about to burst. However let me remind you, I wrote a series of posts in October, starting with Winter coming?, warning you we could see a market crash, and then in Jan I flipped the side asking myself and my readers if Is it over?.

I was cautious along the way. The bounce could easily have been a bear market rally, but getting to fresh all time highs should reduce that likelihood, right? We were getting constructive signs along the way, let me just mention recent The most important market in the world right now post.

And while we’re back where we left it a good half a year ago, let’s discuss the current environment and why the party might not be over just yet.

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Tesla or TeslaQ?

Probably the most controversial company in the stock market is Tesla. People either love it to such extent they almost worship it or they dislike it so much they think it will be de-listed from the Nasdaq exchange. It seems there’s no middle ground. It also seems no other stock divides people that much.

If I said I care it would be a huge overstatement. I don’t. Why would I have to? And as much I’d want to dive straight into your favorite ideological debates, that’s not the intention of this post. I want to warn you of a potential deeper correction that might happen in Tesla’s stock.

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The most important market in the world right now

Back in October last year the German stock index DAX was flashing warning signs for the stock market as a whole (see Winter coming?). We paid attention and whoever was alongside, was able to protect the damage that could have occurred otherwise. However in the beginning of this year we flipped the table and started (cautiously) accumulating stocks again (see Is it over?).

In this post I’d like to present why I think the DAX is again one of the most important markets in the world to watch right now.

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Biotech stocks poised for a breakout higher

After the best first quarter of a year after quite some time, the rally from the low keeps on going. In March I was advising to get cautious if the market decides to start turning lower. Some might have taken that as too cautionary, however I must remind you we’re still in a cyclical correction and approaching upper trading range. To me playing defense is more important than playing offense. Don’t forget, in October last year we got out of longs and how important that was for preserving our emotional health and keeping an open mind in Q1 this year.

A good thing to see is that under the surface some nice bases are being built. This could provide the necessary fuel to extend this rally towards previous all time highs and later even beyond. This has been my thesis since beginning of the year (see Is it over?). One of the nicest bases being built is in biotech stocks. After a magnificent run between 2011 and 2015 when they more than quadrupled, they’ve been consolidating ever since.

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Don’t be stubborn

The markets seldom move exactly as one expects them to move. A few weeks ago, when the S&P 500 was trading at 2800, I was wondering if the move higher had exhausted itself (see Shakeout before higher?). It seems I was a bit too early, the S&P rallied a bit further, to 2860 on Thursday. This was just a day before we saw a nasty reversal with the close at the above mentioned level 2800.

At first Thursday’s price action looked constructive to me. There were quite a few breakouts out of solid bases, the market convinced everyone into believing it can continue moving higher for longer with very shallow pullbacks. But then, on Friday, reality struck and we realized the market fooled us. Most of the breakouts failed hard, and as it seems, most likely marking a short term top.

As stated many times before, I believe we are/were most likely in a cyclical correction and not rolling lower into a full blown recession. However, the key is in managing risk, so don’t be stubborn.

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Shakeout before higher?

We’ve just seen a magnificent 20% two month rally in the S&P 500 index and stock market in general. Yesterday it opened just a bit above 2800, a target area discussed in What to expect next?. But then slid lower for the day and finished just a bit below 2800. Snap back rallies are very typical for bear markets and while the current bounce would constitute as a very typical one, the strength surprised even some bulls. What is a bit untypical is that until this point we haven’t seen any form of a shakeout yet (see more in Typical bottom).

The US markets were in a bear market in Q4 ’19 and some other markets were in a bear market for the good bit of 2018. While we might be seeing the first signs of the new bull market emerging (see Is it over?) we must not get overly excited at this stage. Does this mean we must be going to cash or even get short? No, not at all.

But we must respect a possibility of a quick and nasty shakeout, meaning we must respect risk and manage our positions accordingly. Even if we think the worst might be over, we could be proven wrong later.

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What to expect next?

I’ve been very quiet in the past month. The reason is that I was intensively working on a new product I will announce in the near future. Sometimes you just got to lock yourself in a room if you want to get things done. Focus is so underestimated thing nowadays. It’s just impossible to deliver a high quality product if your mind is all over the place.

Anyway, more about that when time is right. I want to discuss the market with you. Since my post Is it over? the stocks rallied a lot and most have already forgotten we’ve seen a mini crash in Q4. However, the problem is that, while I think there’s a good chance the bottom is in, the current action does not look like a Typical bottom. So, what to expect next?

The market is behaving very constructive as of late and it’s not far fetched to say the S&P 500 could continue going higher to above of its 200d or up to somewhere 2,800 level – the purple area.

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Typical bottom

People love picking tops and bottoms. I understand where this comes from, some just have the urge to prove they know more, they know better. While this might be a viable strategy, one needs to know where the market is currently and if a low has a chance of becoming the bottom. Are we in a 8-12% consolidation phase, a 20-30% cyclical correction or a 35+% secular bear market?

We’re seeing a good 10% bounce from the Xmas lows and it’s easy to feel stupid if you dumped your stocks then but now watching the market go up without you. It’s also as easy to feel victorious if you didn’t sell then, but what if we get a retest, or worse, what if it’s not over yet? Can you withstand that?

I prepared a chart pack of 16 bottoms that occurred since 1962. They might help you navigate through the cycles and picking the bottoms. One very common characteristic in bear markets is that we often see a multiple double digit counter trend rallies, the same goes for rallies near market bottoms.

I bet you’ve heard the old saying that tops are a process and bottoms an event. The following charts prove that bottoms are a process too, even though sometimes shorter in length! There are no V type bottoms really, a much more common bottom is the one that fakes people in believing it’s not over yet, like a double bottom or a low undercut bottom or a bear trap bottom. Let’s go through them one by one.

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