Excerpt from MY BOOK
OK, the market’s headed south. What next? You need to be able to balance your natural sense of hope with the reality of what a chart is objectively telling you and learn to respect the destructive power a downtrend can exert on your equity if you choose to fight the trend. In addition, if you are uncomfortable with selling short, or opposed to it for some personal reason, you will be at a severe disadvantage during a bear market.
Picking bottoms is the hardest job on Wall Street, and frankly, nobody rings a bell at the market bottom. Yet for some reason there seems to be an attraction to declining prices among most participants. Natural human optimism and learned behavior of hunting for bargains in a retail environment provides a “slope of hope” along which stage four stocks decline, crushing the dreams and finances of bewildered longs in its path.
We have all experienced the helpless feeling of searching every news source for a shred of bullishness to justify holding onto a stock in the face of declining prices. This fruitless action only delays the inevitable recognition of truth. It does not delay your losses. It is said that “it is better to be in cash wishing you were in a stock than it is to be in a stock and wishing you were in cash.” This is perhaps never truer than the point at which you are “foraging” for a reason to continue on a course that offers little promise.
For long participants, the stage 4 decline is marked by two brands of fear:
-Fear that the stock’s descent will continue to wipe out their equity (a good fear to have as it may portend a proper action into cash).
-Fear of feeling stupid for selling “the loser” at a point just before the stock turns higher (a bad fear to have). Do not fall prey to the short-term pauses in a primary downtrend; the short term action will typically be resolved in the direction of the larger, more powerful trend of the longer timeframe.
For short sellers, greed plays a role in a declining stock as they salivate at the increasing equity of their account balances. Short sellers are not immune to fear in a primary downtrend. Short term rallies can come suddenly and quickly in a downtrend and the fear of evaporating profits motivates short sellers to buy. There seems to be a general mistrust of the shorting process and, as such, they are often very quick to cover their positions at the very first sign of any short-term strength.
I tend to be very quick to cover short positions because some of the strongest rallies can occur in a downtrend. Holding a short in the face of such an advance can lead to quick and dramatic losses. I would rather cover my position with a profit and stand aside during short-term, and often violent, rallies and then re-enter the position as the stock begins to weaken again. It is my experience that short-term counter trend moves in a primary downtrend can occur so suddenly that trading short is more difficult than long.
Because of the greater volatility in a bear market, shorts generally should be traded more aggressively than longs would be in a bullish environment. When a stock experiences the short-term declines that a short seller targets, there can be terrific opportunities for profits as bids thin out from market makers unwilling to take meaningful inventory and from fearful long holders liquidating in a panic mode.
For a stock in a confirmed downtrend, the rallies are generally feeble, low-volume moves that quickly fail as more frustrated buyers come to the realization that a bottom has not been found. A weak stock is similar to a boxer who continues to stand up to his opponent after repeatedly getting knocked down. The stubborn fighter will ignore the chant of his trainer to “stay down,” much the same as buyers keep coming back to the stock hoping to catch the bottom. These participants ignore the shouts of the market to stay away. Yes, the market does “shout” to us, and the screams are represented by the declining moving averages. When a stock experiences a short-term rally, it finds a renewed source of supply at a level which is lower than the last time the sellers took control; this action is represented by the lower highs on the chart. And, of course, a lower low is created as long holders sell out in disgust as they realize they were unable to correctly make their purchases at “the low.” See how interconnected this all is?