Keep this image in mind... Power of the Pendulum

Update- Tues
What the heck am I doing talking about a pendulum when we are facing markets like these and events like these? Did you go long oil? Alternatively did you go short financials in May after the bear market rally? Did you sell FSLR after its earnings run up ? Did you sell POT at 240 on the flip down from oversold RSI. Neither did I... but as I seek to understand the market more and more I always now think where a stock is in terms of the pendulum and at least consider this in my decisions. The pendulum is a more concrete mental way of incorporating the information from well-known oscillators like Stochastics... very imp it is.
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A pendulum swings from one extreme to the other and increases velocity as it moves through the center of the pendulum swing. A pendulum is slower at the end of its swing range, speeds up as it hits the middle, and slows as it reaches the other end. Then it repeats the process.

In the market many people jump in at exactly the wrong time. They see the pendulum start to swing one way (up or down in the market), see it gain speed, begin to feel like they are going to ‘miss the move’ and that they better ‘get in before it’s too late’, and then end up perfectly aligned for the full brunt of the reversal against their desired direction. The human tendency to get overexcited at just the wrong moment is one of the reasons we see bubbles on the upside and significant over-corrections on the downside. It’s human emotion at work. In fact, the best time to get into a position is when the pendulum has swung too far in one direction or the other and has already just begun to reverse. The goal is to get in on the nascent swing, not the previous one. The maximum gain occurs this way as one can get the most swing from the pendulum. Also, if a trader is too early on the momentum change a stop loss can substantially minimize losses and allow a new entry once the pendulum has swung even further to one end.

Importantly, it may be emotionally difficult to enter a position when the pendulum is at one extreme because our recent memory is strong and has spoken of the large swing we just experienced. However, to be successful we have to be able to use our mind to override false inclinations. We take advantage of the historical precedent and pattern of the market rather than be caught by it.

My view of this market as a pendulum helped me from going short last week. Instead I did nothing, covered my MOS/POT shorts (that I had used at hedges from awhile back against my MOS/POT longs) when the Paulson news came through, and let the market ride. The market was short-term oversold, especially in certain stocks. The oversold condition of the market was evident in the technical indicators such as RSI, MACD, and Stochastics, along with confirming indicators such as volume. I mentioned that the market was oversold in this post.

The market would probably have collapsed further without the Fed bail-out. However, … do you think the massive 700Billion (really prob over a Trillion) bail-out we just saw would have happened if the Dow was at 12,000 and the SP was at 1400?… it is when the swift part of the pendulum kicks in and overextends (threatens to swing right off of its hinge in this case) that we also tend to see Fed action. Overall, we never know when or how the reversal occurs. The oversold or overbought condition, or the extremes of the pendulum, just tell us to watch out for a reversal. When the market or a given stock is on reversal watch this is not the time, in my opinion, to initiate a position. I would rather miss a move than get burned by one. In this market, especially, the rule #1, as Buffett says, is don’t lose money. Capital preservation is extremely important here.

It is important to note that the pendulum analogy is not a perfect one. Unlike a pendulum, the market overall does not always remain in a defined range. It oscillates like a pendulum with a net bias in one direction or the other over time. This enables markets to go up or down. Elliott waves give a more precise picture of how the market moves overall. It combines the oscillations and progress of a wave. I again recommend Elliott Wave Principle by Frost and Prechter. Small book, fascinating material, cheap on Amazon used, excellent background on the market and interesting scientifically.

Right now it is important to remember that we are in a downward move overall. This move is still early in its longer cycle… and PLEASE don’t think that everything is now ok on the long side of the market bc of the bailout. While we may get another bear market rally here the Fed cannot keep the market from going down further in the longer term. I have been waiting for the time when the pendulum would move the market back up so that I could get a better opportunity to short. I am not sure when the Fed bounce will end but I plan to watch it closely. The best part of the Fed bail-out, from an investors’ perspective, is that it provides an opportunity to exit longs at better prices and to go short when the pendulum once again shifts.

Perhaps more importantly, it buys us all some time to try to protect jobs, finances, pay off credit cards, etc… and maybe in the long run it will prevent a cascade effect of panic that would cause the market to over-correct on the downside even more than it naturally should. There is no doubt in my mind that some plan needed to be assembled. However, I do not trust that the current plan holds the culprits of this mess accountable, reduces moral hazard, and generates the transparency necessary for trust to re-enter the financial markets. One thing is clear regardless of what the Fed does- when the drink tab gets too high at some point the bartender stops pouring the drinks and starts demanding payment. The bouncer isn’t going to let America out the door without cold, hard cash. It’s just that simple.

The pendulum can give us short-term warnings and clues. The Fed move may have bought us some time (though at what cost?). In the long run the bill is due.
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Note-most of this post was written on Sunday... published on Monday

Note: I encourage you to go to market-ticker (blog at right) for an excellent look at the current bail-out law and subsequent repercussions.



"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice