The current market reminds me a lot of the beginning of 2007. At that time, the market was moving in a similar fashion: climbing the "wall of worry" on low volatilty.In fact, it took the market seven months to move up about 18% from the bottom. On February 27, the market finally declined over four percent in a day. The move was triggered by a big decline in Chinese stocks and negative economic numbers in the US (Check out the CNN market report of that day).Prior to that decline, experts were warning of a significant pullback for months due to economic expectations. We are in a similar situation right now with several analysts predicting stocks to decline. Yet, the S&P continues to make new heights on low volatility.
Was there a way to predict the date of the selloff from various (sentiment) indicators in 2007? On the chart I plotted several curves, such as NYSE Advanced/Declines, New Heights/New Lows, VIX and MACD. None of them predicted the selloff. You could maybe argue that the momentum divergence of the MACD showed decelerating upward drift. However, the MACD accelerated again in Jan/Feb and thus gave you a false signal (As you might know, I consider these classical technical indicators quite useless anyways). Bottom line is that none of these indicators predicted the downturn. Drawing trendlines or Moving Averages also didn't help.
So let's assume, you were a short term oriented trader at at that time and you would have known that stocks will sell off at some point in the future. What would have been a successful strategy?
a) you could have gotten out of the market during the uptrend and simply waited for the sell off to re-enter. This strategy would have been profitable if you would have sold after November, so almost three months before the sell off . Psychologically, you would have had a tough time between December and February: you needed to watch the market go up from the sidelines and be disciplined enough to not get back in.
b) you could have played the price swings: buy after a pull back and sell on a new height, which is actually my style. Problem with that strategy: You might have bought the days before Feb 27 because the market actually dipped slightly. In order to play this strategy successful, you should have sold everything in the morning of Feb 27 and aggressively opened short positions to play the downside momentum. That day was actually a trending day, so you had a good chance to get back some of your losses of the last swing.
A third, more advanced option would have been to use options to hedge the portfolio and benefit from rising volatility/premiums.
So, here we are two years later. I think that we will see a similar selloff before the end of the year. It is totally unpredictable when exactly that will happen. As we have seen in 2007, trends can run a long time and it is impossible to pick the top.
I'm leaning towards strategy b), but there will be days in September when I cannot monitor the markets all day, so I will probably move to strategy a).
