Monday, September 12, 2011

Building Positions and The Phases of a Bull Market Explained

The focus of this blog is usually about short-term swing trading which is moving in and out of positions which are held from several days to a few months. But it is also important to know about longer-term position building.

Both fundamental and technical analysis can be equally worthy tools to be used in your trading and investing career, but you need to know how and when to use each of them.

I am of the belief that markets trade irrationally more often than not in the shorter term. Have you ever noticed how often an index or stock will move contrary to underlying conditions or major news reports? It happens all the time, to the point where many traders do not even need to listen to news reports as they are all about price action.

Shorter-term traders who use technical analysis dominate the intraday and daily gyrations of markets. Longer-term traders who use fundamentals often place a floor (or a ceiling) under a security when selling (or buying) becomes too irrational and they see value coming into play. And so over the long haul, fundamentals usually trump technicals. So as a general rule of thumb, you should place greater emphasis on using TA the shorter your planned trading duration. The reverse is true for longer term holdings...your time should mostly be spent researching an entity's balance sheet and whether you buy into its "long-term story".

There is a common anatomy to the charts of massive bull runs. After a stock or commodity has fallen out of favor for a significant length of time, you will see a relative flat-lining that will last several years as all but the most astute investors have given it up for dead. During this time, those investors are quietly buying shares as their research has indicated there is extreme future value to this stock or commodity, largely because they see swirling macroeconomic winds that can kick start a major bull market. This is often called the Accumulation Phase. Fundamentals take precedence at this time. This phase requires the investor to have a strong belief in their thesis and supreme patience as they wait for the second phase.

A cup-and-handle or rounded bottom technical pattern often appears in this time. Once the price breaks out above resistance with some volume, trend traders and fund managers begin to "buy-in" as well. This starts the next phase which is usually the longest and most lucrative, called the Participation Phase. It typically lasts for years with a long, steady grind upwards. There are surges and corrections, but it is mostly an orderly, "buy the dips" environment. Fundamentals and technicals are in alignment during the Participation Phase and it is the easiest to actively trade. The stock or commodity gains more interest in the press and amongst active participants, which helps spawn the last and most volatile phase.

The final section is called by various investors as either the Parabolic, Mania, Bubble or Blow-Off Phase. At this point, everything becomes irrational. The chart will resemble a massive super-spike with massive weekly gains and very few corrections. Main Street hears the hype in the news and wants to get on board the rising roller coaster as well.

At this point, Wall Street and the original investors realize that the end of the bull run is near and they start unwinding their holdings and seek to lock in massive profits. There is a saying on Wall Street that "when your taxi driver is giving you a hot stock tip, it's over". Think the Dotcom bubble in 2000 and housing bubble in 2005. Wall Street gets off the roller coaster near the top and lets Main Street ride it to the bottom. The very moment you hear the phrases, "it's different this time" or "we've entered a new paradigm" on CNBC, run to your computer and sell big chunks of your position.

If you are planning to take a significant long-term position in a security, it is vital you know these three phases and recognize your place in time.

I will be editing this post in the next day or two to include some charts to cite as examples, but I really need to get some sleep. So stay tuned and as always thanks for reading!

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