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3 Signs a Market Sell-Off Is Coming Soon

Jeff Macke

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Legendary traders are purported to make enormous profits based on nothing more than their instincts and the voices in their head. There are maybe five such superstars in the world and four of them are probably honest about it.

Those of us not blessed with Mozart-level trading skills are best served by coming up with a finite number of objective measures to inform our decisions to buy or sell a stock or index. It's not enough to "feel" bearish or think the end of the free money era will spell doom for the markets. Whether it's a panicked crash or top, the best moments to buy or sell positions are emotional. The traders who profit are those best prepared and capable of stripping out their emotions.

Which brings us to talented trader and all-around good egg Gary B. Smith of thechartman.com who joins me in the attached clip with his 3 reasons to expect a market decline and what he plans to do in the off-chance he's wrong.

Three Headwinds:

1. Too many stocks over their 40-day moving averages. The Chartman uses this relatively obscure indicator as shorthand glimpse of how overbought the tape may be. Heading into Tuesday's trading, the number was somewhere between 67 and 68%. After yesterday's breakout the number is a whopping 80%, a level normally associated with blow-off tops. "Anytime you get above 65% it's a warning sign," says Smith.

Consider yourselves warned.

2. Stocks have been going straight up for 3 months. The move since December of 2011 isn't unprecedented but it's certainly a yellow light. If you squint you can see a nice, albeit brief, pattern of the S&P500 breaking through resistance then pausing and doing it again; just as bullish tapes are supposed to.

Smith scoffs at the idea. "Normally I like to build a base for more than two days," he says.

3. Market darlings are overbought. Exhibit A is naturally Apple (AAPL) and its 40% move year-to-date. Exhibit B is the fact that it's almost impossible to get long if you're waiting for a dip. Such a move is generally regarded as unnatural at least, and the sign of a bubble, at most.

"I keep trying to buy boring stocks on the smallest of pullbacks and I can't get in!" the Chartman wails.

So that's Smith's plan. Of course good traders assume they'll be wrong occasionally and adjust accordingly. For me that meant selling down to 50% invested then waiting for the S&P500 to prove it could break through resistance at 1,375. Once the market proved its mettle I started accumulating trading longs, despite the temptation to dismiss the move entirely.

Smith's strategy for minimizing the damage of mistakes is to hold two different portfolios: One for "kind of boring stocks" and the other for trading. He's in cash in the latter but he's still taking part in the rally with his more prosaic stocks.

His positioning takes the mental pressure off missing a rally entirely. His conservative positions are making him money so he doesn't feel the need to start chasing the rally. In other words, he's not emotional so he's less apt to make the massive and imprudent moves that have destroyed so many traders.

It's not a sin to be wrong but staying wrong will kill you. If you're on the sidelines and itching to get long you should start thinking of ways to relieve the tension. If, God forbid, you're short you better put some stops on ASAP. If you're wise enough to already have your tells and your contingency plan, you obviously know this stuff already.

Are you short and suffering? Long and smug? On the sidelines and bored? Let us know in the comment section below or Tweet me @Jeffmacke