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My System Is Warning Traders to Brace for a Pullback

Michael J. Carr

When I review my trading systems each week, I look at a number of charts. The first charts are all related to risk, because I believe managing risk is the key to long-term investment success.

There's a mathematical reason to make risk a priority: You need asymmetric wins to recover from any loss.

If you lose 50% of your $10,000 account value, the investment falls to $5,000 and you will need a 100% gain just to get back to even. A 10% loss sends a $10,000 to $9,000, and a full recovery requires an 11% gain.

The required percentage gain to breakeven will always be greater than the loss that you endure.

In any trading system, losses can never be completely eliminated. But I do all I can to minimize their impact.

When reviewing market risks this week, I noticed a few warning signs on the charts.

The 26-week rate of change (ROC) on iShares Core S&P 500 ETF (IVV) is shown below with a 20-week moving average applied to the indicator. Relative strength (RS) is shown at the bottom of the chart.

[Note: I used IVV in this chart instead of the more commonly used SPDR S&P 500 ETF (SPY) so that I can see RS. SPY is used as the basis of my RS calculations so it isn't possible to get an RS value for SPY. You could trade either ETF since both have low fees and small trading costs. I added RS to this chart to confirm the short-term ROC sell signal.]

In the chart, the 26-week ROC of IVV has fallen below its 20-week moving average. This has happened 46 times in the past -- an average of four times a year -- and IVV has fallen 56.5% of the time in the week after this signal occurs.

This signal usually only highlights a short-term pullback and stocks generally recover within a month of the signal. For comparison, there is a 39.6% chance of a decline in any month over the entire trading history of IVV.

Because this is a short-term signal, no action is required in my long-term 26-week ROC system.

This signal is, however, a warning that the long-awaited pullback in the stock market could be near. The S&P 500 has now gone 43 weeks without a 10% pullback. The index went 44 weeks without a 10% correction before topping in 2011, the last time we had an extended run-up in prices.

The charts are now saying that we could see a better price for new stock buys shortly. Of course, stocks could also continue higher without pulling back… but with a 56% probability of a pullback in the next month, it seems best to hold off on adding to positions in the stock market.

While I would not add to any positions at this time, the ETFs that are already in the 26-week ROC portfolio should continue to be held. There are only three positions and risk remains too high for bonds and precious metals.

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