Why Mapping the Mind of the Market Matters

by Nicholas Vardy

 “It's insane to expect a trading system to work in all market types.”

- Dr. Van K. Tharp

This past weekend, I reread Jack Schwager's classic book, Market Wizards: Interviews with Top Traders.

Although first published in 1989, the book's wisdom of world-class traders like Paul Tudor Jones, Bruce Kovner, Ed Seykota and Michael Steinhardt remains eternal.

Rereading these interviews always reminds me of the dedication, discipline and flexibility it takes to be a profitable trader.

It's that last characteristic - flexibility - that took me the longest to learn.

Just because you have an investment strategy that's worked well for a long time doesn't mean that same strategy will work in the future.

That's because change is the only constant in the financial markets.

And if the character of the market changes...

Traders (and investors) must adjust their trading strategies as well.

How to Map the Market's Mind

Investors have been spoiled by the U.S. stock market over the past two years.

Markets have been trending up. Volatility has been low.

Merely staying invested in the stock market has worked wonders in a quiet, bullish market.

It's the kind of market that makes the average investor look like a genius.

But as the old Wall Street saying goes... never confuse brains with a bull market.

As the last two months confirm, it's a lot tougher to make money riding the market's momentum when that momentum fades.

One of the most important lessons I've learned as a trader is to identify "market types."

Here's the way I like to think about it...

There are three primary market types: bullish, bearish and sideways.

And different strategies work for each market type.

So how do you identify today's market type?

Sure, you can use formulas, calculations and arcane technical indicators.

But I prefer good old-fashioned common sense.

Or as Justice Potter Stewart put it in his definition of pornography... "I know it when I see it."

Take a look at a chart of the S&P 500 over the past six months...

The S&P 500 was in a low-volatility, bullish phase up until the end of January.

The market went up steadily almost every day.

And then on January 29, the bull market got the rug pulled out from under it.

Since then, the S&P 500 has traded sideways.

Instead of offering a smooth and steady ride upward, the market became choppy and more volatile.

Is it any surprise strategies that worked up until then have stopped working since?

Trading Different Market Types

I like exchange-traded funds (ETFs) for many reasons.

They allow you to invest in assets you couldn't otherwise invest in, like timber and private equity, for example. They also allow you to trade a wide range of market types.

I like to think of investing in stocks and ETFs in terms of playing checkers and chess.

If you just buy and hold stocks, you are investing along a single dimension.

That's a strategy that worked well enough in a low-volatility, bullish market.

But it's also like playing checkers... All of your pieces are the same, and (with one exception) you can move in only one direction.

In contrast, investing in ETFs is more like playing chess... That's because ETFs allow you to invest in other asset classes besides stocks.

You can invest in bonds, commodities, currencies and global markets.

Like individual chess pieces, each asset class moves according to its own unique set of rules.

Specialty ETFs allow you to take this flexibility one step further...

You can buy an ETF that "shorts" the stock market - that is, profits from market downturns.

You can even short the market with leverage - generating two or three times returns from a market decline.

Like Mr. Spock in Star Trek... you can play three-dimensional chess.

How to Profit From a Sustained Market Downturn

Say you want to short, or profit from, a drop in the Dow Jones Industrial Average.

To do so, you can buy the ProShares Short Dow30 ETF (NYSE: DOG) - a straightforward bet against the Dow.

If you're particularly bearish, you can buy the ProShares UltraPro Short Dow30 ETF (NYSE: SDOW), which doubles the rate of return on your bet against the Dow.

Over periods longer than a day, your returns can vary significantly. Nevertheless, the broad direction of these ETFs remains intact.

The obvious question arises...

Should you short the Dow by buying the ProShares Short Dow30?

As of this writing, the U.S. stock market is still locked in a trading range.

I'd consider a small position in the ProShares Short Dow30 if the Dow falls below both its 200-day moving average and the 23,000 level.

So we're close - but not quite there yet.

Good investing,


Thoughts on this article? Leave a comment below.

DISH Trade Alert

Over the last few weeks, we've talked a lot about "intelligent speculation." Nicholas makes a strong argument above for cautiously testing the waters.

Emerging Trends Strategist Matthew Carr also likes intelligent, speculative plays. In fact, his Switch Trade Alert service is built on the premise that few approaches are more profitable than put buying - that's buying an option that allows you to sell a stock at a specific price by a specific date.

Why does this strategy work? Because puts get a rocket boost when the market gets volatile and rolls over. If the price of the stock linked to your put option falls, you still get to sell the stock at the higher price. So you can buy it at the new low and sell it at the higher, agreed upon strike price (buy low, sell high). Or you can just resell the put option on the open market because its value rises as the stock price falls.

So Matthew is prepared to score big gains on his most recent recommendation, DISH Network (Nasdaq: DISH), which is poised to drop when the market buckles...

Cord-cutting is real.

In total, the U.S. pay-TV market lost more than 3.5 million subscribers last year. Even worse, the rate of loss doubled from 2016's.

And the two largest companies in the market suffered declines twice that of their rivals.

Consumers now have a wide range of television options available to them. There are streaming services like Amazon Prime, Hulu, Netflix (Nasdaq: NFLX) and Roku (Nasdaq: ROKU), as well as video game console options like PlayStation Vue. Then there's Apple TV and Alphabet's (Nasdaq: GOOGL) YouTube pushing into the live-TV realm.

In its 2017 full-year release, satellite provider DISH Network (Nasdaq: DISH) reported revenue slid 5.4% to $14.4 billion.

Meanwhile, average revenue per user fell 2.5% from $88.66 in 2016 to $86.43 last year.

Of the 1.5 million subscribers pay TV lost last year, cord-cutters from DISH accounted for 1 million of that total.

At the same time, satellite companies have higher customer acquisition costs, as a technician has to go out and install the dish. Because of this, companies like DISH still require customers to sign two-year contracts.

For the upcoming first quarter, DISH is expected to report revenue of $3.5 billion. This would be a nearly 5% decline year over year.

And earnings per share (EPS) for the first quarter are expected to come in at $0.72. This is a decline of 5.6% from the first quarter of 2016's EPS.

For the second quarter, DISH is expected to report revenue of $3.47 billion with EPS of $0.68.

Now, DISH does have its own streaming service, Sling TV. And it currently has 2.2 million subscribers for this service. But the company's largest customer base - which is dwindling - is the more than 11 million satellite subscribers.

Revenue is expected to fall more than 4% in 2018 and at least another 4% in 2019.

It's worth noting as well that DISH's net income for 2017 increased to $2.1 billion. That was up from the previous year's $1.5 billion. But the 2017 number included a $1.2 billion benefit from the tax reform legislation.

And that's why we saw diluted EPS for DISH end 2017 at $4.07, well above the $3.15 for 2016.

Earnings are expected to decline not just in 2018 and 2019 but all the way out to 2021.

That means all three of the warning signs we look for are checked off...

  • Regressive Sales Growth: Sales are down both year over year and sequentially.
  • Falling Earnings: Earnings are down both year over year and sequentially.
  • Downward Projections: Analysts expect earnings to decline over the next five years.
Buy the DISH Network (Nasdaq: DISH) September $37.50 puts. The last trade here was $2.53. But the current bid-ask is $2.85 to $3.20. We want to go as low as possible! And our buy-up-to price is $4.50. My Projected Price Indicator believes shares of DISH are ultimately worth $20.72.

- Donna DiVenuto-Ball with Matthew Carr

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