Why Our Stock Market Timing “Buy” Signal Is Now Clinging To A Cliff

Yesterday’s (October 8) selloff was broad-based and ugly, with just about every industry sector getting hit hard (utilities were an exception).

The NASDAQ Composite ($COMP) and small-cap Russell 2000 Index ($RUT), the leading market averages in recent months, were hit the hardest with losses of -2.0% and -1.7% respectively.

The NASDAQ is now the only index still trading above the 50-day moving average (but not by much).

Individual leadership stocks, typically small to mid-cap stocks with a strong history and outlook of earnings growth, were hit hard as well.

Whenever the major indices undergo a price correction, one of the most important factors we analyze is how well leading stocks hold up and show relative strength to the broad market.

So, where does this leave us as we enter the new week?

How To Know When The Tide Is Turning

If leading stocks show relative strength by mostly ignoring weakness in the S&P, Dow, and NASDAQ during broad-based price corrections, it’s a positive sign that tells us it’s safe to carry on entering new trades of these leading growth stocks, the best stocks to buy in a healthy market. 

However, when top stocks begin succumbing to the weight of the broad market’s downward pressure, it quickly grabs our attention and tells us it’s time to lay off the gas pedal and take a more proactive stance with regard to managing existing positions for maximum profits and minimal losses.

So, Is The Tide Turning?

Yesterday, market leader LinkedIn Corporation ($LNKD) sliced through key support of its 50-day moving average on volume that surged to roughly 300% its average daily level. This volume spike tells us banks, hedge funds, mutual funds, and other institutions were driving the selling. Not a good sign for bulls.

Other leading stocks that sold off on heavy volume yesterday included: Qihoo 360 Technology ($QIHU), Vipshop Holdings ($VIPS), Soufun Holdings ($SFUN), Pandora Media ($P), Mercadolibre ($MELI), Priceline.com ($PCLN), and Amazon.com ($AMZN). 

Although $PCLN and $AMZN had a rough day, both stocks are still trading above their respective 50-day moving averages (an intermediate-term “line in the sand” for many retail and institutional traders/investors).

Balancing On The Cliff

The broad market rally is just barely hanging on. If leading stocks begin cracking below their 50-day moving averages en masse, our proprietary Market Timing Model will be forced to shift from “buy” to “sell” mode.

If you’re new to the role that market timing rules play into our overall ETF and stock picking selection, please click here to learn the general concept of our system for market timing, then check out this article that explains the five, rule-based modes of our model for timing the stock market.

Keeping On Our Toes

Yesterday was a busy day for subscribers of The Wagner Daily, our nightly swing trading newsletter (which includes access to our market timing methodology).

On the individual stock side, we sold Bitauto ($BITA) and LifeLock ($LOCK) for decent share price gains of 36.7% and 13.8% respectively. LinkedIn ($LNKD) hit our stop and we sold for an average loss of just 2.7%.  In case you missed it, you may want  to check out How We Bought A Pullback In LifeLock ($LOCK) For A 15% Gain…So Far, a trading strategy video from a few weeks ago that explains why we bought $LOCK when we did.

As for the ETF side, we sold two existing ETF trades yesterday to minimize losses. On SPDR Biotech ($XBI) and Direxion Small-Cap Bull 3x ($TNA), we lost 3.6% and 6.3% respectively. However, these losses were much smaller than the 44% gain we secured in Guggenheim Solar ETF ($TAN) last week (check back on this blog for an educational technical review of this $TAN trade by the end of this week.

How To Be Profitable In A Reversing Market? Simple Math

Many traders, particularly newbies, are obsessed with the accuracy of win rates (percentage of winning trades vs. losing trades) when analyzing how well a trading system is likely to perform over the long-term.

However, the reality is that a trader’s long-term profitability depends largely on other factors, such as the dollar amount of the average winning trade compared to the dollar amount of the average losing trade.

If, for example, a trader has a win rate of 70%, but allows their average losing trade to be 300% larger than their average winning trade, he/she will be net negative over the long-term.

Conversely, if a trader has a win rate of just 50%, but allows the average winning trades to ride to being just double (200%) the size of an average losing trade, the trader will become net profitable over the long-term. 

Lately, we’ve been closing our swing trades with about a 50% win rate (maybe even slightly lower), but our average gain has been MUCH larger than the average loser.

With the three stock trades we closed yesterday ($BITA, $LOCK, and $LNKD), our average winner was a share price gain of 25.3%, while the sole losing trade was just 2.7%.

That makes for a whopping reward-risk ratio of more than 9 to 1 (anything ratio above 3 to 1 is generally considered to be quite good).

To ensure you are alerted to when it’s time to start buying stocks again, based on our rule-based model, sign up today for your risk-free trial to The Wagner Daily.