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Newsletter May 13, 2006 Breaking the Rules Market & Sector Review Is a Crash Coming? Largest Changes This Week This Week's Economic Reports Breaking the Rules Ever notice the traders who make the greatest profits also tend to take the greatest risks. Rule breakers who go their own way. They search for innovative trading methods. They think outside the box. From Jesse Livermore to Paul Tudor Jones, there are many inspiring tales of talented, super traders who make huge profits by bending the rules and doing whatever they want. There are far more traders, however, who blow out their accounts because they don't bring the proper amount of discipline to their trading. You' must learn the rules before you can break them. If you're a novice trader, focus on learning conventional wisdom and how to trade with discipline. If you are new to trading begin by following some basic guidelines. First you must have a well defined trading plan clearly defining how you will enter and exit a trade. Secondly you must learn to manage risk. More than just protective stops you must learn how much of your account dollars to spend on a specific trade and whether or not you should accumulate a position piece by piece or jump in all at once. Additional conventional techniques; avoid such things as trading in the first hour or just before an earnings report. Conventional wisdom is only right when it is, but as a new trader, you don't know when it is right and when it is wrong. In time you will begin to value your experience. The more experience you accumulate as a trader, the more you can anticipate how the markets will behave and how you should act. Some jewels of conventional wisdom are right much of the time, and you should keep some of them in mind. The important point is to survive the learning curve. If you are still inexperienced don't take on a big position like a rogue trader looking to score big profits unless you are absolutely sure of what you are doing. Look at the big picture. Any given trade is just one trade among many, but this is only true when the amount of money you risk is relatively small. If you risk 50% of your account on a single trade then it isn't just a single trade amongst many any longer. It has potentially grave consequences. Manage risk; it's conventional wisdom worth following. When you have years of experience under your belt and become a master trader you may well know when to push limits. An experienced trader understands when he gets on a roll and knows that things are clicking. It may be breaking the rules, but to the master trader, it is how big profits are made. I must note however, that master traders' can afford to take a greater risk. They have well-honed skills, and should they lose substantial amounts of capital, they can diligently work to make it all back. A new trader, in contrast, will have more trouble making back losses, and should they realize a big loss, they must stop trading and recover financially before attempting to trade actively again. A trading strategy that worked well one month may no longer work when conditions change. The master trader is continually looking for new strategies and tries to look at the markets from new perspectives. While the masses look at the market in simple terms, the master trader is more creative. He looks for a new vision, and tries to develop a trading strategy that will capitalize on a unique set of market conditions. Master traders can afford to take bigger risks, newer traders cannot. It is not a good idea to be too unconventional at first; eventually however you will become more creative and go your own way. That is if you wish to reach the status of a seasoned winning trader. Until then keep trading cautiously at first but gradually push yourself to new levels. Market & Sector Review Is a Crash Coming? I must admit being a wee bit surprised by this week's action. The DOW was so very close but just couldn't get to the old highs of 2000. This action is leading many to believe it's all over. But is it? I came into this year firmly believing we would see a 4 to 4 ½ year cycle high, and quite honestly thought we would have seen that high by now (perhaps we have). When I wrote the forecast issue the 4 year cycle was not talked about very much. Now the 4 year cycle is talked about almost everywhere one looks, even in popular magazines. Perhaps that is the reason there appear to be so many bears? Even as most of the market averages march higher, in some instances in parabolic fashion. Markets usually peak with extreme optimism, not pessimism. It is simply all the pessimism I see that has kept me bullish so far this year. The 4 year cycle is not exact, no cycles I know of are, but rather are right or left translated. This cycle could very well become left translated which merely means lasting longer than expected. This week while perusing several message boards and blogs I often visit I began to see talk of another crash as experienced in 1987. This chatter aroused my curiosity since I do vividly recall that crash. I decided to pull up charts of the DOW for then and now. I have to admit the charts look quite a bit similar. Notice the box drawn on the top chart, almost exactly 4 years from the 1982 low. Ideally, that would have marked the 4 year cycle through. Instead of the expected decline the DOW went sideways for much of 1986. In early 1987 the DOW broke above the sideways trading range on increasing volume and then rallied in parabolic fashion for about 7 months into late summer of 1987 when we experienced our first small break. A two week rally attempt followed before the eventual crash in October. The cycle low came in October of 1987 almost a year overdue. The October 1987 crash was the largest (in terms of points) in history. Could our current cycle have another half year or year to go? Possible! Although I believe the probability to be fairly low. During 1987 the DOW rose to a little above 2,700 from a level in 1982 of just under 800, an advance of approximately 240%. A similar rise today would take the DOW over 17,000. Anything is possible but in my humble opinion, highly unlikely at this stage. A 17,000 Dow would be the equivalent of the 1982 through 1987 and similarly overbought. The DOW move at the moment is nowhere near in scope to that move. Thursday (-142 points) and Friday (-120 points) can only bring more crash talk over the weekend. Friday 10/16/87 also saw the DOW decline over 100 points although that was a significantly higher percentage loss than yesterday. Instead of getting emotional over two down days try and remember: the DOW has yet to challenge its breakout point (see chart below), and it is still within its rising channel. Although this is not the time to play hero, the bull market must still be given the benefit of the doubt. Therefore I would seriously doubt a crash is in the cards, at least of the 1987 varity. In view of the overwhelming bearish sentiment around as reflected in what I read, the put/call ratio (1.27 on Friday), and other sentiment measures I would expect a market rally to commence early to mid week. Perhaps something like a follow through down on Monday followed by what has become known as: turn around Tuesday. Assuming that scenario proves correct I think there will be two keys as to whether this rally is for real or should be shorted. Fisrt, watch the volume, if we rally on reduced volume then there is a lack of conviction; be very suspicious. Secondly watch the relative strength of the NASDAQ and the NASDAQ-100 (posted Wednesday and Friday Evenings). Aa a general rule; if the NASDAQ outperforms that is good. if it doesn't - not good . The real concern during the recent advances, at least for me, is the underperformance of the NASDAQ-100 index. The recent advances have been the result of "old economy" stocks. Are we setting up for rotation into the techs? Very possibly! Watch for a possible selling climax in the 100 early this week followed by a reversal upwards and new leadership for the market. If this scenario pans out we could be setting the stage for the DOW's possible parabolic advance mentioned last week. I would put the chances of a new DOW high with technology as the leader, versus we have just witnessed the high's of the 4 year cycle at 50/50. It may not be comforting but it's the way I see it at the moment. Preservation of capital should remain your top priority until risk/reward returns in your favor. Largest Changes This Week This Week's Economic Reports Have A Great Week! Bill Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.