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A Trader’s Perspective…

Christopher Myers
Wednesday, 19 Oct 2011 | 3:27 PM ET

As a long-short fund manager, your objective is to put dollars to work in issues that offer the most opportunity for above average returns. If no such opportunity exists, the better play is to hold to a strong risk management policy and avoid the market altogether. Sitting in cash (i.e. having no investments in your portfolio) from time to time has a few key benefits that are often overlooked.

First, sitting in cash allows you to clear your mind of the mental biases, hopes, fears, and desires that are developed when invested in the market. Regardless of how trained you are to act without emotion, human beings are creatures of habit and are naturally biased. Avoiding the market from time to time allows an individual to effectively evaluate the market and make objective decisions about how to proceed. Second, sitting in cash is the most effective policy in an uncertain environment. In poker, if the odds are in your opponents favor, the statistically correct play is to fold your cards and try again later. Why should the market be any different? Lastly, sitting in cash is an effective hedge against opponents who over trade to try to make a quick buck. Over trading is one of the biggest causes of loss in the stock market. All combined, sitting in cash is often the best risk management policy a trader can employ.

While remaining objective and mostly out of the market the last week or so, an investor would have been able to spot that the market is in the midst of a trend change. After being plagued in a bear-like market for the past 3 months, a few indicators are starting to point towards stocks coming under subtle accumulation. While indicators only paint a small portion of the overall picture, when divergences start to add up within these indicators, the change should give fair warning to the impending shift.

One such indicator, the advance/decline line, as measured on the Nasdaq, recently broke its steady downward trend that started at the beginning of July by moving to the upside. The divergence points to more stocks advancing than declining near a key turning point in the market. Another indicator is the amount of new highs and new lows being hit on the index. Using simple probabilities, your chances of holding a stock that will reach a new high is greatest when many other stocks are moving to new high ground. New highs are starting to become more frequent than new lows, which gives rise to another hint of subtle accumulation and is a key divergence to take note of.

Given the indicators, an investor is best to remain cautiously optimistic that a strong rally is about to begin. It’s very likely that the market is about to start its last major uptrend before hitting an eventual top next year and rolling over into a full-fledged bear market. Many a rally has started after a move down was undercut by a second move to the index’s low. Much like the last leg up in the 2007 bull market, major players often need some time to get on board before the market can power higher.

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