MARKETS SPECTATOR: Avoiding the bull trap

With stocks and major indices globally breaking out to new 52-week and all-time highs, I thought it was topical to discuss the best way to deal with these dynamics.

While it's unlikely, there is always the small possibility of a black swan event and sudden reversal in the equity market. These have an uncanny knack of occurring around major technical levels in markets.

For example, the chart below shows the false breakout (red circle) to all-time highs in the S&P 500 in 2007 that turned into the GFC crash.



While a repeat of this is unlikely, I do think it warrants a little bit of caution as the major global indices toy with these crucial levels.

One way to avoid being sucked into a false breakout or ‘bull trap' is to wait for the market to consolidate after the breakout point. When it moves higher following this consolidation, it's reasonably safe to assume that the breakout has been successful and the market is likely to move higher.

The chart above shows the Australian market breaking out to all-time highs in 2004. It then had a brief consolidation period before breaking upwards again. Buying on the second breakout is a much safer way to enter the market following a breakout.

The second point worth discussing is that stocks trading at all-time highs and shares hitting new highs have a tendency to keep on doing so, frequently becoming the strongest, best performing names over a certain period of time.

Most investors are surprised to learn that a minority of stocks are responsible for the majority of the market's gains. The big four Australian banks are a perfect example of this.

In a research paper by Blackstar Funds entitled "the Capitalism Distribution”, they looked at all the individual stock returns from 1983 through 2006 and came up some very interesting findings.

Blackstar found, "both the biggest winners on an annualised return and total return basis tended to have one thing in common while they were accumulating market beating gains. Relative to average stocks they spent a disproportionate amount of time making new multi-year highs”.

A famous investing adage says ‘if a stock is trading at its all-time high or all-time low, there is a reason for it'.

There is a fundamental, psychological reason behind why stocks at all-time highs tend to continue going higher. No matter when you bought the shares, every single investor or trader is sitting on a profit. It sounds insignificant but it has an enormous impact on how participants react in the market.

Now compare this to a stock that is a long way from all-time highs and consequently has a lot of overhead resistance. As I discussed yesterday, the majority of market participants simply can't accept losses, close out a position and move on.

So once investors are losing on their position, all they want to do is breakeven. The bigger the loss becomes, the more irrational their behaviour and decision making becomes and they develop a huge urge to recoup losses or minimise the damage at any cost.

So when a stock with lots of overhead resistance (trading a long way from all-time highs) goes up, it has to fight through a relentless amount of selling pressure as new sellers appear whose only goal is to get out at breakeven.

This is in direct contrast to the stock trading at all-time highs, which faces little selling pressure as it moves higher.