Thursday, January 24, 2008

Technical Thursdays: When to Sell the Dead Cat Bounce

On the assumption that yesterday’s rally did not produce a selling climax and that more work needs to be done to complete the bull market correction we are in, the next investment strategy decision point will be when to sell/rebalance your existing portfolio. For this, a very useful tool is the same one used for the Lunch Money trades that occur from time to time – momentum and MACD.

The chart to your left* shows the current state of momentum and MACD (second and third lines below the price chart) for the S&P 500. Two points to consider:

1 - MACD is so depressed and, therefore, provides evidence that the market decline is not over as it is nowhere near a crossover point (blue above maroon line), which would signal a key reversal of the near term downward trend**. As a result, the current rally is most likely little more than an oversold market rally resulting in your standard dead cat bounce.

2 - If so, momentum becomes the primary guide to timing the portfolio adjustments one might wish to make. The rule of thumb is when momentum approximates the zero level the portfolio selling/adjustments should begin.

Investment Strategy Implications

For short-term timing purposes, momentum and MACD applied correctly are very useful indicators. The current condition of the equity market suggests that the dead cat bounce will exhaust itself when the oversold condition of the market reaches equilibrium, which is zero in momentum.

Note: There are other alternative outcomes, such as a resumption of the market decline before momentum reaches zero, which will be discussed in future blog postings should they occur.

*click image to enlarge. chart source
**Key reversals require both momentum and MACD to non confirm a new high or low in an index. For examples, please see prior Technical Thursday postings.

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