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How To Avoid The Biggest Mistake Traders Make In A Bull Market

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After the October 17 breakouts to new highs in the S&P 500 and NASDAQ Composite, I got to thinking about bull markets.

 

I was pondering over how much traders and investors must be loving and profiting from this powerful rally stocks have had in 2013.

 

But then a worrying thought popped into my head.

 

It occurred to me it’s quite possible that not all traders and investors have actually been raking in the trading profits, despite the major indices being at new highs.

 

Why? Because I fear that many traders and investors have been feeling the pain of the biggest mistake traders make in a bull market.

 

I’m speaking from personal experience when I say it’s a very real concern.

 

I’ll tell you why in just a moment, but first take a quick look at the breakouts in both the S&P and Nasdaq.

 

The October 17 rally in the S&P 500 Index ($SPX) put the index at a new closing high for the year, which is a great sign considering where this benchmark index was only six sessions ago:

 

131018SPX.png

 

The tech-heavy NASDAQ continues to extend above its prior swing high, and has now gained approximately 6% since our September 6 market commentary that suggested another breakout to new highs in the NASDAQ was coming soon:

 

131018COMP.png

 

With stocks on a seemingly unstoppable upward trajectory, it’s easy to get sloppy and make careless mistakes in the stock market without having majorly negative repercussions.

 

Yet, there is indeed one mistake that has some pretty damaging consequences (in the form of opportunity cost), even in a bull market.

 

Have You Ever Made The Greatest Mistake?

 

In a raging bull market such as the present, approximately 80% of stocks and ETFs will be dragged alongside of the main stock market indexes and move higher.

 

Small and mid-cap growth stocks with a strong history of solid earnings growth will typically outperform the percentage gains of the S&P 500 and Nasdaq by a wide margin.

 

These are the same stocks we focus on trading in bull markets.

 

But even if you fail to buy the best stocks in the market, you can basically throw a dart right now and still have a good chance that the stock you buy will move higher (note this only applies in healthy bull markets).

 

Nevertheless, roughly 20% of stocks and ETFs will still fail to move higher in a bull market.

 

Obviously, it is a frustrating experience if you make the unfortunate mistake of buying one of these dogs.

 

Yet, this biggest mistake is surprisingly common among traders, especially newer ones.

 

So, let’s talk about an easy way to avoid this problem.

 

Failing To Overcome Gravity

 

When I was a new trader many years ago, I’m not ashamed to admit that I intentionally focused on buying stocks and ETFs that were NOT rallying alongside of the broad market (showing relative weakness).

 

Why? Because I wrongly assumed they would “catch up” to all the other stocks in the market.

 

Furthermore, I mistakenly thought stocks and ETFs that had already rallied a large percentage would probably not go much higher.

 

Damn, I sure was proven wrong!

 

What was the outcome of buying these stocks and ETFs with relative weakness?

 

I was painfully forced to watch (what seemed like) every other stock in the market rally, while my positions failed miserably to overcome gravity.

 

Adding insult to injury, the leading stocks that I thought “couldn’t possibly move any higher” ended up being the same ones that once again made the biggest gains on their next waves up.

 

The worst part is I also discovered that when a stock is so weak that it fails to set new highs alongside of the broad market, that stock is typically the first to sell off sharply (often to new lows) when the broad market eventually enters into even the slightest pullback from its high.

 

Once in a blue moon, a stock or ETF with relative weakness will suddenly start to show relative strength. However, that typically only occurs with the luck of some major news event.

 

Betting on future news that may or may not cause a stock to rally is akin to betting on red or black in a casino (maybe worse).

 

It’s All Relative, And That’s All You Need To Know

 

As momentum trend traders, we focus on buying stocks and ETFs that are making “higher highs” and “higher lows,” along with chart patterns that indicate relative strength to the benchmark S&P 500 Index.

 

In a moment, I will show you about a great way to quickly and easily identify relative strength, but let’s first discuss what relative strength (don’t confuse this with the RSI indicator) actually means.

 

Relative strength - Any stock or ETF that has broken out over the past few weeks automatically is showing great relative strength to the S&P 500 because it has rallied to new highs ahead of the benchmark index.

 

One such example is Guggenheim Solar Energy ETF ($TAN), which recently netted us a 44% gain.

 

On the individual stock side, we are currently showing an unrealized price gain of more than 55% in Silica ($SLCA) since our July 8 buy entry, so this is another great example (we will remain long until the price action gives us a valid technical reason to sell).

 

Neutral - Stocks or ETFs that are breaking out right now (in sync with S&P 500) are also decent buy candidates and may eventually outperform during the rally.

 

These stocks and ETFs may not be as good as buying equities with relative strength (on a pullback), but can still offer substantial returns.

 

One such example is Direxion Daily Semiconductor Bull 3X ($SOXL), which we are currently long in The Wagner Daily.

 

Relative weakness - While stocks and ETFs that broke out ahead of the S&P 500 are the best stocks to buy, and some equities only breaking out now may be fine, you definitely want to avoid stocks and ETFs that are lagging behind.

 

I’m speaking from personal experience here.

 

Any stock or ETF that is failing to even keep pace with the current breakouts to new highs in the S&P 500 and Nasdaq has relative weakness. However, don’t confuse this with stocks and ETFs that already broke out to new highs within the past few weeks (ahead of the broad market) and are now building another base of consolidation.

 

A Tool To Stop Being A Fool

 

The good news is there’s a simple tool that enables traders to quickly and easily spot patterns of relative strength and weakness.

 

This tool is a great way to know which stocks and ETFs to avoid right now (the 20% mentioned earlier).

 

Surprisingly, the tool is utilized by simply comparing the daily chart patterns of any stock or ETF versus the S&P 500 Index.

 

The chart below, comparing the price action in a Real Estate ETF ($IYR) against the S&P 500 ETF ($SPY), clearly shows how this works:

 

131018IYR.png

 

It’s as simple as that.

 

If you thought our tool for spotting relative strength or weakness was going to be complicated, I’m sorry to disappoint you.

 

However, our proven trading strategy has always been about keeping our analysis of stocks simple, and this tool is in line with that philosophy.

 

Putting The Wind On Your Back

 

Notice that we compared an industry sector ETF (real estate) to the S&P 500, rather than an individual stock.

 

We did this because it’s a great way to determine if a particular industry group or sector has relative strength or weakness.

 

This is important to know because you don’t want to buy an individual stock that has a great looking chart pattern, but belongs to an industry sector with relative weakness.

 

If you do, the stock will struggle to move higher, despite its bullish chart pattern.

 

In trading, you always want the wind to be on your back.

 

Making sure the individual stocks you buy are part of an industry sector with relative strength (or at least not with relative weakness) is one of the most effective ways to do so.

 

Now that you know this highly effective and easy way to eliminate stocks and ETFs with relative weakness from your watchlist, you have no excuse for continuing to make one of the biggest mistakes traders make in a bull market.

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