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Time for caution...

Posted by Greg Tolpigin on 07-Dec-2017 11:35:41

After a solid run higher in equities its time to begin to taking profits and considering index shorts. There are some serious short-term bearish signals for the ASX 200 and the small caps will be caught up in this. Be prudent as when volatility spikes, liquidity plummets especially in small caps.

- Greg Tolpigin

I have been of the view that the small caps will enjoy a prolonged period of outperformance to ASX 200, within that the “green” stocks will perform best (lithium, cobalt etc) that banks, retail and anything exposed to the domestic consumer should be avoided/shorted and to refrain from picking highs on the US market until price action determines its time.

Now I see reason to change tact, at least for the short-term as I see several concerning signs. Firstly, I am witnessing less bullishness and positive market reactions to ASX announcements from the small caps. Secondly, the stocks that led the Small Ordinaries higher have clearly lost momentum (GXY, ORE, A2M etc) in much the same way that the US mega-cap tech stocks have done likewise and are leading the Nasdaq lower. Simply, leaders are  beginning to falter. I still see ongoing evidence of a slowing domestic property market and little recovery in consumer spending. Finally, the technical setup is beginning to show some downside risks.

As a result of the above factors I think there are risks rising of a 3-5% pullback in the ASX 200 and US equities. Its time to move to cash and clean up portfolios.

The ASX 200 technical formation is similar to that of August 2016, where after a strong rally the index pauses, holds above the moving averages, makes one final 1-day attempt to rally and then eventually “rolls over” with the sell off accelerating once the 30-day EMA is broken.  Price action is identical here and I am very concerned a break of the 30- day EMA @5950 will send the ASX 200 back to 5800.

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Its not just the ASX 200 that is showing similarities to the August 2016 peak, but the Small Ordinaries as well giving more validation to the comparison between the two timeframes and why I am placing a high level of importance on it.

I must stressed first that my target for the Small Ordinaries remains at 3000 for Feb 2018. I believe this is a mid-trend correction and not the final peak. As a result, the subsequent sell off seen post the August 2016 peak is not what I expect. My expectations are for a smaller correction back to 2600/2575 where some great buying opportunities will appear in the “green” stocks.

Lets look at the technical similarities between the two formations. Both have come after a very strong rally that last many months. The final stretch of the rally is characterised by price action that begins to trade in a narrow band (almost a flag) that hugs the 10 EMA (purple line). The RSI exhibits bearish divergence (first indicator) in that final stage and the MACD (bottom indicator) is already heading south. All those identical factors exist now.

As the index begins to break the 21 and 30 EMA, the sell off accelerates. These EMAs are in the process of breaking now and why I believe it is best to begin taking profits especially after the strong run many stocks have enjoyed. I take profits on ORE, OZL, BHP on the long side of the portfolio as I raise cash levels and focus on index puts.

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The market is littered with the corpses of former “top picking” traders who have all been bulldozed by the S&P 500 and Nasdaq. It is why have consistently for the past 3 months stressed that until price action begins to show a peak is in place, picking tops will be hazardous and divert attention to where all the profit making opportunities have been – in the small caps.

Its been a great period but I am concerned its day are numbered and more likely over – for the short-term. I am not picking an end to the bull market here, but rather a 3-5% pullback that has been absent now for over a year. Wow what a run!

Following the market opening higher on Monday after the Senate passed through the tax bill, there was an immediate reversal. I don’t like that type of price action and tend to read it as a warning sign. Subsequently the leading tech stocks that have been the backbone of this rally all saw sharp drops.

Initially we have seen some rotation out of these former leaders and into banks and retail stocks in the US, but I don’t see longevity here and rotation only lasts for a short period before it too dries up and everyone moves to cash.

The price action is underpinning my concerns as the Nasdaq 100 rests on support at 6200 and the EMA’s are being breached as well. RSI divergence exists and in general such divergence in the past as shown in the top chart, the index has struggled for a while thereafter. RSI trendline support is also on the verge of breaking that stretches back 12 months. A break of this could easily see levels back to 6000 or lower.

The S&P500 doesn't quite have the same bearish factors but it still looks like a final move and I expect volatility to begin rising.

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I have also decided to introduce this new page of my favourite buys and sells as discussed in these notes. As I grow bearish or bullish stocks will be added or removed from this list. This should also help identify the specific areas of the market I favour most and vice versa.

Adding: 0

Recent removals: Galaxy (GXY), Cimic (CIM), Automotive Holdings (AHG), OZ Minerals (OZL), BHP (BHP), Orocobre (ORE).

I have adjusted the Long/Short Ratio from 80% long to 80% short.

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