Catching a Falling Knife?

Trying to pick a bottom on a falling stock or index can be a very difficult proposition and, in the trading business, has been likened to trying to catch a falling knife. Last Tuesday, when the Dow rocketed up almost 380 points, there was a lot of excitement and speculation about whether we had finally seen a bottom. Much of that particular move was evidently sparked by an announcement that Citigroup (C) had made a profit for the first two months of the year. The fact that a company has made a profit, particularly after major government intervention, is great, but one has to wonder whether it is earth shaking news. Often, the markets exhibit a tendency to overreact to a news event and though the news was certainly a positive in a market that has been filled with negatives one has to wonder whether the big spike was an overreaction or the start of a reversal.

In my individual coaching sessions, I always suggest that my students try to trade in the direction that gives them an edge. If the market, sector, and stock are all going down, for example, why take a long position? Who or what is to say that it is going to turn up and even if we say it is going to turn up, the question becomes when will it do that? Couldn't the stock just keep going down? Recent history has, once again, taught us that zero is truly a level to which some equities can descend.

While it may be very tempting to jump on board when prices are at such low levels as they have been lately (e.g. GM at $1.50, GE under $8), we need to remember that there is still room below. When stock markets, sectors and top stocks are bearish, my view is that it is best to make bearish plays or simply stand aside. Wait for the actual bullish turn rather than trying to predict. As I suggested in a recent article, no one can predict with certainty. If we think we can, we just need ask ourselves what will the news be tomorrow.

The Dow has been in a downtrend since the latter part of 2007 and it will remain in that downtrend unless and until it breaks up through the downtrend line. The same is true for the Nasdaq Composite and the S&P 500. That is not to say that there cannot be rallies in a bear market, but they are exactly that -- bear market rallies. They are to be expected, but it remains important that we understand the difference between a rally within a bear market and a break in the downtrend that actually can signal a return to the bull. Otherwise, we may find ourselves trying to catch that falling knife (or piano).