That infamous question asked by children in a car, “are we there yet?” The anticipation of getting to the destination prompts the question. The media and investors have been waiting for the index to eclipse the old highs from 2007 since the bottom in March of 2009, and now the opportunity has arrived. Earlier this week we discussed that the S&P 500 index was inching towards the highs and joining the Dow Industrial Average in a breakout. The climb from 1550 to 1565 has been like watching paint dry. That aside, what happens if we get there? And then what if we never get there? The answer to those questions is just as important as getting there.
The first scenario is we get to the high, breakout, and go on to close below the 1565 level. That is likely the worse case scenario in that it would lead to a high probability of a correction or pullback in the index. Being that the headlines are full of those who believe the index is too high to begin with, it would pacify most everyone in that we would hit a new high and get the correction all in one opportunity. Trading this move would be a high risk proposition. If we buy on the breakout with momentum, and reverse, only to see it fail and correct, there is a high probability of losing money. The trade would be to buy on the conviction the index is going higher, or sell short on the conviction the index will reverse and move lower. From my view both have equal risk at this point in time.
The second scenario is we eclipse the high, reverse and close lower, all in the same day. The failed breakout intraday would be discouraging, but the buyers would likely make a second run at the breakout. Thus, the outcome would favor some consolidation near the high with an another attempt to breakout. That setup for the move higher would be favorable for investors who like swing trading. It would give a clear set up with a lower risk entry and definable target. This scenario would require greater patience from the investor along with a defined discipline for capturing the opportunity of the move. This scenario would offer a lower volatility outcome for investors.
The third scenario is we get to the new high, break through and accelerate higher. Of course that is the desired outcome of every investment. The challenge currently with the S&P 500 index chart is the index has run 75 points or five percent with one negative close of minus four points. In other words, I will say what everyone is thinking… how much farther can it go without a pullback or correction? This is like the people in a casino standing at a roulette table looking at the board showing the last ten numbers have been red, and continuing to bet on red. If you have ever seen this happen, you know that the majority of the people betting are betting on black. Why? They believe the statistical probability of the next number being red is infinite. The reality is, the same probability exist when you spin the wheel because the wheel has no emotions in the outcome. The market is a collection of buys and sell daily from emotionally charged investors, who like the roulette player, believes they know what the outcome will be. The reality is, it can happen that the index will trade higher without a correction, and the current probability of this is just as likely as the first two scenarios… even if we are convinced the outcome will be black.
The fourth scenario is we never make it to a new high and reverse lower from here. Unless there is some news out today that is negative enough to create this scenario I don’t see this as the likely outcome, but then I have been wrong before in my projections. If this occurs I would look for a pullback in the 5-7% range and then another run at the high later. Since it is a possibility we have to prepare for the outcome. We are always addressing our stops or exit points based on the time frame of the position, and we would adjust our stops heading into the trading day to account for this possibility.
I am sure we could come up with even more scenarios for the possible outcomes relative to this event, but in the end, what matters, is that you have a plan going forward. What will you do if… The current event of hitting a new high on the S&P 500 index is a great talking point, but the same discipline and strategy has to be implemented every day based on your goals and objectives. This is simply called risk management, we just happen to be talking about a point on a chart that peaks most investors interest. Therefore, use this as a learning opportunity of how to manage all your positions relative to the potential outcome each time you put a position in your portfolio. You will find you become a better money manager because you are addressing the risk of the trade relative to various potential outcomes.
Chill the champagne and prepare for the outcome.