A couple of weeks ago I introduced the concept of stock market situational awareness. We adapted the idea from law-enforcement and military tactics. One of the key points was that situational awareness is more of a mindset than it is a particular set of skills. In his online article on situational awareness, Scott Stewart puts it this way:

The primary element in establishing this mindset is first to recognize that threats exist. Ignorance or denial of a threat make a person’s chances of quickly recognizing an emerging threat and avoiding it highly unlikely. Bad things do happen. Apathy, denial and complacency can be deadly.

Situational awareness involves different levels of awareness for different conditions. A commonly used set of levels is known as “Coopers Colors”. One site described the different levels of awareness this way:

  • White: You are relaxed and unaware of what is going on around you. If you are attacked in condition white, you are in big trouble.
  • Yellow: You remain relaxed, but are aware of who and what is around you. If you are attacked in condition yellow, it should not come as a total surprise.
  • Orange: You have identified something of interest that may or may not prove to be a threat. If you are attacked in condition orange, you should be expecting the attack.
  • Red: If the focus of your attention in condition orange does something you find threatening, you will shift to condition red. If you are attacked in red, you should be fully prepared to defend yourself.

We can easily adapt this system to our own purposes as investors … and right now, my feeling is that we’re in condition orange.

As stock market investors, I don’t think that we can ever afford to be in condition White. That’s why we always use one or another form of trailing stops on our investments. Anything can happen to a stock at any time. As common shareholders, we can’t afford any level of complacency. Our position is never secure.

As I write this today, Volkswagen appears to be on the verge of an overnight 20% correction. Volkswagen! This is a massive publicly traded company, taking a 20% haircut because of a “surprise” discovery of a “defeat device” on their emissions testing.

Earlier this year, Volkswagen made a high of about $253 in April of 2015. If you had been using our volatility tuned trailing stops you would have been out on a 20% correction at around $202. Even if you had been using a 25% trailing stop, you would have been out at about $190.

volkswagon

Today, however, investors in Volkswagen are looking at losses of almost 50% from the recent high, and it could get even worse. That’s tough to take … and unfortunately, it happens far more often than the statistics say it should.

If you’re a bond investor in Volkswagen, you’re not likely to lose your interest payments. Stock investors, on the other hand, simply can’t afford to ever be asleep at the wheel. At a minimum we are perpetually in the Yellow alert conditions. We need to remain relaxed while maintaining an active awareness of our surroundings.

How do we do that? Simple … trailing stops and position sizing.

Current market conditions, however, are far from normal. We’ve been in a six year relentless bull market in stocks. Volatility is expanding beyond its recent ranges in every sector of the market. Our volatility tuned trailing stops are stopping out all over the place.

In the S&P 100, over 60% of the component stocks have hit their Smart Trailing Stops. In the tech-heavy NASDAQ 100, 54% of the stocks are currently “stopped out”.

These are not normal market conditions. I would say that, per the Orange alert condition, we have “identified something of interest that may or may not prove to be a threat.” We should be expecting an attack … and hoping that it never comes.

The broad stock market still remains perilously close to a tipping point. Here’s an updated chart as of the end of the last week:

SP1

Of course, nothing is what it seems these days. As suspicious as I am of this current stock market, I remain fully open to the possibility that this whole correction could be a giant shake-down prior to a blow-off top.

It concerns me deeply that bullish investor sentiment is at a low and bearish investor sentiment is rising. This chart shows the S&P 500 in gray overlaid with what percentage of individual investors (from AAII) are bullish about the stock market and what percentage are bearish.

SP2

The vertical black lines show when bullish sentiment bottoms and bearish sentiment peaks. It’s not clear yet if that’s where we are in this cycle but you can see that each of these times in the past, these turn points have preceded stock market gains.

Another piece of data that has me cautious about leaning too far to the bear side of the boat is my own proprietary time-cycles research. I’ve written about this a few times before. I look to it at critical times to help tell me which way the wind is blowing.

The most important time cycle in the stock market right now is the 119 trading-days cycle. Here’s what it looks like currently against the S&P 500:

SP3

My time cycle studies show that the wind is at the back of the bulls through mid-November.

So again, it’s time to play defense in the stock market and to be on alert but I’m not yet seeing all the signs that a full-fledged Red alert status is imminent. We’re still at the Orange alert level as far as I can tell.

There are still some great looking opportunities out there. A couple that came across my desk today are Lockheed Martin (LMT) and the US home-construction ETF (ITB). Take a look:

lockheed
 

ishares

We follow our stop-losses and position sizing no matter what level we find ourselves at but at the Orange alert level we need to be more cautious than usual.

Staying alert,

Richard_Signature
Richard M. Smith
CEO, TradeSmith
Founder, TradeStops.com