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The Market That Cried Wolf

Today I’m looking at the weekly chart of the S&P 500 Index, which starts near the end of September 2011.

Stock Market Video

The Market That Cried Wolf

This Week’s Fortune Cookie

In Case You Missed It

In this week’s Stock Market Video, Mike Cintolo discusses the generally deteriorating evidence in the market that has caused him to take another couple of steps toward the sideline. He emphasizes that the most important thing now is to be flexible—let the pundits predict where the market is headed, but it’s best for you to follow along week by week to make sure you’re in gear with the market’s major trend. The good news is that there are still a bunch of resilient growth stocks that could take off ... if the bulls can support the market for more than a day or two.

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The Market That Cried Wolf

Everything I want to write about today is contained in one simple chart. Here it is.

This is a weekly chart of the S&P 500 Index, which starts near the end of September 2011. It’s a very pretty chart in just about every respect, showing a market that’s been enjoying a resolute rally mode, and hasn’t been headed off by any weak economic data or nasty news stories. It’s a chart that a growth investor can really love.

But it’s also a dangerous chart, because, as is often the case with the market, it’s been teaching investors a bad lesson. (This isn’t really news to those of you who remember my maxim that, “The market wants to take your money,” but some of you may have allowed that priceless piece of advice to slip your mind.)

Why is this a dangerous chart?

It’s dangerous because for nearly three years the market has been teaching investors that every time the S&P 500 retreats a few percent, it quickly resumes its uptrend and returns to its trend line.

These pullbacks came in October–November 2011, April–May 2012, September–November 2012, May–June 2013, August 2013, January 2014, July 2014 and September 2014. There was also a choppy period in March–April 2014 that looked ominous at the time. And don’t forget the longer pause from March 2012 to near the end of the year when the S&P scored zero net gains.

Each of these dips was a source of anxiety, and every one of them brought a round of predictions that this was the start of a major correction. That’s always a popular prediction, and it will be trotted out on the flimsiest of evidence.

Now, you might think that as a growth investor (and the writer of an aggressive growth advisory on China and emerging markets stocks), I would be advising you to ignore these kinds of corrections as noise and keep your foot to the floor all the time.

But that’s not the danger I have in mind.

The danger in this kind of rally is that it makes you want to think that way. When an index falls below its 50-day moving average, even though you know it’s a danger signal, this chart is telling you that you can act as if it isn’t. And it shows you three years of evidence that supports that.

The market, in other words, has been crying, “Wolf!” for three years. It’s had eight pullbacks and eight recoveries to new highs. (The jury is still out on the pullback we’re in right now.)

And we all know what happened to the boy who cried, “Wolf!” Eventually the real wolf showed up and nobody believed him. (Yes, I know that the point of the fairy tale isn’t that you shouldn’t abuse the warning system; it’s the boy’s fault for getting bored and giving false alarms. But the effect is the same.

In the case of this chart, it’s the market that’s lulling you into complacency.

But at some point, the alarm won’t be false, the market will genuinely roll over into a correction and the investors who sit smugly and wait for the rebound will wind up like pumpkins on the morning after Halloween.

The moral of this story is that the price of success in growth investing is taking every warning signal seriously, time after time, even when the warnings have been wrong over and over.

When the major indexes fall below their 50-day moving average, you need to curtail your buying, purge your losers and tighten the stops on your remaining holdings.

If you have the patience, resolution and discipline to do this every time, it will eventually save your … uh … assets.

And that will make the minor inconvenience of reacting to all those times when the market cried, “Wolf!” seem very much worth it.

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Here’s this week’s Fortune Cookie. Remember, you can always view all previous Fortune Cookies here and Contrary Opinion buttons here.

Tim’s Comment: A genius whose reputation has been burnished by the centuries, Leonardo was one of the most diversely talented men of history, and certainly a doer, for which we are thankful. I have nothing more to say about the quote, but thinking about Leonardo, I’m betting he would have loved the Internet!

Paul’s Comment: If you’re going to be a doer, it’s certainly helpful if you’re a multi-talented genius, but it’s not absolutely essential. Even if you don’t wind up with The Last Supper, by following the rules and paying attention, you can certainly get your dining room wall looking good! It’s the same with investing. I’ve talked to many people who really want to take charge of their own investment programs, but just can’t quite pull the trigger. Let the spirit of da Vinci inspire you and just do it! You’ll have the satisfaction of taking action rather than just complaining.

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In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.

Cabot Wealth Advisory 9/29/14 — Tesla Road Trip

Cabot Stock of the Month’s Chief Analyst, Tim Lutts, writes in this issue about his experience on a road trip in his Tesla Model S, including all levels of charging power. Stock discussed: Tesla (TSLA).

Cabot Wealth Advisory 9/30/14 — Selling Big Losers: Why and How

In this issue, I explain why it’s so important to kick big losing stocks out of your portfolio and avoid such big losses in the future. Stock discussed: Ambarella (AMBA).

Cabot Wealth Advisory 10/2/14 — Big Changes to High Yield

In this issue, Chloe Lutts, Chief Analyst for Cabot Dividend Investor, looks at some encouraging regulatory changes that may increase the number of REITs (Real Estate Investment Trusts) and MLPs (Master Limited Partnerships) available to investors looking for income investing opportunities.

Have a great weekend,

Paul Goodwin
Chief Analyst of Cabot China & Emerging Markets Report
And Editor of Cabot Wealth Advisory

Paul Goodwin is a news writer for Cabot’s free e-newsletter, Wall Street’s Best Daily.