36 Rolls of Toilet Paper

Where is the only place a normal person feels good about spending $30 to purchase enough toilet paper to last a year in one visit to a store? Not only do you need an SUV to get the bundle home, you need a small condominium in extra space in your home order to have enough room to store them. Of course, I must be talking about Costco.

Because the current rally has gone so far so fast, a normal market would be ripe for a pullback. As such, I continue to look for some good shorting idea setups that would provide some gains and portfolio protection if/when the broad market takes a breather. Last week’s EFA short idea was stopped out with a small 1.5% loss.

In the daily chart of Costco, COST, below, the $216-$217 level has been very important over the last 6 months and as such would be expected to continue to be. Before COST finally broke below that level in early December, looking left we can see it acted as support 5 previous times. We know that once a level was support, broken it now becomes resistance which is exactly what we see happening. As the shares of Costco have risen off the December 24th bottom it is starting to struggle to continue its move higher the closer it gets to that resistance zone.  Notice also, how this same resistance coincides exactly with where the rising (red) 200 day moving average and falling (green) 50 day moving average meet adding more importance to that level. With price below this confluence of resistances and struggling, I am looking for COST to pull back here.

The best case is it falls, makes a higher low and forms a cup and handle pattern.  This would offer a great long entry for those with investment capital to deploy. Worst case, it falls and retraces the entire move (or more) made since the December bottom. If this were to happen this, too, would present another (even better) long entry. Of course, it will take a much longer time to complete so investors are going to have to be patient. For those short-term traders, taking a short here with a stop just above Tuesday’s 215.5 high offer up another excellent risk reward setup for those that can short and are nimble.

The World’s Most Important Island

Ok, I have to admit the title is a bit sensationalized. The world, in the case of this blog post includes all of the world except the US and Canada. With that in mind, a very interesting island reversal pattern has developed in EFA, the index ETF that attempts to track the worlds developed stock markets (sans US and Canada).

Island Reversals (From Stockcharts.com)

An island reversal is a reversal pattern that forms with two gaps and price action in between the two gaps. These gaps tell us that the island reversal marks a sudden, and sharp, shift in direction. Even though they are relatively uncommon, island reversals are potent patterns that warrant our attention. 

The alignment of the gaps holds the key. First, note that a bullish island reversal forms with a gap down and then a gap up. A bearish island reversal forms with a gap up and then a gap down. These gaps overlap to create an island of price action, hence the term "island reversal". The island is above the gaps on a bullish island reversal, and below the gaps on a bearish island reversal.

Taking a look at EFA’s chart we can see yesterday’s gap down formed the final candle to confirm the pattern. If you look left, in spite of their rare occurrences, I circled where EFA formed an island top reversal in December which lead to a 10% decline. Because EFA is below a falling 200 day moving average, is making lower highs and lower lows, this pattern has major significance and a warning to investors of the potential for another leg down in stocks. If and only if price reverses course higher soon, fills the gap and closes above Friday’s high does it negate this bearish pattern. Forewarned is forearmed.

 For traders, this is a nice-looking short selling risk-reward setup. Selling short Tuesday’s close and using a stop just above last Friday’s high as your stop, offers a trading opportunity providing a potential $4 gain for every $1 risked. Downside target is back at December’s low.

Back-testing

A book on classical charting would use the chart below of Carvana, CVNA, as an almost perfect example of a head and shoulders topping pattern. Not only does it show almost perfect symmetry but also what can happen immediately after the pattern confirms, a back test.

When I speak of confirmation, I am just referring to price actually breaking and holding below support (red horizontal line). What happens quite frequently once a pattern confirms is a back-test to the (red) support (now resistance) line. Ideally, if you missed the opportunity to short the pattern on the break down, a back-test provides a wonderful opportunity to enter. Additionally, the risk is very small as a break back above the support line (now resistance) would invalidate the pattern and signal its time to cover the short. Typically, with a back-test entry all you are risking is 3-4%.

What makes this “opportunity” a higher probability to occur, is that price is below both the 50 and 200-day moving averages which are bearishly aligned (the 50 is below the 200). This pattern has an associated target all the way back down to $2 (no, not a typo) which is unrealistic. so taking the higher probability alternative, the first target is instead down at last May’s lows near $24, an almost 35% decline from the back-test level. With this opportunity providing more than an 8:1 reward to risk ratio, this is an outstanding setup for those with both able and capable of shorting stocks.

An Historical Perspective

As mentioned in my recent January charts on the move video, based upon looking at hundreds of thousands of charts, markets that decline double digits most often retest their bottom after the initial rally off that bottom. I thought the historical data below would be worth providing to support my observations. From the 12 prior 20% drops from a unique all-time SP500 high, you can see that 11 of the 12 retested prior lows from the initial oversold rally. In the bottom row I have included the current decline based upon Friday’s close for comparison purposes.

While the sample size is not huge it covers every drop that met this criterion since (and including) the Great Depress and help makes the case of why you should seriously consider being patient before buying the first bounce once exceeding the 20% decline.

Maybe This Year

On Jan 2, 2018 I walked into Melanie’s office and told her I had set a goal for myself to see if I could double my small, trading account IRA account in one year (achieve a 100% return).  An ambitious goal but something that is doable with good risk management, some leverage, active trading and of course must include a dash of luck and a cooperative market.

With 2018 now in the rearview mirror and a tally of the results I have to come clean, I did not achieve my goal. In fact, I was far below it. Disappointing no doubt as at one point in the year I was up more than 70% with about 40% of the year left to go I thought it was going to be a slam dunk. I had it all mapped out, I was going to sell everything once I hit that 100% mark and sit in cash and wait for December 31. But, alas, Q4 happened. I didn’t react fast enough to the rapid change in sentiment and so I fell hard with the market. Deal with it big boy, the market is talking and doesn’t care what I want or think. Oh yah, the “Woulda-Shoulda-Coulda” game is a waste of emotional and brain capital too so don’t do it. Its non-productive. If you don’t like the results, change your process.

My return for the year was 25.7%, not bad as I outperformed the SP500 by almost 32%. But those that know me understand “not bad” is not what drives me. So, being the uber competitive individual I am, I will, once again, set another goal to double my account for 2019. The odds are I will fail even worse than I did this year. Why? Because I am human. 2018 provided me the opportunity to fly under the radar with only one person knowing my goal. No external pressure or embarrassment if I failed, just my pride was at stake. You see the sad thing is as humans we have a tendency to act differently the more sets of eyes that are scrutinizing what we do, especially when money is involved. Even though I have the same set of trading rules, because of emotions that drive decisions, I am more than likely going deviate from them even though I know I should not***. Hopefully my genetic stubbornness, adjustments to my process and most importantly my real goal for doing this can keep my emotions in check. I want to make it clear, if I achieve the goal it’s not because I want to gloat or brag, or even because I want a bigger IRA (although I don’t mind this), instead I have something that is way more important to me. I want all clients and readers to know beating the market (and hopefully substantially) is doable in spite of Wall Street’s mantra it’s not possible. If Wall Street is too dumb (and this has nothing to do with intelligence) or lazy, that doesn’t mean it’s not possible. Peter Brandt taught me this and it changed my life. My goal is to do that same for some of you.

Let’s be real. Can beating the market be done every year?  Nope, not going to likely ever happen every year over a long run by anyone let alone me. All of my mentors and people I follow and compare methodologies and processes with do it regularly, but not every year. Each of them has experienced underperforming years, some terribly so. That is going to occur with random markets, it’s inevitable. And what is a common trait is that those individuals become better when they fail. They key-in on and learn from their mistakes/failures, something all of us should do if we want to get better at anything in life. They are also in a continuous loop, never staying idle or complacent but always improving. To be a successful investor all that is required is 1) have a process that provides positive expectancy 2) insure steadfast discipline following the process, 3) access to multiple markets to invest in (more than just stocks and bonds) and 4) an unwavering desire to outperform (a politically correct way of saying being an overly competitive pain-in-the-^%$.

Maybe this year.

Any doubters feel free to email me as I will be more than happy to provide a validation of trades and account values. And no, in case you were going to ask as others already have, I can’t do this for anyone else’s account.  Sorry. On the other hand, if you would like to learn how, please send me an email as I’d love to share with anyone what I have learned (what’s the old Chinese proverb about teaching a man to fish?).

***If you want to learn more about this human trait, there is a really interesting and true investment story you can read, just google the “turtle traders” or email me and I can send you an ebook.