Hedge Fund Trading Lesson: How To Spot A Market Top Featuring PJP

Do you enjoy predicting market tops or calling bottoms before they happen? Or are you an investor who uses fundamental analysis and as a result, you are constantly late to the party?

If you are like most investors, you are constantly trying to buy the very bottom or short the very top of the stock market. Fundamentals always lag the current market price and timing is definitely not a specialty of the fundamental analyst.

Did you know that calling the top and bottom of the market is impossible and that partaking in this ritual will cost you a lot of money in the long run.

Most people end up calling the top weeks/months/years way too soon. They get it right eventually but as they say in life, 'timing is everything' and this is especially true if you are investing in the markets.

I know you will never stop trying to call market tops and bottoms so I'm going to do everyone a favor, I'm going to show you how to react to a potential top or bottom in any stock or ETF. 

Today's installment from the series, Trading Lessons From A Hedge Fund Trader will focus on the ETF PowerShares Dynamic Pharmaceuticals Portfolio PJP as per our reader's request (Ed B.) on the Free Stock Analysis For Your Portfolio service. 

This article is also dedicated to Reginald, he currently works for a Private Equity Fund in the Drug Royalty space and he was my Equities and Futures Back Office analyst at a Hedge Fund.

Fundamental Situation

The PowerShares Dynamic Pharmaceuticals Portfolio (PJP.NYSE) is based on the Dynamic Pharmaceuticals IntellidexSM Index (Intellidex Index). The Underlying Intellidex Index is comprised of common stocks of 30 US pharmaceuticals companies. 

The Top holdings of this ETF include Amgen, Gilead, Celgene, Eli Lilly, Johnson & Johnson, Pfizer and Merck. The stocks in this group benefitted from the Federal Reserve's monetary policies and are behaving like stocks fueled by jet fuel. The ETF's holding are red hot, but we all know that the current market's price action is totally unsustainable.

PJP has a P/E of 20 with a yield of 1.18. The P/E is on the extreme side of value and the yield is on the low end for large money making machines. This is not a story about the fundamentals, this all comes down to the Federal Reserve's monetary policy and their influence on the markets. They clearly want you in risk assets (stocks) and the charts of the ETF's major holdings prove that point.

Learning How To React To A Potential Market Top

As you already know, I always take a look at the long term chart of the stock or ETF that I am analyzing. It really helps me nail down the overall thesis for my stock recommendation.

When you see a stock chart that looks like this, then NEVER EVER short it unless you are a professional. You will get killed, I promise you that.

There are ways to short this puppy but you will need the stock to give you an ideal setup that will allow you enter the short. I'll explain later in this article.

                                                                                                                                             

This chart looks like the typical FED induced chart. Mature blue chip stocks in the Intellidex Index should not have the growth characteristics and chart patterns of upstart biotech firms. 

I treat stocks as to the way they are behaving and not by their name. When a stock's chart pattern looks like a growth company then I treat the stock like a growth company.

PJP is acting like a high beta growth company and not like a blue chip index so I will treat it like a high beta stock.

Do you remember the Cliff Hangers game from the Price is Right? The Yodeler keeps climbing up the steep cliff until he falls of the edge of the cliff.

What do you think happens to the PowerShares Dynamic Pharmaceuticals Portfolio PJP when the FED is forced to taper? 
Add the U.S. government shutdown to the equation and you have the potential for a meltdown.

Let's take a look at the 6 month price history
 

                                                                                                               

The PowerShares Dynamic Pharmaceuticals Portfolio PJP has been resilient over the past 6 months. Nothing, I really mean nothing could keep this Pharmaceutical's price down.

The FED day

September 18, 2013 (The FED day) was a really important day for PJP. Remember how I keep saying that the FED plays a really big role in the direction of the stock market, mark down all the FED days on your charts and see how the market reacts days after the FED release.

                                                                                                                                 

I wrote in a previous article that a CLOSE price above the $47.40 high was a signal that it was OK to go long PJP.

I also listed that we had a short set up for PJP as well. I didn't outline the trade but I gave you a clue in the graph. I circled the important bar and marked the high and low for the FED day. A Close above for a LONG trade and a CLOSE below for a Short trade. I recently introduced the concept of ATR (average true range) in another article.

Homework

How would you combine the FED big bar strategy and the concept of ATR to get into a short PJP trade?

Email me at joellaceda@behindwallstreet.com and i'll let you know if you are correct. This is the best way for you to learn how to be a complete investor. 
Try the challenge. 
If you are correct then I'll give you a copy of the latest Flagship or ETF Total Return Newsletter for Free.

Conclusion

We know it is a suicide mission to be too early when it comes to shorting market tops.

Here are the things you need to see before entering a Short trade near a market top.

1. The long term price history needs to be slowing down and changing shape.
The stock hasn't made a new high since August 1, 2013.

2. The Short term price history needs to show you an actual change in direction.
PJP had 2 consecutive down days below its 50day moving average. This was the first time this happened in over 6 moths.

3. The fundamental reason behind your thesis to go long or short needs to be validated.
In this case we have the FED, it was the major catalyst behind the stock market's accent. The lack of a FED taper when the market anticipated a Taper on Sep18, 2013 did not help the stock go up. The positive news of no Taper (unlimited Fed spending was continued) actually forced down the stock and it hasn't closed above the Sep18 Closing price since.

4. Negative News is making the stock go down. 
The Government shut down has pushed this stock to its lowest levels since August 2013. When a stock is truly strong, even the negative news won't push down the stock. 
The positive FED news actually pushed the stock down and that is a really bad sign.

For more information on the PowerShares Dynamic Pharmaceuticals Portfolio PJP, I will be giving my exact trading recommendations at Profit Behind The Blog and our ETF Total Return Newsletter.

We do not do the typical Buy, Hold, Sell rating. 
That in my opinion is complete garbage. 
I will be giving you the detailed trading plan as seen in the 'Has Disney lost its magic' article. 

This is a cursory look at the PowerShares Dynamic Pharmaceuticals Portfolio PJP and we are not making any specific buy or sell recommendation but merely voicing our opinion of the current situation. Each individual investor must conduct their own due diligence of both the company, the market sector as well as their own financial situation and risk parameters.

If you ever find yourself in a prickly situation, take a breath and pause, call a few audibles and do what Peyton Manning does, take what the defense is giving you.

By Joel Laceda - October 9, 2013 BehindWallStreet.com