Here is a pattern I have noticed in the market about 10 times over the past 2 years:

1) The market goes on a 3-6 week run.

2) The run usually stalls when we get extended from the moving averages, bullishness increases (based on many sentiment measures), and active investment managers are aggressively long the market (based on the NAAIM survey).

3) Leaders start to break down, the market starts to correct down to (or below) its 50-day moving average, and many market participants begin to wonder if the rally is really over?

4) Just when some fear creeps back in (and sometimes it is EXTREME fear), the active managers begin to reduce their exposure, the market stabilizes for a day or two, and the selling abates. Then, we seem to have a non-stop grind to new highs for the next 3-6 weeks. The move higher usually occurs on low volume and without a valid follow-through day, thus further frustrating the longs who are waiting for a signal to get back in, and ALSO frustrating the shorts who don’t see a meaningful downtick.

5) Wash. Rinse. Repeat.

Right now, we are somewhere between steps 3 and 4. Here is the challenge: In the past, these warnings signs would lead to some sort of a pullback. Sometimes, it would lead to a bear market, but most of the time just a normal 8-12% correction. In our current QE environment, the market has conditioned us that If you get defensive and raise some cash, it is a mistake because being cautious has not paid off. However, if you stay complacent, one of these days the market will see some nasty follow-thru selling, and it could possibly destroy some people quickly (especially those who use leverage). Remember that the market is a master manipulator. It conditions us to think one way over and over and over until we are finally convinced of a pattern. Just when we think we have things figured out, the market magically changes character. Keep in mind that a pattern can continue for a while before the market eventually changes.

So what do we do now? It all depends on your timeframe and if you are a trader or an investor. Personally, I always lean towards the defensive side because I manage money for clients. My number one priority is to protect their assets, period! In addition, the best traders I have studied ALWAYS preach defense first. I have no problem reducing exposure at times because I am nimble enough to get back in if I need to. Unfortunately, the selling lately has felt like “forced liquidation.” Also, with QE winding down, it will be interesting to see if the market can muster up another non-stop grind up. Whatever you decide, know your timeframe! Don’t follow anyone blindly (including myself). You should have your own plan based on your own financial objectives and risk tolerance. Good luck!

I can be reached at:

Follow me on Twitter @jfahmy
Follow me on StockTwits @jfahmy