The River Of Value

The best way in my view to begin to understand how the market behaves is to visualize it as a river - a river of value. The center of the river is the 50dema - the concensus opinion of value. The banks of the river can be represented by two envelopes of plus and minus 2.5 to 3.o ATRs (10 period). Flood stage can be represented by two envelopes of plus and minus 5 ATRs (10 period). The above chart shows this representation on the daily time frame.

I have placed arrows at points of value extreme. The red down arrows in 2007 were followed by periods of rapid selling. The gray and green arrows appear at periods of selling climax and trend reversal. The yellow arrows mark points of correction or pullbacks. The horizontal cyan trendlines mark points of trend confirmation.

There is a tendency of those in the trend following camp to focus solely on mechanical entries and exits, but I think this leads to an inability to appreciate how the market moves from being extremely undervalued to extremely overvalued. The period of September and October 2008 show how the trend can carry the market along at an extreme for an extended period of time, which is why we wait for confirmation of turns before initiating new positions in the opposite direciton. However, that doesn't mean that we can't recognize the extreme for profit taking. Waiting for confirmation of the turn may require that we give back a great deal of our profits. By taking partial profits at value extremes, we can reduce drawdowns and maximize gains.

We are now coming off the second trip to the upper red envelope. The trend is up, but this has been a good time to be taking profits as the likelihood of a pullback or correction is high. How it plays out, whether as a period of sideways consolidation or a sharp correction down to the trendline and lower extreme is yet to be seen, and since the trend is up, there should probably be some long exposure while preparing for short term shorting opportunities.