I have empathy for investors who unwittingly became a part of the momo (momentum) crowd, even though I often receive hate mail from them because they don’t like my description.

It is now high time for them to switch to a prudent strategy. Even prudent investors need to be extra careful about three traps ahead. Let’s discuss that but, first, let’s build the requisite background with the help of two charts.

Two charts

Please click here for an annotated chart of Dow Jones Industrial Average ETF DIA, which tracks the Dow DJIA.

Please click here for an intraday chart of S&P 500 futures ES00, which is based on the S&P 500 Index SPX.

Note the following:

• The first chart shows the Arora call Jan. 25 that an external event could hurt stocks. Five days before that, the U.S. had its first case of the coronavirus. As stocks were peaking, I was receiving a large amount of hate mail for raining on the bulls’ parade. But I use hate mail as a proprietary indicator. If hate mail goes extreme in one direction, the opposite usually happens. Please see “How an external event could stunt U.S. stocks.”

• Now the hate mail has changed, showing that many investors still have not taken any protective steps. They believe they will be back to break-even in a couple of months. This is a negative because bottoms are formed when such investors capitulate and sell.

• The first chart shows that the top support zone has broken. I had previously written that there was only a 30% probability of this support zone holding. When a strong support zone like this is broken, all rallies should be considered suspect at first. Please read “A watershed moment is on the way if stocks can’t hold this level.”

• According to our algorithms, forced liquidation of some portfolios has started. This is unfortunate for some but is a good positive step to an eventual bottom.

• The second chart shows three periods of vicious short squeezes, according to the algorithms at The Arora Report.

Three traps

Avoid three traps, which many investors, including money managers, are likely to fall into.

1. Differentiate between real buying and short-squeezes. Short-squeezes lead to artificial buying and often reverse themselves.

2. Even when real buying occurs, be mindful that some of the sharpest rallies occur in bear markets. I would not be surprised to see 20% rallies that fail.

3. Do not make up your mind based on past data. Which means do not refuse to change based on new facts as they emerge….Read more at MarketWatch.

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