“Don’t Fight the Fed” is a rule that we have all heard numerous times in our careers. It is the rule for which Dr. Martin Zweig is most famous. However, Dr. Marty had 16 other rules that he developed in this illustrious tenure as a money manager. According to Mark Hulbert, Zweig “brought a rigorously empirical and scientific approach to beating the market, which, surprisingly, was not the norm among advisers when he began his career.”

This appeals to the way we view the investment world at Potomac. I am not going to do a deep dive on Marty. That has been done numerous times. Instead, I am going to take each of his 17 rules and provide my interpretation of them.

1. The trend is your friend, do not fight the tape.

The simplicity of this rule is the reason that many investors ignore it. Many people feel that it is not intellectual enough to simply follow price trends. The fundamental CFAs often mock the trend following CMTs with jokes like “number go up bro!” as if they are above it. But the profits that you make from trend-following are real. It is more intellectual to understand that PRICE (not the balance sheet, not the income statement, not the cash flow statement) is the ONLY thing that pays you.

2. Let profits run, take losses quickly.

This is another simple concept that many investors fail to grasp. Taking a loss is an admission of failure, of being wrong and, as humans, we hate being wrong. Think about how hard it is to apologize to another person. Taking a profit feels good, it makes us feel smart. As humans, we like that; it means we are winners. Therefore, the tendency is to take a lot of small wins (to feel smart) and keep losing trades for a long time (it is not a loss if you do not sell it, right?).

3. If you buy for a reason, and for that reason if discounted or no longer valid, then sell!

When the facts change, change your mind. Unfortunately, narrative-based investors often become too entrenched in their views. This year gives us a great example of this. They entered the year with a bearish view based on the inverted yield curve, slowing economic growth, and a Federal Reserve that was still raising rates. As the market went higher, these investors remained bearish because breadth was bad, only seven stocks were leading the market higher. As this thesis was debunked by broader participation, the bears have now concluded that the rally is not sustainable because it has been driven by multiple expansions. Beware of “thesis shifting” on your part and on the part of those you follow.

4. If the values do not make sense, then do not participate. (2+2=4)

This rule is geared for the fundamental crowd. My only pushback here is that “value” is subjective. As such, an analyst can twist numbers to make a compelling case on any stock.

5. The cheap gets cheaper, the dear gets dearer.

This is another way of saying stay with the trend, in my view. Also, blindly buying stocks because they are “cheap” on some value metric makes almost no sense. Likewise, rejecting a stock simply because it is “expensive” also makes little sense. Cheap stocks are often cheap for a reason. Expensive stocks are usually expensive for a reason. You can spend time digging for those reasons, or you can simply follow the price trends.

6. Do not fight the FED (less valid than #1).

The rule for which Dr. Marty is best known. Interesting that it is not #1. The Federal Reserve controls the ebb and flow of liquidity in the market. More liquidity usually equates to greater demand for stocks. The opposite is often true as well. But note that even Marty admits that rule #1 is more important. At Potomac, we incorporate both rules into composite models. Those who have been following in 2023 know that our long-term trend model became bullish in January (Rule #1). However, the ”Don’t Fight the Fed” rule has made it hard to stay fully invested for extended periods of time.

7. Every indicator eventually bites the dust.

You must always test your systems and indicators. You should always be looking for new ideas that can add value. At Potomac, we use a metric called max drawdown. If any indicator that we use violates its max drawdown, we immediately begin to reevaluate.

8. Adapt to change.

This is a good rule for life, in general, not just investing.

9. Do not let your opinion of what should happen bias your trading strategy.

This is another rule that many have a challenging time following. We all have opinions; the market does not care. I have had my worst trades (as a discretionary trader) when I have formulated some elaborate opinion on why the market was wrong. THE MARKET DOES NOT CARE ABOUT YOUR OPINION. The problem with having a strong opinion (especially if you have expressed it publicly) is that changing your mind is to admit being wrong (see Rules 2 & 3).

10. Do not blame your mistakes on the market.

Take accountability. At the end of the day, you are the key decision-maker.

11. Do not play all the time.

“Timing” the market is better than “Time In” the market. I know this will upset the passive buy-and-hold crowd.

12. The market is not efficient but is still tough to beat.

I agree with this and push back on the Nobel Prize-winning Efficient Market Hypothesis. However, I believe that the market is extremely efficient, just not completely efficient. It is in the small gap between extremely and complete that active managers go to war with Mr. Market. Ask yourself, do you really want to take on that battle with subjective ideas like valuation and entrenched narratives? I prefer a systematic, rules-based approach with a focus on price trends.

13. You’ll never know all the answers.

The best that you can do is have a solid framework for generating probabilities. If you wait for perfect information, you will likely spend much of your time on the sidelines seeing your hard-earned money succumb to inflation.

14. If you can’t sleep at night, reduce your positions or get out.

Many investors think that they can handle risk when you ask them to fill out a questionnaire. But the true test comes when their capital is put to work. If they are tossing and turning at the sign of the first drawdown, then they are not capable of handling their current level of risk. That’s fine; we are all different.

15. Do not put too much faith in the “experts.”

I love this rule, and technically we are experts. However, this applies more to newsletter writers and even sell-side research analysts. Remember, all investors have different goals and risk profiles. These are usually different from those of the experts. Do your own homework. If you cannot do the work, there are plenty of licensed professionals who can add value.

16. Do not focus too much on short-term information flows.

Learn to decipher signals from noise. We live in a 24/7 soundbite world. The best investors have the best filters.

17. Beware of “New Era” thinking, i.e., it is different this time because…

I started my career at the absolute top of the dot-com bubble. “It’s different this time because of the internet.” I had friends who were graduating college and going to be “day traders” because it was so easy to make money. None of them are in the business today. If you missed the dot-com bubble, you could look at crypto leading into 2022. Matt Damon told you that “fortune favors the brave” in a Super Bowl commercial. It is never different; it is always cyclical.

As investors, it’s essential to stay grounded and not fall for the trap of believing that “this time it’s different.” History has shown that market cycles repeat themselves, and the emotional behavior of investors remains remarkably consistent over time.

In conclusion, Dr. Martin Zweig’s rules provide valuable insights for navigating the investment world. Following trends, managing profits and losses, adapting to change, and avoiding excessive reliance on short-term information flows are just some of the principles that can help investors make better decisions. Ultimately, successful investing requires discipline, objectivity, and the ability to stay true to a well-defined strategy, regardless of prevailing market narratives.

CMT Association’s Market Insights features timely technical analysis of current global markets by veteran CMT charterholders. Each post appears on www.tradingview.com/u/CMT_Association/ in an effort to explain process, tools, and the responsible practice of technical analysis. Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.

https://www.tradingview.com/chart/DX1!/AadiQME9-Reversal-Bar-Patterns-Part-3-Buying-and-Selling-Climaxes/

Reversal Bar Patterns Part 3: Buying and Selling Climaxes

US DOLLAR INDEX� FUTURES ICEUS:DX1!

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In parts one and two we covered the basics of reversal bar patterns including hooks, pipes, and keys. In this piece we focus on the buying and selling climax. In the final installment we will focus on upthrusts and springs.

The patterns covered in this series represent an overt change in the balance of supply and demand. Importantly, very few patterns set up as they would in textbooks or in my examples, but the principles are consistent. Understanding why they occur and developing analysis and trading judgement around them is a primary skill. In this regard, there is no substitute for staring at thousands of bar and candle charts.

One of the more important chart patterns is the buying and selling climax (BC & SC). Climaxes are exhaustion/capitulation patterns. A selling climax (SC) develops as weak handed buyers capitulate. Buying climaxes build as shorts capitulate and timid buyers who missed out on the rally are finally induced to enter. Selling climaxes are more about existing longs capitulating and selling. In general, the complete (perfect) pattern sequence consists of preliminary demand (PD) selling climax (SC), minor test (MT), automatic rally (AR) and secondary test (ST). Of the six, the minor test and preliminary demand are optional.

For simplicity we will focus on the selling climax. Buying climaxes conditions are the direct opposite with the exception that they tend to occur on lower volume than selling climaxes.

Climaxes typically occur in extremely extended markets that have trended a long while. The climax low is often made in conjunction with extremely bearish news flow, dismal sentiment, and a palatable bearishness. Put/Call ratios and other derivative measures are typically at extremes. I begin actively monitoring for the pattern when oscillators reach extreme readings or after a long period of trending behavior. I am more attentive on the second or third foray into oversold/overbought, particularly if there is a pronounced momentum divergence. The appearance of the climax strongly suggests that bad news has already been discounted.

Trends are often defined by three successively steeper trendlines. The 3rd and final trendline is often parabolic and defines the terminal portion of a trend. I am particularly attentive for the pattern to develop after the third trendline develops.

Climax structures are not created by strong handed/well informed buyers buying the weakness, but by over-levered and poorly placed longs capitulating and liquidating positions as their pain becomes too much to bear. The bearish news also lures in new weak handed/trading shorts, who, trapped by the sudden reversal, are forced to cover. The combination of the two clears the immediately available supply.

Once the immediately available supply is cleared, there is not much resistance to the market advancing. In Wyckoff terms the initial rally from the selling climax low is labeled the automatic rally (AR). As the AR develops, shares are often distributed back from strong hands to weak hands. Since supply has been exhausted, the AR can often cover significant ground. Opportunistic short-term buyers of the selling climax often use this rally to sell a large portion of the position built during the climax. Remember that the buyers during the SC are not generally long-term investors but are more likely sophisticated agile traders. They often take advantage of the reaction rally to take trading profits.

While climax behaviors often represent intermediate or long-term turning points, they can also represent shorter term exhaustion of the immediately available supply/trend. As the automatic rally develops new supply will emerge. Longs who resisted selling during the sharp decline to the climax lows, opportunistic traders who bought into the reversal behavior and new shorts all sell into this rally. Additionally, strong handed bearish fundamental traders may increase their line. This is why, for a climax to be trusted, there must be a secondary test (ST) that is well separated in time from the initial low.

In the weeks and months that follow a weekly perspective SC, the market will test near the climax low. The successful completion of the test generally represents an all clear for longer term positions.

The pattern is fractal. That is it shows in all time perspectives. The key is that the secondary test is well separated in time from the climax structure.

Preliminary Demand: There is often a sharp rally just prior to the selling climax. Wyckoff labeled this as preliminary demand (PD), a point at which strong handed longs are beginning to accumulate shares in anticipation of a turn. The PD is an alert to begin monitoring for a selling climax. The PD rally should be noticeably stronger than the rallies that preceded it.

Selling Climax: Climax patterns are typified by extremely heavy volume, much wider than normal price spreads and typically feature a clear reversal pattern (often a key reversal) bar or bars. There is generally an acceleration of the trend, with wider price spreads and a steeper angle of decline. At one time climaxes were mostly single bar affairs, but now the climax structure often builds over several trading days.

Minor Test: In the hours and days after the automatic rally begins, the market will often suffer a setback toward the SC. The appearance of demand on this setback solidifies the odds that the AR rally will cover reasonable ground. In many cases the minor test will only appear on intraday charts.

Automatic Rally: In the days following the SC the market will rally sharply. Volume is typically very strong near the beginning and tails off as the rally progresses. The AR often has a noticeably different character than prior corrections in the downtrend in that they cover more ground and volume is better. Distance traveled is important, the greater the reaction after the climax the more significant its implications. Small ARs are not to be trusted.

Secondary Test: Selling climaxes clear out the immediately available supply in that price zone. Even short-term climaxes can stall the market for a period of time (think trading range). But they can fail, and when they fail rapidly it is a solid indication of a continuing bear market. This is why climax structures MUST BE SUCCESSFULLY TESTED before they represent anything other than short term capitulation.

The test should be well separated in time, and occur on generally lower volume. Selling should be far less intense than on the initial decline. This is demonstrated by the general decline in volume and the angle of the testing decline. In other words, the angle of the decline to test should be significantly less than the angle of the original decline. I prefer to see them play out over several weeks (assuming a daily perspective outlook).

Trading Range: Often the test will take the form of a trading range during which strong hands, usually large institutions, accumulate new long positions. In future installments we will cover the analysis of trading ranges.

At times the market will make a V bottom with no test. In that case, when the new trend becomes unmistakable, you should begin utilizing traditional trend-based entries into positions.

To Repeat: The huge volume and the reversal bar offer a warning that things may be changing. But, without the completed test, a trend reversal is only conjecture. YOU MUST HAVE A COMPLETED TEST before deciding that a low of any consequence has been made.

Climaxes are fractal. They appear in literally every time frame. But the larger the time perspective, the more important the climax. It is also worth noting that the notes around sentiment are not particularly meaningful when working in time frame shorter than daily.

And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.

Good Trading:
Stewart Taylor, CMT
Chartered Market Technician

Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.