Tuesday, May 02, 2006
Yesterday the market left those who have been paying attention a not so subtle message. Recall last Thursday when the Fed Chairman's remarks sent market indices soaring off of support on high volume. You may also recall the fact that a majority of stocks did not participate in that ghost rally. Now, juxtapose Thursday's market reaction to yesterday's counter reaction, also spawned by remarks from a Fed Board member. When the market dropped back yesterday nearly everything participated. Many traders grumbled about the Fed making comments to the media, complaining that the Fed should be more careful with their words. We would point out however that the market was likely looking for an excuse to dump. As we all know stocks trading at multi year highs have recently been trading like they are stuck in the mud. We have argued that this is distribution slowly taking place. Yesterday confirmed for us that we were right; low breadth of participation on Thursday's rally, high breadth of participation on Monday's late day dump. Now we need to keep a close watch on the trend lines. As we pointed out a week ago, the weekly market trends were in tact and stocks were trading at support. Yesterday the QQQQ and Russell 2000 both closed right at their trends. The S&P and Dow are still trading a few points above their trends, but the Dow has very likely put in a top. Do we short? Not yet. As most everyone knows, picking a top in a bull market is risky business. You can be right in general, but not right specifically and if you don't have very deep pockets to ride out the bounces shorting tops can be very painful. The better risk-reward scenario is shorting the failed throwback rally, which often occurs after a trend break. Here's a good example: Note that after the blue up sloping trend broke, the price rallied back up to tag the underbelly of the uptrend. The price struggled at this level for two days and then gave way. As you can see, shorting the throwback is a much higher probability trade than shorting the breakdown. Should we be worried about a market decline here? Only if you are sitting on profits in your long term portfolio. In that instance you should be taking measures to protect those profits with trailing stops. As traders we should embrace these potential developments. With stocks losing momentum into their multi year highs, the number of trading opportunities that actually follow through and work for significant gains have been shrinking dramatically. A good washout is what the market needs to help reset new opportunities. Like Clemenza noted in the movie The Godfather: "This thing's gotta happen every five years or so, ten years, helps to get rid of the bad blood."