4th of July Rally Kicks Off

Right or wrong, institutional money bet on an end to rate hikes yesterday. In yesterday's report we outlined the similarities between Wednesday's market sell off and the down day on October 27. Now with the market up on big volume and the fact that the market never truly followed through lower after the June 8 capitulation day, the chances of a strong rally similar to last November's is quite high. Continue to manage volatility as this market can still shake people out of good positions, but consider accumulating aggressively on dips.

Indecision Rules Before Today's Fed Meeting

Scans today reveal that a very large number of stocks have moved up to tag the under belly of their respective 50-day averages. Meanwhile the major indices have yet to break their downtrends and are trading very close to resistance. Overly bearish sentiment kept a floor under the market yesterday but now we have extremely mixed readings. S&P options traders are extremely bearish, having purchased 4 puts for every 1 call option. QQQQ options traders on the other hand are getting a little too bullish once again. What we have here is a market that can go either way. Either stocks are going to break their respective downtrend lines and start moving back up in a continuation of the relief rally, or we are on the verge of another leg lower. The problem we face today is that virtually no one knows what is going to happen. The market is going to turn on today's Fed meeting and fireworks after the notes are released are probable. Doing anything in front of this meeting with this type of market set up is a gamble that will very likely not pay off for anyone. We would not be at all surprised to see the market move wildly one direction at the time of the Fed release, only to swing back wildly in the opposite direction as the comments are parsed and digested. Bulls and bears are both likely to get burned in the storm so it is our advice to just step back and stay away. We have some open half-sized positions. At this time it is best to just keep open position sizes small allowing for flexibility to react once the dust settles and there is once again an exploitable advantage. Oil stocks and some of the metals have thus far been holding up better than the broader market. It will be interesting to see how these sectors respond to the Fed today.

Gloom and Doom Spells F-L-O-O-R

It feels like we have been in a deep bear market sell off during the month of June but the truth is the market has virtually gone nowhere since it marked what we considered a capitulation day on June 8. Yesterday's sell off simply brought stocks back to the bottom of the current trading range and in doing so inspired hapless options traders to once again take an overly bearish stance. For the first time in weeks both OEX and QQQQ options traders are in agreement. They agree that we are going to correct lower to the tune of buying more than 2 put options for every 1 call option. As our long time readers know, when this group of traders leans too hard one way they are almost always wrong. In fact the accuracy of their bad market calls has proven to be a very reliable reversal indicator. During this 6-week sell off the QQQQ cut through its 200-day average like a knife through butter, not even slowing down to take a rest. In our experience over the years bulls just do not give up on the 200-day average so easily. There were extenuating circumstances as the Japanese equivalent to the US Federal Reserve raised rates last month causing heavy institutional speculators to pull out of their huge metals and oil positions last month causing a world-wide market crash. This in turn caused the waterfall breakdown that forced the US investors to sell down to their comfort levels. Now however as things look ever so gloomy and the market looks to break down to another new low we think there is a very good chance that many will be surprised as the market rallies hard and regains the broken 200-day average on the QQQQ. Note the similarities between yesterday's sell off and October 27, 2005. With bears overly exuberant and with everyone scared, it will be interesting to see if the market does indeed once again surprise the greatest number of people and rally. Today we would like to see a consolidation day. This will give us time to evaluate which stocks to buy and which to avoid.

Gearing Up for 4th of July Rally

We continue to experience wide daily price swings making it necessary to scale into our trades in pieces. Buying smaller shares sizes provides us with several advantages. First it provides flexibility, allowing for us to add on shares once the market provides more information. Second it allows us to move our stops out wider so that we don't get stopped out on market noise. We believe that these and other advantages far outweigh the small increase in brokerage fees. We are nearing the end of the month when trading advantages are strongest and where we generally see a rally due to an injection of new money into the market via retirement funds. This month we could potentially see a stronger rally than usual. The fourth of July rally is a cyclical rally that often arrives as pressures from the "sell in May and go away" culminate into an oversold condition that produces a mid summer relief rally. This year the factors are all in place for just such a rally to ensue. We may see some weakness in the beginning of the week, but we plan on using any potential weakness to accumulate.

Time to Start Buying Dips

There are many tried and true rules related to investing and trading in the stock market. One of these rules is "don't try and catch a falling knife." Contrary to this rule is the strategy of buying the dips. Buying the dips seems to contradict the rule of avoiding falling stocks, so which is it? Well, the answer is that there is as the Ecclesiastian noted, there is a time for everything. Buying dips at the end of May certainly turned out to be the wrong thing to do as the month of June started out with a waterfall-type slide that crushed the bulls. Now the major indices have returned to the downward sloping resistance line that turned stocks back early this month. We are very likely to get another slide back near recent lows. This time we argue however that the time has come to buy the dips. Why? Because there is evidence that smart money is already buying them. Money flow figures have been rising even as the market has been under pressure this week. We are very likely going to get some strong downward moves over the next few days that will shake loose the weak hands, but the way that smart money is now positioning itself we will be looking for a much stronger rally to ensue toward the end of this month. The bottom line is that now is the time to be buying the hard dips and avoiding strength. Use a scaling entry strategy because we don't know where the market will bottom. Recent lows may be tested or the market may bottom slightly lower or slightly higher. Europe is already showing signs that it is ready to move higher. We believe that metals will lead the way in the US markets. Again, don't chase what's going up, but begin to nibble at what's going down.

Europe Leads the Way

The broader US market is still churning, but it's time to take another look at Europe and the metals markets. European stocks beaten down after the emerging market crash has now produced a large number of stocks that have just pulled back to their long term up trends. The accumulation apparent in this market is quite strong and the strong European trend should be ready to resume. Gold and other metals have been hit harder than most but the majority of mining stocks showed accumulation even as they retraced as much as 50% of their recent gains. This shows that there is a lot of confidence in this market by smart money who has been using the gold crash to accumulate for their longer term horizons. It's a good idea to start getting aggressive with this sector as it has a lot of promise over the next few years and right now the miners are relatively cheap.

Bond Market Set to Rally

There is some indication that the bond market is close to bottoming and a potential rally could ensue. This would probably give a boost to the weak market giving us a tradable rally. S&P options traders have already become overly bearish, indicating a bottom is near in the big caps. There remains a disconnect with the QQQQ however as options traders are fairly complacent still and betting a little too heavily on the long side. There remains an open gap on the QQQQ at $37.65 so it is likely that we will see one more plunge before a real floor is in place. Hopefully a plunge back to the lows will inspire enough fear and bearishness that real capitulation can take place and we can then finally put this downtrend behind us.

Trend Still Down

$39.00 is the magic number for the QQQQ. This index is still struggling against its downtrend line, established from the drop, which started early May. If it can close near $39.00 then we might have a bottom in place. As of today however the downtrend is clearly locking in stocks and proving an entry point for sellers to reestablish their short positions. After a two-day rally last week, yesterday we saw what should be a resumption of the downtrend. Since the path of least resistance is down, it is best to position for more downside. Projections at this time show a retest of last week's lows and potentially a minimum of one more lower low before we will see significant support start to develop.

Play the Downtrend

The Japanese Central Bank has exerted pressure on the global market draining billions from markets around the world over the past several weeks. These are the realities of the global economy we are now in. It is likely that the US will pressure the Japanese banks and the bleeding will be tightened before the emerging markets are sent into a tail spin toward depression and western markets slump even lower. At this time the shock is serving to cheapen stocks and create a very nice buying opportunity as investors start to throw out everything in fear. Nevertheless, the downtrend we are now firmly in has not yet found a bottom and until it does shorting strength and breakdowns is the way to go. The stall on Friday should mark the spot where the market will once again turn lower. A move higher this week however should not be taken as a bullish sign, but should rather serve as an opportunity to short higher. As we outlined on Friday the market does not have a base of support and the move on Wednesday and Thursday is unsustainable. A move higher would merely take major indices up to the top of their falling Bolinger bands, setting up another waterfall-type leg lower. In essence, a move lower from the current level would actually be a more bullish scenario. Traders became too bullish once again last week and another long failure would very likely create the kind of demoralization that is needed to set the crowd in the right mood for capitulation. With the economy making some real strides over the past few months a move lower is the ideal set up for a very strong move higher, much stronger than that which we have experienced over the last two years. There is a good chance we will see capitulation this month, but again, until we see it, we need to be selling strength. Because we don't know if the market will fall from current levels or go up to test higher resistance first, it is a good idea to scale into trades.

Why We do not Think a Bottom is Yet in Place

The last two days we have seen a rally nearly as striking as the crash we experienced earlier in the week as last Thursday's reversal day didn't stick. Many want this to be a bottom but we believe that it is not for several reasons: 1. Today is quadruple witching expiration day. The QQQQ and SPY price rally over the past two days has simply moved these two ETFs up to their maximum pain prices. This is called "parking the car in the garage" by Wall Street traders. In other words, the prices have simply moved back up to the point where put sellers maximize their profits and where put buyers over the past few weeks have watched all of their profits erode. Coincidence? 2. The put/call ratio on the QQQQ has gone from 4-1 in favor of puts at the beginning of the week (overly bearish) to an overly bullish 2-1 in favor of calls. This wild swing in sentiment from the bear to the bull side by this group of traders who are almost always wrong at the extremes simply indicate that this wild ride we have been on is not yet ready to stabilize. When two calls are purchased for every put the market will usually reverse lower within a day or two. 3. The QQQQ has only rallied back up to tag broken support between $38.50-$39.00. The SPY has only rallied back up to tag its broken 200-day average. These are classic throwback patterns up to resistance. Pros will use these types of throwbacks to put on shorts and to exit longs that they have been burned on. The market may indeed have put in a bottom but the odds are strongly against it. Longs have a lot of proving left to do. Until we see real capitulation and bottom-building activity we have to recognize the fact that the trend of the market is now down. We are looking for a more significant bottom to form later this month. Right now though surprises are most likely to occur in favor of the trend and again traders are too bullish and the trend is down.

Yes it's hard, but now is where the money is made

The market slide we have experienced this week has been brutal. The drop has been so sharp and the slice downward so steady that it has provided virtually no bounces to sell into. A writer from Real Money made this interesting remark yesterday, which sums up perfectly this week's market environment: The action since the first week in May has been some of the most challenging that I've faced during my trading career. What has made it so difficult is that we have had so many days in a row in which things have gone straight down. Typically, when the market starts to break down, I will continually lighten up my holdings on a bounce. Usually the first big technical breach results in a fairly fast oversold bounce. If you are caught with long positions, that is often a very good time to sell down positions. This breakdown has provided few opportunities to escape long positions on strength. We had one bounce that was fairly limited and that was it. You either sold into weakness or suffered some tremendous pain while waiting for a better exit point. My feeling that this breakdown has been unusual in the degree that it has failed to produce any bounce seems to be backed up by James Altucher's QQQQ crash system, which failed for the first time after 61 prior successes. The idea behind this system is that when the QQQQ is more than a certain level below its 10-day moving average, there is a very strong likelihood that it will bounce back up at least temporarily. In this case, it didn't happen, and that has really made this meltdown much more difficult than ones we have suffered in the past. The good news here is that this correction is much more typical of a corrective move in a larger bullish trend than it is the start of a bear market. Bear markets tend to tease and tantalize hopeful bulls as they slip down a path of hope. Bull markets are known for fierce pullbacks and this can certainly be categorized as a fierce pullback. We would like to remind folks here that as tough as this year has been and as tough as the last few weeks have been that it is important to know when to take advantage of the market's opportunities. After the crash in 1987 many investors spent the remainder of the year looking to get out of the market. The crash was just too scary and the feeling of losing money was just too painful. These same folks didn't buy in again until the market was back in the news again in the late 1990s. The problem is that the crash of 1987 spelled opportunity and those who read the writing on the wall got rich by buying when there was blood in the streets. Take Microsoft for example. In 1987 MSFT was trading as high as $128 per share. After the crash in October of that year it traded as low as $37. Those same shares today are worth $3000 each (calculated for the splits). Right now it is time to start searching for the babies that have been thrown out with the bath water. We don't believe the low in the market has yet been put in, but we are close. Gold stocks are one of the babies that have been taken out to the woodshed in this market and we believe that these stocks are cheap at the current price. Remember, it's ok to get out when the market is falling but it is also important to remember to get back in again. Don't wait until the market starts to look good to get back in. You don't need to try and pick the bottom, but you don't want to wait until everything is rosy again either.

We Were Wrong

Last Thursday looked like things had gotten about has bad as they were going to get. We had expected a retest of the bottom this week but what we got yesterday was anything but a mere test. The bottom formed by a high volume reversal – the highest volume reversal mind you – did not even serve as a point of hesitation in the last hour of trading yesterday. The put/call ratio is nearing all time bearish highs and the VIX is breaking out in force. Both of these events predict a turning point in the next day or two. The problem is that momentum in this market has turned into a convoy of sellers as institutions sell down their inventories in front of the CPI and PPI numbers to be released over the next two days. We are concerned that under the right circumstances the market could find an air pocket to the downside that could bring us down to the expected four year cycle low in nearly one fell swoop. Frankly we had been expecting more lows to form, but we had believed that the market would have significantly retraced some of the damage that was done in May. We clearly called a near term bottom too early. At this point, if the CPI and PPI don't cause a waterfall sell off, we are expecting a relief bounce, but this bounce may be an opportunity to exit open positions and put on shorts. A better buying opportunity is near and this sell off actually sets us up for what could be a phenomenal summer rally. For now though our bottom calling is done and we will step back and wait for a better set up.

Correction Probably Over, But Likely to be Tested

We expect to see a bit more weakness over the next week as the market continues to work on a bottoming process. The danger of the market moving much lower than Thursday's low is minimal at best. Don't expect the market to carve out a "V-type" bottom and go straight back up here, but don't look for a breakdown either. Looking at the majority of stocks, which are in trendless conditions right now, we wouldn't be a bit surprised if they manipulated the market back down to Thursday's lows this week to see if they can shake loose a few more shares from the weak hands tree. Keep an eye on the overseas markets this week; especially the British and Australian markets. Both markets are very close to a bottom and any strength in these markets should trigger short covering and will give the bulls back their lost confidence. Meanwhile, try to avoid the broader market and focus on stocks that are trading somewhat independently.

Revisiting 2002

Prior to the open yesterday the outlook looked about as grim as it gets. We were very uncomfortable shorting against both a spiking volatility index (heightened investor fear) and a crowd that was so bearish that they were putting 4 times the amount of money into put options as they were calls. It is just not a good idea to run with the crowd when the crowd is leaning too hard in one direction. As a result we advised that sitting on your hands and not trading yesterday was the best alternative for all but the daytraders. This turned out to be good advice. After a panicky open we saw massive capitulation taking place as investors scrambled to exit their positions and as smart money grabbed up the shares. What is most notable were the market volume levels. The QQQQ had its all-time highest volume day yesterday as it traded an astounding 280 million shares; and this following a 234 million day two weeks ago, its highest volume number ever prior to yesterday. What does this mean? Well, there are some very strong similarities between volume and capitulation action which took place in July of 2002. Note that in July 2002 the VIX was spiking and the market was spiking downward into high volume reversal days. Following the low in July 2002 the market rallied sharply higher and then swooned into another late summer reversal. October of that year however marked a strong reversal that led to a two year rally. We remember this well because money was easy to make in the market during those two years and we made a lot of it. Why do we focus on July 2002 though? Why is it reasonable to expect a similar scenario to play out? Two reasons: First, the four year market cycle. Every four years the market tends to make a significant bottom as the market responds to lagging election year politics and other political and economic factors. More importantly though, four years ago marks the last time we witnessed such a large spike in volatility and market volume. Smart money is now making their bets and they are betting on upside, perhaps significant upside as early as this fall. Expect some nice roller coaster trading over the next few months. We should be able to make money on both the long and short sides as the market roils in a bottom-carving process. Expect yesterday's lows to be retested in the next week or two or three. Bears have not yet fully capitulated – but they will. Be flexible and be willing to switch sides quickly as the market whipsaws from week to week. This will be a fun ride if you ride with it and don't fight against it.

Crash System Fails

RealMoney's James Altucher developed the J Quad Q Crash Trade several years ago. This trade is triggered when the QQQQ takes a crash run like it did last month. What is interesting about this trade set up is the fact that it predicted a tradable bounce an incredible 61 times in a row. Last week the trade triggered again only this time, number 62, it failed for the first time. Yesterday the QQQQ had a great set up. It was oversold and at support. Tuesday saw a late rally ensue and yesterday morning we had follow through. Then Greenspan spoke. For the third day in a row the market has been battered by Fed members and now the former Chairman speaking publicly about inflationary pressures. This is not new information. They are not telling the market anything it didn't already know. Even so, the Fedspeak has worried the market to the point that every buy set up has gotten hammered back. Yesterday's buy set up rejection was the most troubling as it puts support on the QQQQ into serious jeopardy. Let's take a look: Note the rejection, which coincided with Greenspan's comments, as the QQQQ tried to regain the $39-level. The ETF then proceeded to sell off with the market into the close and even closed below the all important last level of support found just above $38.50. Is this a breakdown and a signal to go short? Yes and no. Technically the QQQQ has broken support and the S&P 500 is threatening its 200-day average. The problem with getting aggressively short here however is the fact that this market has been nothing but whipsaws for weeks now. As soon as momentum gathers in one direction it spins on a dime and heads back the other way. The other problem with getting aggressively short here is that this is what the crowd is doing and the crowd is almost never right at market turns. Four put options were purchased for every one call yesterday. The crowd is obviously overly bearish. What do we do in this situation? Sit on our hands and don't trade. This is the only reasonable course of action to take when the signals are so mixed and the advantages are so hidden. The dust will settle and once it does the pathway will become clear once again. Today going long or going short are both crap shoots.

Accumulation at These Levels

We don't know about everyone else, but the last two days have been exhausting for us. Support testing has been ugly this time around. With the Fed Chairman killing the market on Monday and then Fed board members voicing their opinions in public yesterday, selling has been fierce and support levels have been put to serious tests. Nevertheless, indices and stocks alike are showing bullish money flow divergences when compared to last Tuesday's lows. This means that even as hard as this market has been to endure that smart money has been accumulating even as longs capitulate and give up their shares. We believe that despite what the Fed has been saying in public that the end of rate hikes is probably very near. They of course can't show their hands and some might say that they are even bluffing here so we endure huge amounts of volatility in the interim. Today we expect to see higher prices. In the morning however we could see more support testing; it will depend on whether sellers are exhausted or not. If sellers are out of resources then short covering will likely lead to a quick rally higher. If weakness from Asia bleeds over to the open though sellers might find continued reason to stand firm. Again, historically days like yesterday have proven to be buying opportunities. We believe that we will be able to look back next week and see that indeed, it was a great buying opportunity. Right now it is just exhausting though.

Last Tuesday Revisited

There is something familiar about yesterday's market sell off. It seems like we have seen days like this before. Oh yeah, we had a day just like this last Tuesday. What is also like last Tuesday is the inordinate amount of options traders who are betting on further declines. Two put options were purchased for every call. You would think they would have learned a painful lesson by now but they keep coming back for another dose of pain.

The VIX, volatility index, took another jump yesterday as well. The similarities between yesterday and last Tuesday are mirror-like. The similarities between the market's behavior over the last two weeks and the way the market behaved during the last two weeks last October are also mirror-like in their similarities. The QQQQ still has support at $38.50 so unless that level gets taken out we seriously doubt that the shorts will see much momentum develop. In fact, historically days like yesterday have proven to be buying opportunities.

Yesterday the market sold off when the Fed chair Bernanke spoke about inflationary pressures with hawkish tones. Regardless of what the Fed actually does next the chairman must speak with hawkish tones in order to constrain inflation expectations. This is normal in the late stages of a tightening cycle. We would argue that the Fed is very close to taking a break in rate hikes despite what fearful traders thought yesterday afternoon.

Market May be Ready to Reverse - Oil Strengthening

On Friday the crowd reacted favorably to low job numbers in the employment report. This is because they were expecting that low numbers will force the Fed to take a breather on rate hikes. Of course the enthusiasm attracted profit takers and short positions as these buy the news events almost always do. Technically the sell off from the highs left the indices in poor technical shape with the dust settled on the day. The S&P tagged the under belly of its broken trend and sold off and the QQQQ sold off from its falling 20-day average. Momentum left from earlier buying last week however does not yet appear to have abated. We could potentially see higher prices this week but keep in mind that damage has already occurred and that shorts will be looking to build positions into any further rallies. The commodities market on the other hand is once again heating up. Many oil stocks are resuming their trends and gold prices are hammering out support. We are not confident that gold is done with the downside yet, but certainly any further dips in this sector will represent buying opportunities.