Securities Research Services

Thursday, August 31, 2006

Watch the SMH for Signs of Profit Taking

The SMH is now firmly parked at resistance so we would expect to see profit taking start at any point. Other resistance areas pointed out in yesterday's report are also looming. Next week we will get a better picture of the market's near term intentions. Note: We plan to take off tomorrow for the holiday weekend. We wish everyone a nice and safe holiday.

Wednesday, August 30, 2006

Watch Out for Rising Wedges

The rising wedge pattern is one of the more reliable chart set ups as the contraction of price movement as prices rise reveal the fact that bulls are running out of fire power. Note the S&P 500 traded in a rising wedge pattern from the first of the year until April, when a breakout attempt proved to be a head fake and the price subsequently plunged into a two-week free fall, which gave back the entire gain from the previous five months.

Now take a look at the current S&P chart, represented below by the SPY (ETF) exchange traded fund.

The wedge here is in a much sharper uptrend, but the price is contracting nonetheless. Could the bulls rally the price of the SPY back up to $132? We don't know yet. But if they did, there would surely be a great deal of capitulation amongst the shorts. Likewise, given the low volume in which this steep climb has been driven with, the probable reversal could be sharp and swift. Now turn your attention to the QQQQ, which has been behaving a little better lately. Below we are providing a weekly view of this ETF. Note the red line on the chart just above $39. This represents the 50-week average. Note also the blue trend line drawn on the chart. This line represents the last broken uptrend. Stocks and indices often move back up to retest their broken trends before reversing. We don't know what exactly to expect next, but it is clear that any further rally from yesterday's close is sure to run head long into some serious resistance.

Finally, let's take a look at the semiconductor sector, represented below by the SMH ETF. The semiconductors actually look pretty good lately. They appear to be in a decent uptrend that is rising on decent volume. Also note, however, that yesterday's sharp move put the sector right near overhead resistance, as represented by the rising trend channel. Furthermore, $34.28 represents the broken 200-day average. Thus, any further rallies in this sector are also likely to run into heated resistance. The semi conductors could actually produce some good long side trades after a pull back if it is orderly. For now it is too late to try and catch this trend.

Bottom line: Professional traders are expected to return next Tuesday after the holiday weekend. Any breakout attempts following yesterday's strong close should be eyed very suspiciously. No one knows for sure what will develop next week, but several indices are poised for serious downside if the pros come back with selling on their minds. If, on the other hand, they come back in a buying mood, further upside is likely to be muted by serious overhead resistance. In other words, be extra cautious if you are trading the long side of this market and don't get too aggressively short unless we see some breakout failures start to emerge.

Tuesday, August 29, 2006

Bulls Need to Step Up as Time is Running Out

Tech indices appear to want to continue drifting higher as we move closer to the end of the month buying window. The blue chips, however, found serious resistance overhead as they tried to break out yesterday and once again the S&P and Dow sold off into the close; a bearish sign. The problems with this rally are pretty much the same problem all recent rallies have had lately. Volume is poor, breadth is poor, and there has been a disconnect between the indices. Blue chips have moved way out in front and tech, while making a decent catch-up move, continues to lag. Overall the technical picture isn't terrible, and is for the most part neutral except for a couple of reasons. First, while we are seeing some areas of tech make strong moves, reliable breakouts are not setting up in the sector. We are also seeing more reliable short set ups than reliable long set ups. Most significant, however, is the potential for the bond market to sell off later this week. Technically bonds are ripe for a sell off, which would likely put a nail in the coffin on the bullish case for stocks. Stocks can still improve and rally, but time is on the side of the bears here. The longer the bulls wait to put their technical pieces together the weaker their case becomes.

Monday, August 28, 2006

Don't Read Too Much Into This Week's Action

Look for volume this week to drop back to levels normally only incurred during the week leading up to the Christmas holiday as most of the remaining market participants take off for the beach. It's difficult, and probably unwise to try and cull too much meaning from last week's and now this week's activity. Last week was more representative of traders trading with other traders than it was of actual supply and demand. This week should be more of the same. With this in mind, look for both breakouts and breakdowns to fail. Bet against meaningful price action and look for stocks and indices to bounce between support and resistance. With volume levels low, it will be easier to manipulate prices and gun prices temporarily higher to take out the short's stop losses. Likewise, it will be easy to drop prices below support and take out the stops for longs. We plan to be very conservative this week, only trading where we can see a very clear advantage to do so. Next week promises a fair amount of fire works; though the jury is still out on whether there will be a market breakout or breakdown.

Friday, August 25, 2006

Slow and Boring Trading with Slightly Negative Bias

On the long list of indices we tract, relative strength readings yesterday were all negative, save for the SOXX, semiconductor index. We would read this as more of an anomaly than an indication that the semis are about to show leadership. No, this market is set to drift, with what looks to be a slightly negative bias, through next week. Unfortunately this lazy end-of-summer trading is not likely to lead to much excitement until after Labor Day. We don't recommend getting overly aggressive since what we are seeing now is more representative of small traders trading amongst themselves than it is of real supply and demand. Yesterday, once again, program trading caused a slight rally in the last 30 minutes of trading. One respected analyst indicates that this "propping up" of the market into the close is having only the effect of temporarily staving off the inevitable.

Thursday, August 24, 2006

Follow Through Lower is Doubtful; This Week Anyway

Sentiment has swung wildly back to overly bearish after yesterday's down day. Tech led the way lower but the semiconductor sector showed some resiliency, as did the S&P 500. Our scans today show a lot of bearish set ups and few reliable bull set ups. Nevertheless, we would expect to see the market bounce some today just due to the fact that bears are pushing too hard here. The reason that an overabundance of bearishness can cause the market to rally is not that complicated if you think about it. When the crowd is leaning one way, it means that they have committed their money. If the market fails to go lower due to the fact that all money that can be committed is already committed, bulls can gain confidence and cause short positions to start feeling pain. Once shorts start to get stopped out, their covering causes the market to move even higher. It's not really a question whether the market will deny shorts their sell off event this week. Shorts are likely to be disappointed if that is their hope. The real question is, is this market going to continue to experience serious distribution that quickly shuts down the rallies? If the 4-year cycle is going to take hold when the professionals return after Labor Day, then we should see more distribution and should see stocks struggle as indices near last week's highs.

Wednesday, August 23, 2006

Immediate Trend Nuetral

There isn't much to add to recent comments. Volume is low and the immediate trend is neutral. Bears are betting on an S&P breakdown, which could give it support, but bulls are betting on a QQQQ breakout, which should keep it below resistance.

Tuesday, August 22, 2006

Problems Remain with this Rally

Low volume, as predicted, has arrived. Yesterday was predictably a negative day, but selling never really took hold after an initial drop. We may see more backing and filling today and then could potentially see the market move back up near last week's highs later in the week. There are a number of reasons to distrust strength at this point. First of which is the fact that the bulls never experienced a capitulation event during the last downturn. Moreover, the market has rallied on below average volume. Most significant, however, is the fact that new highs have been sorely lacking. Stocks that rallied last week were weak stocks that rallied on short covering as shorts were squeezed. Significantly, stocks with strong charts trading near 52-week highs, failed to participate in the latest rally. Why is this important information? It means that smart money was willing to buy strength in expectation of the market making a strong bull run. The rally was then dominated only by short covering, which is indicative of a bear market rally, not the beginning of a new leg higher.

Monday, August 21, 2006

Let the Games Begin

Over the next couple of weeks volume should be very low as the pros head out for vacation. Last week's options expiration skews analysis and we will get some idea what real demand is this week, but emphasis should be placed on the word "some" since this week is certainly not going to clear up all questions. Real demand will not be known until the pros come back from vacation after Labor Day weekend. Look for games to occur in this low liquidity environment, with prices swinging widely against both bulls and bears.

Friday, August 18, 2006

Has Everything Suddenly Changed? Don't Bet on It.

All last spring and most of this summer, strength has been sold into. Early this week we had a similar situation, where the market had been trying to rally, but had been knocked back on each attempt. The market is often perverse though and once the pattern of selling strength was well recognized, it did the opposite of what it was projecting and gapped over resistance. Moreover, we have yet to see a real pullback in this trend. Readers will recall that we had a similar situation in May, only in reverse. In May, the market broke down from its long term trend and then traded straight down without one serious pullback. The QQQQ traded down $4.00 before it experienced a 50% retracement of the move. Now we have a mirror-opposite of May's down move and the QQQQ has traded up $3.50 from its lows, again without a pullback. Today is expiration day and a close near $39 on the QQQQ would cause the maximum amount of pain for the maximum number of options buyers as it would cause many of their put options to expire worthless; this after tremendous profits had been logged from the previous few weeks. Interestingly enough, $39 represents the QQQQ's 200-day average and a 50% retracement of the entire downtrend started back in May. In other words, there is some tremendous resistance at these levels. Getting back to lessons the market teaches us: the market taught us that it is good to sell strength, then, once the lesson was well learned, it perversely changed the rules. Do we now buy strength? We argue firmly, No! If the trend has changed, then we will see an orderly pullback from this major resistance level and dip buyers will be eager to get in. If the trend has not changed, we will see something of a panic ensue when dip buyers are not to be found. Today we should see the QQQQ trade near $39. A move slightly over $39 in the next few days is possible, but we would consider that a good opportunity to sell strength. A pullback from this area over the next few days to a week is about as sure a bet as bets go in the market. It is the character of the pullback that will be most telling.

Thursday, August 17, 2006

Watch Profit Taking for a Clue on What Comes Next

Yesterday bulls got the numbers they wanted on the CPI release, allowing them to follow through on the rally started from the PPI numbers the day before. We are still shaking our heads over the failure of the strong bearish signal, which we outlined earlier in the week. In all the years we have traded, it's the first time we have seen this type of failure. Had sentiment figures been overly bearish prior to Wednesday, we would have discounted the set up. They were not. Today we will not try and make any new predictions, but will take a wait-and-see approach. Profit taking should start very near current levels. All indices are approaching major resistance levels. The question is, how will the market react to resistance? Will it reverse with a vengeance? Will it consolidate as dip buyers come in? At this point it's anybody's guess. We will abstain from trading until we get some better answers. It would have been wonderful to have had a crystal ball and to have been buying the ugliness last week, but it doesn't take a crystal ball to see that buying or selling at current levels is risky indeed. Especially with options expiring tomorrow.

Wednesday, August 16, 2006

Bulls Get Their Revenge; Will it Last?

The market continues to be very hard to trade. The short set up we had on the QQQQ yesterday was about as good as they come; perhaps too good. Perhaps the signal was so clear that the only thing that a truly contrarian market could do was to fade the signal. Or, perhaps the lower than expected PPI numbers released before the market yesterday gave bulls an unexpected opportunity to exact some pain from the shorts. The later is the most likely explanation for yesterday's surprise rally. The QQQQ is in a bear market and this rally does not change this fact. It is possible that when the CPI numbers come out today that they will compliment yesterday's PPI release and give the bulls more ammunition to put the bears in pain. As bears cover their shorts, the QQQQ could rally back up to major resistance at $39. This is the reality of bear market rallies. They are quick and painful and they reverse just as quickly as the stopped out bears can slap their heads and say "Doh!" ala Homer Simpson. Alas, we cannot argue with the market, we can only react to it. Should the QQQQ rally up to $39, we will short it aggressively. Until then, it is important to keep position sizes small and trade discipline high.

Tuesday, August 15, 2006

Why are the Bulls so Confident?

Commentators are nearly all barking in unison pointing to relative strength and good breadth on yesterday's rally. Bulls are sure that bears are leaning too hard and that bears are ready to have their comeuppance served to them on a platter. Bulls in fact are so confident of this that they purchased nearly 2 1/2 call options for every put option on the QQQQ yesterday (remember, anything over 2 is overly bullish). We can't understand it. Yesterday we posted a chart of the QQQQ and pointed out how the price has tried to break the downtrend twice over the past several trading days. Yesterday marked a third high volume rejection in just the last seven days. The bottom line is, this market has been very volatile and as hard to trade as any market we have seen. As such, we would not add any more to the short side here, but we certainly would be very hesitant to go long and we would certainly hold current short positions open.

Monday, August 14, 2006

Indices Trading at Resistance

We start options expiration week with sentiment in neutral and with tech indices poised for another leg lower. There are several reasons we think that tech has more downside left in it before it finally carves out some meaningful support. First, the downtrend is still in tact and with prices trading right at resistance levels, sentiment figures, as mentioned above, do not reveal a great deal of concern. Should the crowd be overly bearish here, we might be more inclined to look for a breakout that surprises the crowd, but this just isn't the case. Second, our scans reveal an abundance of stocks trading in bear flags with technical indicators that are overbought. This has occurred due to the fact that the market has bounced softly in relief from the last down leg, which has put many stocks right up against their falling 50-day averages. Pros enter trades at the 50-day average. Finally, the QQQQ has made two recent attempts to break the downtrend, but was rejected on both attempts. Moreover, volume on the rejection days exceeded volume on the subsequent recovery days by a margin of nearly 2:1. Note the chart below. We have highlighted the rejection days and have drawn lines connecting the volume bars representing those rejection days. It is clear that distribution continues to exceed accumulation at this time. Understand that no one can possibly know what the market will do next. All we have to rely on are probabilities. It is important to short when it is scary to do so; when stocks are trading up against resistance and when you are afraid that resistance will be broken. Just like it is important to buy at support when everyone is worried and when your own emotions are telling you "don't do it, support might break." Why? Because it is at these times that probabilities are most strongly in your favor.

Friday, August 11, 2006

Yesterday's Rally Lacking

By now the market is trained to buy any weakness related to terror events. Despite the fact that the market is in a precarious position here, programs kicked in and bought the gap down yesterday and prices closed near daily highs. Wanting on the recovery was significant volume. Likewise, the move just pushed the indices up near resistance levels once again. We will be surprised if there is much follow through from yesterday's move. We would be much more trusting of a rally effort if the market would pull back down near recent lows to regroup and shore up support. We are not seeing any decent long set ups and short set ups look very good here. However, there is some concern that we will get a bit of an overly exuberant follow through rally, which while doomed from the start, could put our shorts in jeopardy of stopping out before the market reverses again. This is why we recommend keeping position sizes small in this market. Program trading has played havoc with position traders on both sides of the trade lately.

Thursday, August 10, 2006

Trend Reasserts Itself

Fears about the economy proved to be too much for the bulls yesterday. Their last attempt at breaking the market's downtrend failed and they are likely out of firepower to lift prices higher from here. This puts the lows from July into jeopardy. Don't fight the trend here. Now is the time to be short this market.

Wednesday, August 09, 2006

Traders Sell the News

The pause in rate hikes sparked a very minor rally before prices took a sharp plunge. This shows that the downtrend is firmly in control and that lower prices are to be had before we get a significant bottom. Nevertheless, QQQQ bears are a little over confident and are leaning too hard one way. The put/options ratio shows that we should get something of a bounce today. The day after the Fed meeting, stocks generally reverse much of the previous day's activity, so it is likely that today will see some price relief from yesterday's sharp move lower. Since the downtrend is still in effect, today's expected strength should help set up better entry points for taking on new short positions. Most stocks remain technically overbought and any strength should be used to open new shorts.

Tuesday, August 08, 2006

Looking to Fade a Potential Fed Rally

Today the Fed is likely to take a pause on rate hikes. The market expects this, but such an event should spark a quick rally nevertheless. Unfortunately a pause at this stage is not going to clear up the worries that this market has in front of it. A pause this time does not take away the question about whether or not the Fed will choose to pause next month. As such, any quick rally after the release – or prior to the release in anticipation – is likely to be quickly sold. Indices and stocks alike are now technically overbought and rallies are generally sold when this is the case. Due to this long string of rate hikes, there are strong indicators pointing to a recession next year and the market knows this. The only scenario that might spark a legitimate rally would be an actual lowering of rates this round as it would indicate that the Fed is concerned with the health of the economy and the market. From what we can gather, however, it appears that the Fed is more interested in fighting inflation in the commodities sectors than it is in the current stock market outlook. This is why, we believe, stocks are projecting more downside.

Monday, August 07, 2006

Fed Meeting Looms Large

On Friday all major indices gapped up and then sold off the remainder of the day. Late in the day buyers started to come back in, but this could have been daytraders taking profit on their short positions. This sets up an interesting situation. The tech sector is overbought and has now sold off at resistance. There has been no evidence of accumulation and ideally, this is a perfect short set up. The problem is, tomorrow the Fed meets and tomorrow's meeting is perhaps one of the most important events the market has had to look forward to in some time. The yield curve on long term bond rates has now firmly inverted, threatening a recession late next year. This puts some pressure on the Fed to pause. The question is, is the Fed interested in avoiding a recession, or do they have something else in mind, such as putting the brakes on the world economy to get oil prices back into line? If the Fed takes a pause tomorrow, as it is expected, then the oversold condition of the indices is likely to move up to even more oversold as prices rally in celebration. We will probably short such a rally, but will need to see what the charts look like after the dust settles. If the Fed raises rates again, it would probably be very bad for stocks and we could see a sharp down day, for as we mentioned, stocks are ripe for a slide already.

Friday, August 04, 2006

Jobs Data Will Lead the Way Today

The market rallied back to resistance yesterday on a bet that today's jobs data will be weak enough to render the Fed with no alternative but to stop their rate hikes during next week's meeting. The problem is, market leading indices, including the QQQQ and SMH, were pulled along for the rally as opposed to having led the way. Accumulation indicators on these two indices have stayed flat even as the price has moved higher, indicating that smart money has not participated in the rally. There is a potential that the jobs data will propel indices higher today, perhaps even pushing them over resistance. We hope that this will not occur however. Capitulation, which is needed to mark a clear market bottom, is strikingly absent and any rally higher from current levels will be performed on very little buying fuel setting the market up for another extreme wave lower. It would be much better if indices turned back here and worked on building a base of support before they rally above downtrend resistance. We can't tell the market to do what we want it to do though so for today, we will wait and see what develops after the jobs report to be delivered before the market opens.

Thursday, August 03, 2006

QQQQ Should Test Resistance

The tech-heavy NASDAQ continues to diverge from the blue chip S&P 500 and Dow indices. Until tech starts to lead the way, any move higher in the blue chip sector should be viewed with suspicion. We are operating under the theory that the NASDAQ, which has been the market leader on all rallies over the last few years, maintains its leadership role. As long as this leader is diverging bearishly against other sectors, the downtrend must be respected and strength must be faded (sold into). There is some evidence of accumulation in the small chip indices indicating we are in the middle of a basing cycle and not a distributive one. Nevertheless, it appears quite likely at this time that we will see the QQQQ head back down to its lows at least once more before it finds enough strength to make a break of its immediate downtrend. We do expect to see buyers continue to buy over the next few days lifting indices slightly higher. We suspect, however, that smart money will be using this as an opportunity to reload their short positions. Look for the QQQQ to test $37.40-$37.60 over the next day or two.

Wednesday, August 02, 2006

Bear Trap Being Set, or the Real Thing?

The QQQQ gapped down and led lower yesterday after a low volume rally up near resistance. The question is, is this a bear trap in the making? QQQQ shorts are buying 4 times as many puts as bulls are buying calls. With bears leaning one way so hard it seems unlikely that yesterday's sell off will gain much follow through momentum. Likewise, yesterday's gap lower is probably more bullish than bearish at this stage. Bears are getting overly exuberant while weekly charts are very oversold and due for some relief. It wouldn't take much to spark a strong relief rally and with the Fed possibly acting next week, this may be the spark that bulls are waiting for to challenge this latest sell off. It might be a better idea to start thinking about buying weakness as opposed to selling it.