Watching and Waiting for Tech to Prove Itself

The QQQQ created a nice bottoming tail over its 50-day average yesterday. This is a good start to end of the month buying. Now we are looking to see if tech can pull out of this first thrust pullback and make a higher high, which would indicate an uptrend is in tact. Right now it is best to interpret this as a ranging market however.

The reason why, we are not seeing a lot of follow through just yet. Stocks that promise to trend have been getting chopped up the same way they were early spring of last year. As such it's best to stay defensive and play the oversold bounces in areas that are ranging, such as the semiconductors, and don't get pulled in to breakouts, which have the potential to fail.

Understanding the type of market environment we are in will help you pick the correct strategy. If we see the QQQQ break firmly over $44.50 in the next week, then there will certainly be a plethora of strong long side set ups that will ensue. Until we see this happen though, it's best to bet against it and continue to focus on buying the dips and eshewing the breakouts.

Range Bound

The market is stuck in a trading range here. Analyzing stocks as if they were trending in this environment causes a distorted reading and causes trades to get chopped up in the choppy range trading they are experiencing here. We have made that mistake with one or two positions this week ourselves.

Even though the market is range bound here, we think that there is a good argument that the market may spike higher in the next few days and make a move to the upper end of the trading range rather than return to support levels. Evidence in favor of this bullish spike is the fact that the VIX is once again spiking, showing extreme fear and measuring the fact that large hedge positions are being placed. Likewise, the put:call ratio remains overly bearish, so any strength has the potential to cause a short covering rally.

On the other hand, over interpretation of Bernanke’s future intentions has the potential to send stocks back to the bottom of the trading range. Odds on this latter scenario are low, but it is a possibility considering the fact that stocks are trading in the middle of a trading range here.

Fed Watch Again Today

The Fed chair speaks today, which is likely to be another market mover. Put buyers continue to keep a floor under the market. Any kind of strength has the potential to trigger another short squeeze like the one we saw last week. Scans continue to produce more longs than shorts, so we remain tentatively bullish just as outlined in yesterday’s remarks.

Dip Buying is a Good Strategy Here

For the fourth week now we are seeing put call ratios in the 2-1 area where almost twice as many puts are being purchased as calls. Being in the camp that is contrarily positioned against the overly bearish crowd is appealing to us. If we were in agreement with the crowd here we would be a bit nervous, but these bearish readings are quite bullish here so we are comfortable in our position of being cautiously bullish.

Even so, the market is in a trading range and is overbought technically. Dip buying has been healthy and bearish sentiment should keep a floor under the market. Until we see a breakout it is best to stay cautious, accumulating a small position on dips but saving some powder for when there is confirmation.

Taking a "Wait and See" Approach

The financials, which led this market up, then subsequently led this market down in the February crash, closed firm on Friday after working through what we like to call a high consolidation pattern over the past two days.

Buyers have regained the upper hand here, but prices are back at their 50% retracement marks. They need to capitalize on the hand they have been dealt in order to keep the trend alive. Until we see prices following through higher, it is a good idea to be conservative here and to not commit any more money to the market than you already have working.

This may be the opportunity where we should be buying hand over fist, but until we see a higher weekly close this week we will not take that gamble. Right now we have a "show me" attitude about the market. As we mentioned last week, no one has a working crystal ball. We can only measure probabilities. If bulls seize this opportunity then probabilities will greatly improve. At that time we will get aggressive like we were pre February 27.

Market Betting on Rate Cuts

The market needed a rest after its strong break back up through the 50-day averages on Wednesday. Yesterday it rested in a healthy, consolatory way, which projects more upside to come.

Right now the market is betting on rate cuts, which essentially mean pumping more money into the system in order to sustain a healthy growing trend in the economy. As long as the market continues to hold out hope for rate cuts (the cuts don’t necessarily need to come mind you) then the market should continue to power higher here. Hopefully Bernanke won’t issue a clarification statement the way he did when he first took over the chairmanship. A statement issued that tells the market it has it all wrong would not be good for stock prices. We doubt he will though. Surely he learned that the market hangs on his every word last time he did so.

Market Picks up Dropped Shoe

The month of market looks to have turned out to be just another bump in the road on the climb, which started last summer. The market’s reaction to the FOMC minutes yesterday afternoon confirmed the failed bear flag.

Instead of dropping the other shoe, the market went ahead and put back on the shoe that it had lost.

Take a look at the financials sector (XLF), which is the sector that led the march up the hill over the past six or seven months.



Not only did it fail to break down, carving out a double bottom pattern on its daily chart, but it has now confirmed that double bottom on a high volume breakout. When market leaders lead the way higher, the trend is healthy. This trend has certainly reasserted itself.

Lessons from Churchill and Old Traders

Churchill was a man who believed in making only loose commitments to the affairs of other countries. He believed that treaties should be made only if there was a benefit to England and that they should be broken if that benefit was lost. He once said “A fanatic is one who can't change his mind and won't change the subject.”

The same should be true in the stock market. It is important to never commit so strongly to an idea that it blinds you when something changes.

We have been very bearish on the market over the past few weeks due to the reasons that we have outlined in past reports. There are a couple of developments that we believe make it necessary to move from the bearish camp slightly into the neutral camp.

Let’s review what is bearish about this market and what is bullish about it:

First, the weekly charts are in a downtrend, having firmly reversed the uptrend which started late last summer. This is bearish and it is compelling.

Second, most stocks and most indices remain under their 20- and 50-day averages. This is also very bearish.

Nevertheless, when sentiment is too bearish, many times stocks just won’t go down. The market almost always goes out of its way to cause the most pain to the greatest number of people. For three weeks in a row now the put:call ratio has been almost 2:1 bearish. This is the longest streak of bearish sentiment that has occurred this millennium. We are very uncomfortable when we are in agreement with the crowd for this period of time. To be sure, this overly bearish sentiment reading is bullish for if the market puts just a little pain to the bearish positions opened, a short covering rally could turn into a market that once again is climbing a wall of worry.

Lastly, the daily charts on many stocks and the major indices have carved out double bottom patterns. The QQQQ, SPY and DIA have all bounced off their 200-day averages twice now. The pattern is not yet confirmed, but if the QQQQ closes over yesterday’s high on equal or greater volume to Monday’s trading, then it will confirm a double bottom. The SPY and DIA still have some work to do.

We do not think these developments are a reason to run out and start buying stocks madly. What they are telling us is that risk is very high here and that stops should be tightened up.

In our scans we are seeing some stocks moving up on what could be interpreted as short squeezes, but we are not yet seeing the type of set ups that compel us to get any shorter and certainly not the type that compel us to jump ship and go long.

Bold traders could certainly take some risks in this market, but an old trader once said “There are bold traders and there are old traders, but there is no such thing as an old, bold trader.”

We think there is wisdom in both Churchill’s and that old trader’s words.

Sellers Remain in Control of the Tape

Major averages closed the week below key support levels last week. This is important because it shows that even though put buying has been particularly heavy, options buyers actually made a small profit when this month’s contracts expired on Friday. This shows that sellers have power here.

Nevertheless, the market is in a minor trading range here. It continues to work out the B leg of the A-B-C correction. It could break lower this week, or it could continue to range again like it did last week. There is no really great way of timing these things. We continue to look for another leg down and evidence continues to support our views.

Don't Forget the Big Picture

Lately we have been repeating our thesis that this market is in an A-B-C correction. On Tuesday we provided an alternative scenario for how this correction could play out in the "B" wave of that correction, noting that within a larger wave smaller waves oftentimes develop. Yesterday's bounce was bullish on its face as breadth was just ok (around 52/48 risers/decliners) and volume was very good. However, the larger trend must be respected here and while we and no one else knows what the future holds, probabilities continue to favor more downside following the culmination of this B wave we are now trading in.

Let's review again last May's correction and see how it continues to parallel the current correction.

May 24th of last year the Dow, pictured below, tested its earlier lows and found support on a high volume reversal day very similar to yesterday's test and reversal (in the lower chart). Following this test the market followed through higher for two days and tagged the falling 50-day average only to reverse lower again. This scenario played out twice in fact.



Key here is the fact that the 50-day average (red line) was declining last May and it is declining now. Could the market have put in a low yesterday and now be ready to rally back up to this year's highs? Yeah, anything can happen, but once again, probabilities and history are not on its side. In fact, bulls may have used up most of their firepower yesterday and the bounce that is likely to follow should be as weak as the bounce that occurred late May.

The game plan is clear here. Wait for the market to run back up to its 50-day averages and short some more.

In the meantime manage your open positions and take options day off tomorrow.

Our Schedule: We are taking our own advice and our office will be closed on options expiration tomorrow. Our next update will be on Monday.

Downtrend Confirms

Over the past two weeks prices have climbed steadily higher to test the 50-day averages most stocks and most indices. The climb came on decreasing volume and as we pointed out several times, it was obviously doomed to fail. Yesterday patient shorts realized some quick gains and overly eager bulls gave back two weeks worth of profit in one day.

Yesterday's high volume distribution day confirmed the market's downtrend, which is projecting a measured move lower. That means that it is likely to make a move similar in length and price to the first leg in this A-B-C correction.

Two things to look for over the next few days:

Options expire on Friday, so bears may be disappointed by stocks that don't follow through lower immediately.

And…

A lot of people are looking for support at the March lows; it seems doubtful that support will be found there, which will cause a panic and a really excellent buying opportunity for the next leg up.

How the Crowd Could Turn Bullish Again

Last week we theorized that the market, represented by the Dow chart below, is in the throws of an A-B-C correction. Wave A represents the waterfall-like decline which occurred on February 27. This is generally followed by wave B, a countertrend rally, also known as a dead cat bounce. Finally, the pattern tends to culminate in a wave C decline, which oftentimes mirrors wave A.

So far the pattern has been developing exactly as predicted. As you can see below, the wave B countertrend rally has been moving up to the 50-day average as volume has been decreasing and the oversold condition, represented by the histogram at the very bottom of the chart, is being worked off.



This is a classic pattern and is setting up very nicely for a short.

But is it too obvious?

There may be a fly in the ointment however: Everyone can see the same pattern. It is too obvious. It makes us very nervous when we are members of a consensus on what the market should do.

Thus far this market has been very difficult to short. The countertrend rally has been a bit stronger than everyone anticipated. Breadth has been good on the rally, even though volume has been poor. Up until yesterday there were way too many put buyers anticipating more downside for downside to actually occur. These are challenges to the short position.

All of this said, we still expect this market to take another tumble. Perhaps it will rally one or two more days. The Dow, as you can see above, still has a bit more room before it tags its 50-day average at 12427. That gives it around 100 points of run time to squeeze the shorts and draw more people in to the bullish argument that "maybe, just maybe this market is going to climb a wall of worry."

A lot can happen over the next day or two to change market sentiment, which can help take everyone's focus off the obvious.

The bottom line:

Even though it's too obvious that this market is setting up for another drop it doesn't mean that it is not going to happen. We are already seeing deterioration in bearish sentiment and more and more are being won over to the bullish camp here. If the Dow can rally today like it did yesterday, it will likely win over many more. We will be watching market breadth readings carefully. Yesterday breadth on the rally was positive. We will be looking for breadth to start to wane as a signal that this countertrend rally is done.

Alternative scenario:

We have been comparing the current market correction to the correction which took place last April. During that correction we saw a large A wave down, B wave up, and then another waterfall-like C wave down again. But let's narrow our focus to just the B wave.

Within a large wave there are sometimes smaller waves. Note that the first phase of the large B wave there was a minor "a" wave up, a quick "b" wave down, and then another "c" wave back up again. All of this took place before the large waterfall C wave sent the market into a tail spin.



Such a scenario could easily repeat itself here and this would go a long way toward destroying the current consensus. If, for example, today the market takes a quick sweep down, no doubt a lot of people would rush to short the downturn. A wave "b" back up would then serve to stop out those eager shorts and more than likely everyone would turn bullish at that point. This would be ideal for lulling everyone into complacency before the next very large C wave down takes place.

We think this alternative scenario has a lot of merit.

Just keep in mind that the market is in a minor downtrend and that it pays to stick with the basics, which are short the rallies not the dips.

Timing is Everything

On Friday the market gapped up on the jobs report, but the reaction to the report tells us more about the market than the report itself. Traders immediately sold the gap, which shows that the rebound rally continues to lose momentum.

The market tends to cause the most pain for the greatest number of people.

At the same time, there continues to be too many traders betting on more downside for this market to actually make a significant move lower from here. When everyone is leaning the same way, the market rarely accommodates them.

Even so, we understand why everyone is expecting more downside. The charts project it. Scans over the weekend showed a very large number of stocks that have been moving up to test their broken 50-day averages on declining volume. The 50-day average is a classic entry point for institutional traders and since volume has been in retreat the entire move back up the expectation for a failure at this level is perfectly reasonable.

Timing is everything.

The big question then is one of timing. Shorting tends to be a more difficult endeavor than going long because it requires very good timing. Over anticipating when a move will occur can put shorts off balance and they often times get squeezed right before the decline they had been looking for actually occurs.

Since options expire on Friday, timing is of particular importance to options traders who have to worry about both time and price. For put buyers who purchased this month's contracts (which were the cheapest and therefore most tempting), if the market fails to decline before Friday, their options will expire worthless – that is of course unless they were genius or lucky enough to have shorted the market before the first major drop occurred two weeks ago.

Now then, what we have here is a market likely to see further price erosion, but one that is also likely to burn the greatest number of traders. What better way to burn the most traders than to refuse to head much lower before Friday's expiration?

Timing this market is not a precise science, but the MACD histogram indicator can give us some clues on what to expect over the next few days. Without going into the boring details about how a histogram measures the market, let's just focus on what the histogram tells us here instead. The histogram is a great at measuring overbought and oversold levels. When the histogram is very deep in the red, then the stock or the index it is measuring can be said to be very oversold.

Looking at the histogram of the Dow below, we can see that a few days ago it was indeed very, very oversold. On Friday the Dow remained oversold, but had worked off a great deal of its oversold condition.



It is reasonable then to expect that the market will not move straight back down off of Friday's weak day, but that we will instead see another few days of either small moves higher or sideways consolidation, which would keep recently purchased put contracts from earning their buyers any money.

Patience is needed as the oversold condition works itself off.

Friday's gap higher was probably an ideal place to short this market. Now shorts need to be patient because the market still needs to work off its oversold condition and cause as much pain for the largest number of people that it can.

Looking to Evaluate the Reaction to Today's Data Release

Bears won the intraday battle for the second day in a row yesterday. The market opened sharply higher, but sellers spent the day wheedling off points and closed the market near daily lows. The market has been moving higher on declining volume as well. After last week's sharp drop, and the thus far weak recovery, it makes sense to look for another leg down after this bounce is played out.

All of that said, today the market awaits a load of pre market economic data. European stocks are off in front of the data release and frankly, no one really knows how the market is going to react here. Will it rally as the market once again builds hope for more rate cuts? Or, will bears finally get the catalyst they need to break down this dead cat bounce? These are two important questions that will be decided after the open today.

Rally Sputters

Hopeful bulls, whether they understand it or not, had their hopes pinned on the all-elusive follow through day. Elusive because follow through is rare in a counter trend rally. The fact that the NASDAQ couldn't stage any strength at all yesterday and that the S&P and Dow both tailed off into the closing hour shows that bulls just don't have what it takes to march this market right back up the hill the way they would like to.

As we pointed out the other day, oil ships and markets both take a long time to make a turn when momentum is behind them. This market has momentum to the downside for at least one more leg lower.

Now, keep in mind that it is important to set your expectations on reasonable ground. Options expire next week and there continues to be a large amount of put buyers out there betting on more downside. The crowd is rarely right and options sellers have a strong record of collecting fees on options that expire worthless. Look for a bumpy ride over the next week, but don't expect the market to make much real progress until options are out of the way. We certainly could see the other shoe drop before next Friday, but that would be an aberration from the norm if it does happen.

To all our female readers: Happy International Women's Day!

Waiting for Better Set Ups

With the market in the middle of an oversold bounce, there are no strong advantages on the long or short side today. We expect that the bounce started yesterday could extend today due to continued put buying, which indicates too many people are still looking for downside for the market to actually go down. Even so, we suspect that there are a lot of sellers waiting for good prices to short this market. Today is a good day to continue playing the waiting game we started yesterday.

Looking for a Bounce; Though We Wouldn't Trade it

More than two put options were purchased for every call option on both the SPY and QQQQ yesterday. This is an overly bearish sentiment reading. More subjective, but nevertheless compelling to us, is the fact that nearly every analyst and commentator we follow has calling for further downside today after the poor close yesterday.

They may very well be right about today, but market sentiment is moving toward and extreme and with oscillators so oversold here, we would expect to see some form of a bounce in the next day or two.

Will the coming bounce be tradable? In our opinion, no. Not unless you are ready to daytrade it and flip the proceeds very quickly. No, rather the coming bounce will likely relieve the overly sold indicators and will sooth the fears of the overly anxious crowd. It will likely even entice many of them to get bullish again and start buying.

We've seen this before though; all too often in fact. Bounce buyers are likely to be sorely disappointed as the bounce fails to follow through and meets with yet more selling. This crowd is getting frustrated, but hope remains alive for a quick recovery. Not until every last long is wringing her hands in frustration will the market finally make a tradable low.

So, we repeat again, the market is in a correction. Bounces are selling opportunities for at least one more leg down.

Asia Setting the US Markets up for More Downside Today

Asian markets are down in a big way today. This is how last Tuesday's sell off got started, so we could see a hard slide continue this week. We had hopped for a bit more of a pullback, but more downside appears to be in order before any kind of meaningful pullback starts. Perhaps later this week we will get a better bounce to enter some less aggressive short positions into. Right now, it is going to take some aggressive trading to take advantage of this fast moving market.

Keep order sizes small in order to manage the risk that comes with chasing momentum.

Rallies are Now Selling Opportunities

The Dow chart offers some clues on what to look for over the next few weeks. Right now the Dow, and nearly the entire market, is experiencing what looks to be a classic A, B, C correction.

Major momentum indicators diverge sharply against other recent corrections on the weekly index views this week. This shows us that this correction is something more than just a temporary set back in the larger uptrend. It also indicates to us that buyers who try to buy the dips here are facing an uphill battle unless they are daytraders who open and close their positions the same day. Any bounce here is quite likely to run out of momentum quickly until the market corrects further and washes out every last inkling of bullish hope that remains.

This is a normal cycle in the market and the pattern repeats itself so often that it's a wonder why so few recognize it until it's too late to profit from it.

Let's take a look.


Leg A:
May 10 of 2006 started off with a slide very similar to the correction we have seen this week. During this slide bulls who were caught off guard either sold in panic or gritted their teeth and held on for a bounce to sell into to get a better exit price. This all happened in leg A down, as seen in the Dow chart below.



After a very sharp sell off the market finally found support, much like the Dow has done over the past two trade days. This encouraged longs who had held their positions through the first leg down and they started to look for the ever elusive "V" type recovery as they imagined that the market would turn on a dime and march right back up the hill. Likewise, many who had sold in panic during leg A down, started to worry that they would miss out on a sharp recovery and they bought back in on the bounce. This occurred during the B leg of the corrective move.


Leg B:
One thing that many fail to understand is that the market is like an oil tanker. Oil tankers, when full, take miles to turn around and change course. The reason why is that they have so much momentum behind them that they need to make a slow and gradual turn. The market also is a gigantic mechanism and when it gets momentum going like it did this week, it needs to work off that momentum before it can make a full turn.


Leg C:
Thus, we see that wave B could not possibly find enough buying strength to overcome the market's momentum and a sharp leg C down ensued. Oftentimes during these corrections, those who held on during leg A down, finally give up hope and capitulate during leg C. When they capitulate, what they don't realize is that the momentum pressure has finally eased and smart institutional money moves back in.

This is why this pattern repeats itself. Human psychology almost demands that it does.

So then, take a look at the current Dow chart.



As mentioned above, momentum indicators are strongly diverged against recent minor corrections. As such, we have to interpret the momentum as down here. If we are correct about this developing pattern, then over the next week or week and a half, we should see a minor bounce, represented by B in the chart above. If this bounce does not turn into a sharp rally higher, which we seriously doubt it will, then we are very likely going to see a great buying opportunity emerge in a leg C down.

As we mentioned in yesterday's report, we will be looking for a minor bounce next week to short into.

You can see then how these corrective moves provide for strong trading opportunities both on the corrective move down and then at capitulation, which usually leads to a great rally back up; sometimes even on to higher highs.

Buyers Now Face the Burden of Proof

The QQQQ failed before it was able to break through resistance at $46.00 and the S&P and Dow both rolled over after a period of consolidation just above their long term breakout levels. This doesn't mean that the market has to go down here, but it does mean that we necessarily have to take on a short bias until buyers prove themselves.

In other words, before Tuesday we were in an established up trend and the burden of proof was on the sellers. Tuesday they met that burden largely. We don't yet know if sellers have staying power, but now the burden has shifted to the longs. They must prove themselves by stepping up and buying.

Unless buying is truly spectacular over the next few days, we will consider this a dead cat bounce market phase and will be looking to work in to some short positions.