Securities Research Services

Thursday, May 31, 2007

Tough and Getting Tougher

The already extremely tough market just got tougher. Yesterday the Chinese market took an almost 7% dive. The last time something like this occurred was on February 27 and the US markets were hit hard. The tricky thing about the market though is that it does its best to confound the greatest number of people.

So, those expecting a slide after the morning gap lower were doomed to face buying instead. End of the month liquidity probably didn't help the issue much either. The morning dip wasn't really much to write home about though. Prices for the most part ran back up to right shoulder resistance on the head and shoulders pattern we have been discussing and they were locked down from there.

It was the reaction to the FOMC minutes that really put it to the bears and squeezed shorts yesterday. The initial interpretation is that the Fed was dovish on rates. Reality is that some members of the Fed are a bit hawkish here and are intent on actually raising rates. With the economy already on thin ice, this has to be disturbing to the market. So, today we will see how the market reacts now that it has had some time to digest the Fed statement.

Early on today we should see more buying as sentiment remains bearish and shorts are vulnerable. We will need to see how the market closes today in order to determine whether or not it is necessary to change our bearish posture.

Wednesday, May 30, 2007

No Need to be Aggressive This Week

We continue to operate under the hypothesis that the market is forming a head and shoulders top. Prices moved up to resistance yesterday, and should be contained roughly near yesterday's close. We scanned the market very thoroughly and we had a very difficult time finding anything worth trading. In the past when we had a difficult time finding good trades the market has tended to be in quiet distribution mode, enticing traders to buy or even sell short, only to stop them out on pure market noise (meaningless volatility). As such, keep your order sizes small here and don't be aggressive. Wait for the right price to come to you, don't chase because you are worried about missing a trade. This is very important advice to heed in a tough market like the one we are in right now.

Monday, May 28, 2007

Clarity Will Come and the Patient Will Profit

Thursday's selling was stemmed on Friday. The question here, was Thursday's sell off the start of something more, or was it just another bump in the road on the way higher?

There aren't a lot of clues to go on. Sentiment is mixed here as too many traders are long stocks and an equal number of traders are too short the indices. This translates to an overly bullish sentiment on individual stocks and an overly bearish sentiment on the indices.

Our scans don't help much. We are not finding many solid entry points to go long at. Very aggressive traders are quite likely to buy now that most stocks have pulled back to their 20-day averages. The problem with this strategy, from our perspective, is that stocks have moved too far, too fast to maintain this steep climb. In the past, under these types of conditions the failure rate has been very high.

Even so, we are in the last days of the month, where liquidity generally drives the market. And since this has been a market that has been floating higher on a sea of liquidity (as opposed to demand based on fundamentals) we may see prices try to move higher early in the week. The big question is, will sellers use rallies to aggressively sell, or will they step back out of the way and let prices drift higher on the fumes of liquidity?

It's difficult to say at this point. What is more clear is that this market is ripe for a larger correction and if they can move prices even higher, then we are only temporarily avoiding the inevitable and compounding the strength of the coming correction.

What is also clear is that being long in this market has led to a great deal of pain. Stocks have been teasing traders by setting up and then burning them as set ups fail. This is not the type of behavior that occurs in a strong market. Because of this, it's best not to be overly aggressive in this market. Keep position sizes small, and be patient as you wait for more clarity. That way, when clarity comes, and it will, you will have preserved your cash to take advantage of the opportunities.

The vast majority of traders get burned in these types of market conditions, when they should be conservative or sidelined altogether. Fighting in confusing markets ends up causing trading accounts to bleed money little by little and when real opportunities return they find themselves so poorly positioned that they can't take advantage.

Friday, May 25, 2007

Correction Underway

Yesterday’s sell off has been a long time coming, and we embrace it wholeheartedly. This is a market that has been moving up on fumes for the past five to six weeks. Volume has been poor on the up days and, for those who have followed us, you know that we have been complaining about the quiet distribution taking place just below the surface.

It’s been miserable finding good stocks to trade during this episode, as most stock set ups have been poor and have just not performed well. Long trades were just not working in that environment. On the other hand, the alternative to being long was just not an option. Shorting stocks over the past month has only led to pain for those who prematurely called a top. This market has been great at running up and triggering stops and the running out of gas before gaining further momentum.

But that was then and this is now. Now the market has finally begun a larger, and much, much needed we might add, correction. We should now begin a new phase in which the market should cycle lower for the next few weeks. This offers a huge amount of opportunity for those who don’t fight the trend. Embrace the downtrend and short the bounces for now. And when this has played itself out, we should see a much more stable base from which to buy stocks again, offering us plenty of great opportunity to make money on the long side again as well.

Thursday, May 24, 2007

Bears Receive a Catalyst

One or two distribution days does not necessarily lead to a correction. However, when distribution days start to pile up, it makes it more and more likely that a correction is about to get underway. This is the case here. We have seen at least 4 distribution days in the past week and a half.

Most notably is the fact that the S&P 500 has tailed off into the close over the past three days now. Likewise, the QQQQ, which broke out earlier this week, is now failing miserably. As you know if you have been following, we haven’t trusted the QQQQ breakout from the start. Primarily because volume was weak and because we couldn’t find evidence that underlying stocks were moving up with the index. This told us that quiet distribution was going on under the cover of rising index prices.

Yesterday’s comments from Greenspan gave sellers the trigger they had been looking for.

Wednesday, May 23, 2007

Sector Rotation May be Underway

The Dow and S&P gave sell signals again yesterday. However, we are highly suspicious that these signals are bear traps. There are a number of technical and fundamental factors favoring a bullish posture in the near term.

First, sentiment is extreme here. Options traders are favoring nearly 3 puts to every 1 call contract. This bearish sentiment is a strong and reliable indicator that prices will move higher. Second, the QQQQ broke out on Monday and then yesterday it spent the day consolidating gains in what will probably result in more upside over coming days.

The market remains afloat in a sea of liquidity. Yen carry trades are likely the main source of liquidity. And right now there is little economic data for traders to take a cue from, so with cash in their coffers they continue to buy.

Finally, we are very near the end of the month buying window when the market is generally positive.

Weakness in the S&P and Dow over the past few days may have more to do with sector rotation than distribution (which is how we had interpreted it as late as yesterday). As such, we are adjusting our posture from bearish to cautiously bullish. Keep in mind that the market is dynamic and it requires a daily reassessment of the data and flexibility. Being married to one opinion can be damaging to one’s portfolio.

Tuesday, May 22, 2007

Price Matters

The QQQQ broke above its all important $47 yesterday. Though by the close it had given back half of its gains and closed right at this resistance level. Nevertheless, from a daily view, and even now on the weekly view, the charts look bullish.

It’s a very tough read here though. For on the day that the QQQQ finally made a move, the S&P and Dow both gave back intraday gains and closed red on heavier than normal volume. For the second week in a row these two indices marked a high volume distribution day in virtually the same price zone.

We scanned the tech sector heavily to see if there is something to the QQQQ breakout. So far there doesn’t appear to be. We couldn’t find one tech stock that we wanted to trade here. Even more distressing is the hard intraday reversal in the semiconductors. If tech is going to break out, it can’t really get far without the semis coming along for the ride (and preferably leading the way). But the Philadelphia Semiconductor Index and the SMH both have minor head and shoulders patterns and are now carving out the right shoulder, which tends to occur before a larger decline.

So what to do? As we said, that’s a tough one. Last August the QQQQ started to power higher in similar fashion. We fought it back then and found lots of reasons why the move shouldn’t be trusted. We also found lots of reasons why it should pull back any day. It ignored all of our “sound” reasoning and powered higher.

We need to be careful not to make the same error twice. Right now the QQQQ is at an important juncture. As noted, it has resistance at $47. If it can follow through and close above this level, then we need to throw out all of our reasoning why it shouldn’t be moving higher and just embrace the move. Right now we can’t find one problem with the QQQQ chart. Our biggest complaint is that we can’t find any underlying tech stocks to buy here. If the QQQQ follows through over the next day or two, hopefully that will change.

In the end, the only thing that matters is price.

Sunday, May 20, 2007

Hangover or Follow Through?

On Friday we said: “If we are correct, the market should float higher today in order to give call buyers (which in yesterday’s case likely represent smart money) the opportunity to escape with quick profits.”

And indeed, the market closed out the week on a high note.

Keep in mind that the run higher in the blue chips is primarily liquidity-driven. The deal with liquidity is that it can be profuse one day and the next day it can dry up. The problem with this is that when the tides turn and everyone starts to run for the exits, there are only a limited number of doors to escape through. This is what occurred February 27. Everyone sold at once and prices took a huge tumble.

There are some closely watched data releases this week, including home and durable goods sales. Could these bits of data drive the market to fresh highs or cause everyone to head for the exits?

Right now money has been flowing to the blue chips as the tech-heavy Nasdaq and more speculative small caps have both remained range bound and have been underperforming. The QQQQ closed Friday at the top of its range, where we have shorted it.

The QQQQ and small caps could play catch up if on the off chance that the market is ready to make a multi year run similar to the one started in 2003. It’s best to bet against these types of breakouts though, as they are anomalies and the probabilities are stacked against them.

Today is the day following options expiration and Mondays following expiration tend to bring options week hangovers, when positions are put on for the next month’s contracts. We suspect that today won’t be any different.

Friday, May 18, 2007

Bearish Divergences on Dow

In the options market yesterday, trading on index options was virtually 1-1 puts to calls. In the equities, though, call buyers were buying nearly twice as many calls as puts. Normally we would interpret this as topping action, since options traders are nearly always wrong at market tops. That is, they tend to short dips out of fear on the way up, but then when they start to embrace the trend (near the top) they finally begin to buy calls on the dips.

Because this is options week though, we think there is another explanation for the heavy call activity yesterday. Expiration games, where the market is driven lower on Thursday and cheap call options are snapped up in order to be sold the following day when selling pressure is released.

If we are correct, the market should float higher today in order to give call buyers (which in yesterday’s case likely represent smart money) the opportunity to escape with quick profits.

Yesterday’s trade saw yet again underperformance in the QQQQ and IWM, leaving us to look for a larger correction once the blue chips finally give way. The Dow is extremely extended here and the rule of regression says that we should start looking for a return to the mean, which means a correction back to the 20- or 50-day moving averages it has moved so far above.

Bearish divergences are already showing up on key Dow indicators, so a correction back to the mean could occur any day now.

Thursday, May 17, 2007

A Look at Resistance

The market is giving mixed signals this week. On Tuesday the Dow tailed off at the top on heavy volume. Then yesterday, just as the market threatened to break down, dip buyers came in and bought prices back up again. Tuesday’s sell signal then gave way to a buy signal yesterday.

Does that mean we should run out and buy stocks? Not exactly. If you check the weekly chart on the QQQQ you will notice two things. First it is overbought technically and momentum has faded over the past three weeks. Second, it has been bumping up against the same resistance line that has hemmed in the index for the past 5 years.

This week has been one of the strangest and most confusing weeks we have seen since June of last year. Frankly, we are not sure we can trust any signal that comes out this week since options expire tomorrow. This one day up, one day down action is more than likely due to the fact that prices are locked in near maximum pain levels than it has to do with the typical tug-o-war that takes place at market turns.

Take a look at the weekly view of the QQQQ chart below for a better idea of how important the $47 price level is:

Note that it has been bumping up against resistance at this level for four weeks now. As the price struggles with sellers in the area it has traded in a range between $46-$47 for the past two weeks. This is the same pattern that has preceded past failures, which led to multi week downtrends.

Now, take a look at a broader view:

The chart above shows the QQQQ’s weekly view from 2004 until present. Note that the current price is bumping up against the same resistance area that has held the price in for more than 3 years.

One of two things must necessarily occur here then. Either the price is going to fail one more time, just like it already has so many times over the past 4-5 years, or the price will break out above $47.

A break above $47 would be a very significant event and it would likely lead to a multi year bull market. A failure at this level may just lead to a regrouping and another attempt at a breakout several months down the line.

We, and we are betting no one else, knows whether or not the QQQQ is going to break out here or if it will fail yet one more time. We continue to think that the wisest position to take here is to short as close to resistance as possible and use tight stops in case a breakout does occur. As we have been repeating this week, we have seen a number of trade set ups fail at current levels. If the market were on the verge of a multi year breakout, we would think that there would be a lot of individual stocks leading the way ahead of the indices. This just isn’t the case. Likewise, important technical indicators, including stochastics and MACD are at extreme overbought levels.

None of these things bar a breakout from occurring. Think of indicators as a way to measure probabilities. Indicators are never right 100% of the time, but if an indicator is overbought at resistance (which is the case here) then the probabilities favor a price reversal lower. Does this occur every time? No. Just more times than not.

Bottom line: It is important to not trade aggressive this week. Options expiration is making the daily market readings very difficult to interpret. And, with a major market leading index, QQQQ, bumping up against resistance, decision making becomes even harder.

The best course of action is to short the indices on the rallies and use tight stops. Anything beyond that would be considered gambling. Putting probabilities on your side is very tough right here, so it’s best to be very conservative until this situation resolves itself in either a breakout or a break down.

Wednesday, May 16, 2007

This is What a Top Looks Like

We preach all the time about calling market tops in a bull market. It’s a dangerous undertaking as stocks can continue to extend for much longer than anyone thinks is reasonable. We broke our own rule on this yesterday as we urged everyone to exit their long positions and open up shorts. The warning sign provided by the massive failure of so many good set ups was just too much evidence to ignore.

It now appears that we were correct. If yesterday didn’t mark a market top, then it sure did a good job of fooling us. The Dow made a new all time high, only to reverse mid day and close with a tailing top. It can be seen best on the DIA chart below. Note the tail on the top, which represents a rejection at the overhead resistance line we have drawn.

Volume was heavy on the day as well. Even more compelling is the bearish divergence between the other major indices, and in particular the Nasdaq and Russell 2000, both of which closed on a negative note for the day after failing to rally with the blue chips.

Adding insult to injury, put buying, which had been outstripping call buying on a 2-1 margin for weeks now, evened out to 1-1 yesterday. That the crowd’s overly bearish sentiment turned neutral on the day the Dow reversed mid day from a new all time high is extraordinary. The crowd is not exuberant here, but they are certainly not fearful the way they were up until yesterday.

Tuesday, May 15, 2007

Quiet Distribution Taking Place

Over the past week and a half we have witnessed the deterioration of great stock set ups. Some we have traded and many more have been on our watch lists. Essentially what is happening is we are seeing the type of stock set ups that work well in strong markets fail to follow through, meeting selling as they attempt to move higher on low volume.

This is typical behavior that precedes a market correction. It’s not easy to see and the good set ups, which appear, serve the purpose of lulling the crowd to sleep as smart money unloads into the rallies. This is why volume is low on up days like yesterday; because smart money is not buying, but is instead selling to the retail investors who are buying in hope of higher prices.

The action is very subtle and takes some time to see it. We have been wary of this behavior over the past week as we have seen some very good set ups fail. The last couple of trading days has now clarified that indeed we are witnessing quiet distribution. We have a rather large watch list, which we have compiled over the past week. Yesterday, more than 90 percent of the stocks on that list, which were looking good on Friday, failed to follow through as sellers picked off the tops.

We are now fairly confident that we are close to a correction. Whether it’s just a quick correction, like the one that occurred on February 27, or a long lasting correction, like the one that occurred during spring of last year we don’t yet know. The market is a flood with liquidity, so depending on whether or not that liquidity is in danger of drying up or not is what is going to drive the post correction market. Right now though, the market is overbought and stocks are vulnerable.

It’s time to use rallies to open up short positions. In fact, it may have been time to do so for the past few days now.

Monday, May 14, 2007

Trading Range Reasserts Itself

Friday morning we provided a chart of the QID, the exchange traded fund (ETF), which trades polar opposite to the QQQQ (Nasdaq 100). In other words, when the QQQQ goes down, the QID moves up at double the speed.

We noted the heavy distribution day on Thursday, which caused the QID to spike on strong volume. The chart provided showed that the QID would necessarily need to follow through higher in order to signal that a new market downtrend was in effect. We also noted that while there was technical damage in the market, that sentiment was overly bearish, making a market breakdown unlikely.

In fact we were correct. Smart money, trading off bearish sentiment, bought Thursday’s dip on Friday morning and indices and stocks alike rallied as shorts felt the squeeze for yet again calling a top too soon.

The result?

We find that the market is still in a trading range, most easily viewed in the price action of the QQQQ. The range is roughly between $46-$47 on the QQQQ. Until $46 is breached into the close, or until $47 is broken through and held into the close, the range remains in tact and what happens next is anyone’s best guess.

The QQQQ still has major resistance in the $47 area and the semiconductors, which broke out of their range, are now back at their major resistance levels as well. The S&P suffered a strong intraday reversal on Thursday, indicating a top. As such, the bears seem to have the advantage here as the battle wages within the trading range. Nevertheless, the bulls have had control of this market for almost a year now and sentiment remains overly bearish, so don’t count the bulls out just yet.

Friday, May 11, 2007

Belated Reaction to Fed not Positive

Extended conditions came home to roost yesterday as the market suffered a significant blow. Breadth was horrible as the majority of stocks sold off in a big way. Technical breakdowns dominated the market, indicating that Wednesday’s strength was nothing more than a bull trap.

The only positive that remains is the ugly bearish sentiment that predominates. When everyone expects the market to roll over, it seems unthinkable that it will accommodate the crowd’s sentiment.

Nevertheless, we can’t argue with the charts, even when weighing in sentiment readings. The chart shows a very weak market here. Likewise, we are starting to see broad failure in our long positions, which is a large warning sign. It is important to not fight the tape here.

Sometimes looking at the market’s inverse can give a clearer picture of where the market is at technically. Taking a look at the QID chart below (the QID moves up as the QQQQ moves down), we can see that a breakdown failure is in the makings. Put into QQQQ terms, this means that the breakout of the Nasdaq 100 may very well be in jeopardy of failure. Breakout failure is usually followed by a hard reversal lower.

If the QID can follow through and recover the downsloping trendline drawn on the chart below, we will have a breakdown failure in the works (which translates into a breakout failure on the Nasdaq 100).

Thursday, May 10, 2007

Positive Bias Continues After Fed

Stocks are really extended here, but a truism about the market is that an extended condition can last much longer than seems reasonable. The bullish case is this:

Stocks and indices continue to consolidate near the top of their ranges, response to the Fed was relatively positive yesterday, and sentiment continues to betray a level of too much distrust.

As long as these positives remain in place, it pays to stay bullish with tight stops.

Tuesday, May 08, 2007

Fed Day a Good Day for Inaction

Yesterday can be summed up in three words: stop running games. The atmosphere of weak buying that has been forcing shorts to cover at higher prices has given way to an environment of uncertainty and indecision, which has kept buyers sidelined and allowed for the types of stop running we witnessed yesterday.

It is unclear whether the market is getting ready to roll over into a pullback here or if the weakness is just a shake before prices turn higher once again. Quite likely the market will be driven by the response to today’s interest rate decision handed down from the Fed this afternoon. Likewise, the market will be driven by sentiment. If fear of a top causes a rush toward put buying, then we will likely see the market continue higher up the wall of worry into the end of the week. If on the other hand, we see complacency and call buying into the dips, then it may be time to wrap up our long positions and start looking to get short.

Today is a good day to just sit back and wait. Trading on Fed day is generally not a good idea. The outcome of today is likely to drive the market over the next few days.

Monday, May 07, 2007

Caution Flag Up

It’s becoming increasingly difficult to trust the market here. The trend could continue, but it appears to have stalled out leaving the market vulnerable for a sharp dip.

Tuesday’s are famous for directional changes, so be sure and protect your gains with tight stops today.

Sunday, May 06, 2007

Stay Long Until Confirmation

Stocks in general closed out the week on a high note. We suspect that there will be a lot of top callers coming out of the woodwork here, which could potentially keep the market afloat as they short too early and then are forced to cover at higher prices. Nevertheless, the market is vulnerable for a correction here.

It is a good idea not to get too aggressive and to make sure to keep tight trailing stops. If we see the market continue to inch higher this week, we may see better set ups start to emerge. If we see the market get stuck this week though, we may find that the truism “sell in May and go away” has once again proven to be good advice. We see no reason to take on a short position until the market confirms one way or another though.

Thursday, May 03, 2007

Breakout Watch

Last week we discussed the possibility of a QQQQ breakout, which would set up the market for serious ongoing gains. Then on Monday, bears struck back and caused some technical damage.

Repairs were made the rest of the week, however, and here we are again looking at the possibility of a weekly QQQQ breakout. Today will be interesting.

Wednesday, May 02, 2007

Bulls Respond

Bulls fought back yesterday as bears are apparently out of bullets. This keeps the uptrend in tact and heals a lot of technical damage incurred Monday.

Sentiment figures are mixed, so this won’t be much of a guide for us today. Slightly more puts were purchased than calls, meaning that there is just enough distrust here to keep things afloat. We would be worried if the bulls came back with enthusiasm. Since they did not, we should still have more upside to go in this trend.

The broader market may be relatively flat the rest of the week as institutional money hesitates in front of Friday’s economic data.

Note: Our office will be closed for a personal day tomorrow.