Rate Cuts vs. The Open Gap

Don't fight the Fed seems to be the mantra that we all need to heed at this point. The blue chip sectors have some major repairs that need to happen before they can be trusted again, but the NASDAQ is in great shape here and should offer some excellent long side set ups once it builds a bit better base of support. This is necessary as the move off the lows this week puts the sector in a bit of a near term unstable condition that is vulnerable to sharp, stop-gleaning downswings.

We will need to watch the financials for a clue as to how far to expect this oversold rally will be able to go. If the financials lag here, it will set up the S&P 500 for another steep decline once it runs into overhead resistance.

And, most importantly, everyone should keep in mind that we have open gaps below left this week as the market rallied on rate cut rumors. The open gap in April didn't matter for some months. It remains to be seen if this time the same will be true. Tread carefully until we can be sure.

Fed Whipsaws Shorts - Again!

On Tuesday we wrote: "Unless the Fed steps in with another surprise rate cut, the market is likely to continue spiraling lower."

Indeed, before the market opened yesterday a Fed board member made public comments that indicated future rate cuts were all but assured. Then later in the day the Fed showed the market that they are aware of risks to the economy here.

This was all the market need to bull doze short positions and rally.

We were caught heavily wrong-footed and suffered stop outs on positions opened the day before.

It's tough to be wrong in the market, but being wrong is a reality and it is how one handles reality that separates the winners from the losers. Winners quickly admit they were wrong and adjust to the changing conditions.

Right now the market is very tricky. Even though short positions were hit hard yesterday there are no guarantees that prices are going to continue to rally to new highs. In fact, the run up over the past two days is very unstable and we are likely to see much, if not most of it retraced before prices move significantly higher.

As we have been saying for weeks now, the broad market is to be avoided here. Focus on shorting rallies in the weak downtrends and focus on buying only in the few strong uptrend that remain. Everything in the middle is just a mixed back that is sure to chop up the trading accounts of those who get sucked in to the false set ups that are prevalent.

More Questions Than Answers

Yesterday's session left us with more questions than answers. The QQQQ refused to break down despite technical signs of distribution.

A sentiment rally is certainly a possibility here, which can squeeze some short positions.

Shorts in housing should be added to if prices bounce here.

Other than that, there isn't much to go on until we see how prices respond today. Europe and Asia are down slightly at the time of this writing, so we don't have a clue how today's session is going to shape up. It's best to stay very defensive here.

What We Said Yesterday, Bulls Didn't Step Up

Despite the very oversold technical condition, the market continues to see heavy distribution. The number of sectors that have spun down into 52-week lows has increased dramatically and the QQQQ trend is in big trouble.

Unless the Fed steps in with another surprise rate cut, the market is likely to continue spiraling lower.

Wait For Confirmation Before Stepping Into the Fray

Volume was extremely weak last week due to holiday trading. Likewise, Friday's 1/2 day doesn't offer us much of a clue as to what to expect as we move into the end of November. Trade set ups should be eyed with suspicion until we see how the market behaves today now that traders are back from their extended weekends.

Today is just not a good day to be stepping into the fray and making new bets. As we have stated so many times here, let others assume the risk during times of uncertainty.

The charts: The NASDAQ continues to outperform the financially heavy S&P and Dow indices. Last week, in fact, the horn was tooted indicating that a Dow Theory sell signal was incurred as the Dow index closed below its August lows.

In general, we don't think the charts alone offer us much to go on here.

The bullish case: Stepping back and taking a look at the bigger picture, we believe that a bullish case has merit though. The charts alone may not tell us much, but if you factor in charts, sentiment data, and seasonality, and insider behavior a bullish picture begins to emerge.

Sentiment readings are at extremely bearish levels. Given that we have just endured a huge sell off and are under oversold technical conditions, overly bearish sentiment can only be read as bullish here.

Insider behavior, according to Mark Hulbert, has turned extremely bullish over the past couple of weeks as the markets were selling back to support:

It turns out that insiders in recent weeks have dramatically cut back the pace of their selling. In the Vickers Weekly Insider Report published Monday, Argus Research reported that in the week ended Friday, the average insider sold just 1.68 shares for every one share that he bought. That's well below the historical average for this ratio, and well below where the ratio stood as recently as early November, when it stood at 3.04-to-1.

Seasonal factors and end of the month factors add to the bullish case here as well. Typically this week is one of the more bullish weeks of the year and December tends to be bullish as well.

The bottom line: The bottom line here is that charts look ugly, but are oversold. Probabilities strongly favor the bulls if you factor in all available data pieces. Nevertheless, the smart move here is to let the market confirm or deny the bullish case here before acting. There is no need to put money to work until the market starts to move again. Right now it's consolidating, but when its next move starts, there will be plenty of time to position yourself to profit if you follow your entry rules and stay patient.

Here's what to look for before acting: The QQQQ, as seen below, is trading in a pennant pattern at uptrend support. This pattern can break either to the upside or the downside. We suspect it will break higher, but it's best to wait for the break before putting more money to work.

Thin Holiday Trading Ahead This Week

Bottoming action continued yesterday as the market was able to pull off a hard intraday reversal toward the close.

Trading volume is sure to be very weak today as institutional traders take off early for the holiday. The market will be closed tomorrow and volume will be even more thin on Friday.

We suspect that the bottoming price action that we have seen over the past couple of days will continue until next Monday when the holiday week is behind us. It's best not to take any new positions this week and instead manage the positions you are now sitting on.

There is no sense in trying to force a trade in a semi-random trading environment.

Note: We will take Friday off this week in observance of the holiday. Have a great Thanksgiving weekend everyone!

Looking For a Snap Back

The transports have now firmly broken their uptrend, so while we can't call a bear market in the sector yet, the bull market is wounded severely.

Banking stocks still have some room before they reach an area where a bounce is likely, so we should continue to see erosion there as well.

The broader market is now at a place where it is likely to rally back up the hill. Sentiment is extremely bearish and indices are at support. It's a good combination for the bulls.

Year End Rally?

We will start off today with another quote from Jesse Livermore. Why? Because there is much wisdom to learn from a trader who was able to build his trading account to a one time size of $130M during the depression era.

Another mistake I made was to permit myself to turn completely bearish or bullish on the whole market, because one stock in some particular group had plainly reversed its course from the general market trend. Jesse Livermore

This is an apt description of the current market. Banks have broken down. Retail has broken down. Transports have broken down. Should we then be bearish on the entire market?

We believe that would be a mistake at this point.

Over the past year the QQQQ has pulled back sharply to the current rising support line it is now trading at no less than three times. Each time the crowd turned extremely bearish and each time preceding this one the QQQQ has inexplicably marched on to make fresh new highs.

The QQQQ is now at a place where we believe bulls are likely to make a stand once again. This is typically a very bullish time of the year as funds buy up stocks to enhance their bottom line for the end of the year. As such, we believe it makes sense to bet against a broad market break down at this time.

Shorts in the weak areas should continue to do well, but don't make the mistake of getting bearish on the broad market too early.

Sentiment Should Keep A Floor - For Now...

The market is at a turning point. It is in an intermediate downtrend but is near primary support. Technically it is in bad shape, but sentiment is so poor here that a break of primary support does not appear to be likely just yet.

Essentially, the market does not offer a very good set up on either the long or short side at this point. It is better to focus only on the areas that offer a strong trend. Transports, banking and housing are in strong downtrends, so these are areas to focus on. It's best to avoid everything else as choppy trading is likely to persist.

Time To Stand On The Sidelines

We are a bit obsessed with Jesse Livermore quotes this week, so here's another one:

but money cannot consistently be made trading every day or every week during the year. Only the foolhardy will try it.

This pretty much sums up the market as we move into options expiration tomorrow. October conditions were ripe for trading. Early November was great for the diligent shorts who were frustrated by stop outs during the month of October. This week is only good for the brokers and market makers. Swing traders need to recognize that conditions are poor for their sport and step aside until conditions improve.

More games are sure to be played, more trading accounts will be chopped up in the choppy market, and more broker fees will be paid until the strongest trends reassert themselves. Do yourself a favor and stay out of the ring while there is a melee going on.

Volume?

Index prices bounced yesterday and breadth figures were good across the board as most stocks saw strength. Missing, of course was volume, but volume doesn't matter, right?

Well, volume kind of does matter.

Nevertheless, the QQQQ has room to bounce before its oversold. The SPY may begin struggling in this area but could potentially see intraday prices as high as $150 before it starts to run into serious selling again.

Don't forget that the intermediate trend is down here, so don't start thinking that it's safe to get back in the water yet as a retest of this week's lows in the next few days is a definite possibility.

Bears Taking Over?

Jesse Livermore wrote:

"The average man doesn't wish to be told that it is a bull or a bear market. What he desires is to be told that specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn't even wish to have to think."

This may be true, but today we are going to take a look at the possibility we are moving into a bear market nonetheless.

Over the past few years it has been safe to buy the dips after sell offs like we experienced last week. There are a couple of important warning signs that this time around may be different.

First, the Russell 2000 index has made a lower high and is threatening to break its multi year up trend and make a lower low:



Next, the Dow Transports have already broken down:



We are not in a primary bear market yet and it is important to not anticipate that we will enter one by making big bets to that effect. It is, however, a good idea to be aware of the possibility that "the trends they may be a changin' "

What would a bear market mean?

For investors bear markets are, well, a real bear. They erode equity in the buy and hold accounts in a big way.

Traders on the other hand should not fear the bear, but embrace the bear. Bear markets tend to be much more volatile allowing for big tradable bounces and quick spikes lower. If the bear market is not struggled against, it can add more profit to the trader's portfolio than a weak bull market like the one we have been in for several years now.

We'll end with another Livermore gem:

" in a major bear market it is safer to sell when the market is down 50 points from the top, than when it is down just 10. The reason is, at down 50, all support is gone, and those who bought the breaks have lost all hope, are demoralized, and in a leveraged market are at the point where they all must try to exit the same small door at the same time."

High Risk vs. Low Risk Ways To Play This Market

Last week the market saw the biggest sell off that the market has experienced in over two years.

Over the past year the market has recovered strongly after each one of these types of sell offs and has marched onward to new highs. We don't know if this time will be any different.

What we do know is that the oversold market is likely to bounce here. What we also know is that buying this bounce is very risky business for anyone other than day traders who close their positions before the market closes.

Right now buying this market is very risky. If it is going to recover, then let's let others assume the bulk of the risk while we focus on the least risky and most probable play in the market; shorting the strong downtrends that are now in tact.

Summary: Buying in anticipation of a full recovery is a very high risk strategy. Selling the downtrends in the transports, housing, and retail offers relatively low risk, high probabilitity rewards.

Those who ignore this are doomed to struggle with failed breakouts and support levels that refuse to hold.

Nasdaq Gets Slammed To The Mat

Yesterday the S&P clearly broke through support on an intraday basis. Yet by day's end, it had forced a recovery very near the support line.

The big story of the day was CSCO and the NASDAQ trend. Cisco Systems broke down in a big way and took with it big cap tech as the NASDAQ trend gave up the ghost. The break down here looks very similar to July 31 when money stream also shot sharply lower on a big sell day.

If indeed this is another July 31 in the making, we will be looking at a dead cat bounce over the next few days that should be used as an opportunity to start working into short positions getting ready for the next shoe to drop.

Unless the Fed comes to the rescue again, and we doubt they will this time, the market is likely to favor the short side for the next few weeks.

Double Top or Inverted Head and Shoulders?

Yesterday we saw another 80% decline day as the market violently whipsawed out of the buy signal it gave on Tuesday. Negative breadth on the NY Exchange reached as high as 90%, meaning that 90% of the stocks traded on the NYSE traded in negative territory.

It is unclear what will happen next, but here are a few things to think about.

First, over the past six months, the market has seen ten 80% decline days. Seven out of ten times the market rallied hard the following day.

Second, while we don't know what the market is going to do next, the S&P can offer us a clue today.



As you can see on the chart above, the SPY closed at its right shoulder support on the inverted head and shoulders pattern it has been trading in over the past 6 months.

Keep in mind that the pattern can also be interpreted as a double top.

What happens next will help us determine what to expect next. If the right should support holds and buyers step in here hopes for a 4th quarter rally will be kept alive.

However, if the market follows through and closes lower today, the only reasonable interpretation will be that the market has entered a downtrend.

What to look for next?

• Follow through lower today would be a clear support violation and a signal to exit all long positions.

• A weak bounce today would offer a warning that support is in danger of breaking soon and would be a signal to exit all long positions.

• A strong rally day would signal that all remains healthy and would keep hope for a 4th quarter rally alive.

More Worry. More High Prices.

Despite all the bad news. Despite the fact that the housing market is in the dump. Despite the fact that oil prices are ready to take out Goldman Sach's Peak Oil Report price of $100. Despite the fact that retail is still in the dump. Despite all this, the market wants to move higher.

This is a wall of worry and it is the reason that it is important not to pay attention to news headlines. Paying attention to the news will make you miss out on some of the best market moves.

A 4th quarter rally is very much in the works here and trading opportunities that made us a lot of money over the past few months promise to continue.

Today we are once gain seeing great long side set ups that offer very promising risk:reward ratios.

Stick to the Fringes of This Market

The SPY arguably made a lower low yesterday, but it was able to close strong trapping shorts once again.

This has been the theme of the market this year. It teases the shorts, traps them and then reverses higher.

Short positions in the weak sectors provided in yesterday's report continue to remain viable. Likewise, longs in the strongest areas remain good bets. We would avoid anything that isn't trading at 52-week highs or 52-week lows.

What's Hot and What's Not

Support levels held on Friday so the market is most likely to see a couple of flat to positive days as we begin the week. However, there are some negative developments that need to be watched closely as we move forward.

First, Market Support Levels:



The SPY (S&P 500 ETF) created a lower high at $155 last week, but when testing its lower Bollinger band support on Friday, buyers stepped in and kept the index from printing a lower low.

So, thus far we do not have a confirmed downtrend in the broader market. We do have a broader market that has lost momentum, however.

As you can see in the chart above, the SPY broke its uptrend at $154 two weeks ago. Now the Bollinger band is starting to roll over. The threat that this can turn into a downtrend is real. It will be interesting to see what happens when the price returns to $154. Will sellers step back in or will the market shrug off the bad news and climb higher?

The QQQQ

Meanwhile, the QQQQ has maintained its uptrend. Friday's test was successful and the price did not break support.

Even so, there are some warning signs that need to be watched here. Primarily, money flow has diverged negatively as can be seen in the chart below:



So, while the QQQQ continues to make new highs, money flow is now making a series of lower highs and lows. This indicates that smart money has been selling the strength starting at $52.

Keep in mind that while money flow gives us a glimpse at what smart money is up to, it is a poor timing indicator. The price can continue higher, perhaps much higher, while the money flow continues to diverge. When prices do collapse, however, they may do so quickly. Thus it is important to keep very tight stops, focus on buying only support tests and avoid buying rallies. Likewise, hedge your positions.

What's Under Accumulation

Chemicals, Food and Beverage, Energy, Aerospace, and Precious Metals.

What's Under Distribution

Banking, Retail, Home Building, Insurance, Publishers, Autos, Trucking, Airlines, Semiconductors

Summary

Everything that is exposed primarily to the US domestic market and/or has sub prime exposure, is already in a severe downtrend. Anything that has exposure to Asian growth, or that benefits from a weak dollar, continues to be in a strong uptrend.

Trend Facing a Severe Test

Everything that was good about the market on Wednesday collapsed as if the rally were built on nothing but a foundation of dry kindling. The NASDAQ still remains in an uptrend, but it wouldn't take much to break down here.

We won't propose that we know what is going to happen next. This market has so many times recently seen 80% negative breadth days like yesterday, only to suck in shorts and then climb higher once again.

This time may be different though. There are a great deal of stocks that are seriously extended. The transport index is breaking down, the economy appears to be heading for a recession, and sub prime woes don't yet appear to be fully priced in.

Bulls have their hands full today. Let's see if they can turn things around yet one more time.

Don Trading Caps

Moves that occur on the day of Fed actions tend to be unreliable indicators of future direction. This time may be no different. Nevertheless, the market reacted very positively to the rate cut. The Nasdaq broke out to fresh highs on solid volume and the S&P and Dow cracked their upper Fibonacci retracement barrier, which was pretty much the last line of defense for the shorts.

It now appears quite likely that the broader market is going to retest this year's highs. Given the momentum behind the tech sector and the continued skittishness of the crowds, it appears likely that the highs will be taken out at some point before the year is over.

This is typically the most bullish time of the year, so put your trading caps on.