Securities Research Services

Thursday, January 31, 2008

Market Momentum Trumps Rate Cut

The Fed is tripping all over itself to lower rates. It has now dropped rates 1.25% in just 8 days. This is a historic number. Add to this a sentiment reading that is increasingly over bearish, and you would think that the trade set up would be bullish.

You would think.

The charts tell another story though. The market's downtrend pulled back on light volume in anticipation of yesterday's rate cut in a classic bear market pullback pattern. Then, yesterday's rate cut was met with a bull trap spike that trapped eager bulls in a mid day, high volume reversal. A classic failure of the 1st thrust pullback, which projects more downside to come.

It could be that the rate cut worked and the economy will pull itself together. The market may in fact not be reacting directly to rate cuts and sentiment here at all.

We think that the most apt metaphor for the market is that of an oil tanker. Oil tankers, when full, must make slow turns that cover several nautical miles before they can reverse their course. If the captain were to attempt a sharper turn, the momentum would cause the tanker to break apart.

The market is like this. Once the momentum gets going to the downside, it takes a great deal of time to change the direction of the move. Momentum is heavy after a high volume failure like the market just experienced is going to take some time to release its energy so that prices can once again turn higher.

Wednesday, January 30, 2008

Don't Game The Fed

The market is currently discounting another rate cut today. There is no sense in trying to game the Fed. The market's oversold condition has slowly worked its way off and we suspect that if the market jumps on a rate cut that sellers will pounce on it the way they did Microsoft's good earnings report last week.

When the pullback turns the corner we will reload with new short positions. Meanwhile it's a good plan to just sit on our hands while others jump in and assume the risk involved in trying to trade the Fed today.

Tuesday, January 29, 2008

Market Drifts

On Monday the market started its holding pattern that is likely to last until the Fed releases meeting minutes tomorrow afternoon.

Prices drifted higher on low volume.

"Drifted" is the key word to pay attention to here. Shorts were not squeezed and smart money was not buying. Sellers were simply on strike for the day; as they are likely to remain today.

One thing is clear. The bottom is not in yet. A trading bottom is not even in. It's best to remain patient here. The market is likely to retest recent lows and perhaps take them out before a true tradable bounce can get started.

Shorting in front of the Fed meeting is going to be tough, so manage your open positions and then wait for the right time before shorting more. A pop higher following the Fed might be the best opportunity for shorting we will get this week.

Monday, January 28, 2008

Upside Untrustworthy

Prices rolled back lower out of a pullback in the downtrend on Friday. This is a classic downtrend rollover. However, with the Fed potentially lowering rates again this week, prices may not gain much downside momentum just yet. It's probably a good idea to be stingy with your short entries here. It's better to miss some downside momentum than it is to get too aggressive shorting this oversold market too low.

That said, we believe that lower prices are in store before a true tradable bottom will be put into place. We have yet to see a true fear-inducing shake out that would mark a good tradable bottom. We would love to see the Dow down 300 points mid day at some point over the next week or two. And, if the Dow can experience such a fear inducing event, a mid day reversal would give the all go signal to go long.

Until we get something like this scenario unraveling, this market is going to be very, very hard to trust on the upside.

Friday, January 25, 2008

A Lesson in Probabilities

We've said it many times before and we will probably say it many times more, making money in the market is all about putting the probabilities in your favor. It could also then be said that you should only trade when the probabilities are favorable.

In other words, there are some markets where probabilities are so low that it is almost guaranteed you will lose money. During these times, cash should be your number one position.

How the Probabilities Stack Up Here

Before we look at the current charts we should probably explain what a situation with favorable probabilities looks like. There are many possibilities, but for the ease of explanation, we will examine a couple of high probability trading situations:

When the market trend is up and prices have pulled back to support on lower relative volume and technical indicators indicate a general near term oversold condition; probabilities are fairly good that you will see higher prices ahead. During these times it pays to look for good long set ups.

Vice versa, when the market trend is down and prices have pulled up to resistance on decreasing relative volume and technical indicators indicate a general near term overbought condition; probabilities are fairly good that you will see lower prices ahead. During these times it pays to look for good short set ups.

A Low Probability Example

On the other hand, if the trend is up and prices are in the middle of a pull back it just doesn't pay to try and pick a bottom where the pullback might exhaust itself. Pull backs are strange animals and they have a mind of their own. No one can see the future and no one knows when and where the pullback will end and prices will once again reverse in the direction of the trend. Trying to guess is nothing more than gambling. This is the environment that chews up trading accounts.

Likewise, if the market is in a downtrend, and is pulling back, you can guess where it might run into resistance, but until it stops and reverses and until the technical indicators flip back to overbought you are going to get chewed up trying to short.

Even worse, since surprises occur in the direction of the trend, you are taking a huge risk if you decide to actually buy against the broader trend.

This is Where We Are Now

We are right in the middle of a low probability environment. The market is in a downtrend; and a strong one at that. Yet prices are pulling back up to resistance. At some point there will be a tradable bounce in the downtrend, but at this point probabilities are very low for opening new short positions as we will show in the S&P chart below, and they are even lower if you choose to step in against the trend and start buying hoping that overhead resistance breaks.

Let's Take a Look at the Charts

As you can see from the SPY (S&P 500 ETF) chart below, the 10-, 20-, and 50-day averages are all in a steep decline (blue, green, and brown lines). This is a clear downtrend.

Also note that volume was heavy on the decline, but as of yesterday volume declined significantly from the previous day. This is typical of a pullback in the primary trend.

So far, so good. We have a downtrend, all major moving averages are confirming, price is in steep decline with heavy volume to the downside and decreasing volume to the upside. All the right conditions for shorting.

However, conditions are not yet right for entering new short positions.

Why? The pullback is still in tact. We can see several layers of overhead resistance including August lows and the declining 20-day average fast approaching price. Yet, until the pullback runs its course (making a lower high by closing below the previous day's low) and the stochastics indicator turns back down over eager short traders are bound to feel some pain.

We are already seeing this. Microsoft reported better than expected earnings and the market was gapping up in after hours trading last evening. We want to emphasize THE RESPONSE TO MICROSOFT IS NOT A BUY SIGNAL (unless you are perhaps a day trader).

What we are faced with today is a market that has the potential to gap up into some areas of major resistance. We are near, it looks like, a turning point where it will pay to reload short positions. But, probabilities are not quite ideal yet. We are close, but until we get there, remember, cash is a position to.

Don't be so eager to put your money to work when all systems are not quite in alignment yet.

Wednesday, January 23, 2008

Good Times Ahead For Traders - Investors? Not So Much

Yesterday's surprise rate cut threw a monkey wrench into the market plunge that was expected after world markets went into a melt down this week. Now the question is, do we have a tradable low in place?

We may have, but keep in mind that bottoms are a process and not an event. A huge amount of technical damage has taken place over the past few weeks and even a .75 rate cut doesn't promise to cause a V-shaped bottom to emerge.

Banking, real estate, textiles, and retail all look to have a near term bottom in place. But, volatility is likely going to continue to be massive and finding a reasonable entry point in these sectors is going to be rough.

Asia is recovering nicely today; especially China. Europe, however, is tentative as they wait to see how the US markets open today. Apple reported after hours and was gapping down last evening.

What we want everyone to keep in mind here is that this market is a falling knife. A dead cat bounce is sure to emerge from somewhere near the current price level; especially now that the Fed has offered a huge surprise rate cut and rumors have it that another .50 cut is still on its way. But a falling knife is a falling knife. It looks like the knife may have stuck in the ground yesterday, but it certainly hasn’t stopped quivering yet.

The Big Picture

It's important to take a step back and check out the big picture in order to understand where we are now at and where we may be headed next. We don't know about everyone else, but we have had a very difficult time trading this market recently. Trading is all about weighing the probabilities and probabilities are typically measured against past norms. This market has been anything but normal over the past 3 months, as we will demonstrate below. The fact that this is not a normal market environment forces traders to recalibrate their analysis to the much more violent conditions the market now finds itself under.

On to the Charts

Let's be clear. As of the past few weeks, the market is now in a confirmed downtrend with a confirmed top in place. Bounces will occur that allow for long side trades – and some of these bounces will be good ones – but the long term trend is now down and investors need to keep this in mind and consider protecting their long term portfolios.

We want to compare this current market top to the top that took place in 2000.

As you can see, above, the 2000 S&P 500 top took place over the course of an entire year. Then, when prices started to roll over they did so in an orderly fashion, simply bleeding lower.

The 2000 market top allowed institutional money time to unload their positions and get short. Retail simply held and hoped as the market dripped lower, wearing them out.

The Current Top

The current market top looks different to us. Over the past 6 months the S&P carved out a head and shoulders pattern. This indicated that distribution was taking place. But, what is different here is the way the market broke down. Rather than bleeding lower offering shorts plenty of time to add to their positions and keeping retailers holding and hoping, the market plunged.

This indicates to us that stocks have become like a hot potato here. Institutions seem to be bailing along with retail. At some point – probably some point near here – the market is going to bounce and likely bounce well. But, keep in mind that this bounce is going to be a selling opportunity. This market top began violently and it is likely to end just as violently as it began. The end looks to be a long ways off to us.

Good for Traders, Bad for Investors

This is bad news for investors but good news for traders. It will take some recalibration to get back in tune with the music of the market here, but this type of volatility leaves open wide areas of inefficiency for traders to exploit. Investors should, on the other hand, consider themselves warned.

Tuesday, January 22, 2008

Step Out of the Way; Things Could Get Ugly

While the US markets were closed for a holiday Monday, world markets crashed. Not sold off. Crashed. Germany was down 7% yesterday and opened down almost 5% more today. London was down more than 5% yesterday and opened 2% lower today. Japan is down almost 6% and it closed at daily lows threatening to move even lower tomorrow. China closed down almost 9% and it also closed near daily lows after being down a whopping 13.7% in just two days. India's Sensex opened down more than 11% today spurring a one hour halt.

This takes us to the US markets. There is no doubt about it. The open will be ugly. The big question is, is this a buying opportunity, a signal to cover short positions, or is it still not too late to sell?

We believe that September 11, 2001 can give us a clue. The market will surely do its own thing today but as you can see from the post 911 market crash it paid to sell at the open:

Prices on the S&P index fell 10% lower from the post 911 market open. And that also followed an emergency interest rate cut from the Fed – no doubt we will get an emergency rate cut this week.

Again, 911 is not a road map as to what will happen today. World markets seem to be selling off harder this round than they did after 911. Probabilities are pretty high that we will see a capitulation event sometime this week and next week at the latest. Probabilities are also pretty high that the gap at today's open will fill sometime in the next couple of weeks.

There are a huge amount of unknowns though. Our advice is, if you are short, stay short. If you are holding long trades, sell at the open today and reenter only after the market stabilizes; you will likely be able to enter at lower prices. Mainly, just stay out of the way today. It could be a bloodbath.

Friday, January 18, 2008

Panic Here Would Bring Opportunity

The advance decliners in all three major exchanges were pushing near 80% decline yesterday. This is typically the number we like to look for that marks capitulation. Volume was heavy, but not heavy enough to be considered capitulation. The VIX finally broke its divergence with the market price action and spiked up near levels where the last two market declines reversed. The NASDAQ is honing in on major support; an area where the market has seen the greatest amount of reversal trading over the past 1 1/2 years.

What all this adds up to is the fact that the market is much closer to a tradable bounce than it is to more pain. Conceivably we could get a wash out capitulation day near current levels that would offer an excellent long side entry.

If prices instead just bounce weakly today, we will likely still be trying to find a bottom next week.

Bottom line here is this: A panic today would be a great buying opportunity. A minor bounce today without more panicked selling would indicate that we should still keep our shorts open and that more selling is likely to ensue next week.

We are crossing our fingers looking for a panic as that's where the best trade opportunity will be.

Thursday, January 17, 2008

2007 Lows Call Out

Bulls fired back yesterday causing short squeezes in some of the weakest of sectors. This fired off a rally in stocks like KLAC, trapping short positions.

The day truly didn't represent any real buying strength, however, for once the shorts covered, no follow through ensued and prices faded strongly into the close.

If the market does get a bounce here, it is likely to get hit hard with more selling. Support at current levels is thin at best and 2007 lows beckon.

Wednesday, January 16, 2008

Continuation Pattern Emerges

Index prices broke down on heavy volume from diamond continuation patterns yesterday. This indicates that a fresh wave of selling will follow.

The bottom in this market is a long way off still, though we are sure to get a tradable bounce at some point. The Volatility Index (VIX), which is used to measure fear, barely ticked forward yesterday so there is a lot of room for the market to move lower before true market-reversing panic sets in.

It appears that investors are waiting for a Fed bounce before releasing their shares. We suspect that they may end up releasing them in a panic a few days from now instead.

Japanese markets, which have been great indicators for projecting the US markets lately, were crushed once again in today's trading.

Monday, January 14, 2008

Stay Defensive

Prices remain extremely oversold, but even so, they continued to slip on Friday.

Buyers stepped in at the close, but buying was tentative and did nothing to erase the damage caused by severe selling throughout the day. The market has a good chance of just bleeding lower from here before a true oversold rally can form.

This is no time to be bottom fishing hoping to catch the oversold rally. It's also not the time to be getting aggressively short. It's ok to manage current short positions, hoping for lower prices as it were, but don't press by putting your entire portfolio to work here. Wait for prices to rally back into resistance before reloading. Probabilities will be much higher after the market blows off some steam.

Friday, January 11, 2008

Use Caution Going Forward

The market responded somewhat favorably to Bernanke's speech yesterday. We would urge extreme caution here though if you are thinking of going long.

Yes, the market is technically way oversold. And now the Fed promises to do something if necessary – not really anything new going on here.

If you are tempted to make a long side bet, keep in mind that you are making a bet against the primary trend. That doesn't mean that long positions won't work here, but since surprises tend to occur in the direction of the trend, risk is very high here. It might be a good idea to use call options if you are going long so as to limit the downside to the premium paid.

Japanese markets today continue to diverge lower, following through to a fresh multi month low, so this is one more headwind bulls must face in order to eke out a gain.

The long and short of it (pun intended) is that the market may certainly be at a tradable bottom here. Yet, it faces a high degree of headwinds to the upside and the path of least resistance is down from here. So, if you are long, be very quick to admit you were wrong and exit if things don't go your way.

Thursday, January 10, 2008

Follow Through Significantly Higher Not a Sure Thing

Yesterday the market bounced off oversold conditions. This bounce was inevitable either sooner or later. What is not clear here is how far the bounce can go from here. Sellers are going to be chomping at the bit to short any rally here and just about every analyst out there is looking for at least two or three up days following yesterday's reversal.

The market tends to make monkeys out of the most people most of the time. Will it make a monkey out of the analysts who are looking for a tradable rally from this level? It remains to be seen.

Right now the market is pinched between the hard place of oversold conditions, increasingly bearish sentiment, and a vicious downtrend that promise to create a strong headwind for the bounces. still has the SPY rated at an 80% sell in the short run and a 96% sell in the long run.

The Nikkei average, which tumbled 4% last Friday, leading to a similar sell off in the US markets that same day, bounced 2% yesterday, only to give back more than half those gains today. Likewise, London's FTSE, which seemed to be stabilizing yesterday, is struggling to keep its gains at the time of this writing today.

Without follow through on the world markets, there is certainly no guarantee the US markets will see follow through today.

This market is guilty until proven innocent and yesterday's strong reversal isn't good enough evidence to declare the market not guilty. It's a start, but that's all it is, just a start.

Wednesday, January 09, 2008

Market Get's It's Head Lopped Off

This is an ominous looking chart:

Above is the weekly SPY chart. A head and shoulders pattern has clearly emerged over recent months and this week we have seen the neckline of this pattern lopped off like Louis XVI's head.

Selling has been extreme in recent days, but extreme is a relative term. When the market turned the corner in 2000 the QQQQs fell 30% before a decent tradable oversold bounce occurred. The Qs have fallen 10% from their December highs so far.

We aren't suggesting a 30% drop here is inevitable, we are merely saying that just because we are oversold here doesn't mean we have to bounce. VIX levels indicate that fear isn't anywhere near extreme. This divergence between the VIX fear measure and price action indicates that prices are now firmly sliding down a slope of hope.

As much pain as this causes investors, frankly, we embrace this sell off. The market has been in distribution mode for a couple of years now and has been increasingly difficult to trade. This sell off relieves the pressure that has been building and opens up vast reserves of inefficiencies to exploit for profits.

They say that stocks take the stairs up and the elevator down. We are already enjoying quicker profits this week than we have in two months

Tuesday, January 08, 2008

View Any Bounce With Skepticism

Yesterday buyers stepped in at the end of the day as oversold conditions reached extreme levels. It is likely that the market will experience some type of bounce from current levels.

Right now, however, the market is guilty until proven innocent. This is not the time to step in and buy the lows for anything more than a day trade. It is in these types of markets that eager buyers provide fodder for the short sellers as stocks are passed from one weak hand to another like a hot potato.

We will be viewing any bounce here suspiciously. Keep an eye out for a run back up to resistance that occurs on decreasing volume. Volume and price is key here. We will be buyers again when a higher low is followed up with a higher high. We strongly urge readers to take the same skeptical attitude here.

Monday, January 07, 2008

Energy Reverses It's Fortunes

We have a very important rule we follow when trading breakout stocks. We never buy a breakout that occurs on one day of heavy volume. We need to see a pattern of heavy volume accumulation that indicates institutional interest before we touch a breakout stock. Following this rule helps avoid failed breakouts.

On Friday we traded two breakout stocks, FWLT and EOG. Both stocks broke out from a strong base of volume.

Yet, they failed. Not only failed, they failed miserably.

So, why did our volume rule fail to protect us this round? These breakouts failed because the market rules changed on Friday. 70% of the market has been arguably in bear market territory for several months now. On Friday, the jobs report was used as an excuse to take the remaining market leaders to the woodshed for a spanking.

The rule of the day was sell everything, and sell they did. This resulted in moving the QQQQ into a primary downtrend and led to a mass failure in the energy sector trend that had been running hard on strong oil prices.

It was a tough day followed by a couple of tough months. The failure in the energy trend, however, gives us a high probability shorting set up. Failed breakouts tend to lead to steep declines and some of the high flying energy stocks have a good ways to fall before they run into support once again.

The market spoke loud and clear Friday.

Friday, January 04, 2008

There is Always a Bull Market Somewhere

Bear market stocks, such as banks, financials, home builders, and retail broke lower yesterday even as major indices held support. This is not a good sign for the overall health of the market. It indicates that the market is under severe distribution and that selling activity is being masked by somewhat stable index prices.

The S&P and Dow have both experienced a series of lower highs and lower lows indicating that they are in the first stages of a bear market. Even so, yesterday prices in these indices refused to break lower, so we are likely to see some sort of a rally before they actually break down.

Likewise, the QQQQ held support.

Our read on this situation is that while the intermediate term outlook suggests lower prices ahead, shorter term, late comer shorts may get squeezed as those with the prescience to sell last week take profits.

Market indices are heavily testing support levels and it seems likely that the last line in the sand will soon give way. That's not likely to happen until stocks regroup a bit. In other words, focus on shorting any rallies here, but don't chase prices lower here as you are likely to get burned. And, most importantly, don't try and buy any downtrodden stocks. These stocks are likely to frustrate buyers as they wear them down by constantly bleeding lower.

Meanwhile, we have a full blown bull market in the oils and oil prices are getting ready to challenge the $100 per barrel level. A strong underlying bid is occurring in stocks like XOM and CVX.

Jim Cramer is famous for saying "there is always a bull market somewhere." We aren't sure this is entirely accurate, but it is certainly accurate now.

BTW, the Japanese market is down a whopping 4% today! This following several 2% down days. Ugly business this.

Thursday, January 03, 2008

Go With The Strong Downtrends For Big Profits

It's not a good idea to try and figure out where this market is going to go next. Selling was profuse yesterday and the uptrend in the NASDAQ is now at risk of breaking down into a primary downtrend.

That said, every single time this sector has threatened over the past few years, it has fooled shorts and rallied. Will this time be any different? Only the mythical crystal ball knows.

Forget about trying to figure it out.

Meanwhile, run with what is working. After yesterday's session, downtrends in a broad number of declining sectors resumed offering shorting opportunities for the agile.

Once again, forget about working on the stocks in the middle and focus on the extremes. 52-week lows should be your mantra here.

Wednesday, January 02, 2008

Leave Predictions to the Gamblers Today

Monday the money managers were on vacation, leaving the day to the day traders. Prices took a dip at the close as day traders punched the clock making an exit. Essentially, we have had no valid clues over the past few sessions what to expect when money managers return today.

Going to the charts; we scanned each individual industry group looking for any areas of the market that are showing unusual strength or unusual weakness. The energies and agricultural continue to trade near their highs, which is bullish, but even these areas did not show any unusual levels of buying interest over the past few sessions.

Likewise, mortgage insurance and other areas that are in strong downtrends, like the home builders and areas of banking that are exposed to sub prime, continue to trade near their lows, but did not show any unusual levels of selling over the past few days.

For months now we have been arguing that the extremes offered some level of tradable advantage, but that everything in the middle offers only random probabilities at this time.

This hasn't changed.

And, since we haven't a clue how money managers are going to handle the extremes as we kick off the new year, it's best to pull up a chair and stay sidelined one more day.

If we had a gun to our head and were forced to make a prediction, we would guess that the weak action in December will give way to buying interest in early January. After that, it's anybody's best guess.

To be honest, it doesn't matter what the market does this year. Those who will make money will approach it objectively, they will run with the probabilities, use good money management, and if they are wrong, they will use their stops and reassess the probabilities once again. Adopting a grand theory about where the market is going to go and then betting in that direction hasn't paid off in the past and it won't this year either.