Overbought?

Stocks are overbought here after 5 days in a row without a pullback. Traders are also probably well aware that volume shrank on the rise. This is absolutely a classic short set up. The question is, will it work?

Our scans are showing us quite a large number of stocks behaving well here. A big, high volume down day would probably eliminate this finding, but it is what it is at this moment. The market usually does what everyone thinks it won't do, so does that mean this time it's going to continue higher?

We wouldn't put a lot of money on this idea, but we wouldn't short without confirmation either. Taking a wait-and-see view here seems to be the most prudent course of action as we enter arguably the most bullish month of the year.

How To Recognize When A Stock Market Bottom Is In Place

The stock market fell 50% from its high this year but if investors were paying attention, they could have avoided most, if not all of the loss. The big questions that remain, however, is where is the bottom and when will it be safe to buy again? Click here in order to learn to recognize a bottom and avoid buying too early the way Warren Buffet did when he lost 50%.

Any thoughts? We would appreciate your comments, good or bad.

Is This Short Squeeze Any Different?

Over the past two trading days we have experienced a short squeeze. Late Friday the market rallied on the news of Obama's Treasury Secretary nominee and then yesterday bulls had the impetus of a Citigroup bailout.

But is it enough?

So far we see no evidence that this short squeeze is any different than the short lived squeezes we have witnessed over the past couple of months. Volume shrank on Monday and prices merely rallied back into resistance.

That said, this is a holiday week and just rallying into resistance is not a good reason to re enter short positions. The big cats will be away this week leaving the mice room to play.

Moreover, it is important to keep in mind that the market remains historically oversold. At some point a significant bear market rally will develop.

The bottom line here is that trading conditions are not very favorable here. If the market can continue to drift higher on decreasing volume then we would go ahead and short again. If it pulls back on lighter volume there might be a good bounce trade to play. As things now sit, we just don't see any real advantages either way (at least ones that fit our trading style) so we will be sitting on our hands in cash waiting to see how things develop from here.

Very Scary S&P 500 Chart

While the SPY has yet to reach its 2002 lows of $71.20, the S&P 500 has now breached those lows.

We try not to make too much of technical analysis when applied to such large time frames since it seems rather dubious that such long term charts expanded to multi year monthly levels can accurately portray institutional positioning for future events. This is because the future is dynamic and investors will be reacting to unknown events in the future.

Let us try and put this in more simple language. Technical analysis lets us peak into the inner workings of the market and lets us know if there is current accumulation or current distribution. Current accumulation and distribution typically is a response to the outlook in the near term, whether it be last week's earnings or next quarter's projections.

But no one has a crystal ball that can tell us what is going to happen a year from now and every day the market reassesses the current outlook based on what the Fed does with interest rates, what the companies are projecting in future earnings, whether the government will bail out GM, etc...

Nevertheless, technically the S&P is in worse shape now than it was in 2002 when it struck bottom last. Technically, there is no real support before S&P 500 $450 and that's a scary prospect. Let's hope the outlook starts to change and change quick.

SPY $85 is Key

On Thursday buyers saved the day and gave bulls hope that a bottom was put in place. Typically a high volume save at support does indeed indicate that buyers are taking back control.

The problem is, on Friday prices once again eroded.

Sellers may have been on strike, but buyers did not step into the void and now we have a market that is just falling on its own weight.

We will get the countertrend rally we wrote about in yesterday's report. However, if the SPY breaks back below $85 on a closing basis then that rally may have to start from lower prices.

The Potential for a Large Stock Market Rally

This week economist John Mauldin writes:

The Potential for a Large Stock Market Rally Everyone knows that there are large amounts of hedge fund redemptions being processed. Some blame the current vicious sell-off on forced hedge fund sales as they have to meet these redemptions at the end of the quarter. This brings up an interesting possibility. My guess is that the large bulk of that money is going back to institutions that will need to put the money to work. Where will they deploy it? If they are projecting 7-8% total portfolio returns, they cannot put that money in bonds. My guess is that it will go back to other hedge funds or into long-only managers. This money will start to go to work in mid- to late January. We could see a very large rally the first quarter of next year. For traders, this will be a chance to make some money. I think it will be a bear market rally, as the recession will still be in full swing, and we could see a pullback when that money gets fully deployed. But it will be fun while it lasts. As traders begin to sense that possibility, we could see a serious year-end rally as well. Would I bet the farm? No, but I offer up the idea as a possibility. And I know a lot of people have large short positions that have made them a lot of money this year. Maybe it is time to think about taking profits. And now a few thoughts on the possibility of bailing out GM.

So let's take a look at the market and see if there are any clues that back up this possibility.

In October we saw the market essentially fall off the edge of a cliff, which changed the volatility parameters and threw our Risk Assessment Meter (RAM) for a loop.

Just a quick summary, the RAM measured the distance of price from the mean (or 50-week average). When prices revert too far from the mean in either direction, then a counter trend rally or decline typically ensues as prices revert back to their mean.

The steep market decline changed the parameters of "normal" oversold conditions as volatility increased dramatically to historic all time highs.

Nevertheless, this does not discount the rule that prices still return to the mean, the increase in volatility just expanded the range. In other words, despite the massive sell off, prices will not go down forever. At some point a countertrend rally will develop as prices return to the newly expanded mean. Except now, since we don't have historical measures to rely on, we won't know how oversold is too oversold until we see prices turn around and rally. We do know, however, that prices will at some point turn around and rally and that that rally will very likely be a whopper.

Back to the SPY chart again:

The SPY declined by a massive amount in October, but over the past 6 weeks we have seen prices settle into a trading range. Last week prices threatened to break down through the floor of this range, but on Thursday buyers stepped in and pushed prices back into the range on a closing basis.

This is our first clue that we are potentially nearing the line in the sand that marks the point at which the markets are now too oversold to go any lower before we get the regression to the mean rally that is inevitable at some point.

We don't know yet if this is it, but the fact that prices have not been able to push through $85 on the SPY on a closing basis is interesting.

This does not mean it is time to buy. Rather, it means it is time to be careful and observant. If prices can break through $85 on a closing basis then we may be in for another decline before a countertrend rally develops. But we haven't seen that yet. Until we do, it's dangerous to open new short positions. At the same time, it's dangerous to open new long positions as well until we get a follow through day to the upside.

We made that mistake on Friday and we paid for it. We are now licking our wounds are will wait for either a follow through day or a breakdown before acting further.

Slip Slidn' Away

What is significant about the market here is the fact that more than 300 heavily traded stocks have already closed below October lows. If the current trading range were a bottoming base we would expect to see market leaders breaking out to the upside, not the downside.

In fact, the only stocks seeing significant buying interest are the recession stocks like NDN.

Meanwhile, major retailers are trading at 52-week lows and oil and construction oriented stocks are down their with them.

It appears as if we are headed for another washout low before any significant buying interest reemerges.

Too Many Still Looking For Upside

Sentiment continues to be unfavorable for the bulls. Even as the market struggled yesterday more became convinced of upside potential. This overly bullish sentiment does not bode well for SPY support, which stands at $90. A break below that level will very likely lead to a retest of last month's lows and could potentially lead to a breakdown and the possibility of a true capitulation event.

Market Sentiment

We had an up day on decreased volume today. This doesn't give a lot of cause for confidence. Even moreso heightened bullishness readings give one a reason for pause as the market continues to struggle to mount a rally: Sentiment readings from Ticker Sense. Sentiment Trader has investment sentiment back at neutral. This is where it has been during each market downturn over the past few months.

Market Rolls Over

The inverted head and shoulders pattern on the SPY is in jeopardy of failing. Leading the way lower are commodities, retail and banking. This could be just trading range activity, but it has a much more ominous look to it.

Break Fails to Show Follow Through

The SPY broke out above the neckline of an inverted head and shoulders pattern this week. However, the breakout failed to follow through and was turned back on slightly larger volume today.

It's a good idea to lighten up on all long positions that are underperforming. We are unsure if this gives us a good short set up. From failed moves come fast moves, so there is some potential that short positions will work here. However, with the flattening 20-day average one has to wonder if we aren't just in for a period of consolidation rather than another sweep lower.

In any case, it's best to exit recently opened longs and wait for better entry set ups again rather than to get agressive in either direction here.

Short Squeeze Underway

Prices rallied higher on increased volume today. The S&P 500 has broken the neckline of an inverted head and shoulders pattern. The price target, if the pattern holds up, should be roughly $110; a significant gain from current price levels.