Regression to the Mean

In this post we will take a look at some of our research for those interested in understanding how we developed the SRS Risk Assessment Meter.

Before we get started it is important to observe two simple observations about stocks and markets.

Observation 1: Markets sometimes trend
Observation 2: Prices tend to regress toward their mean

Above is a chart of the S&P 500 between the years 2000 and 2002 when stocks were last in a bear market. There are two important things to note about this price chart.

1. The long term trend was down, but within that downtrend many countertrend rallies took place
2. Every single countertrend rally regressed back to the 40- and or the 50-week moving averages except one.

If you pay attention, a lot can be learned from this chart.

Here are a few observations that can be made from the above S&P 500 chart:

1. Countertrend rallies are likely to return to the 40- and 50-week averages, giving them a clear price target.
2. When the price is at the 40- and 50-week average opening new short positions can be highly profitable and risk of failure is low.
3. When the price is too far below the mean (40- and 50-week) short trades become increasingly more risky to take and trailing stops on open short positions should be tightened.

Finding the Forest Amongst the Trees

Now let's take a look at the current SPY chart and see if we can't determine why last week's sell signal failed, trapping short positions.

Last week the SPY gave us a sell signal on the day of the Fed rate cut. That sell signal failed and prices rallied on Thursday and Friday last week as seen in the daily SPY chart below.

Could the sell signal failure above have been predicted? Maybe, maybe not. But if we take a look at the weekly SPY chart we can see that risk of failure was high.

Note above on the weekly SPY chart that prices had reverted a great distance from their mean as measured by the 40- and 50-week moving averages. Prices could certainly have continued to fall lower, but risk of going short was high as historically prices tend to regress back to their mean.

The failure of Wednesday's sell signal broke the near term downtrend. This signaled that a countertrend rally is now in effect. Since historically prices tend to tag their 40- and 50-week moving averages during countertrend rallies, probabilities are high that we will continue to see the market rally (with pullbacks of course) until it reaches back to its mean.

Bottom line: It's a good idea to go lightly long on pullbacks, looking to take profit and go short when the SPY reaches the $143-$143.50 area.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Barchart.com 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.

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

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.

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.

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.

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.

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.

Happy New Year!

Happy New Year everyone!

Trading should be extremely light today as the session is sandwiched in between a weekend and a holiday. There is little insensitive to show up today, so most will not.

We suggest that subscribers also take the day off, rest up and go out this evening and have a great time ringing in 2008.

Don't Be A Fool

As we approach the end of the year it seems like as good of time as any to review some basic truths about stock trading.

One basic truth is that no one, no matter how smart or experienced, knows what will happen in the future. The best that can be achieved by anyone is a proper understanding of probabilities and proper action based on current probabilities.

Jesse Livermore once noted:

There arc times when one should speculate, and just as surely there are times when one should not speculate. There is a very true adage: "You can beat a horse race, but you can't beat the races." So it is with market operations. There are times when money can be made investing and speculating in stocks, but money cannot consistently be made trading every day or every week during the year. Only the foolhardy will try it. It just is not in the cards and cannot be done.

This is concisely put. In certain market environments probabilities offer better than random tradable advantages and money can be extracted from the market consistently and quite profitably by those who can read the advantages and who use proper risk management tactics.

In other market environments, however, there simply are no tradable advantages and probabilities promise nothing more than random price action. In random trading environments losses are almost guaranteed to occur because trade set ups tend to fail in choppy, random markets.

The current market environment is trendless. In a trendless environment trade set ups will just not behave the same way they will in a trending environment.

It would seem intuitive to look for ranging stocks and play the range in this type of environment, but the problem is, past performance is just not a predictor of future probability in a trendless market, so even ranges tend to be unreliable.

The solution to this problem is discipline. Heed the warning that traders like Livermore offer: " money cannot consistently be made trading every day or every week during the year. Only the foolhardy will try it." Stay sidelined when there are no advantages.

A trend will eventually emerge again and when it does, you will be able to take advantage of it only if you didn't drain your trading account trying to be in the market each and every day.

Focus on Highly Select Areas

Trading is dull and everyone knows, or at least should know that you don't short a dull market. Opportunities on the long side can be found if you focus on the right sectors and a handful of stocks that are catching a bid.

The Rest of the Week Can Go Either Way

Volume on Monday was understandably low given that it was a short session prior to the holiday. Look for volume levels to remain light until next week when the money managers return from their extended holiday.

Meanwhile, bullish sentiment has been spiking to dangerous levels even as prices have been climbing on decreasing volume. This is a warning sign that a near term correction may be coming to clear out the stops.

That said, so far the bulls remain in control of the larger trend. Let's take a look at the QID, which is an ETF that trades counter to the NASDAQ 100-based QQQQ.

Sometimes it helps to turn a chart upside down to better see who is in control of the trend. Looking at the QID is the same as turning the QQQQ upside down.

As you can see, the bulls are clearly in control as sellers of the QID have been active at resistance:



Probabilities then are that the market is slated to go higher in the intermediate term.

The near term (next couple of days) is more questionable, however. With sentiment figures turning overly bullish, we would expect to see overly aggressive longs pay a painful price for their lack of patience. In the weekly chart above the QID can turn either way here. A retest of the falling trend (rising QQQQ trend) is at least as much of a possibility as a break out to the downside (QQQQ breakout).

The message here, stay patient here and only buy pullbacks; don't be a price chaser.

Longer term: When we move into the new year the end of the year mark ups could potentially lead to a broader degree of selling. This market has been horrible for long term investors and the outlook does not promise to get better in the near term. Be highly skeptical of any upside breakouts here, they may in fact just be bull traps.

Strong Rally, But Skepticism Warranted

This rally may be just a late year holiday run. However, looking at the weekly QQQQ chart it looks like this rally could have legs. The real test will be whether it can take out December highs.

It seems likely at this point that it will. Volume may be an issue. It already decreased on Friday. This coming week volume is sure to be low as it always is during the last week of December. This will make it difficult to draw any conclusions about this market.

The last two years the market has rallied into early January and then turned back hard as selling kicked in. This year may be setting up the same scenario, so it is important to be skeptical of any move and to use trailing stops on open positions.

Buy Signal Kicks Off Santa Rally

In yesterday's report we showed how the QQQQ was at a pivotal point of support. It had to either break down or break higher. Whichever way it went, would likely decide the coming trend.

Yesterday it broke firmly higher on strong volume. This offers us a reliable and strong buy signal.

November and most of this month were teaser months. They put the market into a bearish mood and took shares from weak handed players. We don't know if the market can make a strong sustainable move out of this area of consolidation, but so far it looks like the bulls are regaining their leadership.

Changes Are Coming

The market typically moves from periods of inactivity to periods of strong activity. Over the past seven weeks, the market has seen one sharp three day drop followed by a weak, choppy, trendless environment, as can be seen in the QQQQ below.



Unless you were aggressively positioned for a short by bucking the trend and guessing the top in early November, you haven't had a sustainable trend to exploit since October.

Those with crystal balls called every turn in the chart above, but the rest of us have either just stuck to the day trade trends or have seen their positions fail to gain traction as strong moves reverse from day to day.

But the good news here is, as stated above, markets move from periods of inactivity, to periods of strong activity.

The QQQQ is at a pivotal point here. It has trend support at its current level. If it can rally from here and move up to take out December highs, we could get a sustainable trend going again.

If, on the other hand, it breaks down here, we could potentially see a bearish trend develop into the new year. Either way, this period of inactivity is drawing to a close and everyone should look for trading conditions to once again provide a trend that is exploitable.

Sloppy, Sloppy, Sloppy

The indices look to be turning the corner here, but don't be fooled. This masks the fact that the majority of the charts out there are just plain sloppy.

Don't forget that this is options expiration week. We doubt very much that stocks are going to turn around and march back up the slippery slope they have been sliding down. Sellers are likely to play games with any moves higher, so be careful, don't chase prices, keep order sizes small, and look for the one or two obscure stocks that might be bucking the non existent trend.

Turn Coming

Yesterday's selling concluded with a 70-80% down day for all three major exchanges. Sentiment figures spiked to overly bearish levels and twice as many dollars found their way into puts than calls. These types of figures are typical before a market turn.

Add to this the fact that we are near one of the most bullish seasons of the year and it makes sense to start putting together a list of potential short squeeze candidates.

Cash Remains King of the Hill

Running through scans over the weekend we get the impression that there is potential for another panic situation setting up. Sellers are getting pretty desperate in the retail and banking sectors, among others. Very aggressive shorts might work here. If we were in a true bear market it might make sense to get aggressive on the short side here. The problem is, we are not in a true confirmed bear market. In fact, seasonality would indicate that selling is close to exhausted and that we are more likely setting up for a strong reversal to the upside.

We noted last Friday that short positions taken here have great potential for trapping hapless latecomers, squeezing them as this random market suddenly reverses higher again.

This week options expire right in front of the holiday weekend. Games are going to get played. And since the largest number of positions are building up on the short side by those who have aggressively chased prices, it is most likely the short side that is going to feel the greatest amount of pain at some point this week.

We are itchy to put our cash to work, but conditions for doing so today are at least as bad as they were on Friday; and probably worse.

This market will give us something good over the next few days and as we sit in cash on the sidelines, it is our bet that the market is going to give us a really tremendous buying opportunity.

We know it's hard to be patient, but take another day and let others assume the phenomenal levels of risk that continue to build. When the risk takers pay a price for their impatience, then we will be able to step back in and reap the rewards for staying disciplined in a very tough market.

Cash Is A Good Idea Over The Weekend

Market conditions are tough; as tough as we have seen. The battle for the trend continues and trading is extremely choppy and arbitrary.

Stocks appear to be under distribution, but getting aggressively short is not an option yet. Shorts who push their luck are likely to get pinned against the wall in a Santa Rally, which remains a possibility; perhaps a probability.

Meanwhile, long positions are very vulnerable and failure rates on the long side of the trade are at least as likely to fail as they were last month.

So, what to do?

There are some good reliable downtrends that can be shorted. However, it is important to short strength and not weakness. This is a market that makes price chasers pay the price of stopped out trades.

We need to wait until prices come back to us. Yesterday we attempted a couple of shorts, but the prices moved down and not up into our entry areas. It remains highly likely that prices, even if they turn lower today, will be coming back up to areas where short positions can be put on.

Yesterday we closed out the last of our trades. In this market it is healthy to sit out the weekend in cash. Next week is a new ball game and if we wait, we will get the right set ups at the right times.

Primary Bear Market?

Talk about extreme volatility…

What to make of this market? Traders are getting jerked around like rag dolls here. Over the past month we have struggled to gain any kind of traction. In the past when we have struggled like this, hindsight has shown that we were in a downtrending market during the struggle.

Recognizing the trend when the market is in its initial stages of a downswing is one of the most difficult endeavors in the art of market analysis. We admit, we struggle in this area.

What others are saying:

Don Worden wrote in his report today: ” The market demonstrated overwhelming zeal in delivering its message. No hem-hawing around needed! The practical and safe assumption is that we are in a primary bear market."

The Kirk Report: "Be defensive, hold lots of cash, don't be complacent with your longs, protect your assets, and if you're so inclined, look for strength to short."

Alpha Trends: *summarized* There is a huge battle for control of the trend taking place on the S&P 500. $149 on the SPY is the battle ground.

How the fundamentals come into play:

We are not sure we are in a primary bear market as Worden suggests. Brian at Alpha Trends seems to have pinpointed the situation best when he shows that there is a strong battle taking place for control of the trend. Neither side has taken control yet and the reason why is due to the fact that the market is faced with a new fundamental situation.

The 1/4 point rate cut disappointed the market. There is no doubt about that. The market has determined that the credit crisis will not be eased by such a narrow cut in rates and it has projected that it expects a recession. The Fed, however, has offered up a new approach to the situation. Instead of further rate cuts, the Fed is offering to inject liquidity into the market through other means; means that are as yet untested.

The extreme volatility we are seeing may in fact be a jostling from long to short as Kirk suggests. Or, it could be that the market is trying to factor in the unknowns surrounding Fed liquidity injections.

The bottom line:

As of Tuesday's reaction to the Fed, long side trends are in question. We have continued to see some strength in the strongest sectors, such as Ag Chem, but this strength is not very trustworthy at this point.

Meanwhile, the downtrends in home building, transportation, banking, and retail are showing signs of resumption.

This has been one of the hardest markets to trade in recent memory and holiday factors and the battle for control of the trend that is taking place at this moment don't make things any easier.

It's probably best to be sitting with a good amount of cash on the sideline here and put some money to work on the short side in the downtrending sectors on days of strength.

Dip = Buying Opportunity

Over the past week prices have been climbing without pullback. This has been frustrating as a lot of good stocks have been going up without giving an opportunity to enter. It has been important to exercise discipline and refuse to chase the low volume rise.

Now that the market has sold off hard, predictably, after bullish exuberance and silly expectations for another 1/2 point rate cut, the market is giving bulls a second chance to enter the best stocks.

Today is probably a little early to step in and guess where the bottom of the pullback is going to be. Aggressive traders might try, but prudence would suggest standing to the side and looking for some sort of confirmation that support has solidified.

Bearish bias has returned, however, and a Santa rally into the end of the year is sure to cause the bears pain once again. So keep your powder dry here as this dip is the opportunity we have been waiting for.

Fed Fireworks

The Fed meets today and will release their monthly volatility wave on the market at 2:15 p.m. Look for prices to drift on low volume right up until the release. At release time, the usual fireworks will begin as huge bets are made in reaction to what the minutes mean or don't mean.

The focus today will be on language that indicates further rate cuts, or not. Speculation is sure to be rampant and the first move will likely be faded.

This is all just very normal Fed day stuff. Use the dips to buy the strongest stocks, for once the dust settles, the trend should resume.

History Repeats

July and August of this year the market corrected hard back to the long term uptrend that has been in tact over the past 5 or more years. Following the bounce off the uptrend, in September the market had created an inverted head and shoulders pattern on all major indices. Likewise, many stocks that looked set for further declines in August, had by September and October followed the broader market and created their own inverted head and shoulders patterns as well.

The reason? The Fed had stepped in to bail out the banks.

In November bears started to show their teeth once again as the banks pulled the S&P down and took the NASDAQ trend off its rails. This led to a steep decline back to the long term uptrend again.

Now, here we are again. The Fed is stepping back in and the set up is virtually the same. While major indices don't have a head and shoulders pattern to play off here, we are seeing the same sectors that ran hard in October set up with exactly the same patterns now that we are in early December.

History does indeed repeat herself and sector strength is repeating itself here. If you pay attention, you can profit from the repeat.

Big Cap Tech, Chem, and Industrial Metals are all catching a serious bid here.

The run up last week came on decreasing volume, so we should get a dip buying opportunity this week.

Pay Attention To Where Smart Money Is At

After a very tough month of November, bulls are now back in control and the strong sectors that gave us such a great profit this past fall are once again heating up for more gains.

Like this autumn's rally, it is important to be choosy about where to put your money to work. Stocks in the middle are still prone to choppy conditions; especially with the low volume nature that has thus far exemplified this rally.

Making money in the market is counterintuitive to natural logic. Stocks like MOS are overbought, yet this is where the bid is catching all the dips and where funds are putting their money in order to bolster their bottom line as the quarter runs to a close on December 31.

We can take advantage of this situation by paying attention to where institutional money is likely to support these stocks and entering with them in the high flyers. Every market environment has a theme. The theme of this market is to buy high and sell higher in the areas that the institutions are paying the most attention to.

Market Misdirect Sets Up Powerful Buy Signal

The market threw us a curve ball this week as technicals pointed to a breakdown. It can be very frustrating when the market throws a misdirection at you, but it is important to not let that take you out of the game. These types of reversals tend to turn into strong trends in the new direction.

We are already seeing signs of a strong trend developing again. The same old culprits that we profited from so heavily in September and October are once again breaking out to new highs and showing a great deal of momentum building. These include agricultural chemicals and metals and mining.

So yes, yesterday's stop outs were painful. Nevertheless, they free us up to play the true market direction, which revealed itself yesterday. Now we can once again put our money to work in the sectors that have been offering the greatest profits all year. We suspect that this week's losses will be regained quickly.

Don't Get Chopped Up Here

If you don't have anything nice to say, don't say anything at all. This has always been good advice to follow. Likewise, if you don't have anything meaningful to say, ...

The best we can offer today is that market conditions are extremely choppy. There are no good trends to follow and a catalyst to move the market may not occur until next week. It's best to stay patient here and wait for better set ups. Market predictability is an oxymoron in this environment. It is here that trading accounts get chopped up, so it's best to stand aside.

Downtrends Resume

Yesterday we noted that the longer term trend in the Nasdaq sector was still up and that shorting the broader market was not a good idea. Nevertheless, buying the broader market is not a good idea here either.

Meanwhile, we are seeing downtrends in the weakest sectors showing strong signs of exhaustion after last week's bounce. Technical conditions are ripe for a continuation of the downtrends in retail, banking, transportation, and housing.

Weakness Coming, Then Strength

Traders start off the week with few advantages. The market is quite likely to see weakness early this week. Nevertheless, the intermediate bias of the market should now be up due to the fact that the Fed is likely to lower rates yet again.

If you are a daytrader you should probably be putting on short positions over the next few days. If your timeframe is anything longer, then it's probably best to stand aside and wait for the long side to set up again before acting.

Here's why:

Using the QQQQ as our basis, note that the price is near term overbought and that the open gap below is quite vulnerable.



Swing traders might aggressively short today and hold for the gap fill, but the probabilities on the trade are less than strong. Trading rules 101 dictate that you don't trade against the trend. Below we will show how it is quite clear that shorting the market here is trading against the stronger, longer term trend.

Take a look at the QID, the ETF that trades inversely to the QQQQ (when the QQQQ goes down, the QID goes up).



It is clear that the QID is in a long term downtrend, which by default means that the QQQQ is in a long term uptrend.

So, once again, if you wish to be ultra aggressive here, open some shorts here. We believe, however, that any short positions are vulnerable to wide intraday price swings and that the smart money will be waiting to buy the next dip for a rally that is likely to last into the end of the year.

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.

Buckle Up, Here Comes the Fed Again

The market remains in a holding pattern in front of today's expected rate cut. There is nothing we can add to this observation. When we get a chance to gage the reaction to the cut, we may once again have something meaningful to say about the market. Until then, buckle down and get ready for the ride.

Stay Conservative Today

The market is in a holding pattern in front of tomorrow's Fed decision. It remains unclear what type of rate cut is in store and how the market will react to Uncle Ben's decision.

Now is a time to be conservative, not to make bets on Wednesday's market response. No one keeps money very long trying to get lucky.

S&P Looking Strong

The sharp recovery of the S&P 500 last week provides that index with a strong start to a handle on a cup and handle pattern.

Over the past few weeks now we have been arguing that with bearish sentiment so high and the fact that everyone hates this market so much that now is the best time to be in the market for what has the potential to be a major bull trend.

If indeed the S&P breaks out of a cup and handle pattern here we could see prices rise over the next 6-18 months.

We will say it again. The media and market analysts don't talk about impending recessions at market tops. Put your tin foil conspiracy hats on when analyzing media comments about the stock market. Smart money needs an enthusiastic retail market to sell to at market tops. The media doesn't understand the market and they tend to report the news that is being fed them by smart money.

When the media starts cheerleading it will be time to start selling into the rallies. They haven't started yet.

Focus On Chem While the Market Stews

The market is in a holding pattern and may stay that way until next Wednesday's Fed decision. Meanwhile, there is a sector that offers an excellent trend: Chemicals are in an uptrend and continue to offer high probability long opportunities.

There is no sense struggling with the areas that aren't decissive in this market. Chemicals, as we saw with MOS yesterday, are decissive right now.

What a Wall of Worry Looks Like

Volatility has been heavy over the past few weeks and yesterday didn't disappoint. Early weakness on Merrill Lynch's earnings, however, gave way to buying in the afternoon keeping a strong bullish bias alive.

Moreover, the Walker sentiment report came out last night and we find that the overtly bearish sentiment that was reported last week persists this week.

This is a market that it has paid to pay attention to sentiment with. Everyone hates this rally and hated rallies tend to keep on burning the bears and working their way up the wall of worry.

All the news is negative. Sentiment is negative. Analysts are grudgingly going along with the rally, but complain about impending recessions and poor earnings. And the market takes two steps forward and one step back and another two steps forward again.

This, folks, is a wall of worry.

Bullish Tenacity Keeps Uptrend Alive

One word can be used to describe the bulls in this current market; relentless. The banking sector is under massive selling pressure. Housing looks ready to make another leg lower. The S&P has suffered severe technical damange. And yet, the Nasdaq continues to march higher. Moreover, of the 600 odd stocks in our 52-week high lis, more than 60% are exhibiting bullish divergences on indicators such as money flow and money stream. What we have here is a mixed market with an advantage to the bulls.

Any Rally This Week Should be Shorted Into

The market bounced yesterday, but as we mentioned in yesterday's report, any bounce this week should be considered highly suspect. The Nasdaq is still in an uptrend, but the broader market has collapsed and is likely to continue to be a lead weight around the neck of the majority of stocks.

Under these types of conditions, long set ups tend to fail, frustrating those who fight the trend by giving them just enough encouragement to buy again. Once they buy, however, they find that prices refuse to make new highs and then within a few days prices bleed frustratingly lower until stops are triggered.

We don't know what type of correction we are facing here, but probabilities are high that long positions are going to struggle for a while. For now, it's best to focus on selling the weakest areas of the market rather than trying to buy the strongest areas.

S&P Failure Like a Rock Around Market's Neck

Last week we went against the crowd and went long again after making money on our short position HOV. We decided to do so as market sentiment was overly bearish and trading on sentiment has proven to pay off well over the past few months. This time we were wrong.

On Friday the failed breakout on the S&P 500 proved to be a lead weight around the market's neck and stocks sold off heavily. Most of our long positions stopped out.

Sometimes the market catches you unaware. We have been making money on the majority of our trades for two months now, so staying with the uptrend has been the right thing to do. We got caught pushing our luck on Friday, but that's what stops are for.

The alternative would have been to avoid all risk over the past two months and not make any money.

What we want everyone to keep in mind is that timing the market is an imperfect art. No one gets it right every time. You can, however, make money consistently by making sure you lock it up quickly when you find yourself on the wrong side of the tape.

Mixed Market Raises Anxiety Levels

The S&P closed below its 20-day average while the NASDAQ continued to power higher yesterday. Mixed performance in the indices can easily be explained by one word: Banking.

The S&P and Dow are loaded with banking stocks. The NASDAQ does not have much exposure to this very weak sector. What message the weak banking sector is sending about the market's macro issues here is probably not a positive one.

Even so, we continue to find good long side set ups. On top of that, near term sentiment is highly negative. Finally, we are entering one of the most bullish of seasons. Adding up all three of these factors outweighs the negatives for the trader. Let long term investors worry about the economy. Traders should be focused on the tape that is right in front of them.

The Bears Were Wrong; Again

Over the past few days the market has been under selling pressure. The S&P 500, which experienced a weak breakout last week, appeared to have experienced a failed breakout this week. This fact, and the fact that no one believes in the tech rally that just won't quit and oil prices reaching near $90/barrel, has caused a bearish din amongst pundits that is nearly ear-shattering.

A few weeks ago we had this same situation and if you recall we used the bearish sentiment as a reason to get aggressively long. Doing so paid off very nicely.

Over the past two days we got short and tightened up stops on long positions because technically it was the right thing to do. Today, however, it is time to react quickly to this fast moving market, which demands agility to survive, and get long again.

Over the past few weeks we have been developing a list of strong performing stocks to watch. Some of those stocks have underperformed and experienced heavy selling pressure. Some though showed their true colors and their true colors are very bullish. Stocks that didn't succumb to selling this week are set up to rally hard.

We suspect that roasted bear is still on the menu. Don't listen to the noise. The charts and the sentiment readings are telling us that the correction is over.

Mixed Conditions in Front of Earnings Season

The S&P broke its trend line and is very weak here. Transportation is rolling over, which is a warning sign to the Dow theorists, who need transports to confirm the breakout.

Primarily, we take the market's technicals with a grain of salt here. This is earnings season and earnings season is news-driven, not technically driven. It's hard to get serious about the short side in anything but the weak builders and real estate sectors. It's certainly not a time to get aggressively long either.

As earnings roll out over the next few weeks, we should start to get better set ups once again.

Sector Watch: Metals are mixed now with some industrial metal stocks exhibiting strength and others are under severe distribution. Gold looks to be making a dip in an uptrend. Oil stocks are neutral here. China is now under distribution, but we would hesitate to short it as it can be extremely volatile. Shipping stocks, like metal, are mixed.
The stro
ngest opportunities are now on the short side in the builders and real estate sectors.

Trend Watch In Effect

The market is in a very tough spot here. The S&P broke out, but volume was not intense. Yesterday the S&P looked like a breakout failure intraday, but by the close it was able to move back up and close at new support.

It's tempting to join the other pundits and repeat the worn out idea "market participants are not willing to make any bets in front of the slew of earnings," but that may in fact be what we are faced with here.

As a result, no one can really know what to expect next. The uptrend is still in tact. Commodities continue to behave well. The future probably depends on projections that come with all the conference calls in the next few weeks.

As we noted yesterday, avoid everything but Energy, Metals, Asia, and Shipping.

The Right Thing to Do

On Friday, dip buyers kept the trend alive despite Thursday's hard late-day sell off. The S&P closed the week above its breakout, so double-top watch is now off the table and false breakout watch is on the table.

The tech sector is way overbought and is vulnerable for a sharper correction.

The market is getting tricky to navigate after so many weeks in a row without a serious pull back. We would focus primarily on the hot sectors (China, Shipping, Oil, Gold, Metals) and avoid everything else for now.

Oh, and keep tight trailing stops. It's the right thing to do.

Key Reversal Day May Change Market Character

Yesterday the market gapped higher in the morning and the bull trend looked healthy throughout morning trading. However, in late day trading it suffered a key reversal and indices sold off hard on volume.

This potentially marks a character change that needs to be carefully monitored.

Two likely scenarios to follow are:

Bulls refuse to give up the trend and after a shallow dip, prices will move back up to fresh new highs.

Or...

A top of significance was put in and prices will trade sharply lower in coming weeks.

At this point no one knows.

Focus On What's Working in This Market

Are we starting to see a pattern develop here? One day up followed by one day down? The broader market was stuck in the mud yesterday and stocks outside of a few strong areas in tech and the commodities sectors aren't offering up a lot of confidence to buy in at these nosebleed levels.

It's probably best to be really impatient with the market here and just focus your attention on what is working and weed out of your portfolio that which is not.

And We Now Have Follow Through

We got the follow through we had been looking for on the S&P 500. This means that the broader market is just now starting to participate in the tech and commodities rally.

Even so, it is best to focus most of your attention on the high flying commodities here. Oil and metals stocks are just now breaking out of strong chart patterns like cup and handle, double bottom, and inverted head and shoulders.

We would categorize these patterns as longer term breakouts. Pennants and bull flags are short term patterns that project short term moves. Patterns like the cup and handle project multi month, and sometimes multi year moves higher.

We appear to be at the threshold of a major move in commodities.

Lack of Follow Through Concerning

Yesterday's lack of follow through on the S&P is concerning, but it's not a deal breaker. Yet. We need to watch carefully here to see if the bullish trend can reassert itself. Bulls need to step up to the plate and buy here; if they don't the market will be vulnerable for a sharp correction.

S&P Breaks Out

The S&P did indeed break out Friday. Over the next couple of weeks we will be looking for follow through. As long as there are no major fades this week, the bulls are looking at a good fourth quarter.

S&P Coiled and Ready

The S&P has been coiling into a bullish spring near its highs over the past few days.



This is very bullish.

As noted earlier this week, bears are looking to fade the breakout attempt because they believe that a double top is forming. The problem with this strategy is that double tops are very rare and betting on one offers one of the lowest probabilities offered in the market.

Right now the recovery from August lows looks too sharp. As Einstein reminded us, however, everything is relative. It may be a sharp recovery when considered from a smaller time frame. And, were we not in a bull market it would make good sense to argue that prices are destined to return to their mean.

But we are in a bull market. In September 2006 the SPY was set up exactly like it is now. Then, as we suggest will happen now, no double top was to be had. Prices did not regress to their mean, but the bull trend had its way and bears betting on downside contributed to the rally as they were forced to cover at higher prices.

Recent price action would suggest we will see the same thing occur this year.

S&P Watch, Day 2

Once again, it's S&P watch. The market lost some momentum yesterday, and we may see prices remain flat for a few more days.

To our eyes, the S&P looks a lot like Microsoft (MSFT) a year ago September. Keep in mind that double tops are very rare in the market, so it is advisable to bet against them. September 2006, MSFT was faced with a double top. Momentum waned mid month. Then late in the month it powered higher and didn't look back for several months following.

Of course we can't know if the S&P will do the same here, but these types of patterns oftentimes repeat in the market so this idea serves as a bit of a road map to watch for.

S&P Watch

There is not much new that can be said about the market here. Just keep in mind that all eyes are on the S&P here. It is near breakout levels and given strength in the other sectors, it seems likely that it will indeed break out here. Some consolidation first would be welcome, but not absolutely necessary.

Small Caps Starting to Take Over

The new quarter got off to a raging start as bear's arguments for a double top stung them badly. Most impressive here is the rotation into the small cap sector. The Russell 2000 is finally getting some play as money starts to move back into the more speculative stocks again.

There has been in place a flight-to-safety and the small cap index has been lagging. We suspect that the faster moving small cap stocks are going to start offering some excelling opportunities in coming months.

Once again, dips are buying opportunities. Days like yesterday are fun, but they don't offer the best entry opportunities. Weak days, like last Friday, when the bears are roaring and the bulls are biting their nails, are the days to get aggressive with your buying. Embrace the dips, don't fear them.

Trend Still Up

The quarter ended with a bit of a whimper. This has caused all kinds of speculation about double tops and every other sort of fearful and bearish arguments that distrustful commentators can come up with.

Frankly, we think all the noise is nothing but evidence for a wall of worry. The market is clearly in an uptrend. Tech is clearly leading the way higher, the way one would hope a healthy bull market would enjoy. Prices are clearly ready to test overhead highs.

We hate to predict too much about this week's price action. If we had to make a guess though, we would say that given the level of fear and the bearish predictions getting thrown around, that the market may have some games up its sleeve. We can see the potential for a scary shake out this week that quickly whipsaws the shorts yet again.

Dips remain buying opportunities.

Note: Here's a story that's not necessarily related to the market. We find Dr. Pausch's story to be highly moving and it serves as a great reminder that life is truly precious.

A Beloved Professor Delivers The Lecture of a Lifetime

Randy Pausch, a Carnegie Mellon University computer-science professor, was about to give a lecture Tuesday afternoon, but before he said a word, he received a standing ovation from 400 students and colleagues. He motioned to them to sit down. "Make me earn it," he said.

What wisdom would we impart to the world if we knew it was our last chance? For Carnegie Mellon professor Randy Pausch, the question isn't rhetorical -- he's dying of cancer. Jeff Zaslow narrates a video on Prof. Pausch's final lecture. They had come to see him give what was billed as his "last lecture."