Some Thoughts on Market Sentiment and Breadth

I wanted to share two observations wrt/ current market sentiment and breadth: first of all, fewer stocks are participating in the rally, which is usually a negative sign. Take a look at the number of S&P 500 stocks above the 50 day moving average and compare the situation to the rally in 2010/11:

The situation looks quite similar: fewer and fewer stocks kept drifting higher after the initial oversold burst. Here is the problem: in 2010/11, it took two more months of rallying before the negative divergence finally played out and stocks sold off. The same could happen now. It is impossible to pick the top and we will wake up one morning and stocks will gap down significantly. What do you want to do until then? Sell everything and watch from the sidelines? Hard to do psychologically. That's why I like mean reversion type swing trading, because I "buy the dips and sell the rips".

There is one difference, though, and this is why it is more likely that we will see higher prices in my opinion: sentiment is not overly optimistic. The indicator I'm following is the equity put/call ratio.

 
I'm using a 10 day moving average to smooth out the volatile daily data. As pointed out in earlier posts, the ratio is oscillates in certain domains. During bull markets, the p/c ratio moves between 0.5 and 0.7; during bear markets, general investor mood tends to be more pessimistic and values range between 0.65 and 0.9.

We are currently transitioning from a bear to a bull domain and the ratio is at 0.65, a little bit at the pessimistic side. Unless my assumption is false and we are indeed still in a bear domain, the equity put/call ratio has more room to fall. Note how sentiment became overly bullish during the final phase of the 2010/2011 rally and the ratio dropped below 0.5.

As usual, this is not a necessary, just a possible condition for short-term declines.

Another Swing Trading Setup: Double Dip Momentum

Here is another setup from my playbook. This is my second favorite behind the "Earnings Gap Reversal" setup.

I call it the Double Dip Momentum play: the stock is in momentum mode, outperforming the broader market. At one point, the stock sells off on high volume, but no major news. A weak rally follows, thus creating a short-term bottom (Point 1). The second leg down is important: if this move is weaker than the first decline (weaker in a sense that the stock declines less rapidly, but also on less volume) it shows that sellers are running out of steam. At that point, it is only a question of time when buyers will step back in. Once the second short term bottom is put in ("double dip", Point 2), I buy.

Flotek Industries (NYSE: FTK), a stock that is currently part of the Covestor Model Portfolio,  is a perfect example of the setup:

A classical chartist would probably identify a declining wedge pattern.

Another nice feature in the case of FTK is that the stock briefly broke short-term support around $10.75. A failed breakdown is another bullish sign and I have another setup in my playbook, which trades these patterns.

Note point 0 on the chart: this is where a "breakout trader" would buy the stock. I have not found any statistical advantage in trading these breakouts, especially when they come without major news. I'm only willing to trade them on headlines, which really shift the underlying fundamentals.

What Happened Historically When the S&P Broke Out to New Highs?

The S&P 500 is trading right below a 52 week high around 1350 and could break out to new highs soon. What did the index do historically when similar setups occurred? To find that out, I looked at new 52 week highs when the prior high was recorded more than four months earlier. I found five incidents since 1995:

At each of the events, it would have paid to buy: the rally kept going and the index traded higher four months after the breakout. In the cases when prices consolidated after the new high, it would have been a profitable strategy to buy into the consolidation.

Even though the number of events is small, the findings suggest that the momentum effect is at work.  

How Could Markets Surprise?

The markets tend to surprise the maximum number of investors. So what could they do now to follow this rule? The obvious price action for the S&P 500 is to fail at long-term resistance around current levels. A more surprising patten would be to break out to new hights, thus signaling a new bull market and suck in more investors from the sideline only to reverse higher and set up a "bull trap".

I do not say this is the most likely scenario, but a trader has to be open to every possible outcome. At least from the sentiment standpoint there is more upside potential: major psychological indicators are in the neutral zone because prices consolidated "under the hood" in recent weeks.

My portfolio is positioned on the long side, so I am obviously bullish as well. However, I would start taking profits when markets break out to new hights.

What Happened to Small Caps on Feb 6?

I do not have an answer to the headline question, but something happened. On this day, the Russel 2000 started to underperform the S&P 500. Small cap performance is often a good indicator for investor's risk appetite. Did someone flip the switch to "risk-off" mode?

A look at the daily chart reveals what might had happened: beginning of February, small caps moved  vertically and actually gaped up. A classical exhaustion move?  I guess we will know soon, but I would keep an eye on the Rus and increase short exposure when the index closes below 810:

Disclosure: Covestor model is long TZA

Should you Buy Gold or Silver?

Gold and his little brother Silver are making headlines again, so which one should you buy?

Here is my approach: since I don't care about fundamental supply/demand relationships, I like to look at price itself and focus on whoever is currently outperforming the other. The following chart is the price of Gold divided by the price of Silver. When the curve is rising, you want to be on Gold wagon; otherwise, Silver might be the better investment. Both metals are of course highly correlated. Obviously, Gold had outperformed his less expensive peer from August 2011 until January (red line). In 2012, however, Silver took the lead. At this point, it is not clear, who will lead us higher. It looks like Gold could make the race, but I would keep watching this chart and then decide which direction to go:

Keep an Eye on This Pattern

I recently came across the following pattern on a couple of stocks/sectors, which formerly had been leading the market higher: it is sort of a 3-push structure, with each new high coming in on a weaker move than the prior high. In addition, relaltive strength vs. the S&P 500 declined. I'm not sure if this is part of a regular consolidation or sign of a top. It might be an interesting short setup.

Here are just three examples: Cisco, Regional Banks and Ecolab. The funny thing is that these stocks/ETFs operate in entirely different sectors.

Feeling bored? Then Trade This...

Greece was just "bailed out" and related stocks enjoyed a nice rally on the news. Since the dust keeps settling, it might make sense to short Bank of Greece again. The stock had a good 150% pop in January and broke out of a consolidation to the downside yesterday. The key with this trade is to apply strict money management and a) keep position size small b) follow your stop, which I would put at $3.7. So far I do not have a position, but might consider to take this trade. Volume has been massive, though, so downside potential could be limited.

A Short Term Portfolio Hedge

This week, I put on a short-term mean reversion trade in order to hedge my long positions and reduce portfolio beta. Small caps had a parabolic move in recent weeks and I expect a minor pullback soon. The longer term trend is still intact of course and buying will probably pick up again at lower levels. I'm using TZA, the 3X inverse small cap ETF. I'm basically trying to benefit from a potential 2-3 percent pullback:

Challenging Weeks Ahead

The 2012 equity rally has been relatively easy to trade so far and the Covestor Model performance shows exactly that: the account is up 8.5 percent for the year as of February 3. Unfortunately, the days of easy money are over in my opinion, at least in the short term. Equity markets are extremely overbought and the S&P 500 is reaching an important long term resistance at 1350. At this point, I would like to see a pullback to at least the 20 day or even 50 day moving average before committing more money on the long side. The market, however, will do its best to challenge investors and hurt the maximum number of participants. The best way for Mr. Market to do that is by actually breaking above 1350, trigger some buy stops and pull in the last non-believer. A similar situation occurred in  October 2010 (see chart below): the S&P 500 briefly set a new high in a rapid move only to consolidate in the following weeks. It had been a weak move, though: the number of stocks above the 50 day moving average was smaller than a couple of weeks before the event. I would therefore follow stock participation and market breadth like a hawk in case we see SPX running to new heights.
 
February will be challenging for short term traders because the market could drift higher for some more days or weeks: they need to sit tight and not get sucked into the market, which can also mean temporary underperformance if one is not 100% invested.

Why I am Long Silver

I like Silver a lot these days and I recently added SLV to the Covestor Model Portfolio. Two reasons: Silver should be one of the beneficiaries of the renewed investor's speculation for QE3 as well as an attractive technical situation:

Essentially, SLV just broke out of a gigantic "declining wedge" formation, suggesting sellers are exhausted. The size of the wedge is fairly big: it took SLV over six months to create the formation. Edwards and Magee suggest that prices usually do not take off immediately after bullish wedges, so there is still time to get in or increase the position on pullbacks. In general, one has to manage position size especially with Silver because the metal can make very violent moves and the trade can raptly go against you.