Half a Loaf

The NASDAQ broke out to new recovery highs yesterday and did so with rather convincing price action. Volume, unfortunately, was another story. There was little participation in the move. While we feel confident in asserting it is because of the time of year we caution against making an allowance for this type of questionable behavior. Our experience is that volume shows up when it feels compelled to do so no matter how many people are on vacation.

If there was any day during this holiday period where we would expect higher volume it would have been Monday. There are only two full trading days remaining this week and each successive day is likely to see progressively less volume as we get closer to Christmas. As for next week you are more likely to get a pulse on a 106 year old man than in the market.

Unless volume makes an appearance we believe you should trade this new rally leg with caution. What does caution mean? Should you cut and run at every hint of an intraday correction. No. But you should likely approach this move as a swing trader would, looking to take profits after a measured move out of a base or at a sign of exhaustion. Remember, though, that this is a bullish time of year and it appears good profits can be made in the closing days of 2009.

We have said for weeks that we were looking for a final market burst higher before a correction would take hold. Today’s move validates our thesis. New highs on light volume in an extended rally could well signal the first intermediate term correction of the bull market might begin next month.

But for now there’s sufficient rum in the market egg nog to make the holiday season that much brighter.

Naughty or Nice, Santa Could Visit the Markets This Week

Week after week we continue to maintain a bullish bias. Week after week the market looks at times ready to break down only to threaten to break higher on the climactic leg we expect for the rally.

With Christmas on Friday and many traders away from their desks it would seem unlikely that the market would stage a high volume move at this time. Asian markets that suddenly threaten corrections could also keep it in check. The Shanghai Composite has broken back below its 50 MA once again after some ugly selling late last week. It has now been over four months since this bourse, the international leader of the current rally, has made a new high. And Hong Kong’s Hang Seng has put in place a threatening looking top. Should these indices and others follow through to the downside this action could eventually put our own markets into correction, given that they have been poor stepchildren to the performance of international stock exchanges this year, clear followers and not leaders.

But we still believe the best prospects for making money continue to be made on the long side and that investors will fare best by preparing to take advantage of a robust resumption of the rally, no matter how unlikely.

We have cited the emergence of new leadership in prior columns. Indeed the Philadelphia Semiconductor Index ($SOX) moved last week to fresh recovery highs. And we have noted that smaller caps have staged successful break outs as the small and mid cap indices, which had lagged until recently, have rebounded smartly. Further, many large liquid leaders that had previously led the rally continue to base and are well positioned to emerge. Apple (AAPL) has put in a mature flat base (we have recently recommended watching for entry on our sister site) while Amazon (AMZN) has about pulled back to its 50 MA, an area that should intrigue most traders. On any resumed rally these big caps could help expand breadth and move the broad indices higher.

The bounce in the dollar has forced the volatile correction of hard assets we foresaw, but that might be ending now. The dollar ran into significant resistance on Friday and formed a reversal bar. Conversely Thursday the price of gold broke down below its previous lows and its uptrend looked ominous. But Friday saw good support and suggests if gold is not yet set to rally again it might well have put in its lows. These are important developments because a declining dollar has been matched by a rising stock market since March. A resumption of trends might well be at hand.

Also encouraging are the weekly charts of the major indices themselves. A friend of ours recently pointed out there has been little accumulation in either the S&P 500 or the NASDAQ over the last couple of months, and indeed he is correct. But the NASDAQ continues to trade near its highs, closing Friday at a fresh recovery high and the S&P 500 has now formed a highly bullish 3 Weeks Tight (3WT) pattern on top of a previous 3WT pattern, suggesting Santa could indeed be coming to town.

The Extended Period Extends

Bulls got their Christmas wish today as the Fed stood just about completely pat, as we expected they would. They reconfirmed that they will sunset some liquidity programs, but these plans were telegraphed to the market months ago. The wind down of some of these programs is actually the first step in the removal of accommodation but thus far the Fed has not given any hints about when they will go further.

The market closed poorly but reaction immediately after Fed announcements is often best ignored. The market usually takes at least overnight to digest the Fed action and accompanying statement. Without anything significantly different we believe it will be treated as a non-event.

What we’re most impressed with is that the market, while still in basing mode, has actually already subtly started another leg higher. New leadership has started to assert itself, which often happens in advance of the market itself breaking authoritatively to new highs.

HMO’s have moved nicely higher as it has become apparent that whatever healthcare plan comes out of congress will avoid any serious damage to their business models. While these stocks could lead we’re more taken with the emergence of cyclical groups like chips and airlines.

Indeed the Philadelphia Semiconductor Index ($SOX) and the Dow Transports ($DJIT) have already moved to fresh recovery highs. This is significant because these groups tend to outperform early in an economic recovery. In other words, the market is increasingly convinced that the recovery is real. We’ve repeatedly discussed the likelihood of this paradigm shift and we’re seeing it confirmed in real time as investors seek out those sectors that are likely to benefit as the economy continues to improve.

With new leadership beginning to assert itself, and with smaller cap stocks starting to outperform again after lagging badly during the recent market basing period, we continue to believe it is only a matter of time before the market begins another leg higher.

Not Ready

The market stalled at resistance once again today. Technically it seems destined to retreat from its highs.

Market commentators are crediting hot PPI numbers and a dour “pre-earnings” comment from GE for today’s poor tone. But the PPI numbers were released before the market opened and the session saw the NASDAQ and other indices rally to fresh recovery highs. And besides, the hotter PPI numbers were not much more than a reversal of the cooler numbers witnessed just last month. A trend has certainly not been established. As for GE, this is a company that has struggled throughout the financial crisis and as a turnaround strategy intends to focus on government incentivized businesses. If this was once a bellwether it is now captained by executives that seem clueless in how to weather this storm.

No, the market went down today because it simply wasn’t ready to move higher. Especially in front of an FOMC statement on interest rates to be released tomorrow afternoon. Speculation abounds as to whether the Fed will alter policy or the accompanying statement, but this is a Fed that has been cautious to a fault in not surprising the market. We doubt they will change their statement about rates being held at low levels “for an extended period” without amply telegraphing it in advance. Thus far there hasn’t even been a hint.

While market prices are likely to continue to “fluctuate,” as J P Morgan once famously said, we still believe another leg higher remains a likely resolution. Provided the Fed is not ready to remove accommodation, and we clearly don’t believe they are, they have provided sufficient stimulus to the economy to induce solid growth. We believe the market will rally into what it anticipates to be “better than expected” Q4 earnings.

In the meantime we are encouraged that stocks have held up in the face of an aggressive move higher by the U S Dollar that does not seem anywhere near over. With each day that passes the link between the two asset classes, that have been inversely linked all year long, appears to be weakening. Stocks and the dollar rallying together would be a heartening turn of events and a sign that we are awakening from what has been a national nightmare.

Market Indices Hold Near Highs, Defying Correction Expectations

There has been subtle distribution across the indices. While price has held up internals have not been as favorable. But we remain in a consolidative phase. And with indices of all varieties holding near their recovery highs the sentiment of traders we speak to remains incredibly bearish. We read this as a positive sign.

We also read as positive the market’s ability to hold while gold and the dollar enter what for now appear to be counter trend moves. All year stocks had marched higher as the dollar’s value eroded. Now with the US Dollar Index moving above its 50 MA for the first time since April and technically poised to go higher, stocks are simply pausing, not aggressively retreating as one would expect given the inverse correlation between these asset classes.

Meantime the aggressive advance on the stock indices since March has signaled many of the events that are unfolding today: signs of a recovering economy and a banking system that, while far from healthy, is far from the insolvency that was threatened just a year ago. Again, one would expect stocks to sell this news when it occurs, but it has yet to happen.

Not long ago we surmised that there has been a paradigm shift in the market. That it is now focused on returned growth and the prospects of sharply accelerating earnings in the year ahead. Every day the indices continue to quietly base adds credence to that assertion. And a solid break out to new highs and another leg higher would confirm it.

Most of our stock suggestions on our sister blog have been mired in neutral these past few weeks, not triggering or stopping out as the market chops up position traders. But we continue to have suggestions for stocks that we think have the ability to ignite on another leg higher and we invite you to review our ideas.

If at First You Don’t Succeed

The indices remain paralyzed in a holding pattern. Most traders remain convinced that a significant correction is only a matter of time. And investors have certainly given cautious clues, bidding up utilities in a clear flight to safety and yield.

And if the indices haven’t broken down the argument can be made that investors would prefer to take profits in early January, postponing an appointment with the tax man into next year. They certainly appear to be in no mood to take further chances before they can close the books on what has been a most profitable year for many.

Further, the Three Weeks Tight pattern on the S&P 500 we detailed in our last column has broken down with price undercutting last week’s low in today’s trading.

And yet we still believe the market needs to be given the benefit of the doubt. The index dailies yield setups that call for higher prices. Failure here could be devastating for the market uptrend but most leading stocks continue to hold up just fine in their price structures.

In fact our bellwether, Apple (AAPL), which had recently broken below its 50 MA on volume, bounced back with a vengeance. Whether this is a temporary reprieve remains to be seen. In the meantime we can only know what the market is telling us, which is that big money is continuing to support what has been the bull market’s most important institutional stock.

The Market Will Head Higher

There. We said it.

For three days in a row into the end of last week the major indices flirted with fresh highs and were beaten back. Friday’s gap up was sold off on such enormous volume that even we were convinced the uptrend would yield to its first significant correction.

But a funny thing happened on the way to the sell off. It was arrested.

The daily charts of the major indices, especially the Dow and the S&P 500, look ready to head lower. But pull up weeklies and read a different story.

Friday closes are important. They allow us to read the true intentions of institutional investors on weekly charts while turning down the “noise” of dailies. Leaving your money invested on a Friday means you have to endure two days of uncertainty before the markets will again allow you to adjust your appetite for risk. A handsome weekly close indicates big money is feeling fairly contented. And that’s just what we have with Friday’s close.

The chart of the S&P 500 shows a pattern familiar to all of O’Neil’s students: Three Weeks Tight (3WT). During an uptrend O’Neil preaches that three tight weekly closes in a row, where the closes are within 1% of each other, are bullish and that breakouts from this pattern are opportunities to add shares. While the index closed below the highs of the 3WT formation the advance on high volume is clear enough. And the index closed in the upper half of its range.

The NASDAQ has completed a corrective pattern that saw it sell off under its 10 MA weekly on volume at the end of October only to right itself, move back over the line, pull back to it in light volume and now break to fresh market closing highs on the highest volume in five weeks.

The catalyst for Friday’s wild action was the employment report, which took the market by considerable surprise with its positive implications. Real growth, not simply stimulus ephemera, appears to be in the making, and the market was ebullient.

Clearly the late morning sell off was due to concerns about The Fed likely ending its easing policies far earlier than anticipated given the change in perception about the economy. We have long said that we are of the opinion that the rally will conclude when the liquidity orgy is over. When investors started to sell the news in the late morning we weren’t surprised.

That they had second thoughts about doing so going into the close did surprise us. It is clearly bullish and an indication of a possible change of paradigm for the rally with liquidity no longer its raison d’etre but rather the certainty of resumed growth.

We witnessed violent sector rotation, which was responsible for the indices ending with gains. The commodity liquidity plays, led by gold and gold stocks, sold off hard. Meantime Small Caps surged over 2% as investors segued into growth oriented stocks that are most likely to benefit from resumed domestic growth and avoid the negative effects a reversing dollar will have on the bottom lines of larger cap companies. And transports and semis, traditional harbingers of growth, surged to new 52 week closing highs.

How these trends play out over the coming week will be crucial. Recently we suggested it was time to take some profits in gold to make sitting through an inevitable correction easier. The trade in gold has been so one sided that when it broke it did so with a large gap down from all time highs. We predicted this is likely to be a volatile correction and the inevitable questions about whether this is a correction or change in trend will emerge should severe selling continue.

Whether the moves in gold and the dollar are corrections or changes in trend will dictate where the opportunities will be in the weeks ahead. We expect a continuation of the rotation we saw on Friday, but as always will follow the market assiduously for clues.

The Market is Set for Weakness to Follow Through

Yesterday we advised that failed new highs in the indices could lead to some selling pressure and we saw that into the close today. Whether this selling was protective in nature in front of tomorrow’s employment report or the response to other stimulus doesn’t matter. Clearly the market is braced for bad news.

We saw signs into the close that selling could be a multi-day affair. The stock that is the clear current leader, Amazon.com (AMZN) staged a reversal on volume. While not ominous this stock hasn’t touched its 20 MA since it launched its break out October 23^rd. A betting man would lay odds it has such a rendezvous in its future.

But until we see serious selling and the thinning leadership cracking we will maintain that holding profitable existing positions and searching for proper entry in correcting leadership stocks remains the best course.

In the meantime we have posted on our politics blog, a rare event in itself, usually inspired when our passion is stirred on one burning issue or another. Today’s entry is a defense of our beleaguered Fed chairman. We invite readers to have a look.

Stay the Course

We are rarely at a loss for words but we have to admit when we’ve been bettered. The current market has simply stymied us. The markets have been in a trading range for two months and bearish divergences abound. It is difficult to come to market on a daily basis and find a unique way of saying the same thing. Nevertheless we will try.

Stay the course.

This is likely unwelcome advice for frustrated investors who may have exited the market weeks ago and seek reentry at the most propitious point. The indices have broken down only to recover; and then broken out, as they did today, only to duck back into their bases.

But while the break outs across the markets universally failed today to us there was nothing ominous about the action. Volume was light and the bears made little headway after the stall. That doesn’t mean today’s action won’t have consequences. Failed new highs can often yield to an increase in selling pressure. But nothing about today’s action suggests another attempt into new high ground isn’t in the near term future for the indices.

On the positive side the small cap indices have led the market the last two days. They have lagged badly during the current consolidation and have put in lower highs, setting up a threatening pattern. The aggressive gains are welcome. And the world leading Shanghai Composite, which took a beating last week, first on news that banks would have to raise their reserve ratios (potentially threatening lending activity that has driven the stimulus program) and then on the Dubai debt crisis, have rebounded smartly and on good volume.

We’d like to present a chart for your study:

You may be forgiven if at first glance you think this is the current S&P 500. After all, it does have some familiar attributes: a sharp rally that began in March; an aggressive uptrend throughout most of the year; and a tiring rally during the fall in which the index made little headway.

But it is not today’s S&P 500. It is the NASDAQ Comp from 2003. Samuel Clemens would be pleased at yet another example of how history may not repeat but often rhymes.

We now present another chart:

This is the same chart only with the time frame extended into January 2004. The market topped after that profitable little burst and we endured a rather choppy 2005. But if history doesn’t repeat, it suggests you should stay the course.

Of course there is no guarantee that the uptrend will deliver another leg up. Until the markets make a pronounced move higher we would not be aggressive in allocating new funds, opting only for situations that are clearly bullish by price and volume action and at proper buy points. Entries without catalysts in the current environment are invitations to endure choppy trading, make little headway and take small, but frustrating, losses.

An excellent example of what we seek is Potash (POT), which we profile on our sister blog.

A Resilient Market Demands Your Attention

Markets worldwide have looked fatigued since mid-October. Some bourses have made marginal new highs and the American Dow has actually fared the best, posting its best November since the 1930’s. But leadership has thinned along with the new highs list and the markets have been susceptible to selling on bad news.

But if buyers can gain little traction neither can sellers. The Dubai default last week was tailor made to trigger a significant correction in tired indices that have achieved outsized gains, giving nervous investors an excuse to lock in gains. Markets around the globe scored significant losses on Thursday. The Shanghai Composite suffered two sessions of heavy losses in three days on huge volume, disturbing its resumed uptrend. And yet by Friday the selling had been arrested. And today it has been reversed.

Don’t let the fact that Dubai is a rather small place deceive you into thinking this incident was much ado about nothing. International crises have been triggered by seemingly minor incidents because of the mind set of investors. Clearly, even in a world where a subset of investors is sufficiently nerve wracked to invest money in 3 month T bills yielding 0% there is far more resolve in the minds of many investors than we may have given credit.

The market’s “rest” these last six weeks coupled with the reaction to the Dubai World default leads us to the conclusion that we are set up for a break out move higher, probably sooner than later.

Where do you look for investment ideas? We’ll try to cover some on our sister blog, but the market clearly favors three sectors that we have long suggested. Big cap stocks with plenty of international exposure. Commodity related stocks and their pick and shovel brethren. And BRIC stocks of all shapes and sizes, particularly of a Chinese flavor.

We continue to believe that China is heading for a significant hiccough, but we play the market that is in front of us. And the trends that have been in place since the uptrend began in March should continue to extend themselves for the duration.

A Catalyst

With its strained upside action the market has shown it is tired and only in need of an excuse to stage a significant sell off. Today it has one. The emirate of Dubai has threatened to default on its debt.

On the face of it this is a fairly mundane matter, an extension of the commercial real estate difficulties we have seen emerge throughout the developed world. But this is The Emirates, an emerging market that is supposed to be an engine ready to lead the developed world out of its morass. That it could be a part of the morass cannot inspire confidence.

Dubai is unlike other emirates. It has no oil and has relied on debt, mountains of it, to transform itself. The emirate has been in difficulty for months and on Wednesday the government there stopped reassuring debt holders and instead asked them to accept delayed repayment.

The prospects of contagion cannot be dismissed. Neither can the prospect of a significant American equity market sell off.

Although we do not know with any certainty we can imagine the scenario that led to these events. The overarching Emirates government probably wants a claim to pieces of Dubai’s mortgaged jewel properties in order to make them whole and Dubai is likely refusing, thus leading to their demand for a debt holiday. Ultimately we believe that the Emirates government and Dubai in particular will resolve this matter with a solution that will be grudgingly accepted by creditors, as the prospect of outright default and the lack of confidence it would cause would be mostly absorbed locally.

But in the larger perspective the notion that emerging markets are the new engine that will drive worldwide recovery should take a well deserved hit. Chinese markets have been rattled recently by the government’s plans to reign in the centrally authorized lending that has been the conduit for their domestic stimulus. It has been this stimulus that has been a major source of worldwide market enthusiasm this year. When combined with Dubai’s debt crisis, those pushing domestic equity markets higher after their impressive run will be forced to think twice about exposure at these levels given the lack of growth domestically and the prospect of vulnerability in overseas markets that have heretofore been the raison d’etre for the rally.

GDP Growth Augurs Poorly for a Robust Recovery

Q3 GDP Growth has been revised. Originally thought to be 3.5% it was reduced Tuesday morning to 2.8%.

This is dreadful.

We have emerged from a recession that might well have been the worst of the post World War 2 era. And growth is not much below trend, which is generally considered to be about 3.1%.

So why are we disappointed?

Because growth coming out of a recession tends to be like a stock exploding from a base as it embarks upon a fresh leg higher. Readings of 5%, 6% or higher for at least a couple quarters are not uncommon. Coming out of the recession on growth that is already below trend augurs poorly for the prospects of this recovery.

A good part of the performance could well be attributable to the ephemeral effects of the stimulus bill passed by Congress earlier this year. We might be registering positive GDP growth before we otherwise would and there exists the possibility that we could get a true break out quarter in the coming months.

But the economic tea leaves aren’t pointing in that direction. Instead we are left with a recovery far more fragile than we have seen in the past. While stocks have enjoyed quite a run in anticipation of recovery, at some point the market might well express its disappointment. We cannot say we haven’t been warned.

Small Caps Suggest a Period of Sideways Trade

A week ago we thought we had a tiger by the tail. Small caps, which had lagged the market badly, led a broad move higher. The 52 week high list looked as healthy as it had since the October market top. We posted numerous suggested plays on our sister blog. We positioned ourselves for another market leg higher.

But by the end of the week the S&P small cap 600 had given up all of Monday’s gains and then some. While the major market indices have recently made fresh 52 week highs the small and mid cap indices have not. And in spite of a furious rally again this morning small caps are clearly stuck in a trading range. Without their participation market upside is likely to continue to be restrained and limited to a narrow group of stocks.

There are plenty of examples of markets that have based with narrow leadership after a considerable run, only to move smartly higher when conditions allowed. The key is to not get chopped up in range bound trading, caught trying to position yourself for a larger move only to get repeatedly stopped out.

Money can clearly be made in a narrow group of large cap stocks. The market is favoring them at present because they are likely to have international exposure. With better growth overseas than domestically and a steadily sinking dollar that magnifies repatriated earnings, growth opportunities are likely to be better than with small caps, which tend to have limited resources and sell mostly in their home market.

More specifically mining stocks of various stripes are outperforming as they price in reaccelerating growth in Asia and Latin America. So are the “pick and shovel” companies so necessary to their operations.

And BRIC country stocks are faring well as the worldwide bull market continues to be led by these bourses. Capitalization doesn’t matter in this instance as participation is broad.

But chasing this small leadership group can be dangerous. Given the narrowness of selection they are obvious to the market and thus increasingly crowded with late arrivals that will prove to be weak hands at the first sign of trouble.

If you can catch these stocks on a pullback to their 10 or preferably 20 MA’s they might yield satisfactory swing results. Otherwise managing positions with substantial gains and sitting on cash could continue to be your wisest course of action.

We find the stock selection of a major growth mutual fund of no small renown to be revealing. The Fidelity Contra Fund, long a leading growth fund in spite of its massive size, has McDonald’s (MCD) as one of its top 10 holdings. This large cap international company clearly fits our profile of a stock that is attracting investment dollars in the current market.

We don’t mean to disparage the fund’s stock selection or the stock in question, but MCD has posted single digit year over year earnings growth this year on single digit revenue declines. Obviously the fund is counting on a resurgent domestic economy as well as continued international growth to ramp up earnings and sales ahead of expectations in the coming year. They are probably right in their assumptions and likely to make money in the position. Just the same, it’s telling when this is what passes for a growth situation in what we are coming to define as the “new normal.”

And it’s another reason to curb your enthusiasm.

Curb Your Enthusiasm

In July the rally was over. Everybody knew it. The S&P 500 had formed a bearish head and shoulders pattern on the daily chart and had fallen through the neck line. The March lows were up next.

And then it didn’t happen.

Instead we got a furious rally that extended 7% into new high ground on the NASDAQ and better than 6% on the S&P. For the first time market participants became convinced they were in a bull market.

Then in August the indices broke lower. But volume was light and bulls stepped in immediately to stanch the bleeding. The indices shortly broke to new highs. Investors were now confident of an enduring bull.

Just when investors were feeling invulnerable the market very quickly corrected again after making little progress into new high ground. But once again the indices found their footing and moved to new highs by 5% on the NASDAQ and nearly 4% on the S&P.

Almost routinely the correction in the second half of September was scooped up by investors. Yet this time the markets made even less headway into new high ground: just 1% on the NASDAQ and under 2% on the S&P.

October’s correction featured the NASDAQ undercutting a prior low, usually a late confirmation of a more significant correction set to unfold. But rather than succumb the indices again bounced back. This time the gains into new high ground were about ½% on the NASDAQ and 1% on the S&P.

And while the indices increasingly sputter on every move to new highs negative divergences abound. The narrowing of 52 week highs is our favorite, easy to gauge indicator. The breakdown of formerly leading stocks and cautionary signs given off by others is more subtle but cannot be ignored.

The latest casualty is Green Mountain Coffee Roasters (GMCR), a mid-cap that more than trebled during the bull market. It's fallen hard under its 50 MA, a key level for stocks in uptrends. Meantime Apple (AAPL) and Baidu (BIDU), two major institutional favorites of the rally, have potentially put in double tops that sport unfavorable volume profiles and appear vulnerable.

We still believe the markets will continue higher until the liquidity punchbowl is withdrawn by The Fed. According to the OECD in a release out this morning that might not be until late 2010.

But that doesn’t mean a more severe correction won’t be in the offing. The markets have avoided that to date and new bulls can go a year or more without a correction of 10% or greater. But we can hear the indices groan with every uptick each time they enter new high ground. Clearly the upside is limited for the moment. It might be time to take a step back and curb your enthusiasm.

Small Caps Reassert Themselves as the Bull Market “Re”-Broadens on Signs of Retail Strength

We have long preached to watch what people do, not what they say. Consumer confidence took a hit last month and that’s understandable. Unemployment is at a 26 year high. So when a surveyor asks a person whose employed how they feel about the state of affairs, but whose neighbor might be out of a job and who just got done hearing another report on how gloomy the economic environment is, that person is apt to say “just horrible.”

But according to Monday’s retail sales report that person is feeling good enough about their personal situation that they have ventured back into shops for clothing and household items and has resumed treating themselves to an occasional meal out. They’re not buying homes or furnishing them yet, but these purchases tend to come later in the recovery cycle.

This news sent the stock market to significant gains on a bump in volume. The major indices have now all broken to fresh recovery highs, but most importantly market participation broadened as small caps led the way with a gain of nearly 3% and the 52 week high list climbed back above 400.

What’s just as encouraging is renewed vigor in the Shanghai Composite, which led the rally worldwide from March through July before embarking upon a difficult correction. That has clearly concluded and the index has its August highs in sight.

Given the market’s performance today we’d again venture into smaller capitalization names, many of which have set up well in constructive bases capable of supporting fresh legs higher. Check out our sister blog for some suggestions.

All Roads Lead to Big Caps, Gold and Select Miners, and the BRICs

We reviewed a host of ETFs this weekend, hoping to find areas that are not yet apparent that could join the market’s thin leadership in a broadening rally should it occur. What we found is that there are no surprises at all.

We were shocked, for example, at how well a steel ETF is holding up given the poor posture of many steel stocks. But nearly 25% of the ETF is comprised of two iron ore stocks, Rio Tinto (RTP) and Vale (VALE). Iron ore is a key ingredient in the steelmaking process and these stocks are in strong uptrends, near 52 week highs. RTP is well situated to sell into China, and VALE is Brazilian. Another 10% is in Brazilian steelmakers CSN (SID) and Gerdau (GGB) and 6% in South Korean maker Posco (PKX), which is contiguous to China. Brazil and China, of course, are two of the BRIC markets leading the rally. Other than that there isn’t much happening in the world of steel, but the theme is clear, ore and BRIC companies or companies well placed to sell into BRIC markets. And, oh yes, they all happen to be Big Caps.

We looked at two retail ETFs and noticed a divergence between RTH and XRT. The former is at new highs while the latter has mounted a feeble rally attempt off its 50 MA. What’s the difference? The RTH is biased toward big caps retailers; It includes stocks at or near 52 week highs like Walgreen (WAG), Costco (COST), Gap (GPS.) and the parabolic Amazon (AMZN). The top 10 holdings account for over 80% of the fund. The top 10 holdings of RTH, which is packed with out of favor smaller cap companies, account for little more than 17%.

The tech ETF XLK is at new highs. Its 10 largest holdings account for over 60% of the ETF and include market leaders such as Apple (AAPL) and Google (GOOG). These two stocks have scored impressive gains since March and remain on the rampage. But it doesn’t hurt that stocks like Cisco (CSCO), Hewlett (HPQ), Microsoft (MSFT) and IBM (IBM) are included and are at or new 52 week highs.

Gold and gold miners speak for themselves. They have led since gold began its break out move in early September.

Only 119 stocks made fresh 52 week highs in Friday’s trading. That’s a sign the rally is mature and nearing its conclusion, but that doesn’t mean that the increasingly crowded new highs won’t go higher. Indeed, if the market doesn’t stage a broad sell off the parade of money into a decreasing number of stocks could well lead to impressive gains during the rally’s last days or weeks. It’s no accident that institutional money is finding its way into the most liquid stocks in the market.

We still recommend a cautious stance but can’t argue against joining the parade of money into big cap leaders, and we’ll post some suggestions on our sister blog. Many are not offering the kind of entry points that would make us comfortable for a multi-month hold. But as long as you are willing to keep a tighter reign during sell offs there exists the possibility of further gains to be had in a market that might not yet be ready to succumb.

Growing Negative Divergences Threaten the Market Uptrend

Stocks continue to bolt higher on earnings. AMZN was spectacular in late October, PCLN in early November. Just yesterday CTRP had a more modest gap to 52 week highs, but it was impressive nonetheless because the stock had run into the report.

So what’s the problem? Participation. There’s no volume in the market on up days. And on down days, like yesterday, it spikes higher.

That’s a sign that institutions, whose money is needed to move the market, aren’t so eager to commit. You should follow their lead.

After the market appeared to flout yet another more serious correction we posted a number of long ideas on our sister site. Most of them stopped out. As we’ve mentioned before, when technically sound ideas do not work it is because you are fighting the market’s true intentions.

There are stocks that continue to perform impressively. We mentioned a few earlier in this post. But their list is thinning. That’s another warning that shouldn’t be ignored.

The market can continue higher. The massive amount of liquidity floated by central banks worldwide has clearly led to a rise in all asset classes and continues to under gird the stock market. It might well continue to do so, but that doesn’t mean the market cannot abruptly correct.

We believe all but intraday traders need to be cautious in the absence of robust upside volume.

Liquidity Uber Alles

The stock market continues to move higher. Yesterday two important averages moved to fresh recovery highs. The NASDAQ 100 finished in new high ground while the S&P 500 marked a closing high.

As you might expect on a semi-holiday volume was light. But that continues a disturbing trend of an absence of participation on the part of institutional investors. A key argument for continuation has been that reluctant money managers who have doubted the rally’s staying power have to throw money at the market in order to stay competitive with their bogies. But if that were the case we should be seeing significantly higher volume as the Dow last week and now two other major indices move to fresh highs.

And speaking of highs, the 52 week highs list continues to be negatively divergent from the last trip into new high ground. Last month we saw nearly 700 52 week highs. Now, with all major indices save the NASDAQ in new high ground, that number is less than 300,

This speaks to the incredible levitating effect on the markets of Fed induced liquidity and the subsequent dollar carry trade. History teaches that without more significant participation the market is vulnerable to a sudden and ugly reversal, yet day after day the evidence on our screens defies that notion.

Antidote Needed for a Weak Tape

We’ve spoken about the positive resolution to the market’s crossroads, but market internals have been weak enough to cast lingering doubt on the uptrend.

Thus far only the Dow has made a fresh recovery high while the other indices lag. The number of 52 week highs is divergent with the last time an index saw new highs. And the entire move dating back to the beginning of last week has come on light volume, juxtaposed to the high levels of distribution we saw on the decline from the prior highs.

This is all fixable with an advance by the other major indices to fresh recovery highs. Indeed the S&P 500 futures have accomplished this feat in pre-market trading this morning.

The index will need to hold these levels to prevent yet another negative divergence. Worldwide central bank liquidity policies have sustained the market to this point, but central bankers cannot force the hand of institutional investors. Their resumed participation is critical. Without them the market remains in an unsettled position.

Resolution

In Take the Money and Run Woody Allen plays a man who is completely inept with women. His friend offers to set him up with a woman who wants only sex. The woman comes on to him in her apartment in very obvious fashion but when he makes a pass she slaps him, refusing his advance. The very next scene shows our hero descending the steps of his unrequited love’s apartment building exclaiming, “How could I have missed those signs.”

Very clearly we missed obvious signs in our piece yesterday. Last week we advised that The Fed statement insured that the market would resolve its correction to the upside. We honestly didn’t expect it would occur so quickly but clearly the G20 announcement that we discussed in yesterday’s entry did the trick. Light volume continued but it is very clear that stocks are just another asset class that is going higher because of the worldwide torrent of liquidity. With finance ministers from all over the globe reaffirming The Fed’s policy over the weekend buying should have been two fisted and on far higher volume. If there is a danger to stocks, it will not come from monetary policy anytime soon.

We had mentioned that we were prepared for the long side and posted some suggestions on our sister blog. The best performer of these, by far, was Apple (AAPL). The others were mid-caps that were higher but met with limited enthusiasm. The reason appears rather obvious to us. Big caps have international exposure and thus will benefit from a dollar that will not soon rally.

This is not to say that mid and small caps should be ignored. Of nearly 300 52 week highs on Monday 45% were midcaps and 38% small. But a check of the major markets shows the big cap indices making or closing in on new highs while the mid-cap index lags and the small cap lags even the mid-cap. But selectivity will be key in these arenas. Smaller companies will be far more beholden to the domestic economy.

Clearly commodity based stocks are leading the charge, but we think there are excellent opportunities that are not so extended in the medical, technology and retail space, and we’ll be posting them on our sister blog throughout the day.

Crossroads

The current correction across the major indices is in keeping with corrections we have seen throughout this year, which have measured from roughly 4 - 8%. Market participants could therefore not be faulted for expecting an upside resolution. In fact, a significant higher volume gain this week could end the correction and reestablish the uptrend.

There is an argument to be made for bull market continuation. Poor news last week, especially in Friday’s jobs report, only led to higher prices. Earnings season has gone well, although sales growth was not encouraging. And many leading stocks continue to hold up well in their uptrends. Several are breaking impressively to 52 week highs. Over the weekend the G20 essentially relented to Treasury Secretary Geithner in backing the continuation of stimulus measures and as we go to press weak dollar plays are flying and stock market futures indicate another attempt at market follow through is underway.

And yet the markets begin the new week at a crossroads. While we must be on guard for a bullish resolution the bulk of the evidence weighs in favor of a deepening correction.

We’ll focus on the NASDAQ in our analysis but our comments are equally applicable to the S&P 500.

A weekly chart of the NASDAQ shows a clear shift in volume patterns over the last seven weeks. Whereas earlier in the rally there was robust upside volume interspersed with lighter volume declines, of late the opposite is true, with the market selling off on heavy volume and bouncing on light volume. Last week was a case in point with impressive weekly gains marred by below average volume.

The daily shows us the development of a Head and Shoulders top. This pattern is most often successful when upside volume dries up as the pattern progresses. That is clearly the case so far.

A negative resolution might not occur immediately. There could yet be further upside in this oversold bounce in the market. But unless upside volume mars the pattern we could well end up with significantly lower prices later this month.

No Tea Leaves Needed to Parse This Fed

One of the most common parlor games in the business press is to muse about when The Fed will begin to remove monetary accommodation from the market. Or at least change the wording of the statement released after their meetings to signal to the market that a policy change is imminent. This page has long been of the opinion that the bull market will remain viable until this finally occurs. After today’s statement release it appears we are not close.

Lost on the public amidst the speculation is The Fed’s dual mandate, something we have been as guilty of overlooking as the next talking head. With the Humphrey Hawkins “full employment” bill in the late 1970’s The Fed was mandated to manage monetary policy not just with an eye to inflation but to employment as well.

This is why The Fed routinely appears late in removing monetary stimulus after recessions have clearly ended. Unemployment is a lagging indicator and the economy has long since been on the mend by the time it improves sufficiently for The Fed to begin raising interest rates.

We have not been alone in thinking that this time it must be different. The Fed has unleashed an extraordinary amount of stimulus into the system and we felt they would have to be timely in removing it lest it lead to an inflationary environment, violating their other policy charge.

But $80 oil and nominally record high gold prices seem to be insufficient to jar this Fed from their focus, which is to insure that sufficient stimulus remains in the system to ward off the deflationary effects which are normally the direct result of a financial calamity such as we endured in 2008.

The Fed’s resolve, which they have made abundantly clear in personal statements by various members for weeks, is an ongoing all clear sign to the carry trade to continue to bid the price of assets higher. While there must be some target prices for oil and gold that will force The Fed out of their somnolescence we are clearly not close.

The stock market is in a correction. And we believe lower prices are ahead in the near term. But The Fed has promised us today a second leg higher after this correction. You’d be foolish not to believe them. today’s statement release it appears we are not close.

Lost on the public amidst the speculation is The Fed’s dual mandate, something we have been as guilty of overlooking as the next talking head. With the Humphrey Hawkins “full employment” bill in the late 1970’s The Fed was mandated to manage monetary policy not just with an eye to inflation but to employment as well.

This is why The Fed routinely appears late in removing monetary stimulus after recessions have clearly ended. Unemployment is a lagging indicator and the economy has long since been on the mend by the time it improves sufficiently for The Fed to begin raising interest rates.

We have not been alone in thinking that this time it must be different. The Fed has unleashed an extraordinary amount of stimulus into the system and we felt they would have to be timely in removing it lest it lead to an inflationary environment, violating their other policy charge.

But $80 oil and nominally record high gold prices seem to be insufficient to jar this Fed from their focus, which is to insure that sufficient stimulus remains in the system to ward off the deflationary effects which are normally the direct result of a financial calamity such as we endured in 2008.

The Fed’s resolve, which they have made abundantly clear in personal statements by various members for weeks, is an ongoing all clear sign to the carry trade to continue to bid the price of assets higher. While there must be some target prices for oil and gold that will force The Fed out of their somnolescence we are clearly not close.

The stock market is in a correction. And we believe lower prices are ahead in the near term. But The Fed has promised us today a second leg higher after this correction. You’d be foolish not to believe them.

Economic Recovery Will Mitigate Damage in Commercial Real Estate

The national real estate virus wasn’t just residential in nature. It infected the commercial sector as well. There have not been as many dire headlines as residential has had because the commercial side peaked later and as such has not yet felt the full effects of the downturn. According to common wisdom it will shortly and this will raise the curtain on a second act of banking failures across the country.

As is our usual take on conventional wisdom, we doubt it.

We do not dispute that regional banks have significant exposure to the sector. Nor that many loans are under water and coming due, around $2 trillion by the end of 2010. Bank losses are projected as high as $300 billion in the next year yet they have made few provisions for write downs.

With vacancy rates approaching 20% many landlords are experiencing a cash crunch and struggling to stay current on their mortgages. And with real estate valuations having declined substantially from their peak many buildings will not qualify for refinancing.

In order to forestall damage to their balance sheets banks will likely take a short term approach and extend the loans when they come due. Over time this is an awful strategy and is a key to what led Japan to its “lost decade,” in which the government allowed the fiction that moribund loans on bank balance sheets were still performing. These so called “zombie banks” were so financially constrained they were unable to lend and in the absence of a healthy financial sector the economy stagnated for more than a decade.

Industry executives are in a panic. The Real Estate Roundtable is an industry group that would like a mortgage modification program similar to that which has been introduced to a certain degree on the residential side, where the government incentivises banks to write off some portion of mortgages they hold that are under water.

But in the face of all this talk of Armageddon came a report on Tuesday of a rebound in the sector. Prices rose 4.4% in the 3^rd quarter for the first gain in over a year and the largest in over two years. While one quarter doesn’t signal a trend it is notable that the number of transactions increased for the second quarter in a row. A bottom might well be in for the sector.

Further, MIT’s Center for Real Estate tracks supply and demand sentiment and their demand index moved 12% higher, marking the first gain in two years. The demand index reflects what potential buyers are willing to pay and it is now increasing.

These developments do not alleviate a clearly tenuous situation in commercial real estate (CRE). Prices could move higher for several quarters and would still be well below mortgage values on many properties. But in a world that has become convinced that the economy cannot improve without government intervention we have yet further evidence that economies heal on their own. And tentative signs of a bottom in CRE could well stem the most dire predictions of failure in the sector as the general recovery gains momentum, vacancy rates stabilize, landlord cash flow improves and the number of troubled properties begins to mitigate.

Expect a Surprise in Friday’s Jobs Report

Lately we’ve been discussing how even good news fails to drive the market. But Friday’s jobs report has the potential to catch the market completely off guard. Most market participants are expecting another dismal report and the unemployment rate to perhaps pass the long anticipated 10% threshold. But if Monday’s ISM report is any indication there may be a shock coming.

The manufacturing index posted its third consecutive reading over 50, which is the dividing line between expansion and contraction. The index was much stronger than expected, coming in at 55.7, the highest reading since well before the recession.

But of greater interest to us is the employment sub-index. It crossed the 50 threshold for the first time in over a year, posting a reading of 53.1. This is an early indication that the jobs report will not be as bad as feared, and in the current market environment “not as bad” could be a catalyst for a countertrend rally.

Of course there is the matter of a Fed meeting on Wednesday that has the potential to move the market as well, but if the market is oversold and looks ominous at the close on Thursday buying some calls ahead of Friday’s jobs report might yield a quick, low risk profit.

Cyclical Bull, Secular Bear

The title of today’s blog entry has become cliché but it holds true. We are in a lengthy period of “resting” in the stock market in which the indices consolidate the gains of the prior 18 year bull run. Markets sell off aggressively, base, rally aggressively and then repeat.

We have been in a secular bear market since the NASDAQ topped in March 2000. There have been cyclical bull periods during this time, most notably in 2003, 2006-7 and this year. But the indices have gone literally nowhere. This is the calling card of a secular bear market such as we had from 1966 – 1982 per the Dow chart shown below, reprinted with permission of Telechart.com.

Why do we bother to mention this? To remind readers that in spite of the exhilarating rally we have witnessed this year we are not in a period similar to the 1950’s or 1990’s. It would be a mistake to assume that the market will embark upon a constructive consolidation only to continue higher in a few months time. While the secular bear markets of 1929 - 1942 and 1966 - 1982 featured a number of second legs higher after strong bull moves there were even more instances of sharp rallies being followed by excruciating periods of choppy sideways trading or renewed sharp declines.

How then to gauge the current situation? For anyone but day traders it’s watch and wait. And there will be plenty to watch for this week.

We’ll be most interested in how the market responds to news. We recently reminded readers that in the current environment news will work in favor of the bears, as all but the best news will now be interpreted as bad. Witness the selling after the release of the GDP report last week. Rather than 3.5% growth being interpreted as a good sign all we could hear were reactions that this was stimulus engineered growth that would have no lasting power to drive the economy, and thus the markets, forward.

We will be watching to gauge the markets’ reactions to the ISM index today and the October jobs report on Friday. The market has been well warned to expect the unemployment rate to exceed 10% and it will be interesting to gauge the reaction if we finally cross that threshold.

We’ll also be interested to see how company and sector specific news pans out. Will animal spirits flow in the energy sector off Denbury’s (DNR) acquisition of Encore (EAC)? We have repeatedly discussed energy’s leadership role late in the recent bull market and covered it in depth on our sister blog as a sector that should be monitored for opportunity.

And will CIT’s bankruptcy filing further depress the financial sector?

Beyond all of this the FOMC will release a statement after their meeting on Wednesday. We have long been of the opinion that the bull market will not truly end until the Fed ends its easing policy. While they have clearly signaled that interest rates will remain unchanged the market’s reaction to any change in the course of quantitative easing will be telling.

On the negative side of the ledger is the retreat from risk that we are witnessing. This is most clearly illustrated by the failure on Friday of AEI’s IPO to price. We believe this was the most important story of the day but it received little coverage. It was just a few weeks prior that IPO’s were pricing well. Now they are being viewed with suspicion, especially private equity issues like AEI that are seen as little more than exit strategies ladled with debt with little appeal to new shareholders.

Finally we’ll continue to watch with interest the fate of Apple’s (AAPL) stock. Sorry if we sound like a broken record but this was the most liquid institutional leader of the rally and if cannot hold up we believe little else will.

Better Than Expected

Yesterday was better than expected. We’re not talking about the GDP report. Or jobless claims. We’re speaking about the market’s performance. We were impressed.

This year has taught us to allow for the highly unlikely. The market has had an ugly turn down, many bullish stocks are breaking down. We expect others to follow. We should be in for a correction lasting the rest of the year if not longer. And yet there were the indices bolting higher yesterday on news everyone knew ahead of time. While volume was lighter than the previous day it was above average on both exchanges. After all that selling we were quite surprised to see such eager buying. But there it was.

Is it end of month window dressing for institutions? We won’t know for a while. But count Thursday as Day One in the market’s latest rally attempt. O’Neil tells us we need to see a “follow through” on Day Four or later. Most rally attempts fail before follow through after such an ugly pullback as we have seen and require multiple shakeouts. We won’t anticipate and will continue to expect further declines. But combine yesterday’s performance with the “firsts” we have seen this year and we will be prepared for any resolution.

Could stocks support a renewed rally? Many stocks bounced back in light volume and appear to be prospects for second legs lower. But a surprising number are holding up well so far. How stocks like AAPL, GOOG, AMZN, JOYG and myriad others continue to fare will be crucial.

Most impressive yesterday was the behavior of Brazil’s BoVeSPa. The index, which we had previously discussed as picking up the mantle of leadership in what has been a worldwide stock rally, had pulled back for the first time since its impressive second leg higher that began in July. The index galloped off its 50 MA, a logical area of support, on significant volume. Brazil is a commodity based economy and energy and ore stocks of various stripes led the last leg of the market’s advance in the States. The action of the BoVeSPa could well signal that those stocks have much further to go.

On the bearish side the Shanghai Composite posted its fifth distribution day putting that market’s uptrend in peril. And closer to home the broad Medical sector, one of 33 that IBD lists, has taken over the top spot in IBD’s rankings. Medical stocks often take what could dubiously be called “the lead” during corrections because they are usually thought to be reliable growers in good times or bad (you can’t put off treatment for illness until economic growth returns). Of course most of them don’t lead as much as they go down less than other sectors.

In a year that has been difficult for even seasoned traders to grasp correctly today should be especially interesting. Watch the leaders that have held up. They will be your best clue to the immediate direction of the market.

Panic

The sell off intensified on Wall St. yesterday. Traders were so panicked most stocks in uptrends couldn’t so much as attempt to rally off what are now multiday pullbacks to their 20 and 50 MA’s. Many stocks have severed their 50 MA’s and appear to be headed into significant corrections. This kind of hysterical exiting of stocks will lead us to a bounce sooner than later, but we think even frequent traders are best off on the sidelines.

Why? First, it’s difficult to time the coming bounce with a significant enough portion of your assets to make it a worthwhile exercise. Second, traders so insistent on catching “the turn” will likely take sufficient losses on multiple failed attempts to seriously mitigate the gains they might reap catching the bounce successfully.

But there’s a far more important reason. Given the destructive nature of the recent sell off, the bounce, when it comes, isn’t going to lead to sustained gains. It will likely come on lighter volume than the sell off, sufficient to relieve oversold tensions.

The best play in our minds is to gauge the caliber of the coming bounce. If it is feckless and low volume as we expect your time is probably best spent targeting stocks that rise back to key levels for short sales. Given the pattern that is developing on the indices it is almost assured that there will be another leg lower than can be quite profitable for short selling.

If you do play the long side on a bounce bear in mind the market psychology is different now. You cannot expect the same gains out of a long setup that you would just last week. And news will now work to your advantage because the market will find a way to consider all but spectacular news as bad.

Should the time come we’ll try to post some short sale ideas on our sister blog. Until then we intend to keep our powder dry, waiting for the opportunity of higher odds plays.

The First Significant Correction of the Bull Market Appears Confirmed

The cautionary flag we raised in last Thursday’s entry has turned from yellow to red. In spite of some outstanding performances by individual stocks, such as Amazon.com (AMZN), the market has suffered continued and incessant distribution. Intermediate term investors belong in cash. The market is now for traders only.

Distribution is a warning but we’ve seen distribution before throughout the rally and where it’s been heavy all it’s led to have been brief pullbacks of 4 - 8% followed by more aggressive upside. Why do we feel this time is different? It’s in the stocks. We’re seeing break downs instead of pullbacks. That’s a huge difference.

Many leading stocks now trade below the 10 MA’s on their weekly charts, an important last line of support for aggressively uptrending stocks. And a good many of them are Chinese ADRs, which have been a key leadership component throughout the bull market. Yesterday the Shanghai Composite staged a breakaway gap to the downside on increasing volume for the fourth distribution day of its current rally. This is a poor turn of events for the dominant bourse of the international bull market, which had recently broken through important resistance on volume and appeared poised for new yearly highs. What is notable is that during the initial stages of that market’s correction in August Chinese ADR’s held up well on the American markets. Not so Tuesday as many have now entered pronounced downtrends.

Most prominent among these is BIDU, perhaps the one true institutional leader from the menagerie of Chinese ADRs, thus making it the most meaningful for market interpretation. The stock had improbably soared off the March market bottom against incredible odds. Price was buried under an avalanche of overhead supply by falling more than 75% off its all time high. Stocks that fall that hard rarely stage a second act, and if they do it can take years for them to recover. But BIDU managed to quadruple en route to new all time highs.

BIDU reported impressive earnings and sales after Monday’s session. But they guided lower for the 4^th quarter due to a new advertising delivery system that they fear could cause some disruption in their business. The market’s response on Tuesday was swift and brutal.

You might expect this in a stock that has quadrupled and is pregnant with longs that have both hefty gains to lock in or were late to the party and scurrying to cut their losses. But that’s not the type of behavior we saw earlier in the rally in reaction to bad news in market leading stocks.

Take Vistaprint (VPRT). At their last earnings call they guided below consensus. The stock gapped down but lost less than 5% and went on to make new 52 week highs eight sessions later and continued to appear on the list in the ensuing months. In fact, it was one of the dwindling number of 52 week highs during Tuesday’s session.

And what of Arcsight (ARST)? In June ARST beat The Street but guided lower for the following quarter. Tremendous share price volatility ensued but the stock actually closed higher the session after the report was released. It, too, went on to make further appearances on the 52 week high list.

The reaction today to BIDU marks a shift in sentiment. Bullish markets lend the benefit of the doubt to their leadership. Bearish ones simply crush them. BIDU was road kill on Tuesday.

There are other reasons for our conclusions. Recent break outs have failed, a sure sign of a market that is preparing to correct. In fact, we owe readers a mea culpa. In spite of our caution on the market we couldn’t resist recommending two trades on our sister blog on Monday, in TSRA and HMIN. These were fine setups but we knew better. Both promptly failed. The fact that they didn’t work doesn’t mean formation like these aren’t valid. But they require a market uptrend. We were clearly fighting the trend and that’s a loser’s game. We violated O’Neil’s rule about following the market, the M in CAN SLIM. Clearly the “M” is pointing lower.

And we spot yet another divergence on the new highs list. With the major market indices a bit more than 3.5% off their 52 week highs, the 52 week highs list has fallen to about 60 stocks. Contrast this to the last correction on the indices, which reached a depth of better than 5.5% on both major indices on October 2^nd. On that day the 52 week highs list still numbered over 100.

The immediate catalyst to the sell off appears to be a bounce in the oversold US Dollar. This is leading to a sharp pullback in the commodity and energy stocks that had recently moved to the fore. We would expect an oversold market bounce at some point but believe the dollar could well rally further as the market corrects. As we have pointed out numerous times the dollar has been in a pronounced downtrend for the entire duration of the stock market rally. And unless that link is broken the dollar will have to exhaust itself before the market can either resume its uptrend or mount another.

How deep will this correction be? We think you should keep an eye on AAPL, clearly the most liquid and institutionally sponsored of all the leadership stocks. The stock suffered a rare day of distribution Tuesday, pulling back to its 10 MA and dipping into its earnings gap higher from last week. You’ll recall we previously suggested selling AAPL on the violation of its upchannel. The question is how much damage it will endure. The technical signs indicate a bounce is imminent. Watch to gauge the caliber of that bounce. It should be on volume and move price to new highs. If not we’d look for a further correction in both AAPL and the market. If a stock like AAPL succumbs to real selling, not just a meandering journey on non-descript volume to its 50 MA, it could be a lengthy rest for the bulls.

Amazon’s (AMZN) Incredible Strength Yet Further Validation of O’Neil’s Trading System

We trade based on William O’Neil’s CAN SLIM system, outlined in his legendary book “How to Make Money in Stocks.” It is a must read for anyone that seeks to maximize what we focus on in our blogs.

In the book O’Neil preaches to invest only during market uptrends in companies whose sales and earnings are accelerating sharply. They should have something “new” about them to drive the stock – a product or service that breaks new ground and makes the company’s stock a “must own” for growth oriented institutional investors. It is this money that drives share price appreciation that we seek to have work for us.

Amazon.com’s performance after earnings Thursday evening reminds us of the rationale behind O’Neil’s method. The idea isn’t to buy anything breaking out of a cup with handle base, which has become the all too simplistic interpretation by the general public. Rather it is to figure out what are the institutional MUST OWNS and position yourself in them prior to their big moves.

Two months ago an O’Neil trader told us Google (GOOG) was a must own again because of new initiatives they had that would only bolster their dominance in search. Sure enough, when GOOG “beat the street” recently the stock flew. Institutions simply had to own it.

AAPL continues to innovate and deploy a steady stream of new products the public falls in love with. The stock has been in an uptrend since the market began rising in March and also gapped up big on earnings last week. Another institutional must have.

And AMZN, with its ground breaking Kindle reader and hammer lock as the go to destination for online purchases is similar. In the last two quarters there was a huge jump in the number of mutual funds owning AMZN’s shares. Notice the gap up on the chart in September on huge volume as institutions forced their way into the stock. Thursday night’s report lit the match.

Figuring out the institutional must owns during market uptrends is the secret to How to Make Money in Stocks. These days innovating Big Caps are back in style with institutional investors and their volume footprints have been the clues to entry.

Reconsider the Source

In August we ran a column entitled Consider the Source. It was in response to Rochdale Securities’ analyst Richard Bove’s call to sell financials because they were “trading on fumes.” We argued that Mr. Bove has a poor track record of calls, having implored the retail public to buy and hold banks all throughout the market implosion last year. Fortunes were lost heeding his advice.

After Mr. Bove’s call financials, as measured by the SPDR Financial Sector ETF, went on to gain more than 10% to their recent peak and the market moved higher as well.

We mention all of this because late in yesterday’s session Mr. Bove issued a Sell recommendation on Wells Fargo (WFC). The stock promptly tanked on enormous volume taking the market with it.

While readers of our prior column know what we think of Mr. Bove’s acumen we would be remiss if we didn’t remind ourselves that even stopped clocks are correct on occasion. And while the market eventually disregarded Mr. Bove’s previous negative prognostication this time it appears it seized on it as the excuse it was looking for to do what it wanted to do: sell off.

We view yesterday’s closing action with alarm. The market has been having difficulty moving higher on good news and traders are clearly taking profits while they can. Given the increased distribution we have seen of late along with other clear sell signals, like the break of an increasing number of stocks from their bullish uptrends, the failures in the moves of individual stocks to new highs, the divergence in the 52 week high list, and major market leader AAPL’s euphoric rise through its upchannel line (which we have well chronicled here and on our sister blog) we believe the market could be in line for the first significant correction of the bull market.

(NB - 52 week highs list divergence – In a previous column we pointed out that markets tend to peak when the major indices hit new highs with fewer 52 week highs than previously. Yesterday, as both the NASDAQ and S&P 500 hit new recovery highs, the indices scored only 451 52 week highs as opposed to nearly 700 when the indices hit new highs on October 14th.)

We previously stated that we do not believe the current bull market will end before the Fed begins to cut back on the excessive liquidity in the market. While Fed and Treasury policies have clearly debased the dollar and unleashed inflationary trouble signs in oil and other commodities, that time has not yet come. Given this and other bullish signals we see around the world, including the outperformance of commodity based stock bourses, such as Brazil’s, and the resurgence of China’s market which we chronicled recently, we expect this to be a constructive consolidation. But it is likely to exceed the 4 – 8% corrections we have seen to date. This might well be difficult for longs to sit through and we feel you should act defensively, raising stops in winning positions.

As always we could be wrong. An extended correction does not have to occur. But given the minimal gains off the last market pullback and the lack of participation since then as measured by lower trading volumes as the markets moved higher, we feel caution is the prudent position at this point.

Given that we expect a constructive consolidation we will be profiling on our sister blog those sectors and stocks that we think you should focus on as a correction unfolds.

The Potential Market Impact of a Topping Apple (AAPL)

On our sister blog yesterday we pointed out that AAPL has violated a key sell rule for an uptrending stock: price action has gotten overheated to the point that it is breaking above an upper channel line on a log chart. To be valid the upper channel line has to extend back at least four to six months. AAPL’s dates back to May.

History teaches this is a warning sign that the stock’s run is about finished. But it doesn’t have to be immediate. It’s an early warning system, if you will, and puts holders on notice that they should be scrutinizing the stock’s trading action with extra care.

Today AAPL has bulled ahead to all time highs on huge volume. Since it filed its earnings report it has gained, as we go to publication, nearly 9% in less than a session and a half; the gain is better than 11% off its recent lows. For a big cap like AAPL that’s pretty heady stuff.

The gap up, the volume explosion, the upper channel line violation. When taken separately there is nothing extraordinary about any of them. But when taken together they speak to the possibility of AAPL topping in a price climax.

A true price climax will see price advance at least 25% in a week or two. And volume should remain heavy. We are thus a long way from seeing this type of price action but with AAPL clearly the table is set.

Which leads us to the main focus of our musing: AAPL is the institutional leader of the current bull market. It is widely owned and universally loved and has been rewarded with excellent price appreciation off the market’s March lows. Should AAPL top, will this be a “tell” for this leg of the bull market?

History suggests unless it is accompanied by other price climaxes it doesn’t have to be. In late December 1999 and early January 2000 Qualcomm (QCOM) was THE market’s darling stock in what was a sea of wonder stocks. The stock climaxed in an orgy of buying that saw price appreciate almost 60% in four sessions. During the frenzy one analyst, who probably never lived it down, prognosticated a $1000 target for what was an $800 stock at its peak.

The NASDAQ's uptrend took a quick 8% hit but lived on for another two months during which time a lot more money was printed on the long side. When it finally peaked there were a plethora of climaxing stocks, the most blatant signal the bull market was at an end.

So keep an eye on AAPL. Understand that if it climaxes it might have a significant effect on the market over the short term, sufficient that you will have to closely monitor your positions. But unless it is accompanied by similar action in other leading stocks the market is apt to absorb the punch and move forward.

The Shanghai Composite, Poised to End Correction, Could Augur Well For the Bull Market

Earlier today we posted a cautionary piece on Apple (AAPL) on our sister blog. If the institutional poster child for the current rally reverses it could bode poorly for the market.

And although there have been solid reports posted by key companies the market is clearly having difficulty moving higher. After a tremendous run off the March bottom investors might be selling the recovery news as the recovery finally becomes obvious to all observers.

So a more significant correction than we have seen to date wouldn’t surprise us.

But action in the Shanghai Composite suggests any correction could be merely a consolidation of gains prior to a further run.

In our recent commentary we suggested that the outsized move in commodity stocks has enabled aggressive upside in key commodity based markets, most notably Brazil, that have assumed leadership of the global equity rally from China as that market has corrected since early August.

But although it has suffered through a significant correction the Shanghai Composite, that had more than doubled off last October’s lows before embarking on its first serious correction, appears set to challenge its highs.

It didn’t always look like the correction would yield to another rally attempt. At better than 20% the correction was significant. The market bounced weakly and then embarked ominously on a second leg lower. But last month the composite found its footing. Upside was halting and distribution threatened the move, but today that market broke forcefully above an important resistance area and closed at the highs of the session.

It is now perfectly situated to make a run at the August highs. Success is not assured and in our view failure here would be a cautionary sign for the American markets. But given the volume of the recent gains and eager high of day closes we do not think it is likely to stumble. While that wouldn’t assure continuation to new recovery highs it indicates that the global bull move is not yet finished and corrections continue to be buying opportunities until we get less persuasive signals.