Déjà Vu All Over Again

Two Mondays ago the Shanghai Composite had a dreadful day. The index, which had pulled back to its 50 MA in what appeared to be a garden variety correction, broke through this key support level. Because it had led the global equity rebound it triggered worldwide selling. Bourses all over the globe gapped lower and registered ugly losses.

But on the NASDAQ volume was lighter than the previous session. That’s a strange dichotomy and we ignored the divergence, focusing on the ugly price action that normally presages a change in trend.

We know what happened since. The markets clawed back from the start of the following session and went on to make new highs. The upside was stymied by Friday’s distribution, which we detailed in our last column.

This morning, on yet another Monday in which the Shanghai Composite was in precarious position, it happened again. The composite broke to new lows and now seems certain to test its 200 MA. We discussed why we thought this would occur in a previous column. We also suggested that the US market would have to lead of its own accord, rather than take cues from foreign sources in order to sustain its own uptrend.

While we predictably saw gap down selling in the States today a decoupling from the Shanghai market might be underway. The gaps down were less spectacular than two weeks ago and the indices closed comfortably off their lows, indicating that the American markets might becoming “inoculated” to the Chinese correction.

Clearly the American markets have more ballast than their critics give them credit for. But we know the upside has also been tested and found wanting. A correction more through time than price could be in the offing. Whatever occurs, dormant market periods bring fresh opportunity but in the interim patience is required. Forcing trades when the odds favor choppy conditions that are best suited to triggering stops can result in giving back hard earned gains that are better reserved for when a clearer market direction emerges.

Churn, Churn, Churn

We might not be as eloquent as Pete Seeger (who set the words of the Bible to music in Turn, Turn, Turn) but if “to everything there is a season” then Friday’s action could well foreshadow the end of our uptrend “season” or at least indicate that it needs a good rest.

Friday we published a piece urging investors to “turn down the noise,” our point being to tune out others’ opinions and simply key off what the market is telling you. Our admonition so quickly thereafter might seem a bit strange but the market is a never ending story and each day’s action holds the potential to change the tenor of the market. We believe Friday’s did.

In our last piece we noted Thursday’s bullish close after ugly opening action. We said that it opened the way for upside and we got that when Intel (INTC) released bullish news in the pre-market on Friday. But after a gap up open we saw steady selling for most of the rest of the day. The NASDAQ closed positive but barely so and in any event well off its highs. Worse, the action occurred on high volume, the highest of the week on both indices and above average on the NASDAQ. It’s unusual to see such big volume on a non-options expiration summer Friday.

This kind of high volume trading where the indices end near where they started is called churning and it’s a sign of distribution. Clearly on Friday smart money was selling to latecomers who were excited by Intel’s news. What this action tells us is that the news had been widely discounted by the market during the course of the more than five month uptrend.

In fact good news all week last week succeeded in moving the market little and the weekly charts of both the NASDAQ and S&P 500 both reflect little change from the week before on elevated volume, so we have distribution apparent on the weeklies as well.

A correction does not have to happen. But given the mounting distribution on the indices, their inability to hold gains on myriad good news, and the rampant bullishness increasingly on display on CNBC and as reflected in the Investors’ Intelligence survey, which now shows 51% of investment advisors bullish as opposed to less than 30% at the market bottom in March, we believe it is time to take a defensive posture with your actively traded portfolio.

For starters we would be reluctant to initiate new positions in equities.

If you have stocks that, after the seven weeks since the uptrend resumed, have at last achieved a 15 – 20% gain from their most recent break out points, we strongly urge taking profits. Most stocks become increasingly subject to correction after they achieve a 20% gain over a course of many weeks.

Apple (AAPL) is an excellent example of a stock in which to take a profit. The stock’s last buy point was $144.66. On Friday, seven weeks after its break out, it hit an intraday high of $172.49 for a gain of better than 19%. Given that the stock broke into fresh high ground but surrendered all its gains into the close on volume that was higher than the previous day, we’d nail down a profit in the stock.

There are a number of stocks we recommended on our companion blog that have eight week holds on them because they swiftly achieved a 20% gain, often a sign of higher prices ahead. This coming week will be the eighth. Some are holding up well, others are in fresh bases. Whatever the case, if they no longer have a bullish posture we would consider a graceful exit this week.

Should a correction occur we have no idea how severe it will be. But being out of harms way allows us to unemotionally consider our options secure with our recent gains.

Turn Down the Noise

The hardest part about riding a rally correctly is the wall of worry that accompanies every bull market. As prices rise the call of the bears can become overwhelming. And the cacophony of voices only mounts as “smart money” investors who were early to the party become increasingly skittish about protecting their gains.

We’ve had a number of smart money calls for caution over the past few quiet August weeks. Just yesterday on CNBC noted floor trader Art Cashen said he “sold some stock” in financials, preparing for a pullback. Many technical analysts insist we are overbought and due for a correction. One well known aggressive trader who trades our style and has his own subscription newsletter this week said that he is not eager to be long, although he won’t shy away from outstanding opportunities. Which begs the question, if he’s not long the outstanding opportunities that have already presented themselves what has he been doing?

Yesterday the market opened quietly but sellers quickly gained control. Losses were swift and harsh, especially on the NASDAQ. If you were on edge given the prevailing smart money sentiment it might have been difficult to check your emotions, which can be a trader’s most difficult battle.

But a quick check of volume indicated that trading during the first hour yesterday was the lightest of the week on either exchange. There wasn’t much conviction behind the selling. If anything the lack of volume created an easy opportunity for the bulls. They took full advantage.

By the end of the day the indices clawed back their losses and posted modest gains. More importantly, after staging recent breakouts to new highs and having been stymied in attempts to move higher they had now tested the downside and lived to tell the tale. That left the market open to the upside move that had eluded it, and we got that with this morning’s gap up open on Intel’s (INTC) raised guidance.

Investors are climbing the wall of worry again as the indices have surrendered much of their early gains leading to concerns about a reversal day. That might well end up being the case. But for now watch your stocks. If they are holding up well in their uptrends and not selling off on volume stick with your positions. And remember that a number of the stocks we have recommended that have outperformed have eight week hold rules in effect, whatever the smart money says.

We’ve acknowledged that this has not been the easiest rally for growth investors. Leadership has been narrow and mercurial and much of it has been thin. We’ve discussed why this is likely the case in another column.

But that’s no reason to sell winning positions. The market uptrend continues. It won’t forever. But while it does stick with your winners. And by all means, turn down the noise.

An Unexpected Recoupling?

Nine days ago in this column we warned of a correcting Chinese stock market and expressed concern that the rapture over the Chinese economy’s ability to heal itself and drag the rest of the globe to prosperity could well be a chimera. Given that the rally in stock markets worldwide has been led by the Shanghai Composite this remains a real concern.

Since our column the Shanghai bourse righted itself and mounted a rally attempt. O’Neil has a superb method of monitoring the prospects for a rally. Simply put, after an index puts in a bottom and scores its first day of gains off that bottom it must be “confirmed” by a “follow through” on the fourth day or later with a significant gain on higher volume than the previous day. While this might sound unscientific it has a tremendous record of success in insuring that a savvy trader doesn’t miss a market turn while not wasting precious time chasing every feeble move higher.

The rally attempt began last Thursday. The Shanghai Composite continued moving higher Friday and Monday. Today, on the fourth day of the rally attempt and the first possible day it could be confirmed, the index suffered an ugly loss. At its low point it was down about 5% on the day. It recovered but still was off 2.6% for the session. Worse, the session featured higher volume than the previous day. O’Neil refers to this as a distribution day and his studies show that distribution so early in a rally attempt is usually a sign of impending failure and fresh lows ahead for the index in question.

All of this occurs as the reservations expressed in our prior column have been borne out. On Friday the Wall St. Journal reported that Chinese bank regulators are worried about indiscriminate lending on the part of banks, which have been encouraged to lend by stimulus money being pumped into the system. Regulators took measures to limit further lending which will slow the economy in the short term. The hope of course is to limit the buildup of bad loans on bank balance sheets similar to what occurred here in the States during the housing mania and became apparent only when the economy started to falter.

Then yesterday Chinese Premier Wen said that the economy faced difficulties due to the slowdown in exports to the US and that even given the stimulus it was difficult to boost domestic demand to pick up the slack.

With leadership from the Chinese market likely lost for now the question hanging in the air is if the American market can lead on its own merits as it has in the past. Our stock markets have seen repeated bouts of distribution over the last few weeks, mostly in reaction to weakness in China, but have thus far held their ground.

The buzz the last few years is how the emerging BRIC countries would decouple from the industrialized West and become the tail that wags the dog. While they are no doubt industrializing at an impressive pace, improving the lot of their citizens and bolstering the prospects for greater standards of living worldwide, the American dog, with its economy triple the size of China’s, just might wag the tail far longer than anticipated.

Why "Leading Stocks" Aren't Leading

While there have been some incredible gainers among the stocks we follow on our companion blog for the most part this leadership has been narrow and thin. We can’t find 20 stocks that pass our fundamental metrics, usually the starting point of our evaluation process. This isn’t what you would expect of a market that has seen the major indices rally 55 – 60% off its bottom. What can account for this marked underperformance of “leading stocks” when we expect just the opposite during market uptrends?

A look at weekly charts of the NASDAQ Composite and S&P 500 is illuminating. In spite of the incredible gains the NASDAQ would have to climb another 41% from here to match its old highs; the S&P 52%. Once put into perspective it is evident that they have only begun to mitigate the damage done during the bear market.

Compounding this is the time element. While the 2000 – 2002 bear market on the NASDAQ was far worse than the 2007 – 2008 bear for either exchange, the turn of the century bear played out over 31 months. This gave the business cycle time to rejuvenate. Within a few months of hitting bottom there were scores of publicly traded companies hitting our growth radar screens with the supercharged growth we look for beginning to become apparent.

That’s not happening this time around. The reason is likely the span of only 16 ½ months for the recent bear. While that amount of time can be on the long side for typical 20 – 30% bear markets it clearly pales by comparison to the turn of the century bear with which it has more in common, given the depth of its correction and impact on the economy that it reflects.

This amount of time is insufficient for companies to emerge with the kind of earnings acceleration we look for to drive true growth stocks. Thus we are left with stocks like AAPL in our portfolio, a solid performer having doubled off the March bottom but sporting flimsy growth stock fundamentals of the sort we would ordinarily pass over.

Time heals all wounds and certainly in time there will be a fresh crop of outperforming growth names. But that might well be for another market cycle after the current uptrend has run its course. For now we broaden our parameters as we look to expand our universe of outperforming stocks.

There’s Been a Change of Heart

There are many factors that make up a successful trader. Knowing how to cut losses short is probably the most important. Being flexible in your approach to the market and open to all possibilities is also crucial. Exercising such flexibility we believe it is time to change our mind.

Stripping out the behavior of the Shanghai Composite, which we have discussed, and the continued winnowing of leading stocks, which is a cautionary sign, we have been presented with evidence of a market this is simply resilient and resistant to significant correction. The Shanghai Composite has corrected over 20% in the last few weeks but our market suffered only an ugly day on Monday with no follow through since. As we approach today’s session the indices have taken back all of their losses and a number of leading stocks look just fine in their uptrends.

The behavior of BIDU, a leading stock that comes from the leading market index, was our tell for a market correction. Monday BIDU and the market gapped lower. Volume was higher but not extreme. Still, the activity usually signals heavy seas ahead. Yesterday in this space we opined, “BIDU has shown…fortitude, pushing into its gap on some volume. But it needs to close that gap and climb into its previous range. History tells us that is unlikely.” Well, it’s time for the unlikely. BIDU has climbed back into its range and is a buy back right here.

There are several factors at work. One is the leadership of the immature Shanghai Composite. This is a very restricted exchange and is very young. Both factors contribute to outsized volatility. Second is the influence exerted by Asian trading on US exchanges. For years the US dog has almost exclusively wagged the tail that is the world’s other markets. No longer. The US is now as subject to influence from other exchanges as they are on ours. This has created significantly more market “noise” but needs to be accommodated to avoid being shaken out of successful positions. Finally, the US markets have signaled that the “green shoots” paradigm is still very much in favor whatever the Chinese markets might signal.

There will likely be continued “noise.” But stunningly the market trend remains up and you need to reinvest to take advantage of the intact uptrend.

Volume is Only Skin Deep

Yesterday’s action was quite encouraging for the bulls with the major indices posting gains on higher volume than the previous session. That’s called accumulation and is generally bullish.

Are we therefore backtracking from our previous column where we suggested a significant correction has begun? In a word, no.

If beauty is only skin deep so too can be volume. It is often misleading to judge a trend based on a narrow slice of activity, in this case higher prices in one day on higher volume. Dig deeper and you’ll find a less bullish tale.

Stocks that had been leading the market found little favor yesterday. GMCR continued to fall apart, unable to find even a modicum of support. It has now tried twice to turn higher and failed both times. NTES is finding decreasing interest in pushing higher off its 50 MA. BIDU has shown more fortitude, pushing into its gap on some volume. But it needs to close that gap and climb into its previous range. History tells us that is unlikely. And AAPL, which had gapped down on higher volume, has tried to climb back on decreasing trade.

There are stocks that appear to be holding up. PWRD and STEC have been resilient. But all this activity tells us is that leadership is narrowing. Worse, nothing is emerging to take its place. Without leadership a market cannot substantially advance. And given the magnitude of the advance we have experienced off the March lows that means a significant correction is likely.

The Chinese market bounced nicely overnight, but that doesn’t begin to mitigate the impact of the correction there. As the Chinese market has led the global rally it will either take a salvaging of the “China leads the world into recovery” paradigm for the markets to recover or they will have to decouple from this theory and rise on their own merits. Here in the States, with employment numbers printing fresh lows this morning, that seems wishful thinking at this juncture.

Catch a Wave

It’s time to catch a wave, surf not Elliott. It appears there will be some fine swing shorting opportunities in the near future but the set ups will likely need some time to mature. In the meantime an August trip to the beach isn’t a bad idea.

Tuesday’s action across the indices augers for further weakness after a corrective bounce runs its course. The indices didn’t recoup even half their Monday losses. Worse, trading volume was pitiful. The translation is elementary: there was no conviction behind Tuesday’s buying.

After two shallow and brief corrections of the March rally in May and June we are now likely headed for a significant correction at the very least. The weakness in the Shanghai Composite that we previously discussed and the hard gap down on Monday point us in that direction. While we believe the uptrend will endure we fully expect the indices to test their 200 MA’s before all is said and done. A correction of this magnitude can last a couple months. That would take us to the end of October, which is a time of year that has been quite favorable for market rallies over the decades.

But we are getting ahead of ourselves and putting our own expectations on the market, which can lead to a lack of flexibility, the last thing a successful trader can afford.

Our first order of business is to focus on stocks that have had the biggest runs since the March bottom. As they rally back on soft volume they are likely to provide solid short setups over the coming week or so.

But for now patience is a virtue. Down is the inevitable course, but stocks can bounce a lot more than you think when the change of direction becomes so clear to the crowd.

Out of the Pool

We wish we could have been more timely with our call to get defensive. It only gradually dawned on us Friday afternoon that the market could be in real trouble. Our tell was BIDU, which along with the imploding Chinese market was the focal point of our weekend cautionary tale.

There wasn’t a lot of time for action between our 3:55 PM EDT epiphany on Friday and Monday’s gap down open. But if you took our advice you exited the market on the first rally back on Monday to limit the damage. We can’t say we are pleased with the yield from our month long foray into long positions. We made money, yes, but sold well off most stocks’ recent highs.

But this is the game we play. We make propitious entries when we believe an uptrend is beginning and look to position ourselves for an extended run to big gains in what we feel are the best stocks the market has to offer. History teaches us that this is a reliable way to make big money when a market turns bullish after a bear correction.

This approach has not yielded stellar results this year. The bounce off the March lows has been best played by buying badly down stocks left for dead and watching them as much as quadruple. The safer but still profitable alternative would have been to just buy the major indices themselves.

The jury remains out on whether we have experienced a bear market rally or the beginnings of a new bull market. After the 2002 final bear market bottom stocks bounced but didn’t make spectacular gains for five months. It’s been about that length of time since the March 2009 lows so bulls can make the argument that leading stocks might only now be set to gain steam.

Bears can point to a horrific bear market that took place over a period of about sixteen months, perhaps not enough time to digest the stunning losses realized during this rout. Juxtapose this to the thirty one months of the 2000 – 2002 bear. They can also point to narrow leadership that for the most part has provided only halting gains.

Ours is an alchemy of reading charts and interpreting economic conditions. For now the clearest path is down for the indices but beyond the next couple of weeks we need more clues as to market direction. We’ll continue to post our thoughts as those clues come to light, and recommend trades on our companion site, long or short, when we see the opportunity to make good gains.

Does a Subtle Lack of Bullishness in a Leading Chinese Stock Auger Poorly for the Market?

Friday we came to market quite upbeat. The stock market was consolidating in a tight range, through time as traders say, rather than through price. We were anticipating adding to our position in BIDU, which has been one of the market’s leading stocks, at the end of the day.

Like the market BIDU had made strong gains during the late July rally and had consolidated in tight fashion since. At the close Thursday BIDU’s weekly chart showed three consecutive tight weekly closes. O’Neil says that sort of action can be a reason to add to a winning position. Of course a Thursday close on a weekly doesn’t count. We needed to see continued steadiness Friday before the pattern was confirmed and we could add. We were ready.

But an ugly thing happened to BIDU on Friday. It took out the bottom of its pattern. Not to worry, we thought. Trading was on light volume and it could always rally back into the close making the setup all the more bullish for having tested the downside. And indeed the market showed some of the resilience we’ve come to expect of it the past month and rallied into the close. We expected that BIDU, one of the strongest stocks in the market, would be leading that charge. Instead it was financials that recovered a bit. BIDU was mostly left behind closing at the low end of its range. Not the kind of action you’d expect from a leading stock.

Should we be that concerned? We think you need to be on guard and here’s why.

BIDU isn’t the only leading stock to show disappointing action of late. Last week saw NTES completely break down. And GMCR has pulled back to its 50 MA. The pullback was in light volume and looks constructive, just what you’d want of a leading stock when it corrects. But it’s correcting to a far greater degree than the market. If GMCR is a true leadership stock it should be correcting sideways, if at all. Such underperformance by leading stocks in a market uptrend is a cautionary sign for the health of a rally.

BIDU is by far the most important Chinese stock in the current rally and it seems to have caught the Shanghai Flu. The Shanghai Composite Index is the leading major stock market this year, far outpacing gains on other bourses, including the American exchanges. But it has been suffering a case of jitters the last three weeks pulling back to its 50 MA for the first time since the worldwide rally began in March. Worse, Friday’s action saw it break the 50 MA for the second day in a row and for the first time close below it.

The Shanghai Composite Index could merely be enduring a well earned respite. But if so we should expect to see a forceful rebound from its current decline and Friday’s action doesn’t embolden a bull. As the leading index its fate will have important implications for markets worldwide.

What could be happening? There exists the possibility that the “China rapture” currently bolstering world markets is an empty pile of promises and the markets are coming to that realization. There has been plenty of euphoria over the resilience of the Chinese economy and the expectation that it will lead the world in recovery and perhaps in the future. Western liberals are in awe of the supposed success of a command economy in a way we haven’t seen since economist Paul Samuelson declared in the 70’s that the Soviet model was superior to the West’s because it could more efficiently direct resources.

Lost on observers are all the flaws inherent in such an economy which, because of the controls on it, doesn’t have the ability to self-correct. China has launched a stimulus that has thus far boosted growth and it has the resources to self finance that stimulus and make it ongoing. But the stimulus focuses mainly on lending to state enterprises, which are notoriously inefficient. The ability for the Chinese economy to continue to absorb this type of spending has not been questioned although we know from recent experience that these ongoing misallocations of resources can have disastrous consequences as we saw with the government encouraged American mortgage market.

Despite all the stimulus induced growth China remains an economy that is heavily export dependent but the United States isn’t coming back quickly as the major growth driver. Even when the US recovers its consumers will not have the balance sheets to revive the economic model on which China launched its growth curve. There is brave talk that China can focus on exporting to African and South American markets which are not as deep a well as the American market but supposedly broader because they encompass so many more people, but this is fantasy. Selling manufactured goods to people that cannot afford them isn’t a valid strategy no matter how many of them there are.

Part of the worldwide market rebound this year has involved a bounce in resource stocks, induced by what seemed to be China’s insatiable demand for raw materials. But there is emerging evidence that China was simply hoarding resources, restocking during a period of light demand in order to avoid the sharp price increases their outsized demand has caused in the past during periods of significant worldwide growth. Now that they have restocked demand could fall precipitously.

Is it reasonable to extrapolate all of this from one afternoon’s trading weakness in a Chinese stock? We don’t like to “think” too much or overtrade during a market rally. But when leading stocks suddenly stop leading we also believe it’s important as a trader to anticipate when a trend can start to move against you and what could drive it. It doesn’t have to happen but the pieces could well be falling into place. We don’t advocate nervous trading habits but we don’t believe now is the time to allow positions with strong remaining gains to move against you.

The Market Keeps its Own Counsel

Journalists are always attributing market activity to a certain news trigger that they can grasp and build a story around. But the market moves in broad arcs and what it does on any given day is often for no discernible reason and often not associated with that day’s news.

We mention this because it appears to us that the stock market was of a mind to sell off when it got out of bed this morning. In spite of encouraging pre-market news indicating that inflationary pressures remained well contained and industrial production picked up for the first time in ten months the market gapped down at the open and continued lower. Selling seemed determined from the opening bell.

The NASDAQ was already down over 0.75% when, at 9:55 AM EDT, journalists got their reason and headline for tomorrow’s financial sections. Consumer sentiment came in well below expectations. Upon release of the news the markets sank lower.

The sentiment results could not have been a surprise. Unemployment is high and likely to trend higher in the near term. Foreclosures remain high. Consumer spending is poor. And politicians in Washington DC are debating an unnerving number of lifestyle altering changes which have only added to fear and uncertainty. Consumers are simply morose.

While this could well be the beginning of the end for the March rally it should be noted that today’s selling is on lighter volume than yesterday. We are thus unlikely to chalk up a “distribution day.” Volume started out heavier but has lightened up. While it is true that summer Friday’s are well known for light volume as traders escape their desks early for destinations in the Hamptons, volume will find its way into the market when it needs to and it simply won’t today. That’s a saving grace for the bulls

Another is that many of the leading stocks we follow and have profiled are lower on the day but not selling off on volume.

While the market could continue lower on higher volume next week we don’t deal in hypotheticals. For now there is a distinct chance that the sell off that began today could lead to a buying opportunity should it continue to be low volume and constructive.

Yesterday’s Productivity Numbers Add Credence to a Turn in the Economy

Last week in this column we seized on an upturn in Average Weekly Hours to suggest that the economy could be turning. Yesterday’s productivity numbers go hand in hand with the AWH report and underscore that possibility as non-farm productivity surged 6.4%, the highest gain in six years, which, not so coincidentally, was a time when the economy was last coming out of a recession.

This number isn’t foolproof. We saw a big productivity surge in the midst of the last recession, which was a “head fake.” But it tells us that businesses have aggressively positioned themselves for a downturn by slashing payroll faster than output has declined. While the human element of people losing their jobs is tragic this lays the groundwork for brighter times ahead.

Surging productivity bolsters corporate profits. Contrary to popular belief it is a turn in corporate profits that will begin the recovery. True to form we saw those bolstered profits during the recently concluded earnings season in which myriad companies across many industry groups not only beat analyst estimates but raised guidance. It was these reports that were the impetus for the second leg higher in the markets that started in mid-July.

Last month’s Average Weekly Hours hinted that a productivity surge such as this might be coming. As we explained last week corporations do not immediately hire when they begin seeing things pick up. They ask more of those still employed, expanding their work week. That an upturn in productivity last quarter yielded an increase in AWHs last month is yet another promising sign that a rebound is underway.

As always revisions in government numbers can cast a different light on these developments a month or two out. And we do not know how much of the nascent turnaround is based on the ephemeral effects of the government stimulus. But once again the market has found reaffirmation of its economic revival thesis. Those shorting the market should rethink their position.

Consider the Source

In his 1970 book “Ball Four,” which chronicled the life of a baseball player, ex-Yankees pitcher Jim Bouton related a vignette about a fringe major league catcher named Greg Goosen. Goosen had been a NY Mets prospect in the mid-60’s. In those days if you couldn’t make it with the awful Mets you were sentenced to a career in the minor leagues and that’s where Goosen ended up. According to Bouton Goosen himself related Mets’ manager Casey Stengel’s verdict on him: “We have a fellow in spring training name of Goosen,” Casey related to the press when Goosen was just breaking in, “twenty years old. And in ten years he has a splendid chance of being thirty.”

Bouton and Goosen crossed paths in the minor leagues. One night on a base hit to the outfield catcher Goosen stormed out from behind home plate screaming at the top of his lungs, “second base, second base,” trying to get a young outfielder to throw the ball to the correct base. The outfielder completely ignored Goosen and threw the ball home to try and catch a runner instead. Goosen was visibly disgusted and from the dugout Bouton yelled, “But Goose, he had to consider the source.”

This morning analyst Richared Bove advises taking profits on bank stocks because they are “trading on fumes” and fundamentals have not yet improved. He argues that investors are bidding up shares because of a change in psychology towards the stocks as opposed to a change in earnings.

While they do not have the fundamentals we look for in market leading stocks the fact is that the rally off the March bottom has been led first and foremost by financials. Given their gains Bove’s suggestion makes sense to the “thoughtful” investor. After all, when a stock moves higher quickly it only seems logical that it should come back to earth. But this kind of thinking is the reason why most traders and investors are unsuccessful. They avoid buying stocks that have moved aggressively higher during market uptrends because they are “extended,” when these are exactly the stocks they should be focusing on, seeking entry on the proper kind of market pause. And if you are invested in a big winner the worst thing you can do is sell it to buy shares in a stock and sector that has underperformed.

Bull markets are built of many things. But the paramount ingredient is psychology. Markets begin turning higher before earnings improve and usually top before the business cycle concludes. To not grasp this most important fact is to insure an unhappy trading career.

We’re not arguing to buy financial stocks here. And we’re not claiming that the market uptrend will continue. But we don’t believe you should sell a position in a winning stock or sector until the market sends you signals that it is becoming exhausted, and as of this writing we don’t have those clues. To call for selling a big gainer because of misplaced psychology is to misunderstand the dynamic behind the markets.

Mr. Bove is no doubt a decent and sincere fellow. But he is the same analyst that consistently recommended purchasing financial stocks as they melted throughout the summer and autumn of 2008. On his recommendation people bought shares in many financial stocks at that time and watched their investments in Lehman and Bear Stearns go to zero and Citigroup and others lose almost all of their value.

For those investors who believe that Mr. Bove’s advice is “thoughtful,” we recommend considering the source. The kindest thing we can say about Mr. Bove, who is 68, is that in ten years he has a splendid chance of being 78.

While the Smart Money Positions for a Market Top, Be On Guard to Add to Winning Positions

The crowd is almost always wrong. Day after day traders come to market with the same sentiment. “We are overbought, the economy cannot sustain the rally, position yourself for downside.” And day after day your writer sees trader after trader take short position after short position and almost always stop out for a loss.

This doesn’t mean that the market won’t correct. It is certainly entitled to it after four strong weeks of gains that have initiated a second leg higher off the March bottom. But from the action on the indices and trader sentiment it appears any correction is likely to be contained.

Rather than worry about a general market pullback well positioned longs should simply observe how their stocks trade. This is generally not the time to be initiating new positions, which would be in stocks that are either extended, and thus risky, or laggard, and thus usually not worth your focus. But it IS a time to prepare to add to existing winning positions should they continue to act well.

You should look to add to your biggest gainers. They are the markets leaders and, although it might seem counterintuitive, are likely to be the stocks that continue to gain the most in a continued market uptrend.

For the most part these candidates should be trading tightly in spite of having large gains. That means they are correcting through time rather than price, a highly bullish development. They should base in this fashion for at least three weeks and you should add smaller shares as they move to fresh highs.

Many of the best stocks having been trading tightly for a couple weeks, meaning you’d like to see continued constructive action for another week at least before adding to a position.

We’ll be watching the stocks we recommended on our sister site and advise when and if the opportunity arises to add to our best positions.

Green Shoots Continue to Embolden the Bulls

In economics you can’t extrapolate anything from one month’s data and when data is first released it’s preliminary and subject to revision. But it’s the kind of number that jumps out at us when we read this morning’s employment statistics.

Average Weekly Hours increased to 33.1 in July. Last August that number stood at 33.7 and every month since it’s either held steady or ticked down. This is literally the first increase in nearly a year.

Why does this intrigue us? Because AWH is THE indicator to watch as an early read for an improvement in unemployment.

During a recession businesses cut costs to survive and one of their biggest costs is often labor. As economic conditions improve employers are loathe to expand their work force. They have likely been stung badly by the downturn and are uncertain about a recovery. So they rely on their existing workforce to do more. They will only start rehiring after this “slack” in the labor they currently employ is put to work.

There will be a revision to this number that can change the whole equation. And next month’s reading might tick back down again. We’ll need to see a good three months worth of higher numbers before we can draw any firm conclusions.

But the conclusion for the market is clear. The rally off the March lows has become a play on economic resurgence. With even a hint that employment numbers, the laggingest of lagging indicators, might be starting to turn that thesis remains intact. And so, likely, will the market’s bullish bias.

The Fed Threatens to Take the Punchbowl Away as Inflation Plays are at Inflection Points

The price of gold is poised to break above a trend line connecting the March 2008, March and May 2009 highs. Above this line lies a break out to multi-decade highs which would be the most telling sign yet that central banks around the world have printed enough money to insure unbridled inflation.

Not uncoincidentally the US Dollar is breaking down, as clearly seen on the Dollar Index (DXY0). In the eyes of inflation players a significant move lower, which is threatened, would be the comeuppance for a US government that has done everything in its power to invite a collapse of the currency and a soaring in the price of all things priced in dollars, leading to an ugly bout of inflation and an unwelcome 1970’s redux.

Our Fed is no doubt the most egregious offender of all central banks. But Fed chairman Bernanke has said he has an exit plan and if rumors are true he is about to put it into effect. Don’t look now, inflation players, but The Fed could soon be taking the other side of your trade. That’s a fight we wouldn’t enjoin.

Yesterday afternoon Bloomberg reported that former Fed governors Gramley and Meyer surmised that the Fed will announce next week the halting of “quantitative easing,” the policy by which the Fed continued applying easier monetary policy after lowering interest rates to zero by buying US Treasury debt. This policy, of course, further aggravated market fears about the US monetizing its own debt and stoking an aggressive inflation.

While former Fed governors are not definitive authorities they are likely well informed and the Fed could well be using them to “float a trial balloon” regarding policy. We think the market would welcome this decision.

Ending quantitative easing is just the first step in firming up monetary policy. Further steps are unlikely to follow quickly as Bernanke himself has recently mentioned that he intends to maintain a zero interest rate policy into the foreseeable future. But this first move might well be enough for now to soothe inflation anxieties, supporting a dollar which is at a precipice and taking away gold’s juice, just when the party was about to get into gear.

Thoughts on Today’s “Distribution”

According to “O’Neil Theory” today was a “Distribution Day” across the indices. That’s a day in which an index is lower by 0.2% or more on volume greater than the previous trading day. The higher volume signals institutions selling to lock in gains during a market uptrend, as opposed to a market that pulls back on lighter volume signaling that key market players are content with their positions and expecting further upside.

O’Neil’s studies have shown that roughly five of these Distribution Days in the span of a few weeks can spell the end of an uptrend and signals market participants to lighten their loads.

But not all distribution days are created equal. While we won’t quibble with the maestro himself today’s distribution was rather mild, with the indices finishing well off their intraday lows, especially the NYSE indices: the S&P 500 and the Dow Jones Industrials.

These indices are especially instructive if you peak behind the curtain at today’s action. NYSE volume picked up considerably, but the volume burst was BUYING not selling.

Technology has sparked the latest phase of the market rally but make no mistake, financials are the truest of market leaders during the impressive uptrend that was launched off the March bottom. They may not have the leadership qualities we look for but there is no denying their technical strength. Today was an impressive display.

Citibank (C) normally trades about 300MM shares. Today, as it surged over 10%, it traded 1.8 Billion, more than sextuple the average and an amazing amount.

Here are some others that shot higher on somewhat less incredible volume totals but significantly higher just the same: AIG 134MM as opposed to 12MM, FRE 52MM vs. 6MM and FNM 115MM vs. 11MM.

Two fisted buying in the financials today accounted for your “distribution” volume.

At least one commentator I follow has noted that technology, and thus the NASDAQ, have been lagging since last Thursday and suggested that should these stocks roll over they will likely take the rest of the market with them. While anything is possible it is far more likely that technology stocks are taking a rest after their remarkable moves, making a bullish sideways correction through time while another leading sector takes the baton. When you see that kind of participation the only rolling over the market is likely to do is over those looking for a top.

If You Bought Right, Sit Tight

We have arrived at the “sitting” phase of the renewed market rally.

To paraphrase famed investor Jesse Livermore, “It never was my thinking that made the big money….it was the sitting.”

Most of the stocks that will post the biggest gains have already broken out and we have profiled them on our sister site. They signaled themselves to us during the March through May rally. We focused on many of them, scooping them up when the rally resumed in mid-June and haven’t been disappointed. Our latest addition is TNDM, which we discussed on Thursday. But new buying opportunities are likely to be increasingly limited in number during this phase of the rally, which is now extended and obvious.

So what do you do now? If you bought properly, just watch. Or sit, as Livermore averred.

Bear in mind that the best stocks will give you clues about the durability of the market rally perhaps more than the major indices will. Anyone in the stocks we have recommended surely has noted days when the indices were about flat yet their account was up smartly. The market will be tired when these stocks begin to show signs of wear.

So we sit for now, watching for negative clues such as new highs on light volume or bouts of high volume distribution. We hold through earnings and don’t trade out of boredom. You should never consider making money dull and should try to avoid sub-par merchandise for the sake of a quick trade. The worst thing you can do before the rally is over is “lock in a profit” for fear of losing a big gain. It’s the big gainers that often become even bigger gainers.

Nearly three decades ago Tom Petty sang “The Waiting is the Hardest Part.” We wonder if he ever read Livermore?