A Better Tuesday

Believe it or not we’ll take Tuesday’s action over Monday’s. Monday saw tremendous gains but on suspicious volume. Tuesday’s action suggested that rather than make a case against Monday just maybe we should consider giving it a “bye.”

The averages were lower and volume increased from Monday’s abnormally light levels. But it remained light. And trading was confined to the upper part of Monday’s expansion bars. That’s bullish.

Most importantly leading stocks continue to hold up and even post gains on volume. We consider top performing stocks to be the ultimate arbiter of market health and so far they are faring quite well with over 200 stocks on the 52 week high list.

We still believe caution is warranted as the market continues to look with a jaundiced eye at the growth story, taking poor data as a cue to correct. Having said that we are likely to continue to enjoy some ballast in the market for the next day and a half. That will take us through quarter end window dressing and the flush of fresh money into the market at the beginning of the month. It will also take us into the final hours before Friday’s jobless report when we’d suspect caution will retake the market ahead of these anxiously anticipated numbers.

Take advantage of fresh long opportunities as they arise, but in the current environment don’t forget to mind your stops.

Volume Knows No Holiday

Yesterday was the solemn Jewish holiday of Yom Kippur. It was a day of atonement and fasting. It was certainly not a day when most Jews work. And given the large number of Jewish traders it was understandable to many that volume was quite light.

Not to us.

We believe that volume finds its way into the market when it needs to. We’ve seen “quiet” summer Fridays and pre-holiday sessions explode with volume when it was warranted. While there was no earth shattering catalyst for volume Monday, we expected far greater participation on an explosive up day after a three day pullback. Its absence is especially suspicious given the bearish nature of the decline, featuring distribution and low of day closes.

We believe you should still be playing the market on the long side. Leading stocks are holding up and a number of stocks are still making fresh highs. Indeed we have continued posting trading ideas on our sister blog.

But we also believe you should look at the market with a jaundiced eye given the negative signals we have seen, which we have detailed. Another up day on lackluster volume would be cause for yet still more concern.

Meantime the leader of the worldwide rally, the Shanghai Composite, is also in a precarious position and the direction of that bourse could well influence trading around the globe, just as it has all year. That market remains in a confirmed uptrend but it has two days of distribution and one day of churning, which are not generally positive signs so soon after a change in trend. Price has continued lower on progressively lighter volume, a potentially bullish divergence. But the absence of a forceful reversal is yet another yellow caution light.

Reassurance Could Be Weeks Away

Our prior instincts were correct. Late Tuesday we ran a column entitled “The Fed as Catalyst.” In it we mentioned that we had wanted to discuss stalling in the NASDAQ as a cautionary tale earlier that day but were forced to scrap that idea when the market broke to new highs in the pre-market.

But it turns out the caution was warranted. As we had suggested the Fed’s policy announcement on Wednesday was a catalyst for selling, as the market suddenly became worried about removal of liquidity from the financial system. The break above the highs was a fake out and the beginning of a correction.

After three days of selling that correction looks like it could last several weeks. All three days of the correction the market closed not far off its lows. You expect that early in a decline but after two down days Friday’s performance bodes poorly. The sellers had exhausted themselves as witnessed by sharply reduced volume that day. But buyers, who heretofore had stepped up on the slightest hint of selling, were nowhere in sight late on the third day of the pullback. In the final hour the markets sank into the weekend.

We’ve discussed liquidity concerns as the reason for the pullback. It was reinforced by a sudden drop in recently resurgent home sales and durable goods numbers that were flat, after the market had fully priced in a nascent recovery. Clearly the bloom has come off the growth rose and made traders anxious.

We expect market uncertainty to continue as we have now arrived at the doorstep of earnings warning season where the entire market is likely to be less eager to bid prices higher.

After three down days we should expect a bounce. But we would not be surprised if it were less than enthusiastic. If that is the case we would take full advantage of it to sell mature positions.

We believe earnings season will allay growth fears and revive the uptrend. But there are at least three weeks between then and now and there could well be volatility in the market that weak hands would rather not endure.

You Didn’t Get Me Down, Ray

The 1981 movie Raging Bull, which chronicled the boxing career of Jake LaMotta, depicted the famed 1951 fight between LaMotta and Sugar Ray Robinson known as the St. Valentine’s Day Massacre. It was given that name because the fight took place on St. Valentine’s Day and because Sugar Ray beat LaMotta badly, scoring a Technical Knock Out in the later rounds.

The important word here is Technical. LaMotta was proud of his ability to take a punch and claimed to have never been knocked out in the ring. When the fight was over LaMotta was out on his feet, slumped against the ropes, but not “knocked out.”

In the movie LaMotta approached Sugar Ray in the ring after the bout and taunted him, “you didn’t get me down, Ray.”

We could say that yesterday about the NASDAQ. Bleeding nearly 1.5%, out on its feet and threatening to go lower it refused to do so late in the session and rallied tepidly into the close. Most importantly volume was reduced from the prior session thus limiting the damage.

With RIMM issuing less than stellar results after the bell the selling could well resume.

But many leading stocks are holding up rather well in their uptrends. To cite just a couple examples BIDU finished well off its lows on a burst of volume; AAPL, though selling off in above average volume and closing near its lows remains in a brief consolidation where it has rested after last week’s romp.

We do not argue for complacency. But if a well purchased stock has yielded you a 40 - 50% gain during the rally and there is nothing exceptional about its pullback it deserves the benefit of your doubt.

And for now so does this impressive, resilient rally.

(Check out our companion blog for some stocks we’re watching for possible purchase if conditions are favorable).

As Gently As They Could

Tuesday we suggested that if the Fed were impolitic in announcing the end of the massive liquidity they have unleashed on the market in so many forms it could end the streak of unusually uneventful FOMC announcement days and disturb the market’s uptrend. Wednesday the Fed was as delicate as they could be in delivering the news but the market got the message and didn’t like it one bit.

The Fed announced what Chairman Bernanke had previously mentioned almost as an aside: the recession is over. And while it reassured the market that interest rates would remain at “exceptionally low levels…for an extended period,” it also made it clear that the extraordinary quantitative easing is likely to cease in the foreseeable future. Last month the Fed extended their purchase of Treasury bonds through the end of October. That date was not extended further. And while the purchase of agency debt and MBS were extended through the first quarter of 2010 this was done only to accommodate a slowing of activity in these sectors. The program will terminate by that date.

Profit taking ensued into the close as the market now understands that the liquidity floodgates will begin to close, however slowly, as we move forward. The dollar firmed up and inflation plays got hit.

The Fed could have been far more hawkish. For example there was no mention of draining liquidity as had been reported by Bloomberg late Tuesday. When the market has time to reflect we expect that any correction will be short lived. The Fed went to great lengths to point out that it will continue to be supportive of recovery.

The true test of how bullish the market will remain will be today’s performance. Very strong markets correct for all of a day or a bit more. Most important will be the action of winning stocks. Many held up well yesterday. Continued ballast in these market leaders, even in the face of a weak market, will be a signal to stay the course.

The Fed as Catalyst

We had a piece all ready to run this morning about churning on the indices, especially the NASDAQ, which prior to today closed tightly for several sessions on elevated volume. That’s a sign that longs are taking profits under the cover of strength from late comers. It normally precedes a price correction.

We felt the indices might be vulnerable and that we had the catalyst: the Fed’s upcoming announcement at 2:15 pm EDT Wednesday.

And then the market gapped higher today and the indices rose, the NASDAQ to new recovery highs on continued good volume. Such is the strength in the current market environment that “smart money” taking profits hasn’t been that smart after all. And so called smart bloggers have to rework their not so wonderful columns.

But we do feel investors would be remiss not to lighten up on underperformers in their portfolios. The market is extended and while we expect any correction to yield to higher prices sluggish stocks could be vulnerable to a more severe decline.

Why are we of the opinion the FOMC announcement could be a profit taking event? After all Fed days have been non-events for the most part during the rally as interest rates are at zero, the Fed has indicated it intends to keep them there “for an extended period,” and the market has gorged on the liquidity.

But for the second meeting in a row rumors from reliable sources are floating about the imminent beginning of the Fed’s exit strategy from their liquidity policies. Last month we wrote a column on former Fed governors opining that quantitative easing would be ended. They were misinformed. Now tonight Bloomberg is citing “people with knowledge of the discussions” that the Fed has started talks with bond dealers about withdrawing some of the liquidity they have pumped into the system through reverse repurchase agreements, although the timing for this is not indicated.

It is highly unlikely that the Fed wants to upset the markets at this juncture. With the financial system recovering and interest rates at record low levels many banks are in position to make enough money to heal their wounds. But with the economy clearly starting to recover the velocity of all the money pumped into the system will increase and with it the risk of inflation. The performance of the dollar and gold these last weeks has told us that.

If the Fed is impolitic it could scare a market that is well extended. Of course our concerns could well be misplaced and the market that much higher tomorrow evening. We hope so. But with good gains under our belts don’t forget to weed the weaklings in your portfolio ahead of a potentially actionable event.

Shanghai Continues its Surprises

We have a very strong bull market on our hands. It has been led by the Shanghai Composite and we have chronicled the recent travails and triumphs of that bourse as it has moved through a correction and back into an uptrend over the last month and a half.

We have noted that it is small and restricted and thus volatile. Far more so than more mature markets. We have also noted that the US market might have to resume leadership of its own accord and it has acted of late as though it could carry the burden. This week could well tell the tale.

Since the last time we discussed the Shanghai Composite’s resumed uptrend trading has turned rather stormy. It has encountered a day of high volume churning, which is subtle distribution as selling into strength masks underlying weakness, and two days of outright higher volume selling.

Friday’s action was particularly disturbing as the index plunged more than 3% closing not far off its lows.

Today the composite mounted a reversal, although we won’t have volume figures for several hours so we do not yet have a handle on whether today’s action represents conviction or just an oversold bounce.

We were encouraged Friday when our markets didn’t follow Shanghai lower. But whether our markets react or not it is important to remember that volatility during a rally is to be expected and even welcomed as it can set up new buying opportunities and pullbacks in winning holdings that justify adding to positions. The rally is now remarkably distribution free and we would view declines, which we expect to be constructive, as buyable events.

Resistance Is In the Eye of the Beholder

The market has had a heck of a run. And the higher we go the higher investors scale the wall of worry. The latest cause for concern, which has been mentioned prominently by technical analysts, is that the S&P 500 is at an area of significant resistance and that longs need to be cautious.

The S&P 500 was torched during the recent bear market, surrendering all its gains from the 5 year bull and more, undercutting the 2002 lows from the previous bear market. But price has snapped back impressively. A monthly chart shows that price is now beginning to penetrate an area represented by the bottom of the trading range that prevailed throughout most of 2004, which technicians are describing as resistance.

We all know the rote definition of resistance. It’s a prior price point on a chart above the current price. But ideally it’s more than a price point. One price point jutting out on a chart doesn’t really offer up much resistance when you think about. It’s a series of opens and closes within a general price area where there was a large amount of activity that serves the purpose. That creates congestion and indicates there are many holders of the stock from that level. That’s what we have on the S&P chart from 2004.

The widely held theory is that as price approaches this level from below those who got long the stock in the area of resistance, who have been holding the stock at a loss, will embrace the opportunity to get out even. Thus price will meet the resistance of this selling when it enters the area. It will need to push into the area a second or third time to flush out the weak hands before it can move higher.

Is this valid? Absolutely. But with myriad caveats.

The most important of these is the time factor. O’Neil’s market studies show that the effects of resistance begin to fade in as little as 12 months. And by 18 months resistance is no longer much of a factor.

Why is this? Because people tend to hold losers for only so long. After a period of time they take losses for tax purposes or look to move the money into an alternative investment. They come to terms with it. But it takes time.

In other words after a year and a half that “area of resistance” on the chart you are looking at is just a bunch of opens and closes with diminished significance.

Another way of looking at resistance, which might be peculiar to the current market, is to simply ignore it! The recent bear market saw massive forced selling as the country’s financial system was on the verge of default. While this might sound like an outlandish approach, take a good look at charts like BIDU and AAPL amongst others. These stocks simply plowed through rather recent resistance after hideous declines. It’s almost as if the buyers from the left side of those charts had disappeared into thin air. When you think about it many of them did.

However you look at it to our way of thinking the 2004 “resistance” on the S&P 500 has validity only in as much as traders are looking at it and acting off it. We doubt there are any holders from 5 and more years ago just twitching at the bit to exit break even.

But bear in mind enough traders keying off of a point they feel is valid will influence trading in the short term. Traders with a longer time horizon should tune out the noise.

Like it’s 1999

Well, maybe not 1999 (we like the facile and sophomoric Prince reference, so please indulge us). But the market’s gains seem to have hit hyperdrive this month. For the first time since the rally started in March 52 week highs exceeded 300 today. That number is not excessive. If anything we are shocked it has taken this long to achieve.

Why does the market party? Let us count the ways.

The “green shoots” the market anticipated in March and started seeing during the spring have turned into a nascent recovery. Positive economic signals are everywhere. As we discussed in our last column the negative news has been “baked into the cake,” previously factored into the market and therefore now ignored. And the market is rallying on every positive shred of good economic news that is released.

On Tuesday September 1st the market appeared to embark on a correction, suffering ugly price action with a close at the lows on all the major indices on a considerable increase in volume.

But also on that day the ISM Manufacturing Index posted a reading of 52.9. That marked yet another in a string of increases, but most importantly crossed the 50 threshold dividing contraction from expansion thus confirming manufacturing’s return to growth.

The market came to it senses, went no lower the following session and took flight on September 3rd, taking sustenance from further positive news along the way.

To wit:

Last week in this column we pointed out that, protectionist objections aside, the rising trade deficit that was released on the 10th is a sign of a worldwide economic revival.

Today the government released Industrial Production results for August and the news was stellar, with production coming in better than expected and July’s numbers revised significantly higher. We have often argued that pork barrel stimulus is a waste, more a political stunt than an economic tonic. Sure enough today’s report shows that the economy is recovering on its own as industrial production rose across the board, not just in the steroid induced auto sector off the “Cash for Clunkers” program.

Also today came good news on the consumer inflation front. Simply stated, there isn’t any. While Tuesday’s producer numbers ran hotter than expected they had been in a protracted decline. And in any event producer numbers have a poor history of seeping into consumer prices. The liquidity provided by the Fed is succeeding in stanching deflationary pressures while inflation is kept at bay for now.

Also on Tuesday came fine news on the retail sales front. Even allowing for the Cash for Clunkers program they increased by 1.1%. While a sales tax holiday accounted for the robustness of the gains the salient point is that consumers are willing to spend if given the proper incentive.

And why shouldn’t they be? Although the August Employment Report showed yet a further increase in the unemployment rate and gave no signs of imminent improvement, statistics indicate that those who have jobs, and they number more than 90% of the work force, have over the last quarter enjoyed a slightly expanding work week (the significance of which we discussed previously) and month over month wage gains. This is yet another portent of a “better than expected” holiday season.

And where is the party occurring? We were quite surprised by today’s results.

Aside from our gold investments our portfolio is heavily tilted toward “leading stocks” in the software, medical, Internet and technology sectors. While we had a very profitable day we are used to seeing our basket of stocks outperform and they didn’t today. A look at the sectors that really motored is instructive because it uniquely reflects the forces behind the current market.

The four top performing sectors in our database, all scoring about 3% and higher, were Real Estate, Banking, Metals & Mining and Materials & Construction.

Banking has been the clear leader since the March bottom. And well it should be. Even those institutions with toxic balance sheets should be able to earn their way to health with Fed policy that is essentially designed to loan banks money for free on which they can then make incredibly wide spreads.

Real Estate and Materials & Construction are flying on the liquidity available in the system. Heretofore loans may have been hard to obtain but the market is telling us that difficulty won’t continue into the future. It’s also telling us that the horrid Commercial Real Estate market, which is forecasted to get much worse, may well have a happier ending.

While we have launched gold and gold mining trades on our companion blog we have also opined in this space that we are uncertain as to the success of a “gold as a harbinger of inflation” paradigm. With the price of gold rather constant when quoted in other major currencies for the moment its price expansion seems more attributable to a weakening dollar than inflation pressures. With the administration and the Fed apparently not eager to bolster the greenback this trend could well gain steam and become the leading story of 2009’s fourth quarter.

Don’t Confuse Yourself with the Facts

One of the things we hope to achieve with this blog is to help people understand how the market works. We don’t claim to be the Oracle at Delphi and would never insist we can divine the market’s intentions, but having well over a decade’s experience in watching the market minute by minute and day by day we have developed a keen sense of the market’s rhythms; rhythms that most laymen, indeed many traders, either do not or will not grasp. Without accepting these rhythms your trading career will be unsuccessful.

We have spent over 30 years trading in markets of one type or another. The most surprising observation we have made over that time is that intelligence and success in life have little correlation with market success. In fact, there is nothing worse than a bright accomplished man bringing the traits that made him successful to the market (women are different believe it or not – in our experience they are quicker to hear and obey the market’s rhythms!).

The first mistake is trying to apply common sense to the market. GDP was just reported higher. A stock just reported better than expected earnings. The market/stock must go up. Sorry, but no. Not necessarily.

Next is the idea that you can quantify the market, distilling it to an equation that will come out a certain way given certain stimulae. Again, sorry. That dog, as our southern friends say, won’t always hunt.

The insistence that the market can be solved, that it can be understood with precision, is a canard. In Sunday’s New York Times Business Section, Cornell economist Robert Frank wrote an article titled “Flaw in Free Markets: Humans.” It amazes us that an economist of Mr. Frank’s stature can pen an article with this title. Markets work BECAUSE of humans. They wouldn’t work with a cooperative social species like bees or ants, who all contribute toward the common good. Could you imagine a market led by bees? They’d all wait for the Queen to make her bid, then wouldn’t dare trump it out of deference.

No, Mr. Frank, markets are peculiar to species like us. And as humans we are all subject to the same emotions. It’s very hard to understand the market perfectly when you are subjected to its stresses and pressures in real time.

In order to best understand how stocks will move you first have to understand how the market is moving. A company can release an ugly earnings report during a market uptrend and not suffer severe consequences. It might even go higher. In a bear market that same report could lead to the stock price of the company being crushed.

How can that be? During a bear market the excesses of the previous bull are being worked off. Chances are most stocks have frothy valuations after a bull run of a few years. A disappointing earnings report will cause investors of all stripes to flee the stock. That will include those who rode it to fat gains, understanding it is time to take a profit, and the late comers who desperately need to cut a loss short.

When the bear turns to bull, as we have seen this year, there are numerous factors driving prices higher. Chances are the central bank will have increased liquidity in an effort to stem the tide of recession. That liquidity will help to float all asset prices including stocks. Add to that the anticipation of earnings recovery and then acceleration. And stock prices start to levitate. An ugly report after the market has turned might well be forgiven. It’s reflecting the past and the stock has already been beaten down. The market is looking forward now, beyond the report to better times.

Today we saw this process front and center in the steel industry, something we know a bit about having spent 25 years trading steel. Nucor (NUE), one of the nation’s leading steel producers, released a statement before the start of trading that it’s third quarter earnings, which had been expected to be just below break even, would actually represent a loss of 15-20c a share. Coming into today’s trading Nucor had seen its stock price climb about 57% off the market bottom in March although it was little better than flat for the year. At the opening bell the stock gapped down. It then proceeded to trade higher the entire session, gaining more than 2% on the day.

Why did this happen? The company “explained” its loss in the press release. And it reaffirmed that it still expects to return to profitability in the fourth quarter. So the stock price, which traded in the $80’s last year when the company made almost $6 a share, resumed its march back towards $50. The market is looking forward to better times, expecting the company to post earnings of nearly $3 a share next year.

We are in a bull market. The market will look to interpret all information it receives in the most positive possible light. That doesn’t mean we are immune to corrections. But it means that the market wants higher over time. Traders spending day after day trying to position themselves short for a correction are missing the train. Trade with the liquidity driven, earnings recovery trend. For now, and probably for a good while longer, that’s higher.

All That Glitters

Gold is all the rage, having broken the key $1000 price level this past week. The break out appears powerful and launches from a well formed price pattern that seems well suited to support a 20 – 30% run.

This move comes as the US Dollar mounts a break out of its own, this one to the downside. The buck seems set to test last year’s multi-decade lows.

These are well known inflation signals. But with inflation readings in check, US Treasury rates going down and the Commodity Research Bureau Index having collapsed from all time highs last year and not mounting much of a bounce there seem to be conflicting signals in the air. After all if inflation is incipient we should expect to see US Treasury rates going up and the price of commodities other than gold (and silver) accelerating.

We can’t be blamed for asking if the move in gold is a bull trap.

The bursting of liquidity bubbles tends to be a deflationary event. We saw this with The Great Depression in the United States and in 1990’s Japan where prices collapsed and the economies along with them.

The key lesson of these events is that to fight the bursting of a liquidity bubble one must flood the system with liquidity. That doesn’t mean passing pork laden stimulus bills designed to stimulate nothing but your supporters’ interests. It refers to making sufficient liquidity available in the system to insure that it can continue to function and allow losses to be taken.

During the Depression liquidity was removed. The price of money was increased and the system was allowed to collapse upon itself under Hoover Treasury Secretary Andrew Mellon’s “liquidation” policies.

In 2008 the Federal Reserve Bank did just the opposite. They initiated numerous programs to insure that the system wouldn’t collapse, accepting moribund collateral from myriad financial institutions in exchange for cash, enabling the system to continue operating. And they have monetized US Treasury debt to insure the price of funds stays as low as possible in an effort to nurse the financial system back to health by providing financial companies with the cheapest possible source of funds, thus insuring profitable margins in lending operations.

In so doing they have massively increased the money supply. The late Nobel economist Milton Friedman (a hero of this blog) taught us that “inflation is always and everywhere a monetary phenomenon.” The break out in gold and decline of the dollar are the market’s reaction to increased dollars in the system, which the market fears will lead to sharply accelerating inflation.

But this doesn’t have to happen.

What’s missing from the equation is demand. Simply stated heretofore there hasn’t been very much of it for all the money that is sitting in the system. The rate at which money “turns over” is called velocity and without sufficient velocity inflation will not make an appearance.

But we’ve had numerous signals over the last month or longer that recovery is taking shape and growth is returning. It is those signals to which gold and the dollar are likely responding. As growth gears up so will the velocity of money and with it inflation could well rear its ugly head.

It is therefore incumbent upon the Fed to begin to remove this heavily spiked punch bowl. They have already announced they will begin to phase out some of the liquidity programs they introduced last year. Further announcements are likely to follow. If the Fed can remove sufficient liquidity from the system inflation does not have to rear up. That could well be the reason interest rates are staying put and commodities other than gold and silver are not taking off. The market is conflicted and there is at least some confidence that The Fed is up to the task.

Frankly we have our doubts. The Fed is a non-political institution and technically free from pressure from lawmakers and the administration. But with Democrats firmly in control of the government their key concern is likely to be unemployment. Not that Republicans don’t care about jobs, but Democrats have a key constituent in the union movement that is likely to be quite vocal about an unaddressed unemployment rate that is moving rapidly towards 10%. Both they and their patrons believe government can dictate employment and The Fed is likely to feel tremendous pressure to leave liquidity in place until unemployment begins to move lower.

That would be a tragic error. Employment is a lagging indicator. It is one of the last things to improve when growth returns to the economy. To wait until employment is recovering is to wait far too long.

Of course removing liquidity won’t necessarily be a painless task. It could well dampen the recovery. The Fed has a delicate balancing act on its hands. It will no doubt be pilloried from all sides in the months ahead as one interest or another fears the consequences of The Fed’s actions (or lack thereof).

We hope Mr. Bernanke has a rabbit deep in his hat. In the meantime we are long gold, per our companion blog, but secretly hope it’s not a successful trade.

Better Late Than Never

On Tuesday we headlined that the Shanghai Composite appeared to have confirmed its rally. Weakness in our market combined with Shanghai’s correction had caused us to be cautious. But Monday we noted that Shanghai was on the verge of follow through while our market had held up remarkably well. We therefore became very aggressive off the open on Tuesday and have been well rewarded.

We get price readings from Asia in real time but volume is significantly delayed. When we received volume readings late in the day it was apparent that Shanghai had not followed through. Volume was actually lighter than the previous session.

But markets worldwide continued to act well on Wednesday and we saw no reason to be less aggressive in our stance as our markets opened. The move that day on the NASDAQ left little doubt that any feared correction was not materializing.

So it is almost a moot point that the Shanghai market followed through today. We feel it’s worth mentioning because of the power of this resumed rally. Follow through days by definition are impressive, of course. But today’s gains coincided with good news from the government about the performance of the Chinese economy. The report had been widely anticipated and the market had run hard in the days leading up to the release save only for a relatively mild and well contained decline on Thursday. A sell the news reaction would not have surprised us. Yet the market advanced 2.2% closing not far off its highs.

The index did stop just short of 3000. Traders often take profits at milestones like this. That combined with the index having moved into an area of heavy resistance might well signal consolidation next week.

But the world’s market leader is back on track and, as we predicted in our column last Friday, is leading bourses around the world to new highs.

Further Confirmation the Stock Market Has Gotten it Right

For many years protectionists bemoaned the American economy’s Balance of Trade deficit. This figure constantly reflected that we imported far more goods than we exported, which fueled the argument that unfettered trade was unfair and needed to be restricted.

Economists long countered that a trade deficit wasn’t a sign of impending doom but merely reflected dollars in overseas hands that would have to be brought back to our shores and invested in our domestic economy, a sign of an increasingly interconnected world.

They also argued that, given world trade patterns, a shrinking deficit would bode ill for the US economy.

Over the last year protectionists have gotten a chance to see up close what type of economic conditions are reflected by a sharply smaller deficit. We’ve experienced a painful recession as it has shrunk from around $65B to under $30B. In June it was just $27.5B.

The trade deficit was driven by a number of factors. One key was our need for imported oil given our obstinate refusal to expand domestic exploration and production. That meant we needed to let other countries bring oil to market for us.

And, admittedly, Asian economies with a mercantilist approach to growth managed their currencies to support their “export” model of development. Americans had a party with this paradigm as we were the beneficiary of cheap money and cheap goods that fueled significant growth and considerably raised our standard of living. It also, of course, led to the series of bubbles we have experienced this decade, from stocks to real estate to commodities.

The shrinking deficit was driven by the reversal of these trends. But after falling precipitously last autumn and winter to below $30B it appeared to have stabilized this year, holding under $30B from February through June. Now the report for July, released this morning, reflects the largest monthly gain since February 1999, rising 16.3% to $32B.

The report gives real reason for enthusiasm. Increases in automotive and oil imports were expected, given the Cash for Clunkers program and the rising price of oil. But oil was not a significant contributor to the increase and the increase is far more than a bump from the artificial Clunkers stimulus. Instead the report was a surprise because of import growth in other sectors that had been considered moribund, most notably in consumer goods.

This is likely a harbinger of a better than expected Christmas season and better than expected growth in the entertainment sectors (think restaurants and travel) and is yet another confirmation of what the stock market rally has been telling us the last six months: that growth is coming back.

While the rising deficit is good news it is unlikely to lead to deficits anywhere near as large as we saw in the past. The falling dollar will impede American’s hunger for imports and also force a change in the focus of Asian economies, making them focus more on internal development and less on nurturing industry for the sake of overseas sales. The result will be a healthier and more sustainable mix of world trade.

But for now the rising balance of trade deficit indicates the world is on a nascent growth track. But you knew that already. The stock market has been telling you so.

Err to the Long Side

There’s a lot of hand wringing amongst traders. The market has been difficult to trade and refuses to correct, except for occasional brief ugly incidents that scares longs and emboldens bulls, only to leave the former regretting their selling decisions and the latter ruing their shorts.

But we have a bull market on our hands and it needs to be respected and given the benefit of the doubt. Today’s market action should make that apparent.

In a nod to the bears we will point out that the NYSE traded higher on lighter volume. But we must also note that volume was above average. And the NASDAQ was simply stellar with no equivocating: superb volume and new highs for the year.

One of the unfortunate undercurrents of the market is that it seems to go up as the dollar goes lower, and notably lower it has gone the last several days, breaking key support levels. And to underscore the point about the dollar gold has taken off and appears to have launched a significant move that will take it to all time, though not inflation adjusted, highs.

Why is this unfortunate? These are signs of nascent inflation. The stock market isn’t going up as much as it is being debased by a lower currency.

But while this is a fine argument for salon parlors and the economy might have plenty of roadblocks at some date in the future, we are in the business of trading today’s market for a living, and not overthinking or having to resort to making excuses for having just missed a terrific move. The bottom line: a rising market combined with the long positions we have posted on our companion blog have paid well the last several days, no matter the reason.

There may well be retrenchment ahead. But the clear message of the market is to widen your stops and stay invested until the performance of leading stocks tells you to step aside.

Shanghai Composite Appears to Follow Through

Earlier today it appears the Shanghai Composite confirmed its rally. The index gained 1.7%. We await volume confirmation, which is critical, but already stock markets around the world are marching higher following their leader, as we expected they would.

This has been a difficult market for intermediate term traders to navigate but with many stocks holding up well in their uptrends and others already reasserting themselves in advance of today’s market move we believe it is critical to be invested in top tier names as they pass buy points.

We expect to discuss a number of these today on our companion blog.

Ephphatha!

The Roman Catholic Gospel this weekend related the story of Jesus curing a deaf mute so that he could hear and speak. As he touched the afflicted man’s ears the command he used was the Aramaic word for “be opened,” ephphatha. The symbolism of course is that he wanted all men to be open to his word.

Reflecting on this concept of staying flexible to hear messages we might ordinarily tune out we can’t help but think how it relates to the market.

The last few weeks have been a struggle to stay invested as the market chops violently back and forth. We have twice seen ugly breaks that appeared to auger corrections, on Monday August 17th and again on Tuesday September 1st. And yet the first time there was no downside follow through and the market went on to post new highs. And thus far there has been no follow through to last week’s break, although the bounce back was on light volume and appears to be a bear flag.

But, we suggest, ephphatha!

There can certainly be follow through to the downside as market participants come back from summer holidays and volume returns with them. With the indices seeming to groan with every move higher and the limited progress they make when they break to new highs that would appear to be the smart money bet.

We are uncomfortable, however, with the number of people that are skeptical of the market here and for that reason and the dogged performance of many leading stocks, which we shall discuss, we believe we are at a juncture where the big money to be made is by erring to the long side.

Because it is a deeply liquid widely held institutional stock Apple (AAPL) could be the poster child in this regard. We suggested nailing down a profit in the stock a week ago Friday and who could blame us? The stock had run nearly 20% seven weeks after its break out, traditionally a time when an uptrending stock will correct. It had retreated from an intraday new high on a burst in volume further signaling that at least a short term top was in place.

But APPL’s action this past week was impressive. On Friday the stock made a 52 week closing high. The weekly shows a Three Weeks Tight pattern that O’Neil suggests is often a sign of higher prices to come and often a place to add shares to an existing position.

And the number of Chinese stocks that have held up well after ugly breaks with the Shanghai market on August 17th impresses us. Perfect World (PWRD), FUQI International (FUQI), Netease.com (NTES), E House Holdings (EJ) and myriad others have either bridged their gaps down, are in the process of attempting to do so or appear to have put in healthy consolidations and look poised to make the attempt. Few have simply sunk lower signaling more significant corrections are likely in their future. Longtop Financial (LFT) strikes us as perhaps the exception to the rule.

Most striking was the performance of Arcsight (ARST) on Friday. ARST is not a stock we would normally profile. It’s too thin for us, with a 50 day trading average of only $14MM. Thursday after the bell the company reported triple digit year over year EPS increases for the seventh time in eight quarters. And for the seventh time in eight quarters year over year sales gains met or exceeded 25%. The company also raised guidance.

It shouldn’t be any surprise, then, that ARST gapped higher on Friday and broke out of what O’Neil refers to as a sixteen week Ascending Base. But frankly we were surprised. Markets that are poised for correction don’t see stocks perform in this fashion. Rather in a correcting market they usually seize on one negative metric or another and sell off or see muted upside.

In spite of ARST’s raised guidance we felt the market would focus on their slowing “beats” and forecasts for sharply decelerating earnings. Analysts appear to have caught up to the company’s rhythms and after a number of significant beats they beat by just 1c this quarter. That should lend legitimacy to forward forecasts that see year over year EPS acceleration slowing to less than 20% next quarter and turning sharply negative the quarter after that. But the market cast aside those concerns boosting the price sharply out of its second stage base.

Ephphatha!

Today the Shanghai Composite, which we have been closely monitoring (see our last column), failed to “confirm” its rally attempt. In fact it put in an unattractive day, posting a gain but failing to hold onto a significant early gain, closing higher but well off its highs. While not fatal it often signals a period of consolidation ahead.

But that doesn’t detract from the cautionary signs we are seeing about becoming too bearish. We suggest being poised to take positions in stocks we shall detail on our companion blog should the market confirm our suspicions and lurch once again to the upside.

Ephphatha!

Shanghai Composite Staging a More Spirited Rally Attempt

In Thursday’s session the Shanghai Composite sported a nearly 5% gain in strong volume. It was the third day of a new rally attempt. The index remains in a significant correction, having declined over 20% from its highs.

As we’ve explained previously, a market rally off an index low is generally only considered to have a chance of turning into a valid uptrend if it stages a considerable advance during a session (generally at least 1.7%) on an increase in volume no earlier than its fourth day off the bottom. We refer to this as confirmation. (For more details on this methodology see Paragraph 2 of our previous column, An Unexpected Recoupling.)

Today, in the fourth day of the rally attempt, the market tacked on a bit more than a half percent in lighter volume. By our metrics the rally remains unconfirmed but we feel it is intriguing.

The composite is rather insignificant in terms of capitalization and not a true representation of market values in China. Because of trading restrictions companies whose stocks are listed on both the Shanghai exchange as well as foreign bourses tend to have significantly higher valuations on the Shanghai market than the foreign exchange.

Why, then, do we follow it so closely and attach such significance to its trading action?

Because in the intermediate term activity in any market is as much psychological as anything else. Markets work efficiently over time, but their mechanics are to stage exaggerated moves in one direction and then another. And these moves have an underlying theme, whether it is the technology revolution (1996 – 2000 bull market), the belief that the technology revolution will not have the impact at first predicted (2000 -2002 bear market) or the race for perceived scarce resources (2003 – 2007 bull market).

The theme of the current investment arc, which has fueled the move off the March lows, is that China is an emerging behemoth that will lead the world to growth nirvana as it industrializes, lifts the standard of living of its huge population, and asserts itself on the world stage. Anyone who has paid the scantest attention to the history of economic development knows that this can be a painful and protracted process. This story line is unlikely to pan out as anticipated. But intellectualizing the market will lead you to trading failure. We embrace the markets’ broad arcs and try to profit from them.

And so we avidly follow the adventures of the Shanghai Composite, warts and all. The current move comes amidst news that Chinese authorities are trying to bolster investor confidence by expanding the amount individual institutions can invest in the stock market from $800MM to $1B. While this would ordinarily be a legitimate reason for bullishness the authorities have not increased the aggregate amount of foreign money allowed on the exchange. We therefore view any rally based on enthusiasm over these new regulations as suspect.

But it is not our place to approach the market with preconceived notions. We trade what we see and for now we wait to see if Shanghai can confirm its rally. Between now and the next US session on Tuesday there will be two trading sessions in China and we will follow them closely. If the rally confirms the odds are quite good that markets around the world will snap to and follow their leader to new highs. Alternatively should the rally falter we will become more aggressive on the short side as we anticipate a perhaps deepening correction.

The Correction Confirms

As we mentioned on our companion site this past Tuesday, the ugly price and volume action in the market that day confirmed the correction that we had been anticipating was underway.

Yesterday in further confirmation the markets were unable to reclaim even a small portion of their losses as volume dried up. This action indicates that the markets are digesting the move lower before moving even lower later this week or next. While a near term bounce could be in the works it is likely to be limited in nature.

There is no way of telling how deep or long the correction will be. Given the severe correction in the Shanghai Composite, which has led the rally, and given the sharp gains off the March bottom at least an intermediate term correction would not surprise. The entire rally could be over as well, although we have no indication of that and are still in the camp that we should see another leg higher later in the year.

In the meantime the gold trade we recommended on our companion site last week triggered yesterday. A successful long in this commodity should not surprise us given that market corrections often spur capital to seek safety and gold has long been seen as a refuge.

We entered one equity short as well and will be looking for further short side opportunities, especially on a small market bounce.