Better Than Expected

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

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

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

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

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

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

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

Panic

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

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

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

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

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

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

The First Significant Correction of the Bull Market Appears Confirmed

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reconsider the Source

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

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

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

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

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

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

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

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

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

The Potential Market Impact of a Topping Apple (AAPL)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Will Sector Rotation and Earnings Reports Preserve the Bull Market?

Earnings season got off to a fine start last week with Intel (INTC) and JPMorgan Chase (JPM) filing reports that beat The Street in all metrics. But earnings season is heavily slanted toward financials early on and the balance of reports out of the banking sector were disappointing. Even Goldman Sachs (GS), which on the surface filed an attractive report, missed their whisper number and didn’t shed a lot of light on their real estate vulnerabilities.

The result was ugly selling in the financials on Friday. The sector is far from breaking down technically but does not appear poised to continue to lead. This is important because financials were THE early leadership in the bull market, even though there are precious few quality plays in the sector. Going forward they don’t have to lead but they must hold up. And other sectors must step up to assume the mantle of leadership. Otherwise the market could prove vulnerable.

Fortunately we’ve seen rotation into energy stocks, which now dominate the new highs list. Indeed on Friday oil broke out to new recovery highs from a well formed base. This is the latest sign of an overall rotation into commodities. Precious metals began a similar break out move in early September.

These moves are being driven by a witch’s brew of factors, not all of them healthy for the economy or the market in the long run. On the positive side are continued signs of a global recovery. But on the negative is the dollar, ever weaker due to Fed policy thus driving the dollar denominated price of commodities higher. These moves in commodity prices hint at nascent inflation and have the potential to haunt the market if they continue too strongly.

This rotation has been reflected in international leadership. The Shanghai Composite led the worldwide stock market from March into August but it has been correcting since. The correction has been significant, about 23% at its maximum depth, but is showing tentative signs of ending. But even as Shanghai paused to consolidate its massive gains commodity based economies have seen their stock markets take up the yoke of leadership, with Brazil and Russia moving smartly higher since early September. Russia is a small and less significant market. But Brazil is an emerging commodity power and its market is more significant to our analysis. It is up about 20% in that time and better than 75% for the year.

While the market has the technical wherewithal to hold up much will depend on earnings this week. INTC has hinted at a strong refresh cycle in computers and the market will want to see further evidence of that from Apple (AAPL), which reports after the bell today, and Microsoft (MSFT). Beyond that the market will want to see a better performance than reported by the banks last week. In addition to “better than expected” earnings reports it will demand expanding top lines and optimistic guidance to reinforce the recovery paradigm that has driven it higher since March.

The Market Takes a Punch

A few days back we asked if it could be so easy. The market had risen for nearly two weeks off the bottom of a brief correction in anticipation of a good earnings season. And in spite of that advance that we feared priced in the good news, on Wednesday it confirmed new highs off good reports from Intel (INTC) and JPMorgan Chase (JPM).

But two days of numerous less than stellar earnings reports have the market back on its heels. Today is especially ugly with the indices down significantly on higher volume as we near midday, an unwelcome sign of distribution.

But there is an important bullish indicator that should not be overlooked. It’s Google (GOOG).

We’re not advocating buying Google. But they posted a report that is impressive given the economic climate. And what’s most important is the stock, after a hefty advance, has gapped higher today, making repeated new intraday highs and doing it all on huge volume.

The market is taking it on the chin today. And it could well go lower. But generally speaking important stocks like GOOG don’t burst higher in a market that’s about to implode.

It might be difficult for traders that take an intermediate term long approach. But we still believe the key is to stay long the market. Google is telling you so.

The 52 Week High List Promises a Sustained Bull Market

The current bull market began as a delicate thing. For months it consisted of badly beaten up stocks bouncing for huge gains and not much else. There was no leadership. The 52 week high list was oddly barren. That’s not the way markets with any promise behave.

Of course we weren’t recovering from just any bear market but a frightful gouging that carved 50% and more out of many stocks. They needed time to heal. With Wednesday’s rally we can finally say that they have.

It wasn’t until the market gapped out of its first major consolidation of the rally on June 1st that 52 week highs first crossed the 100 threshold. At that point the bull market had already gained 44%. We have been around the public markets for a number of years and cannot recall the last time such a massive gain was achieved without leadership.

It wasn’t until September that the market routinely began posting over 200 52 week highs. And only recently did it first post 300.

Why do we focus on this? Because healthy bull markets routinely post at least 500, 600 and more new highs when they are in rally mode. At extreme points in the rally they can achieve far more.

During the last phase of the previous bull market in 2007, 52 week highs numbered 600 and greater at various stages of the rally. This is the optimal sign of market health and of a rally that can be sustained. Notably the last leg of the rally in the early autumn of that year was accompanied by a weakening 52 week high list. By the time the S&P 500 peaked in October of that year the market boasted 700 52 week highs. A few weeks later, when the NASDAQ peaked the S&P 500 was less than 2% off its highs. But the 52 week high list had sunk to just over 400 stocks.

With today’s rally the Dow regained the much ballyhooed 10,000 point level. But far more significant to us is that 52 week highs numbered almost 700.

And along with this surge it should be no surprise to find that the breadth of leadership has expanded. The sinking dollar and fears of nascent inflation have re-enabled the commodity trades. Oil and gold are ascendant and so are stocks in their sectors. While energy stocks, which heretofore have not had a leadership role in the rally, are now the top category of 52 week highs, they have not replaced leadership in retail, software, medical, finance, IT and services, only augmented it.

Traders have doubted this rally since its inception. For bulls this wall of worry is welcome. But the bursting 52 week high list hints that it is far from over.

Can It Really Be This Simple?

Another Seinfeld “day about nothing” yesterday took an interesting turn after the bell when Intel (INTC) reported lower earnings and sales on a year over year basis. But the numbers were “better than expected” and supported the bull market’s recovery paradigm. Futures gapped higher after hours.

This morning futures have extended their gains after J P Morgan Chase (JPM) obliterated earnings estimates. How this is a surprise with zero interest rates and a wide yield curve, conditions under which a child could make money, is beyond us. But as we’ve said repeatedly, what matters is the market’s reaction and the market is flying.

Today is an important day. The market has been rising for the better part of two weeks off its recent correction low in anticipation of these earnings reports. Volume has been a bit tepid of late, especially on the NYSE indices. True, Monday was a semi-holiday, Friday the day before a semi-holiday and Tuesday was “the day before the earnings barrage.” But the magnitude of the move and reticence on the part of the bulls leaves some doubt as to whether this is all priced in. In short, the bulls are badly in need of a big win. That would be a strong move to new highs on robust volume.

There’s no doubt we’ll be gapping higher today. But we’ve seen this picture before, most notably last Thursday when good news sparked a gap, a run, and exhaustion into the close. We’ve been arguing since the recent correction began that the uptrend was likely to resume. We won’t change our minds now. But we might if we see selling into today’s widely anticipated ebullience.

Seinfeld Hits the Market

For more than a decade in the late ‘80’s and throughout the ‘90’s comedian Jerry Seinfeld had a now legendary half hour comedy show that prided itself on being “about nothing,” focusing on the prosaic events of an everyman’s day. Yesterday’s market was a lot like that.

Due to Columbus Day the bond markets were closed. With bonds usually providing a key piece of market direction volume was even more listless than usual and stock prices meandered throughout the session. We can’t read any significance into the session nor will we try.

We are on the cusp of a widely anticipated earnings season. The market has moved mostly higher over the last week and more on rather light volume reflecting investor expectations but also their cautiousness. With Intel (INTC) beginning a three week barrage of earnings reports with their release after the bell a shake out lower wouldn’t surprise us during today’s session.

Warnings of Nascent Inflation as the Market is Poised for New Recovery Highs

The stock market posted broad based gains last week, with defensive sectors up 2 – 3% and most growth oriented sectors up 5 – 7%. The exceptions were Energy at 8% and Metals & Mining at 11%. The performance of these latter two sectors speaks to underlying inflation concerns as the world returns to growth.

Although volume was lighter on the week we don’t view this as a problem, especially on the NASDAQ. Distribution has been light and NASDAQ volume was above average for the week. Even on the S&P 500 where volume was below average the power of price has been impressive.

The market is set up to move to new highs (indeed the Dow has already achieved fresh recovery highs) on anything it interprets as good news on earnings reports. It is likely to take significant disappointment to derail it. Bear in mind we refer to what impresses the market. Traders have been looking for weakness in the market for seven months now and have to avoid putting their own biases on it. If raised guidance by, for example, an Intel doesn’t impress you but the market moves materially higher, we suggest your trading will be far more successful if you respect the market’s judgment and trade with its trend.

We note some interesting developments in bonds. After aggressive rallies off the March lows money has begun to come out of investment grade corporates (using the ETF LQD as a proxy). The rally has been less impressive in municipals (MUB – not shown) but it seems to be experiencing distribution as well. Meantime junk bonds (HYG), while having suffered some corrective action have recovered well. This occurs while interest rates on treasuries at the longer end of the yield curve have begun to move higher ($FVX, $TNX shown, $TYX).




Treasury rates staged an impressive rally off the March bottom but have been consistently easing since June. Last week they turned aggressively off their lows but remain well off their highs. We cannot conclude by their charts that they will return to their highs soon. But the overall pieces of the puzzle suggest, with the increasingly likely passing of a more costly health care bill than expected and indications that there will be further fiscal spending (stimulus) by the administration, that interest rates on longer term Treasuries are likely to go higher over time.

With money coming out of lower yielding instruments we don’t view this as anything other than an interest rate play as corporate junk bonds (HYG) continue to hold up, negating any interpretation that this move could be a flight to quality, where money seeks shelter from risk.

While these trends are far from confirmed and are simply casual observances at this point, rising rates on longer term treasuries as a reflection of inflationary expectations coupled with an expected low growth recovery could be an early harbinger of a return to 1970’s style stagflation.

A Deceptively Strong Day

Yesterday we advised that we expected the market to stutter as the major averages traded aggressively over a two day period off their lows and into their downtrend lines. While corrective action from here could certainly still occur one couldn’t have asked for a better day under the circumstances than the markets delivered today.

The NASDAQ and S&P 500 both traded in tight ranges near the rally’s highs on sharply reduced volume. Money managers are clearly loathe to sell even ahead of retail numbers that the market knows are likely less than stellar and employment numbers that have also lagged of late.

Meantime leading stocks continue to outperform a flat market. Have a look at the likes of GOOG, BIDU and AMZN, just to focus on familiar big cap names that have already scored impressive gains off the March bottom. This kind of behavior bodes well for a market that is likely to see new highs itself sooner than later.

Gold and the U S Dollar Resume Their Trends, Auguring Well for the Market

In the current environment of copious liquidity the Australian central bank became the first to begin to remove the punch bowl by raising interest rates by ¼% overnight on Tuesday. The Austrialian economy, heavily resource dependent, has not been significantly impacted by the financial crisis and rates had only been lowered to 3% in a nod to harmonization with other G20 countries.

World markets took the move as a sign of emerging recovery and strength and rallied sharply. American indices were all up in excess of 1% on higher volume, although NYSE volume remained disturbingly below average, a stark contrast to the higher volume selling last week.

Two of the four conditions we mentioned as necessary for the uptrend to resume asserted themselves today: gold resumed its rise and the U S Dollar its decline. This trade was helped along by news out of the Middle East that OPEC nations are in talks with consuming nations about pricing oil in something other than dollars. While there is likely truth to this rumor oil is a relatively small market and a switch from the dollar wouldn’t be a critical blow to the currency, but it fed the resumption of the trend in sentiment.

Given the moves in the dollar and gold it should come as no surprise that commodities helped lead the market higher. But market strength was relatively broad based, an indication of a more powerful move than we had expected.

Prices on the major indices have now rallied back to their short term downtrend lines, an indication of likely volatility ahead. But while we expect a pullback of some sorts from here we clearly underestimated the eagerness of money managers. Big money is clearly willing to position itself ahead of earnings in an effort to not be left further behind. While we expect good results this earnings season pricing in such outperformance ahead of time will make the market vulnerable to any disappointments, which could well be as simple as guidance that is perceived to be not strong enough.

But be forewarned: betting against the trend in the larger sense is a bad idea until the market gives us clear evidence to consider otherwise. Today’s action tells us it is nowhere close to doing so.

While we have urged caution in our commentary and believed that the correction had yet to bottom, we have been firm in our conviction that this pullback is buyable. If you’ve followed our sister blog you know we’ve been following the market’s promptings and putting some money back to work. We believe stops must still be minded but today’s evidence suggests the bottom of this correction has likely been put in place.

Anemia

The market managed a heck of a bounce today. But volume was anemic. This is further validation of our previously expressed belief that the recent lows are likely to be tested and probably broken before the market can attempt another leg higher.

The continued outperformance of leading stocks today, however, reinforces our belief that this pullback is buyable, although we believe it remains too early to put cash to work. We still look to next week when earnings reports begin in earnest as the likely catalyst to spur the market higher.

Until then bone up on stocks we have profiled in the past on our sister blog. A good number are well positioned as buy candidates should the market turn. In addition we continue to add stocks to our coverage universe and update some of those that have scored excellent gains and may be presenting fresh buying opportunities.

Perspective on the Correction

Friday’s economic data fit perfectly with the current “glass half empty” approach that has been the excuse for the current market correction. Employment numbers were worse than projected and factory data suggested economic momentum might be ephemeral.

Technical warning signs abound. The major indices all closed near the lows of the week on above average volume. And copper (JJC), which we discussed in July as more than just a commodity play but a leading indicator of economic growth, is leading the NASDAQ to the downside and declining on volume beneath its 50 MA after putting in a topping formation the last two months. A reversal in copper is critical, in our view, if the market uptrend is to resume.

The dailies of the major indices are indeterminate for the immediate future, which is why we suggested exiting recent longs in which you might not have sufficient cushion to endure an ongoing correction.

Thursday’s downside priced in Friday’s ugly economic statistics but the markets still declined Friday, albeit on slowing volume. While that could be a sign that selling is exhausting itself here, technically after a three day decline we had every right to expect some type of reversal in Friday’s performance. We might still bounce early this week but it is not a given.

When all is said and done, however, we continue to operate on the assumption that this pullback is buyable. We have four reasons.

First, economic recovery is first and foremost about earnings, not employment statistics and consumer sentiment, and we expect another excellent string of quarterly reports. Granted, last quarter was mostly driven by cost cuts and commodity savings for producers while sales growth was anemic. We expect cost cuts and commodity savings to continue to contribute to the bottom line while sales growth will show signs of acceleration.

Second, in spite of a bounce the last two weeks or so, the US Dollar Index (DXY) remains in a downtrend that has been in effect since the March bottom in stocks. Unless the dollar reverses to the upside we expect a weak dollar to continue to be supportive of stocks.

Third, gold remains secure in its break out. This is important because it supports our thesis of a weak dollar. But it does something more. It indicates the market, which began to sell off (as we predicted it might) on fears the Fed would begin to remove monetary accommodation, is ultimately confident that day of reckoning is still sufficiently far enough into the future to warrant further upside in equity prices.

And this leads into our final assumption: that the market rally will endure until the Fed ultimately begins to remove accommodation. We believe the economic statistics we have seen the last few weeks will be sufficient to convince Fed members, for all the bluster of some of the governors, that the time is simply not ripe to drain liquidity from the system. Indeed we believe that could be well into 2010.

When it does happen, combined with some anti-growth policy changes the Democrats are mulling, the market reaction could be brutally ugly. But that is for another time. For now focus on the correction as it continues to unfold and be prepared to secure excellent entry in leading stocks should we see signs of an impending reversal.

The Future of the Correction

This morning’s jobs report was as bad as the market feared and although the market is in negative territory at midday the damage to the indices appears contained because yesterday’s action seems to have for the most part priced in today’s report.

There will be plenty of time for us to discuss this morning’s data but for now what is of importance is how the market reacts to it. That will likely give us a clue as to how much further the correction has to run.

To put it succinctly, the market very badly needs a reversal day. That would mean a finish on the major indices above yesterday’s closes and on higher volume. While such a setup wouldn’t necessarily result in a march to new highs it would likely lead to further upside next week and then a possible retest of the correction lows, clearing the way for ultimate upside resolution.

Anything short of this kind of setup probably means lower prices at some point over the next week or so. And that would mean a likely test of the September and perhaps August lows.

That certainly wouldn’t preclude the possibility of the uptrend resuming but as intermediate term traders we’re not interested in that scenario, which could mean a correction on the NASDAQ in the area of 10+%. We’ll take profits in remaining positions should today’s close not favor this morning’s low as the bottom of this correction.

Tone Deaf to Growth for Now

As we suggested yesterday the markets saw further downside and rather quickly at that. The NASDAQ has now declined better than 5% from its high with the S&P 500 down about 4.7%. The averages are now within the range that contained all previous corrections off the March bottom, which have been approximately 4 – 8%.

That doesn’t mean there isn’t more downside ahead. The volume flush at the close into the lows of the day bodes poorly for tomorrow’s session, the pace of which will be dictated by the pre-market jobs report. Clearly many traders did not want to be long in front of a major economic release in a market environment that needs little excuse to interpret things bearishly.

As we’ve discussed the market has seized on flys in the growth story ointment as an excuse to correct. It’s not as if good news doesn’t abound. Pending home sales gained for the seventh consecutive month. And although the US ISM reading missed expectations it remained comfortably above the 50 point for the second month in a row signaling that the economy is expanding. The new orders component was above 60. This should have overshadowed the regional report yesterday that indicated a return to contraction. But the market has turned tone deaf to the green shoots story for now.

Leading stocks remain secure in their uptrends. Many are pulling back in light volume. This is a sign of likely continuation of the rally once the correction has run its course, which we still believe will await the release of earnings reports.

But new buys are not working and should thus be avoided. Cash is king except for positions with fat gains initiated earlier in the rally that should continue to be held in the hopes of adding to them once the dust settles.

Market Comeback Unlikely to Forestall Further Downside

The market was slightly lower yesterday on some mild distribution. While we do not see distribution as a problem for the rally at this point that doesn’t mean the correction cannot deepen.

After opening higher the market sold off hard upon the release of the Chicago PMI. Last month this very report was the first solid evidence that the recession had ended as the index hit the 50 point, which demarcates growth from contraction. With expectations of a 52 reading the market was stunned when the report decreased to 46.1.

Economic recovery is not a smooth affair and the market, at the precipice of a severe sell off, came to its senses and righted itself into midday. While that was impressive the late day decline indicates that the correction likely has further to run. Bear in mind there’s been no significant follow through to Monday’s low volume expansion bar off the pullback. While the market climbed back to a certain degree the fact remains it ended lower on volume and began a second pullback off the highs without making a new high.

Importantly, during the most recent upleg of the rally the market ignored any bad news and seized on factors that indicated a return to growth to push its way relentlessly higher. But since the recent peak on 9/23 the market is focused on negative economic news and of late there has been a parade of it. And opportunities to focus on the negative abound ahead of us with the ISM index out later this morning and the employment report on Friday.

Plus we are in earnings warning season. Ultimately it is corporate earnings that define when a recession can reliably said to be ending and we remain three weeks away from any lift these reports can give. In the meantime the market, given its current wont, is likely to seize on any high profile warning as a reason to slap investors.

We still believe the rally has further to go given the way leading stocks continue to hold up well and even make new highs, but that the market is likely to continue trading in ragged fashion for the next few weeks, testing the mettle of traders. However long the volatility endures, until the rally can firmly reestablish itself caution is warranted in initiating fresh positions. And unless you have a sufficient cushion in your core longs, tight stops are recommended.