An Entire Weekly Strategy Session {from March 3rd, 2013}

I. THESIS FOR THIS WEEK: THE WILD PRICE SWINGS AND INCREASED VOLATILITY OVER THE PAST TWO WEEKS HAVE COME WITHIN THE CONTEXT OF A CONTAINED PRICE CORRECTION, THUS FAR. AS A RESULT, SWING TRADERS CAN NOW TRADE AGAINST LAST WEEK’S LOWS AS A CRITICAL REFERENCE POINT, FULLY AWARE THAT NOT ALL SLOPPY CONSOLIDATIONS IN AN OVERARCHING UPTREND RESOLVE IMMINENTLY LOWER. KEYING OFF PREVIOUSLY LEADING SECTORS LIKE THE SMALL CAPS AND FINANCIALS TO REMAIN IN SHALLOW CORRECTIVE TERRITORY SHOULD BE AN EXCELLENT GAUGE OF THE ACTION GOING FORWARD, AS IS THE RESILIENCE OF THE MARKET IN THE FACE OF A STRENGTHENING U.S. DOLLAR AND SLUMPING COMMODITIES. 

The New Year’s Eve deal reached by Congress to avoid automatic tax increases delayed the automatic federal budget cuts for two months, which are currently under consideration in another Washington showdown known as “The Sequester,” or “Sequestration.” Congress and the White House can act to replace or cancel the relatively significant cuts, but right now both parties seem far apart on the issue.

In fact, we have what appears to be an impasse. By law, the sequester is designed to cut about $85 billion during the current fiscal year (which ends Sept. 30), half from the defense side of the budget, half from the non-defense side. On Friday evening, it was reported that President Obama signed an order that starts putting into effect across-the-board budget cuts after he and congressional leaders failed to find an alternative budget plan.

The relevant point I want to make with respect to the market is to observe whether stocks use this event as an excuse for indecision and consolidation, such as what we saw each of the past two weeks. Instead of viewing the Sequester as a catalyst for a market sell-off, keep in mind that stocks have rallied sharply leading up to it. Thus, if we look at the Sequester as simply an excuse for stocks to do that which they wanted to do anyway–reset after a strong uptrend–then we avoid the stress and confusion of trying to piece together each bit of news that comes out of Washington and what it may or may not mean for the market. Of course, if the market shrugs off the Sequester and continues the rally, then that should take clear precedence over anything happening in Washington.

Moving on, as we wind down another earnings season, keep in mind there are plenty of different styles that can be profitable in the market as a trader. My discipline is to usually not hold trades through earnings reports. If you do want to hold a position through the firm’s earnings report, I would suggest that you consider lightening up the position a bit before the announcement in order to mitigate the known unknowns/risks you are assuming.

Either way, I urge you to check and then double-check your current portfolio holdings to see when the firms you own are scheduled to announce earnings. As a swing trader, I am almost always looking to significantly reduce or outright close a position into earnings. There are simply too many external variables, particular to the firm in question, from an earnings report for me to have an edge. As an example, even if you do possess some type of insider or unique information about a given firm’s impending earnings report, there is still no way to know how the market will react. Stocks can just as easily sell-off on great earnings as they can on horrific ones, and vice-versa.

With that in mind, I want to point out one crucial difference between specific earnings reports relevant to the stocks of firms you own versus politics, a broad economic report, and monetary policy decisions. In trending markets, up or down, the macroeconomic data (not microeconomic, such as earnings reports) tend to be interpreted by the market in favor of the prevailing trend, even if the numbers wildly miss or easily crush expectations.

In sum, macro reports should not be treated as the sole reason to exit a stock, whereas a specific firm that you own reporting earnings most certainly can. Moreover, the reaction to the initial reaction in terms of the price action by the market after a given data point or earnings report is what matters most to swing traders.

Technical analysis has its clear limitations in that it can usually only analyze that which is currently known and legally knowable by the markets. To presume that charts can dictate everything into the future is pure folly. Trading, for all intents and purposes, is gambling, as we are wagering on outcomes yet to be determined. Instead of running away from that fact, a better approach is to embrace sound risk management principles and become astute speculators.

II. THE WEEK AHEAD

A. CURRENT MARKET POSTURE

1. The Increased Volatility and Size of Price Swings Each of the Past Two Weeks is Consistent with a Market Consolidation After a Prior Steep Uptrend. With Last Week’s Lows in Mind, Traders Now Have a Clear Point of Reference off of Which to Base Their Long Exposure.

The increasingly popular analysis amongst many market players and pundits now seems to be that the broadening, or “megaphone,” channel pattern on the Dow Jones Industrial Average and other indices is a clear warning sign of an imminent major market top. To get right to the point–A broadening channel on a major index after a prior uptrend is not a guarantee of a top, or anything close to it, particularly without adequate evidence of necessary downside price confirmation. Over the years, I have detailed various megaphone formations, some of which proved to be wildly bearish, namely the April 2010 megaphone on the S&P 500 Index which led to the May 2010 “Flash Crash.”

However, those patterns do not, in fact, always resolve lower. (The megaphone is considered a potentially bearish setup after a prior uptrend due to the increasingly loud argument [more dramatic price swings, uptick in sell volume, etc.] between bulls and bears, which tends to favor a bearish resolution in this context, as opposed to the more traditionally-bullish quiet, mild indecision). In addition, also consider that the Dow is not far from all-time highs of 14,198, set back at the October 2007 market top. As a general rule of thumb, if a widely-watched index comes within close proximity to a massively important price level, there tends to be at least one touch of it, if not an initial overshoot.

Instead of simply calling out tempting chart patterns and getting married to that thesis, we must be rigorous in framing the price action within the proper context. Here, the market has been in a strong overall uptrend not only since last mid-November, but especially since the beginning of 2013 with a steep rise higher. With slowing upside momentum as February progressed, it was only a matter of time before we saw a correction of some kind. Usually, a bullish market will feature its first correction after a steep uptrend to be contained, staying roughly within 3-5% of recent highs. We know the S&P 500 corrected from 1530 down to 1485 over the past two weeks, which equates to about a 2.9% correction.

Thus, despite the broadening patterns of higher highs, but lower lows on many index charts (the Dow is most pronounced, in this regard), the overall uptrend dating back several months should not dismissed out of hand as being capable of pushing this market higher yet. As has been discussed in these Strategy Sessions for months on end, uptrending markets are uniquely difficult in which to declare a major top, even more difficult than selecting the bottom in a downtrending market. Even when it becomes correct to raise cash and adopt a more defensive posture, as it was in mid-to-late February, respecting the distinct possibility of a contained correction before the uptrend resumes is certainly an important concept for traders to have in mind.

Moreover, the “spinning top” weekly S&P 500 candlestick we discussed last weekend did not quite confirm lower in the way the bears wanted to see. Last Monday morning’s gap higher to 1525 on the S&P and subsequent reversal all the way down to 1485 set the stage for bears to seize control the rest of the week, to confirm the prior week’s signal for a potential reversal of trend in the spinning top. However, bears essentially lost their grip on the initiative, as buyers stepped in to largely recover what was lost on Monday’s fade.

As a result, the S&P 500 Index weekly chart printed a “long-legged doji” candlestick last week, which simply denotes continued wild indecision. However, putting this into context of our contained price pullback thesis, we must at least respect the possibility that last week’s lows marked the downside of this correction.

The updated weekly S&P chart below indicates that the steep angle of the ascent of the rally in January has now turned sideways in recent weeks. This flattening out of price, even with the increased volatility, which to be expected in a consolidating market, compels swing traders to be equally prepared for an imminent and sizable move in either direction. It is, indeed, more enjoyable to be fairly certain of a particular outcome, but since the cyclical bull market began in March 2009 we have seen our fair share of both shallow and deep price corrections.

Regarding specific strategy headed into this week, the 30-minute chart of the S&P 500 offers excellent reference points. The suggested strategy here is to trade against 1514, 1500, and especially last week’s 1485 lows. As each one of those levels is lost, traders should become increasingly defensive, raising cash, taking profits, and cutting losses quickly on the long side.

That said, you can see the emergence and near-completion of a bullish inverse head and shoulders pattern on this timeframe. The “neckline,” or price trigger to likely set the pattern in motion, would be an upside breach of 1525, last week’s highs. The measured move, or target, of the pattern if triggered, would be 1565 (taking the neckline [1525] and subtracting the lowest point of the “head,” [1485] and then adding that number [40] back to the neckline).

Consistent with the analysis above, traders should keep these levels at the forefront of their approach next week and not stray too far from their discipline, as a move either way is likely to be a large one.

2. Although the Previously-Leading Small Market Capitalization Stocks and Financials Lagged Last Week, Observing Their Weekly Charts Offers a Similar Type of Trading Setup as Described Above.

I know that I gave you plenty of material to ponder in the previous sub-section, so let us get right to it: If this correction is going to be a contained one, then the high beta small caps in the Russell 2000 Index and the financials should hold last week’s lows. Even if there is a rotation to other areas of the market, such as the Nasdaq stocks, these heretofore leading segments of the market should at least base sideways rather than roll back over for fresh correction lows.

Specifically, the often-overlooked 10-week moving average (light blue line, on each respective weekly chart below for the small cap-led Russell 2000 Index and XLF, ETF for the financials as a sector) served as strong support last week. The reason why I describe it as strong support, at least initially, is the long “shadow” at the bottom of each weekly candlestick. This indicates that buyers arrived on the spot even after the seemingly ominous reversal lower last Monday. Despite both segments finishing lower for the week, overall, note how they each rallied back from the lows to close near the highs of the week.

Again, if the current broad market correction has run its course for a relatively contained pullback, then it logically follows that the 10-week moving average zone should provide firm support for leading sectors such as the small caps and financials. Recall that moving averages are best used as reference for strength or weakness, rather than automatic places to buy or sell. Here, the 10-week moving average acted as strong support. Moreover, the $17.10-$17.20 area is a major, multi-year price level for the financials, as the horizontal purple line indicates on the second chart below, That, too, should provide support in a shallow pullback.

With this in mind, the suggested strategy is to trade against last week’s lows in both the Russell and financials. Below 894 on the Russell, and below $17.16 on the XLF, however, and we simply must step out of the way and respect a deeper correction in the works.

3. The U.S. Dollar Has Strengthened Considerably in Recent Weeks. During That Time, Although Commodities Have Been Sold Aggressively, Stocks Have Remained Overall Quite Resilient.

Generally speaking, the U.S. Dollar and stocks have been inversely correlated in recent years. A strong Dollar usually meant that risk was “off,” and investors were seeking a relatively safer haven against a deflationary backdrop–A return of capital, if you will, rather than a return on capital. Similarly, a weak Dollar often meant rising stock prices with rising commodities to boot, as risk appetite was deemed to be “on.”

Over the past several weeks, it is worth noting that the U.S. Dollar has rallied sharply. We know that copper, crude oil, gold, and silver have sold off aggressively in that time. With the above inverse correlations in mind, that should not come as much of a surprise. However, it is interesting to note that stocks failed to follow commodities lower in the swoon, thus far remaining not far from recent rally highs.

To be sure, no correlation lasts forever. Over the course of a cyclical bull market, it almost seems inevitable that stocks will detach from inter-market correlations and eventually trade in their own world, oblivious to the commodity complex and currency markets. The bearish equities argument is that slumping commodities indicate another deflationary event is upon is, just like in 2008. However, equity bulls could easily counter that weak commodities and a strong Dollar are just what the stock market (and the easy monetary policy of the Federal Reserve) needs in order to continue on higher, against a backdrop of no inflation (but diminishing deflation) and a resurgent currency which is not pulling down stocks with it. In essence, the arguments almost cancel each other out as we await the final verdict from the market.

When we look at the weekly and then monthly timeframes of the U.S. Dollar Index, we can clearly see a long-term downtrend, yet there is considerable room for a higher bounce on top of what we have already witnessed, up to around the $85 area.

With respect to stocks, though, if the market can continue to keep price corrections contained even as the U.S. Dollar strengthens, it can certainly be seen as a blow to the bearish equities thesis.

4. Charts of Interest

A few of the ADR’s out of Japan caught my eye, again. Recall that Japan has been on a tear since last November. In recent weeks we have seen these stocks consolidate rather well, with not much giveback. As a result, I like the following long ideas on strength.

Also continue to watch the consumer discretionary stocks, particularly versus the more defensive consumer staples. Last weekend, the discussion here centered around discretionary stocks finding support quickly, after their recent underperformance. Indeed, the XLY, ETF for the discretionary sector, not only regained the losses from Monday’s sell-off, but also most of the losses from two weeks ago as well. Now we see if bulls can capitalize on this resurgence.

Here is the updated weekly chart comparing the discretionary stocks to the staples, by their ETF’s. Discretionary stocks looks to have put in a reversal, hammer-like candlestick last week. Again, upside follow-through is key.

Crude oil is working through a multi-year symmetrical triangle, with lower highs, but higher lows. These tend to be tricky patterns to play, in the sense that we often see one initial move out of the pattern–up or down–which proves to be a fake-out before price reverses in the other direction for the true move. Either way, after years of false moves to either direction, we figure to finally be close to the real thing in crude. From long-term compressed moves often come sustained, explosive ones.

B. LEVELS TO WATCH

V. QUOTE OF THE  WEEK

“Be as smart as you can, but remember that it is always better to be wise than to be smart.” – Alan Alda

-chessNwine