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Longer end of bond market still unwinding!

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Since our 11:00 Update on OptionInvestor.com and IndexSkybox.com we're still seeing a good round of selling in the long end of the bond market. The 30-year YIELD ($TYX.X) has jumped to 5.591% and the 10-year YIELD ($TNX.X) is jumping to 5.14%. To me, this is a major reversal in thinking that is starting to take place on a longer-term basis. I feel this bodes very well for stocks longer-term.

So why aren't stock headed higher? I do think that today's action is a "determination" to take some profits off the table in the stock market. But this sets us up for what I think is going to be some excellent trading opportunities going forward. Below I'm going to discuss a pattern to look for. Hopefully subscribers will take some time to understand the pattern and why we should be looking for similar occurrences near-term. I think there's going to be some excellent bullish trades coming up. The bond market is selling the "he@@" out of the long end and raising cash.

Equity bulls that stepped up to the plate in the last couple of months are paying themselves and this should be the case. Those that have been sitting in bonds and seen some impressive stock gains will most likely begin buying support.

First sell signal in the upward trend

I sure hope subscribers are trying to understand and use some of the point and figure charts we show on a daily basis. While they seem unconventional at first, their measurement of supply/demand and various techniques give important insight for traders.

The current market environment is getting ripe for an old point and figure charting saying. The saying is "the first sell signal in the upward trend is often times a buying opportunity." The "reason" the market environment is ripe for such a pattern is that we've now got some leaders leading and we should most likely be finding some of the mid-tier stocks begin to respond.

Here's what I'm talking about and what to look for going forward. Let's take a stock like PeopleSoft (NASDAQ:PSFT) that we turned bullish on back in mid-October. It's a classic example of a stock that you and I classified as a leader or "strong stock" in the software sector.

PeopleSoft Chart - $0.50 and $1 box

The first "sell signal" in the newly created upward trend (remember, bearish resistance had not yet been broken to upside) came at $23. A trader playing this pattern would have observed the sell signal, placed the stock on his/her "watch list." Eventually, the stock traded the $22 level (Oct. 18th), then reversed up 3-boxes from there at $25 (Oct. 19th). A trader may have taken the trade bullish at $25, and followed with a stop at $21, which would be a sell signal.

Is the trade going to work? You and I want to have some idea if there is anything in the above chart that hinted of longer-term bullishness. Often times, the first sell signal in the upward trend is simply a test for weak bulls. The pattern works "best" in a market environment of uncertainty. Is the economy in recovery phase? Is the world coming to and end because of terrorism? This kind of stuff.

In the PSFT chart, that "sell signal" at $23 most likely is what we call a "bear trap" and some shorts that weren't monitoring bullish% or relative strength got "whacked" if shorting at $23. This also creates the sharp reversal higher when the stock immediately moves against them and they look to cover that mistake. That covering by bears and further "loading up on the pullback by institutional bulls" is what helps create the powerful move higher.

Why has the stock performed so bullish? In my previous question of "is the trade going to work" often times is hinted at with the first bullish vertical count off the bottom. As outlined in the chart, a trader taking the trade bullish on the reversal at $25 must have some type of longer-term bullish target. The vertical count from the extreme bottom indicated that the stock had bullish potential to $49.50. Was risking $4 to your stop at $21 worth the potential reward of $49.50? What you want to do is measure the longer-term risk/reward and see if it is bullish enough to keep an institution buying the stock. See how PSFT has yet to give a sell signal (column of O's exceeding a previous column of O's)? The "explanation" for a lack of sell signals is that "smart money" has had some idea and conviction toward a higher stock price.

Does the stock need to trade $49.50 or the current bullish vertical count of $59 for a trader to get some success? Heavens no!

Relative Strength is very important!

Not every stock chart that gives "the first sell signal in the upward trend should be a bullish candidate. Has the stock been showing some type of relative strength vs. the broader market. Chances are, a stock that is NOT showing some type of out performance is not going to be a very good candidate. In fact, you may find that you buy the 3-box reversal and then get stopped out for a loss, simply because the stock you bought was not on the radar screen for institutional buying.

Relative Strength Chart of PSFT vs. S&P 500

On October 29th, the RS chart of PSFT vs. the SPX was very close to reversing back into a column of X. Since we had not seen a RS "buy signal" yet, any trades taken long should have been under the condition of "bearish", but close to reversing to "cautious bull." A good strategy would have been to LIMIT trade size to 1/2 or 1/4 position bullish. Then if success found, add to the position as bull proven correct in their analysis and trade set up.

Use in the future!

Look at the current trading of PSFT objectively. Doesn't both the Relative strength chart and the point/figure chart hint that the stock is a bit "overextended" and could pull back some? Hopefully you say "yes it does." Is this a stock to be shorting? Hopefully you say "No way!" as the stock has been outperforming the market (S&P 500) and should be considered a "strong stock on pullback."

In early August, we did profile shares of PeopleSoft as BEARISH, can you figure out why? August in the "red 8."

Jeff Bailey
Senior Market Technician
Option Investor

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