Option Investor
Market Wrap

Will the liquidity continue to move the market or is this "a fork in the road"?

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       WE 1-08          WE 12-31         WE 12-25         WE 12-18
DOW     9643.32 +461.89  9183.43 - 36.56  9217.99 +342.17  + 85.22
Nasdaq  2344.41 +152.22  2192.60 + 29.52  2163.03 +119.15  + 34.52
S&P-100  636.02 + 32.08   604.03 -  3.91   608.91 + 25.30  +  8.49
S&P-500 1275.09 + 45.93  1229.23 +  4.15  1226.27 + 46.31  + 18.02
RUT      431.23 +  9.27   421.96 + 16.42   405.56 + 11.78  +  3.93
TRAN    3360.28 +210.97  3149.31 +108.48  3044.08 + 73.44  +100.82
VIX       23.88            25.41            22.04            28.07
Put/Call    .48              .55              .52              .47

Will the liquidity continue to move the market or is this "a fork in the road"?

For the week the Dow was up +462 points or +5%, the S&P +3.7%, the Nasdaq +6.9%. The Russell-2000 limped into last place with +2.2%. The big gains in the Dow were helped by Alcoa and AT&T both announcing stock splits. Record volume for the week culminated in the NYSE doing 940 mil and the Nasdaq a whopping 1.29 bln shares on Friday, the second largest volume day ever for the Nasdaq.

By now you have heard all the glowing adjectives the news reporters are using to describe the market performance in the last week. With the three major averages, Dow, Nasdaq and S&P all setting new record highs on Friday everything seems too good to be true. Normally when all the signs line up like they did this week, it is time to duck.

Every indicator except one is pointing to a continued January rally. The new highs/new lows is very positive. The Dow MACD is accelerating. The liquidity (new cash) coming in to the market is setting records, $7.8 bln this week alone. The previous record was Jan-1997 of $29 bln and we are on track to smash that record.

The economic reports continue to amaze the analysts. The employment report on Friday showed the lowest unemployment in 41 years, since 1968 and the Vietnam war. The economy is booming. The dire earnings predictions for the S&P have lessened and now the estimates are beginning to rise again. The bleak forecasts simply did not come to pass. The global economy is starting to mend. The cyclical commodity stocks are starting to see new life as investors are anticipating the rebuilding process in Asia.

It is scary. Everything points to a huge bull rally. Even noted "cautious" analysts are starting to say 10,500 or better in the next six to nine months. Even the oil service sector is coming back to life. The only sector analysts are not recommending is the Internets. This only because of the speculative bubble that currently exists.

So why am I cautious today? OVERBOUGHT. The market has simply gone up too far too fast and must correct before the rally can continue. It is a normal event and does not even have to be serious. But it needs to happen. Every stock we look at as a possible pick has spiked up 15-25% in the last two weeks. This is not healthy. The farther up we go without a profit taking spell is inviting disaster.

Funds, driven by new cash, have been buying everything in view. They are however also driven by historical analysis. They know the market will sell off and they will soon start hoarding cash while they wait for the next entry point. This will eventually hasten the sell off as they quit buying. Nobody wants to buy at the top only to lose -10% the next week. Sure we all feel it will recover that 10% and more within a couple weeks but by waiting for the profit taking you can get in 10% cheaper.

If you have been a reader for some time you know I am a trend trader. Nothing goes in a straight line. Every stock has cycles. We refer to this as the 3-5-7 day cycle. In brief, normally if a stock goes up strong for three days it will drop one on profit taking. If it goes up five days it will then drop three. If it defies gravity and stretches the up string to seven then it could profit take for five days. Before you start those emails just remember I said "normally". Also it does not have to actually drop several days in a row. The stock can just "consolidate". This could be alternating up/down days or several days of choppy trading while the price stays the same.

The liquidity pouring into the market now has lengthened the up trends and shortened the down trends. But just like gravity the trends will eventually dominate. The higher up a stock rises without a sell off will make the sell off more severe when it comes. How much will a rising stock sell off? The rule of thumb is 25% of the last up trend. CSCO was up +13.88 last week. Using the rule of thumb you could expect a -3.50 drop for profit taking. Now, here is the problem. CSCO's average daily gain last week was +2.78. If it continued up another two days before the Nasdaq sells off then CSCO would be up another +5.56. Would you trade a -3.50 drop for a +5.56 gain. Does water run down hill? The catch? If you add the 5.56 to the 13.88 from last week then CSCO is up +19.44. 25% of 19.44 is now $4.86. If the expected drop is $4.86 then the $5.56 gain becomes more of a wash. Remember the longer a stock moves up without a drop for profit taking the bigger drop it will have. Maybe instead of -25% it becomes -35%.

The point I am trying to make is the cycle will repeat. It is like stretching a rubber band. The farther you stretch it the harder it is to stretch and the stronger the snap back when you let go.

The market overcame several attempts at snapping back last week. Thursday's -7.21 at the close did not tell the tale. The market spent the day in negative territory and rebounded from a -118 deficit at the close. Profit taking was attempted but the cash coming in at record rates sent fund managers in "dip buying" mode prematurely. Friday the market tried four times to break the 9550 level on the down side and in fact spent a large portion of the day in negative territory before jumping +100 points in the last 45 minutes. Traders were again watching the dips and testing the limits. The cash infusion is fueling the dips now but it will not last. Historically, traders and fund managers know the piper must be paid and they will quit buying.

The signs of an impending sell off are there. The market breadth is weak. Thursday the NYSE declines beat advances 1952 to 1136. Friday the declines again edged advances 1518 to 1501. Two days does not make a trend but it shows the underlying weakness. Look at this chart of the Dow.

The red line is the advance/declines. The bottom graph is the daily volume. Black is an up day, red a down day. The strong volume last week was a good sign but the divergence between the Dow and the A/D line on Thr/Fri was not good. We have had a strong up trend on the A/D for eight days and this could be the start of a resting period. Again, the qualifier is the large amount of new cash coming in to the market. This could prolong the current rally and put off profit taking for another day or two.

Now look at a Nasdaq chart

The Nasdaq has been moving up strong for some time. The volume is increasing and we have had six record closes in a row. Notice the trends in the past. In the last three months we have had two four day positive close streaks, one five day and two six day streaks. The four & five at the beginning of Nov could almost be one long streak. Notice also that every streak is followed by several down days or several alternating days of ups and downs.

What I am trying to get across is the "trending" cycles. As option traders we are hampered by the choppy trading at the end of each streak. Time premium decays while we are waiting for the next move to start. While we feel the rest of January we be up from here, we also feel that a period of profit taking is imminent.

Professional traders have developed the patience to wait for the correct entry points in any market. It is painful to watch the stock you want to play move up for a couple days while you are watching from the sidelines. It is not as painful as watching your investment dwindle away from taking a position at the wrong time and having to wait for a possible recovery just to get back to even. Look at this chart of United Technology.

See the cycles. See the two big profit taking drops in the middle after two strong rises. There are seven streaks of three or more days of positive closes. Where would you like to have bought UTX?

The end of this lesson will play out over the next several days. The Nasdaq is the most likely to break due to the long streak but it is also the most recommended sector at present. A fundamental tug of war. The Dow (only 30 stocks) may continue to move upward while the NYSE takes a breather. The weak advance/decline line could continue to weaken and eventually drag the Dow down. Cash is expected to continue flowing in at record rates and could support several more days of upward movement before the market gets so top heavy that it cannot support the momentum. Remember, I am not saying don't buy. Just plan your buys using some common sense and don't whine if the stock goes up a couple more dollars while you are waiting. Profit comes to those who are patient. If we do get a big sell off we advise jumping back in as soon as the averages start back up. The cash on the sidelines will be buying the dips aggressively.

Good Luck

Jim Brown

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