Sentiment moderates as market finds some footing

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The comments below were provided by Kevin Lane of Fusion IQ.

The markets found their footing a bit late late last week after three days of selling.  The stabilization occurred in and around key moving averages (the 50-day on the NASDAQ and the 40-day on the S&P 500).  Two factors we noted during this recent run-up still persist; investor fund flows continue to find their way into equity markets and anecdotal sentiment is still doubting and not embracing this rally. That said, measured sentiment also has moderated as seen in the chart below from the American Association of Individual Investors (AAII), which shows bulls have fallen from north of 60% to 36% as of yesterday. It’s hard to have big corrections when liquidity flows are in and sentiment remains skeptical. While logically it may make sense that the markets need to correct, I found out a long time ago, and the hard way, that markets don’t care what we think. Rather they march to their own drums and most times the obvious and logical trade is the wrong trade.

Additionally, markets only correct when trading successes seduce investors into thinking the game is easy and they have it all figured out. This overconfidence lends itself to over-commitment on the long side via leverage, until investors exhaust their buying power. Markets don’t go down when everyone is sourcing for short trades or when the loudest voices in the crowd are the skeptics. Moreover, it also takes persistent distribution to turn the tide from up to down and, other than Tuesday, so far the sellers have only been a one-act (one-day) show.

For now, as uncomfortable as it may be for some, the trade is still up. It you are fully invested and with positions that are significantly lower in cost basis, then firstly, congratulations, and secondly, sit just back and relax.  For those who fit the former description your job at this point is to make sure you have good trailing stops or hedges in place for when the correction does unfold.

The greater risk awaits those who are underinvested (or net short) and adding new positions with at the money or slightly in or out of the money cost basis.  We say there is more risk simply because the S&P 500 is up 24% from the August 2010 lows, just a mere six months ago. As legendary hedge fund manager David Tepper of Appaloosa stated on CNBC just a few weeks ago, any time the market has a big rise there is simply more inherent risk because prices get more expensive.

So, for the latter group of investors, the trick is simple; keep searching for setups on new money positions that have good upside potential (however you measure that, i.e. fundamentally derived targets, point and figure objectives or the next overhead resistance levels) but with limited drawdown risk (i.e. the difference between cost and stop loss/exit point).

Now that we have talked strategy a bit, let’s take a look at some of the markets’ technical levels. As seen below, the S&P 500 found support in the 1,302 to 1,295 support area (red lines). This level also coincided with the index’s up-trend line (green line). Any close below yesterday’s low would open up risk to the next downside support near 1,270.

As seen below, the transports had much more damage done on the sell-off than broader markets, by scoring a false breakout above their previous peak only to rapidly fall back below (purple line) the previous peak.  Subsequently the transports dropped below 5,000 and bounced off support in the 4,960 to 4,910 area (red dotted lines). At this point we view the weakness in the transports as an inverse trade to the rise in crude and  not a buckling economy. Either way, any drop below this recent support level would be a negative on the transports.

To wrap up our mid-morning missive, the trend is up until proven otherwise and a few % points sell-down from the highs are not proof enough to get your bear claws out yet. Before we do that we first need to see how the indices regroup from the recent sell-off and whether they can muster news highs or fail to do so. Then we would need to see a few days of distribution like Tuesday but only with more frequency and persistence.

To use an analogy, when hunting big game it’s better to travel in a pack than be a lone wolf and right now the lone wolf is the one searching for a top.  Wait for more evidence to appear before turning negative and only join the hunt when the pack (the sellers) are in full force.  If you deviate from the strategy you will continually get nicked.

Source: Kevin Lane, Fusion IQ, February 25, 2011.

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