The Role of China

China PMI:

Euro Stoxx 50 (weekly chart):

Oil (weekly chart):

Interesting correlations! Judging by the way the markets moved from last November, the West has become less dependent on growth from China.

The Rodeo

It seems to be true that the market shakes out most participants before a bigger move. It is like a rodeo and I was thrown off.

The put/call ratio is still oversold and the market finally shows strength today:

I think the gap up will force some shorts to cover, which will push the market even higher. If the market stays strong in the following days, it will give valuable information for the intermediate term top I am expecting. Should the recent highs be reached fast and with weak breadth the descent will be dramatic.

Stop is at 1299

Got to leave my desk. I am expecting a strong close today.

ST Trading: Long at 1304.75

ST Trading the SPX; Sell Oil

The market is reluctant to go up and its behavior is not exactly what I had envisioned. The pull back from the highs is already 45 points long, much bigger than other similar moves at previous tops.

The put/call ratio is oversold, but it does not imply that the market cannot continue downwards.

However, I will still have a bullish short term bias as long as yesterday's SPX lows hold. I will try again to go along as soon as I see some convincing positive action today.

Meanwhile the price of oil has gone wild. Here is a weekly chart of the April contract

I agree with Mr. Futia's analysis regarding market sentiment towards oil. I do not know about long term (years) but over the intermediate term his conclusions match my expectations of a weaker economy for a while.

This means that a good trade idea would be to sell oil. I have measured the previous up moves for this contract and the latest rally seems as big as it can get at current levels. I think a top may be in the cards even today. By my calculations, selling above $104 is a bargain.

The easing in oil prices might also spark a short term rally in the stock market.

ST Trading: Stopped Out at Break Even (1298.75)

I had set a stop loss after yesterday's close.

Entry, Stop Loss and Target

ST Trading: Long at 1298.75

ST Trading: Out at 1303

Made a mistake by leaving my desk and not putting in a stop loss.

I will try to buy again on a drop below 1300 after the lunch.

ST Trading: Long @ 1310.5

ST Trading for February the 23rd

The put/call ratio is oversold after yesterday's big drop.

Bearishness rules again judging by the most read news stories on Marketwatch.com

Also, given that the market topped during lunch time on Friday, I do not think the market is going to continue down from here over the short term. I think there will be good opportunities to go short for the intermediate term at higher prices.

This is why I will try to go long today as part of my short term trading strategy. I will only do it after a decent pull back, preferably below yesterday's close.

ST Trading: Covered at 1313.5 ES

The market is too weak and we are near the close. I will try again tomorrow.

Which One Is It?

The market had already dropped 29 SPX points, broke a support level and quickly bounced back. So I went long.

If the market went even lower and touched an even more visible support, the drop would be 33 points long, exactly the size of the Jan 19-20 one.

ST Trading: Long @ 1314 ES

Market Outlook

The pace of change in real retail sales is slowing down as expected:

The stock market has some catching up to do.

I expect the market to be very volatile in the next few days, as volatile as it has been at recent more important tops (January 2010, April 2010).

The action might resemble the last 2 weeks of January this year, although I think this time the break out will be to the downside.

The amplitude of the range was 25 SPX points back then. I noticed that this value is a good approximation of other similar ranges, so 1320 SPX could be a short term buy today or tomorrow for a move to the recent highs.

The Yield Curve, Inflation and the Stock Market

In the first phase of an usual economic recovery the stock market marches on the "growth and low inflation" theme. I cannot say that the current economic recovery is usual but the theme seems to have been the same; especially since low inflation has implied very accommodative monetary policy. Eventually however, this theme becomes "old- fashioned" and the markets correct.

We can gauge if the markets are playing this theme by looking at a long term yield curve chart (yield curve defined as the difference between 10 y rates and 3 mo rates):

When the yield curve steepens (the series rises) the "growth and low inflation" theme is what the markets are pricing in. It happened in 2003-2004 and it has also happened until recently.

However, a time comes when the economic recovery goes on to the next phase: "growth and rising inflation". This is visible on the chart after the beginning of 2004 as the series started falling. This second theme still means rising stock market prices over the long term but the transition involves a correction.

Here is what the SPX did after January 2004, when the yield curve started falling:

Since the yield curve has steepened (risen) a lot lately and has reached levels that represented turning points in the past (black line on the first chart), I wondered if we could expect the same shift between themes now.

One gauge is the inflation trend. Inflation is much lower now, but by looking at trends in sticky CPI prices (a kind of a core CPI concocted by the Atlanta Fed), I concluded that we might be at a turning point.

Notice how the series has fallen in both cases. In 2004 after turning to the upside it continued rising. If this were also the case from here on, short term rates would start rising more (or falling less) than long term rates, thus, the yield curve would start falling and the stock market would find itself mostly in the context prevailing at the beginning of 2004.

It seems that the current recovery got at this point late, but it it did, and this has bullish implications over the long term (several years). Over the intermediate term, however, the implications are bearish.

Time to Try the Short Side

Important economic data has been reported during the week. I will update the charts over the weekend.

Meanwhile, I think the short side can be tried again in the next days. The put/call ratio has finally spiked:

Also, the upside looks limited at least over the short term:

So, it is time again to sell rallies above yesterday's close. However, given that Monday the markets are closed, I think a better strategy is to wait until Tuesday. The market has the tendency to change course only after holidays even if it is ready to do it before.

The ST Trading bias becomes "short" again starting next week.

Still Diverging

The divergence continues between the ratio and the market.

The put/call ratio is in general very volatile but with enough experience one can guess by and large what the market did just by looking at the ratio. It is not the case lately, however. The two are diverging again (green segments). I am saying "again" because the previous case was as recent as last week (red circles). In my experience, these divergences lead to a push higher by the market and at least a bullish spike in the ratio. This time may be no different and it supports my recent expectation of a move higher, around 1341 SPX, before another top attempt . The steep divergences in the cpc also lead bigger corrections.

Moving Higher

As I pointed out earlier in the week, the market is on its way to 1241 SPX. That is where it will make another attempt to top for the intermediate term.

The put/call ratio is supporting this scenario since the recent rise in the stock market has not led to any bigger bullish spike:

For the short term, the long side should be favored but I will refrain from trading given my expectation of a more important top.

China PMI

The series below is the China PMI (not the HSBC one).

I have marked the inflection points. Generally, they corresponded to inflection points in the US stock market. The only exception is the one circled in green, the latest one. For this one, the market top should have arrived somewhere in December or January, given the previous pattern.

This suggests that even if until recently the US economic recovery has been mostly a China story, the markets are now pricing in a self sustaining US recovery. This has longer term implications, suggesting that there are several years of economic expansion ahead, provided there is no major external shock.

Tomorrow

The start of the "weaker than expected economic data" season is tomorrow with the retail sales report.

Every time in the past when the series above turned from current levels, it went lower. Sometimes it made a small bounce but even that was followed by a move lower. This has usually corresponded to corrections in the stock market.

Covered the Other Half of My Short at 1327.25 ES

Top Moved Higher

The market action at Friday's close is more consistent with breakout than capitulation. The put/call ratio suggests the same:

Indeed, the ratio made a bearish spike on a bullish day. This usually tells me that the market has some room to grow and this is the main reason I started covering. I will cover the other half of my position today as soon as I see some indication of strength.

I still expect a top in the following period but from a little higher level. Given the recent market rhythm, I expect it around 1341 SPX.

SPX hourly chart

Covered Half the Short Position @ 1328 ES

Update

The market has traded and stayed at new highs for the day after the lunch. For me this is an indication of strength and it suggests I am too early with my short. So I will cover half of my position if we have a strong last hour of trading.

I will cover the other half on a probable pull back on Monday.

The Spike

The put/call ratio has made a bullish spike yesterday indicating the market is finally ready to head down:

In the past I have seen the market top without such a spike but it gives important confirmation to my short bias whenever present.

I think a bigger rally is a sell today. I also expect significant weakness to be followed through.

Market Outlook

This is a scheduled post written immediately after the US close on Wednesday. I am not at my desk on Thursday.

I think the market is ready to head down. Today we might see a rally to new highs in the first part of the session followed by a steep drop. If the market fails to drop after such a rally and continues higher after the lunch then I will consider I was wrong and that I need to start covering my short.

Another possibility is a gap down and drop. It is hard to asses which is more probable so early before the open but I lean towards the first scenario.

See you on Friday.

Analogy

Nothing much to add today. I still like my short position. The fact that I sold high enough is making it easy to manage risk. Even if the market goes against me, it cannot go too far before becoming overbought. This is the main reason fading the market is a good strategy for entry. The important thing is not to be too early and this is the hard part.

The overnight ES action looks encouraging but I do not think the market will break today. I rather expect a small down day followed by a rally and a big sell off tomorrow. Something like the 1st of September 2008:

I believe that if we see a top the following days this is the most probable scenario because the market closed at its highs yesterday and usually tops take place in the same session the market makes new highs.

ST Trading: Covered Short at 1319

The market tested the 7 h EMA and reversed, making a strong hourly close.

ST Trading: Short @ 1318 ES

Market Outlook for Tuesday

I was expecting a much weaker close yesterday. The market had the chance to sell off but did not take it. This leads me to believe that it is going to consolidate for a day or two before heading down.

The put/call ratio is suggesting a top is in the works:

The ratio did not reach the recent usual overbought level but this is normal behavior before bigger corrections. It may be in a period of transition, where overbought and oversold levels are lower.

For ST Trading, my bias is short. I will sell a bigger rally above yesterday's close or after an hourly close below the 7 h EMA. I will keep in mind that the market may just whipsaw for 1-2 days.

Short at 1318 ES

I am assuming the top has already been made close to 1323 SPX or 1320 ES

Entry

Cup & handle projecting to 1323 SPX. This looks like a good level to short.

Ready to Short

I am ready to sell for the IT correction. I would first like to see the market move up for the first part of the session, implying that the early bears are giving up. I think the best time to short will be after the lunch, between 1316 and 1321 ES, but I will try to adapt to what the market gives me.

Shift

My conclusion from Ben Bernanke's recent speech and Q&A is that he thinks the recovery has become self sustained. I have mainly two reasons to believe that:

> He strongly suggested the US should pay attention to its fiscal situation in the near future. This means fiscal tightening and Mr. Bernanke would not suggest it so strongly if he did not believe in a continuing, self-sustained recovery.

> He made the point that GDP has started growing above the 2.5 % level, a fact that is expected to be positive for the employment rate.

This is a shift in expectations that was not previously evident.

Here is the link to speech and Q&A. Unfortunately, embedding the video resulted in some errors.

What does this mean for the markets?

I think this is going to negatively influence the stock market over the intermediate term. It will also be bullish for the dollar in the same time frame.

ST Trading: Out at 1303.5 ES

The market reversed and made a strong hourly close above the 7 h EMA and a cluster of 3 resistance levels.

ST Trading: Short at 1300.5 ES

Trade Plan

I think (and hope) the employment report is going to be good today. This might fire up a big rally that would kill the early bears (there are a lot of them) and offer a very low risk opportunity to sell.

I am ready to short any move at or above 1317 SPX, about 10 points above yesterday's close. As I said before, the highest the market can go short term is around 1320 SPX, with a high probability that it is going to touch that level.

Looking into the near future, I still expect negative surprises when it comes to the economic reports. I commented before on the expected path of retail sales and PMI. Here is another series that is near the top of its interval of variation and has already turned: the pace of change in real personal consumption expenditures on durable goods

The chart is from 1995 to today. I define the pace of change as the three month average of the monthly percent change.

For the ST Trading, my bias starting today is to short bigger rallies above the 7 h EMA, or after a strong close below it.

Hysteria

While thinking about the more important events in 2010, I realized that there were several hysteria among market participants. Here is how they were reflected by the covers of The Economist and how the markets behaved after that:

> February 2010: China Hysteria

- the cover

- the market: SSEC vs SPX

> April 2010: The US Recovery Hysteria:

- the cover

- the market

> June 2010: The Double-Dip Hysteria

- the cover

- the market

> July 2010: The Euro Default Hysteria

- the cover

- the market: EURUSD

> October 2010: The Weak USD and QE2 Hysteria

- the cover

-the market: USD Index

> December 2010: The 2nd Euro Default Hysteria

- the cover

- the market: EURUSD

Pretty good consistency! What's the next one? At the moment I think it is food price

inflation. Again, the timing seems great with the looming correction and economic

slowdown.

Timing the Top

The put/call ratio is finally starting to reflect the rally in the market:

The ratio has done a good job keeping me from shorting last week. Yesterday's spike suggests the market is finally ready to top. Additionally, since after the huge rally only 88 % of the volume was on the upside, yesterday qualifies as a capitulation day.

I think the next few days will be choppy with an upside bias leading to the employment report on Friday. The highest the market can go is 1320 SPX, obtained using the Fibonacci levels applied to the rally from September 2010:

Notice how the market tends to pause around the levels. Only the 61.8 level (the lowest yellow one) is matched by me at the highs of the first significant correction (around 1150).

My plan is to take an opportunity to go short for an IT correction after the employment report. Shorting before is risky since expectations are high. Being patient and selective is the best way I know to make money on the short side in a bull market.

For the ST Trading, my bias was long this week but there was no larger pull back to fade so I decided to stay on the sidelines.

Top Economic Activity

Very strong ISM report today. It is suggesting the recovery is more and more solid. Usually the bull market rises further over the years when the economy gives such a reading in PMI. Shorter term however, the market corrects as the good news is generally already factored in and as the economy slows down for a while. I think this time around will be no different.

The chart below shows the PMI values from 1981 to today:

Note: the dates are approximations

In the past, the current level was associated to tops in the PMI. I checked the SPX chart for each instance and every time a correction followed.

Outlook for ST Trading on Feb the 1st

Nothing much to say on the markets today. The put/call ratio is still oversold which would suggest going long, but after the big drop on Friday the market has only went up with almost no pull back. Since it usually drops fast at least once in the days following a big sell off, I expect to see this today.

Once such a pull back occurs, I am ready to go long for the short term, especially since the NFP this week might attract buyers.

I expect to see at least something like this on the daily chart:

SPX behavior in August 2009

Update: I cannot say that I expect the market to resemble the above given the probable big gap up today, but I think a 10 point drop would satisfy my expectation. This would mean a little lower than yesterday's close if the market opens around these levels.