The Week Ahead in Stocks: Sling Shot?

I have a general theory of markets that I have employed into my trading models. It is a rather simple theory and not to be confused with a major finding that has occurred before. Essentially, it is the rubber band theory. When the rubber band gets too stretched, it can break or shoot back in the opposite direction. In regards to a company, if it is the former, the company is going out of business. If it is the latter though, the given company is about to shoot higher, much quickly than many anticipate. Now with that said, I have a model that measures the market relative to itself of the past week. When it gets to a certain level, too high or too low, either the former occurs (rubber band breaks) or the latter breaks (major reflex rally). So as I looked at the scary markets Thursday night, I debated which way the S&P 500 was going to track: The former or the latter?

It appeared to the former for much of the trading session as the bears came out swinging around the 770 level. This kept a lid on the gains and the market, by extension the bulls, threw up their hands and sold their positions - and down the market went! All of a sudden, a new headline came across: Tim Geithner, new treasury secretary for President Elect Obama. Well, it was the best news the market could have at the time as the power vacuum, so quoted by the talking heads on CNBC, had now been filled. Sure, Geithner does not take power till the middle of January. However, since he is the head of the NY Fed (nice rhyme), he can almost begin acting as treasury secretary as soon as he wants. Thus the power vacuum disappears and the S&P, manages another big rally, after pushing the rubber band too far in one direction.

So the question is this: Is this another sustainable bounce....wait, we have not had a sustainable bounce so let's rephrase: Can the rally continue? Now before you bears jump all over me for being stupid and asking such a question, ask yourself this: With thanksgiving coming up, a period known as a time where many funds close up their books for the year, what do you think will be the trade? Well, my thinking is this: The bears who have made a killing in 2008, will cover any position that has made them a good deal of money - only to lock in their fee they charge to their clients. This will put upward pressure on anything that is over extended on the downside and conversely, anything that has rallied dramatically will be sold into to lock in the gain for the year.

With that said, I am basically playing this market with a tight stop. First and foremost, I like my long position, entered around the 750 level Friday. However, I am carrying a tight stop on the position as we again bounced from an overextended rubber band. This such occurrence last showed its ugly face on October 9th and a rally occur ed 2 trading days later. This time around, the selling never materialized on the 10th - only a rally - so the circumstances are slightly different but at the same time, argue that they might be different as the rally of this current bounce occurred on day 2. This could mean the shorts are more willing to cover at this which leads me to my conclusion: I believe the market is very oversold. My indicators have me long and I shall stay such. I am looking for a move back towards the the 850 level over the short term. I would look to add to this position via a stop though given the level of the futures post C News, the add appears unlikely.

Intermediate to Long Term
On Friday as the market tore away from the lows, on the back of the aforementioned, I lifted my long term shorts on the market and covered my longs on the bonds on a hunch that we would be able to defend the 2002 closing weekly levels. The close at 800 sort of counts as as successful defense. However, in order to prevent the long term bearish trade from retaking control, the S&P must begin to rally back over the 850 level in the next few weeks. To me this would count as a reversal off the lows. The major headwinds in the way: The BB model which favors the bears and the financial conditions index which actually turned down for four of five days last week, after rallying for a good month.

Thus overall, the charts argue for some bullishness over the intermediate term. Longer term, we need to see a few things reverse course: Financial conditions improve more dramatically, corporate earnings start to improve and viewed risk removed from the marketplace. Till those issues occur, 1000 might cap any rally for the next year or two.