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Should You Chase this Rally?

Jan 03, 2013
Chad Karnes, CMT

The markets rallied over 4% on 12/31 and 1/2. Is now the time to chase this rally? We see many reasons to not trust this market's continued advance.

The market is up over 4% in as many days and it looks like the Fiscal Cliff worries are behind us!  Rally Hats on!  At least that is how the media justified the rallies surrounding this New Years.  A few of the many enthusiastic headlines are below:

"Wall Street ends 2012 riding high on “cliff” deal optimism – Reuters

“Stocks rally on hopes Congress might act” – CNN Money

"Global Stocks Rally Over U.S. Cliff Deal" -  Wall Street Journal

This sounds all good and dandy, but optimism and hope are not appropriate investment strategies. Are global markets including Brazil (NYSEARCA:EWZ), Austria (NYSEARCA:EWO), and Hong Kong (NYSEARCA:EWH) really rallying because of the U.S.'s Fiscal Cliff?  Tell me again how fundamentally the corporations there will be affected by it?

It's not a fundamentals driven rally and hasn't been for awhile.  We know this because the overnight derivatives futures market, as opposed to the cash market, is the tail that continues to wag this dog.  We must therefore turn to other data beyond fundamentals to help guide us.

Fool Me Once, Shame On You

Doing a simple Google search for news headlines the week leading up to Christmas reveals that stocks indeed also rallied that week because of “Fiscal Cliff Hopes”.

There is just one problem with this. The Dow (NYSEARCA:DIA) was very near its monthly highs of 13,365 at the time.  Today, even after the 12/31 “Fiscal Cliff Rally” and the 1/2 "Fiscal Cliff Can Kicking Rally", the Dow (NYSEARCA:DDM) is once again at that level.  Buying then on Fiscal Cliff hopes would have put you through a lot of pain before just now getting back to even.

The media it seems can find any reason in the world for a rally, a decline, or even a flat day - anything to get your attention and to generate noise. 

We prefer a different approach that focuses on data instead of rhetoric when it comes to investing, and that data is warning us not to chase this rally here.

Warning Sign One – Sentiment Extremes

The media's justifications for why the market rises or falls are always after the fact and not based on anything more than rhetoric and possibly even self interest. The good news is we can actually use it as one of many available sentiment gauges to help us make more informed decisions.  Bullishness abounds in the news, but uber-bullishness is a warning sign (have I mentioned that 10 out of 10 Wall Street Strategists are projecting a market rise in 2013?)

Analyzing investor surveys also allows identification of sentiment levels that are more likely associated with tops or bottoms.

Sentiment surveys are lagging in nature, meaning they reveal information that has already been acted upon, and actually is the reason they are reliable. 

When a survey participant is asked if they are bullish or bearish, they have likely already acted accordingly.  When survey participants are uber-bullish they have already purchased long positions and there is less money available to chase rallies and drive prices higher.

Right now many signs of sentiment are revealing market participants are as bullish (and long) as they were at the 9/12, the 4/12, and even the 7/11 market tops. 

This is typically bearish because it means they have already gone “all in long”.  Who is left to buy and continue to drive prices higher?

Warning Sign Two – Show me the Money

Another data point that the market is likely closer to a top than a bottom is the CFTC’s (Commodity Futures Trading Commission) Commitment of Traders report.  The agency requires futures traders to register as either speculators or hedgers.  Historically, speculators eventually lose and hedgers eventually win.

The hedgers therefore are the “smart” money and following whether they are long or short can help keep you on the right side of the market.

Right now hedgers are excessively short.  In fact hedgers are so short, they are at levels last seen only at the 9/12, 7/11, 10/08, and 2007 market tops.  This is a big bearish warning sign.

Warning Sign Three – Technical Break Downs

In our published ETF Profit Strategy Newsletter, back on 9/21 we identified the importance of 1430 and why if it fails a near term top is likely in.  “We will be waiting for prices to drop back below the Fed low of 1430 to give us a signal that the top is likely in”

On 10/19 in the next month's ETF Profit Strategy Newsletter we again alerted readers, “We are waiting for prices to maintain below the Fed Support Zone @ 1430 to give us a signal an intermediate top is likely in”.

On Tuesday, 10/23, prices breached that level eventually bottoming out at 1343 (NYSEARCA:SPY) in November where we identified a profit taking opportunity as well as a buying opportunity on 11/16 in our Technical Forecast.

“A break out (of the downtrend channel) likely means the decline is over for now and prices will work their way back to the Fibonacci retracement levels (1390-1418).  A rising 60 minute RSI lends strength to this option.  This is the scenario I think will happen given the seasonally strong days surrounding Thanksgiving and the overall historical biases.”  Price indeed broke out of the channel and reached 1410 on 11/23, a 50 point rally in a week that eventually capped out at 1448 (NYSEARCA:SSO) on 12/19.

More than two months later on 12/31 the S&P (NYSEARCA:UPRO) closed the year at 1426 and down from the September Fed driven rally high of 1475.  After the deal rally on 1/2, the S&P even still is below its yearly high of 1475 with little sentiment support to drive it higher.

Now that the Fiscal Cliff worries are "behind" us, why then is the market still not higher than it was at its September peak?

Today’s Technical Backdrop

The following chart accompanied the Technical Forecast on 12/30.


Along with this commentary, “The potential remains for another rally back into the Fibonacci zone on Monday before a resumption of the downtrend.  If this is the case then price should peak above 1420 one more time (1424 is the R2 Pivot tomorrow).  Therefore very aggressive traders can buy a trendline breakout at 1414 (in red in above chart) Monday morning.”

This indeed occurred on 12/31 as the sharp snapback “Fiscal Cliff” rallies provided a buying opportunity at 1414, taking prices beyond the Fibonacci levels and back to 1454 on 1/2 for a quick 3%.

Keep in mind that this is all on the back of already extremely bullish sentiment and no doubt those surveys will get even more extremely bullish with the recent rallies. 

For the S&P, 1398 remains a key support that bulls must hold.  If it fails, there would then be only one level left to keep the intermediate trend from turning officially down and increasing the likelihood prices fall below 1343.

Combining the technical picture with the overall extremely bullish sentiment and smart money shorts, we feel the odds that the market sees 1398 again are higher than the odds the rally will continue.

The ETF Profit Strategy Newsletter uses common sense technical analysis combined with sentiment and fundamentals to provide a short, mid, and long-term forecast along with actionable buy/sell and target recommendations.

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