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Three Things Have to Happen for the Market to Overwhelm the Profit Takers


Profit takers want to move in. Here's what could stand in their way.

The first quarter of 2012 was a great quarter for the markets. The S&P 500 (SPY) was up 12%, which was its best first quarter since 1998. Recent history tells us that a quarter like this is most often followed by another positive quarter. But then why the frequent market downdrafts of late?

The market has a mind of its own. The recent market gyrations seem to be biased downward – potentially indicating a market that wants to go down. It looks and feels a lot like profit taking. After a quarter like the last one (and with the December quarter up 11% also), it shouldn't surprise anyone that profit takers want to move in.

So what is it going to take to see the market overwhelm the profit takers and make some hay here? I think three things have to happen:
  1. Earnings season has to be an unmitigated success. No equivocating. Earnings need to be strong.
  2. Economic indicators need to continue their trend of being steady and positive. These don't have to be fantastic – just steady.
  3. Europe has to muddle along – and avoid the proverbial "you-know-what the bed" scenario.
Remember that profit taking is a strong market force. For it to get overwhelmed, we really need all three of these things to happen. The S&P 500 will not start a run for $1450 or $1500 without these three things occurring.

When I look at these three, No. 1 still has some potential but it is not locked in yet. Earnings have been solid but not spectacular. As of Friday, about one-fifth of S&P companies had reported and 80% beat Wall Street forecasts, according to Howard Silverblatt, the senior index analyst at S&P. But it is still too early to declare a victory here. Apple's (AAPL) earnings this week will be a big part of measuring No. 1 -- and will influence this market no matter what.

As for No. 2, the economic indicators have continued to be solid. We just want to see positive measures. We don't need to see big positive surprises. In fact, the measures could be negative if they are within the expected fluctuation for that measure. We had a positive confidence measure this morning: the confidence index inside the equipment finance industry rose from 61.7 in March to 62.1 in April. Not spectacular – just solid and in the right direction.

As of this morning, No. 3 still seems to be the biggest weight on the market. European elections fuel uncertainty, and ambiguity is never good for the markets. Also, the Dutch government is facing a financial collapse. Its government could not agree on austerity measures. This is a supposedly AAA-rated government, but you can smell the downgrade right around the corner. Europe is not helping matters here in the US, thus giving more fuel to the profit takers that are looking for an excuse.

So expect the market to continue to test some new lower levels here over the next few months. For me, it looks like an opportunity to sell some out-of-the-money puts in the stocks or ETFs you like. Sell the near month put options close to the current market price. You might get triggered in to ownership at an even lower price if the market pull back continues. If it doesn't, then you made a small tidy profit in just a month.

Editor's Note: For more from Wayne Ferbert, go to Buy & Hedge ETF Strategies.
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No positions in stocks mentioned.
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