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Twilight zone trade to reality trade



I believe after an important intermediate-term low is reached (October 2002) there are three stages that follow. The first stage is the perception trade, which accompanies a market spike because there are no sellers left and the dominant psychology becomes "it can't get any worse so it therefore must get better. " Once the market becomes deeply overbought from both the short and intermediate-term standpoint, it enters the twilight zone, which refers to a trading range period where both positive and negative arguments are compelling and the market gets whipped around based on the near-term psychology and indicators. I had defined the near-term trading range on the S&P 500 (SPX) as 875-945. That range has been broken giving way to the final stage after an important low is in place.

The last part of the move after the intermediate-term low is the reality trade. This is the period that could be either negative or positive, depending how the fundamental and technical backdrop progress while in the twilight zone. The fundamental issues haven't improved as much as many would have hoped and the technical landscape has deteriorated:

· Near-term trading range support levels have been broken. In addition, in the context of the current bear market, once an important support level is broken - the first oversold reading should not be used as a buy indicator because initial levels of oversold has led to a more prolonged period of oversold (Exhibit 1).

· Consolidation period outlined on the two-year chart looks like it has been resolved to the downside and looks a lot like last years six-month consolidation pattern that was also resolved to the downside (Exhibit 2).

· The intermediate-term picture for the SPX and NASDAQ Composite (NAZ) continue to argue for caution as downtrend remains firmly in place as momentum continues to wane (Exhibit 3&4). Since the market became overbought and turned in late December, the best-case scenario in the context of a bear market trend is for a trading range environment where time relieves the overbought condition vs. rapid price deterioration. Clearly, breaking the near-term range makes the best-case scenario rather unlikely.

The problem with a trading range is that you only know it is broken once it is broken on a close. While I thought that support would hold, clearly it didn't and that can't be ignored because there are very few signs of fundamental, valuation and geo-political improvement since the trading range began - hence the term reality trade.

I would like to mention that this is a very unique environment and would not recommend taking an aggressive stance until there is a good enough reason to believe an extreme enough level has been reached. From any vantage point, I don't see that level quite yet. Friday, I suggested that the market was reaching the bottom of the near-term range and could provide an opportunity for a trade back to the upper end of the range. Once the range was broken on the close, support now becomes resistance and waiting for a turn is more important that predicting it absent any real evidence.

Exhibit 1 - SPX support was broken and oversold can become more oversold.

Exhibit 2 - Consolidation pattern appears to have been resolved to downside.

Exhibit 3 - SPX intermediate-term picture continues to urge caution.

Exhibit 4 - Not much better for the NAZ

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