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Good vs. Evil



So far so bad on the call for a retest of the recent highs. Just three short weeks ago, there were many proclaiming the kickoff of the new bull market and some felt foolish for looking for a pull back when for the first time in recent memory, everyone had enthusiasm again. Yes - the Evil Tony was playing his hand looking for the correction of the seven-week rally. On the other shoulder, the Good Tony continued to expect that any pullback would be brief and limited because momentum was strong and the seasonal and structural factors were still in favor of stocks.

All said, since that call for a correction I have tried to outline how the vast majority of rally was behind investors as the market moved from the lovely perception trade where many are caught short and need to buy on a dip, to the twilight zone trade where supply and demand are more in equilibrium. That basically means that short-term momentum fluctuates while intermediate-term momentum wanes. The twilight zone trade sets up the opposite of the perception trade, which is the reality trade where many are caught long and need to sell on a bounce.

Clearly, the market has been weaker than I would have thought over the past few days. While I continue to believe the vast majority of the rally is behind investors for the foreseeable future, I have been expecting a retest of the recent highs over the coming weeks. So far that obviously hasn't taken place - yet. Nothing yesterday happened to change that view because again it isn't based on fundamental factors. In trading or investing it is important not to rationalize a past and current view with new news. For example, I expect an oversold bounce, but to say that I do because Oracle (ORCL) had better fundamental news would be a mistake. I have contended that the markets action since the low in October has not been based on fundamentals, so to use a fundamental data point now would be a justification for my position vs. a reason to be in a position - that shouldn't change and when the reasons change so should the position.

My reasons for believing the vast majority of the gains are behind us hasn't changed in the past three weeks - the weekly stochastic indicators for the S&P 500 (SPX) and NASDAQ Composite (NAZ) have become overbought in the context of a downtrend and have lost momentum (exhibits 1&2).

Exhibit 1 - The SPX remains in downtrend and has lost momentum

Exhibit 2 - The NAZ is in the same intermediate-term position

My reason for expecting an oversold bounce hasn't changed either. The mood has become somber again, the longs are scared (especially new ones) and the time to sell was when the SPX and NAZ were overbought three weeks ago, not when they are oversold as they are now.

Exhibit 3 - Selling on optimism makes more sense than on pessimism.

Exhibit 4 - The NAZ is pretty oversold

Source of charts is Baseline, Inc.

The point is that I still expect a bounce, but how people act on and react to it depends on your time frame and risk tolerance. If one is aggressive, buying in anticipation of it (painful so far over last few days) with the ability to sell quickly (right or wrong) may make sense (the Good Tony). For those who more conservative are likely still overexposed to equities and wish they never heard of a stock two months ago, may use any bounce as an opportunity to lighten the load (mental and financial) (the Evil Tony).

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Check out those new charts - pretty snazy Casey!
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