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Recent Market Action Means Consolidation Is Coming

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There's no doubt that the majority of stocks are in solid technical shape, but a lot of them have made some really big moves lately and will inevitably take a rest.

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Well, I have to say that the bulls did an exceptional job last week. A big move out of that lateral channel the previous week left the indices extended to the upside and up against significant lateral resistance at the November highs. But while a sell-the-news reaction to a big gap higher after the Bush-era tax cut extension was announced, stocks just continued to chug higher.

To say that we've had a very complacent environment recently would be an understatement. The dismal jobs number, continuing debt problems in Europe, and the ever-present threat of further efforts out of China to cool off their economy have apparently been forgotten. Indeed, it seems that the only concern over the past several days has been being left behind.

Under the surface, traders have taken this contented attitude to heart, shifting their focus day to day to and from whatever seems to be running that day. Eastman Kodak (EK), Lululemon Athletica (LULU), AIG (AIG), Synergetics USA (SURG), Sunrise Senior Living (SRZ), China Shen Zhou Mining & Resources (SHZ), Korn/Ferry International (KFY), LoJack (LOJN), Taser International (TASR) are just a small sampling of names that have given day traders outstanding opportunities to knock out quick gains. They've also been extremely active in a couple of recent China IPOs, including SemiLEDs Corp (LEDS), Youku.com (YOKU) and E-commerce China Dangdang (DANG).

One result of this slow-motion melt-up, however, has been that the S&P 500 has developed a high-rising flag. A lot of that has been the result of some encouraging sector rotation, and investors shifted their attention from the resource sectors to the financials, but it's a pattern that we need to pay very close attention to. Ideally, the market would have a more lateral bent to work off its overbought conditions. Sometimes this pattern is followed by the market hitting a nasty air pocket, and it's hard not to wonder if market players are just waiting for some convenient excuse that will result in stocks working off their overbought conditions in a not-so-pleasant manner.

The point here is that it's easy to be wary about something coming along to let the air out of the bulls' tires, but don't be too quick to discount the persistent nature of this type of move. From a purely technical standpoint, the action over the past few days has dramatically reduced the odds of the bulls making a lot more progress without some sort of consolidation. Regardless of how it occurs, a review of the charts over the weekend shows a huge number of stocks that are exceedingly stretched to the upside. There's no doubt that the majority of stocks are in solid technical shape, but a lot of them have made some really big moves lately and will inevitably take a rest -- some more vigorously than others.

The way to play this, of course, is to keep trading smaller and smaller. Reduce position size, raise stops quickly to protect gains, and hit the eject button if something isn't acting right. Above all, though, don't try to anticipate a top. This action can't last forever, but trying to guess when it will end is an exercise in futility.

We have another gap higher to contend with this morning. Lately, gaps have been faded, but those initial pullbacks have sucked in dip buyers and left the bears out in the cold. We'll see if that pattern continues, but while there are plenty of negatives to consider, right now they simply don't matter.

Steve Smith's OptionSmith portfolio is +40% in 2010. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.
No positions in stocks mentioned.
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