Lighten Up Into This Rally

 | Jan 10, 2012 | 3:30 PM EST
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Some people have a natural inclination to buy when the news looks good and the market appears headed higher. I have the opposite inclination. I sell rallies. When the market is popping, that's the only thing I do. I have never bought a share of anything in my life when it is going up; I only buy when it's getting hit.

That's not happening today, so I have been selling into the early pop. Of course, not all rallies are created equal: some rallies are better to sell into than others. This one isn't a perfect storm for selling but it's close, and here's why.

For starters, the Halloween Gap that I highlighted last week as resistance and a possible upside target at 1285 in the S&P 500 (SPX) has been filled. That marks the completion of that retracement pattern. The bullish part of that story is that the market blasted through that gap and went 11 points higher to the 1296.46 level. The bearish part of the story is that in the process of that sharp pop, some gaps were created in the cash averages and another island reversal was formed in the futures. That has pullback written all over it. In the SPX, the gap is at 1280.70. Yes, it actually shows up for a change, though not in the scope that it should.

SPX: Popping Through the Halloween Gap
Source: optionsXpress

Again, where you can really see what's going on is in the futures. We have to do some creative charting in order to show the island reversal formed this morning from the Halloween Gap in the futures, based on the now-expired December contract. Note that the island in the futures is 1279.75 to 1281 because the high last Tuesday was 1279.75 and the top of the Halloween gap was at 1281 (basis the December contract). That is now a downside target, just like the now-filled island from Jan. 3 at 1264.50 to 1273. Recall, that island was aborted during last Wednesday's pullback. The gap from 1252.50 is still partially intact, but that island is gone. If the pattern repeats, we can expect a pullback to abort this island at the 1279.75 level, but that holds above the gap at 1275.50, the bottom of today's orthodox gap.

S&P Futures: Another Island to Abort
Source: R.J. O'Brien Futures

Adding to the near-term bearish picture is the action in the Russell 2000, which, in all fairness, is having a good day today. In fact, the Russell 2000 has also easily filled its Halloween Gap at the 761 level. The issue here is that there is another resistance level just above the current highs. That area marks the Oct. 27 and Oct. 28 highs at the 769 level. A move above 770 is necessary to point higher. A failure to pop above that level will add to the significance of the resistance in that area.

Russell 2000: More Resistance Just Above Current Levels
Source: optionsXpress

Then there is the market's increasingly overbought condition. Monday, the McClellan Oscillator settled at an already overbought +112. At today's close, assuming the market holds its current gains, the oscillator will be quite overbought.

Then there is the sentiment outlook, which is worrisome from a contrarian standpoint. First, the American Association of Individual Investors has weighed in with a remarkably low reading of bearish sentiment. The latest data reveals only 17.2% of respondents are now bearish. Apparently, that's second only to the readings from late 2010. Similarly, the VIX just hit a new five-month low of 20.05 (shown below). In case you're wondering how all these investors can be so bullish after all the hand-wringing just a few weeks ago over Europe's never-ending debt woes and pending defaults, I've been wondering the same thing. For an answer, I refer to the brilliant musings of the great John Maynard Keynes, who, in his 1936 book entitled, The General Theory of Employment Interest and Money, wrote:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."

So the basic idea is that we are not just investing in what we think, but in what we think others will think and do, looking to take advantage of trends and the greater fool theory and all that.

Applying this to contrarian investing, the next step is to make judgments about what others will think and do. In this case, it's not because we want them to buy our stocks so that others will buy the same stocks in an infinite regression. Rather, we want to know what others will think so that we can bet against that thinking. Today, now that everyone is an amateur psychologist and familiar with sentiment data, maybe one reason for the extremes in bullishness is that everyone assumes that the other guy is bearish. In fact, maybe this also has an infinite-regress component to it. Maybe we are bearish because we assume the next guy is bullish because he bet on his neighbors being bearish, and so on. Infinitely. Thus, you have an infinite regress in contrary indications of sentiment. Maybe that's what's going on with all that supposed bullishness, and not much more.

VIX: Maybe It's Nothing More Than a Beauty Contest
Source: optionsXpress

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