Waiting on Weakness

 | Jan 27, 2012 | 8:58 AM EST
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"To be prepared is half the victory." --Miguel de Cervantes Saavedra

We have flat action in the early going as market players wonder whether a long-anticipated correction may finally be kicking in. The weak U.S. dollar is helping to hold the market up in the early going, but there isn't much news flow and most of the major earnings reports are now out.

The challenge has been a very common one over the last few years: to what degree do you anticipate weakness when the market has been steadily uptrending on diminishing volume and is obviously overbought? What makes it harder is that the move is so lopsided with virtually no weakness for weeks, so there's no real support. The dip-buyers keep coming and the bears, who keep anticipating a rollover, end up providing short-squeeze fuel for more upside.

The easiest mistake in this environment is not to stick with long positions that are acting well simply because you anticipate a correction in the broader market. My methodology is to take profits into strength, so I find myself holding more and more cash as the market uptrends without a break. The problem is that this sort of action does not keep producing a new supply of setups. Virtually everything becomes extended, and the only way to put cash to work and stay long is to be willing to chase.

One lesson I've learned is not to be aggressive trying to short the indices. It's very easy to start averaging in prematurely in hopes of catching a turn and then finding yourself deep underwater as the indices refuse to come in. It has generally been better to wait for weakness and then hope to catch some follow-through to the downside once it starts.

GDP data are hitting and are quite weak. That may explain why the Federal Reserve was so focused on low interest rates Tuesday, but it gives the bears a little more ammunition after the intraday reversal Thursday.

The fate of this market still lies with the dip-buyers, who have not given up easily. Normally, the dip-buyers have to be caught leaning the wrong way a couple of times before they start to doubt their strategy, but the change in mood can happen very fast and we have to be on guard.

I'm not at all averse to buying some new longs if I can find them, but I'm playing tighter defense and I'm going to protect gains zealously. I have a small index short on and I'll be looking for an add if the dip-buyers fail to mount another energetic bounce.

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