Let the Buyers Beware

 | Oct 27, 2011 | 5:45 PM EDT
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The EU debt crisis is under control. Apparently, Germany and the other big EU countries aren't going to let Greece drag them into a black hole. It must be time to buy stocks now that they are back to four-month highs and in the black again for 2011.

I don't think so.

The time to buy stocks was actually a few weeks ago when the picture wasn't so upbeat amid all the hand wringing about the end of the EU, the coming Greek default and impending doom for the U.S. -- including the now-forgotten recession. That was the time to buy stocks.

Or maybe the time was Wednesday, when the S&P 500 sold off 35 points to its previous 50% retracement at 1222. But now? Again, I don't think so. That is, unless you like buying tops (and I really don't). In fact, I'd rather miss a move altogether than be accused of buying a top. I'll leave that for the guys who get excited about every upbeat headline and buy 30-point, gap-up openings on the S&P 500. That's not me.

As you might have guessed by now, I am selling into this pop. Will the market go higher? It probably will -- but not by much without an intervening pullback over the next few sessions. I came into the session net long in all of my accounts up to 40% levels at Rydex. I'm also short bonds and long junk bond funds. All that stuff is moving in my direction today.

The bond market (not junk, just Treasuries) was smacked a bit today by asset allocation models that use proceeds from bonds to help drive stocks higher. That also works for me. But I'm not buying anything to add to bullish bets. I'm just looking at ways to unwind bullish positions, which is easier said than done since I hold a bunch of ratio spreads. I'm long in-the-money SPDR S&P 500 (SPY) November $121 calls and short a bunch of out-of-the-money November $128 calls and December $132 calls. Getting out of these isn't the easiest thing on a day like today. Nevertheless, that's what I am trying to do.

Giving me some confidence that a good dip might be just around the corner are some of the usual things that I look for, like the collapse in the Volatility Index (VIX) to multi-month lows, which has the usual crowd falling all over one another to see who can buy the top tick. Then there's the McClellan Oscillator, which was already overbought Wednesday as it settled at an already frothy +205. Today should be at one of the most overbought levels of the year, no doubt north of +300.

VIX: Today's new low at 24.70 isn't bullish for the near term.
Source: optionsXpress

Of course, there are many superlatives being tossed around about this move. Apparently, this is the biggest monthly gain in the S&P 500 since January 1987. On CNBC, they must think that's a good thing. Recall that a few months later in 1987 we had that thing called the Crash.  And so it goes. The market has been on a tear, so the thinking goes that it must keep going higher. Maybe so, ultimately, but over the next few sessions, I doubt it.

I am likely to take profits in my remaining SPX positions but continue to hold modest positions in the Dow, Russell 2000, Emerging Markets, Junk Bonds and my short positions in the treasury market.

Another reason I suspect a pullback is not far away is the massive gaps left this morning. The gap in the Russell 2000 is a case in point. Today's enormous gap at 727 to 739 is a huge target for a pullback. It's very rare for a gap of this magnitude to remain intact for very long. Granted, on the bullish side of the equation, there is today's bullish island reversal (below), which points higher. But how much higher? Not far above current levels is the .618 level at 766.63. That might be a good spot to sell into.

Russell 2000: Closing in on its .618 retracement.
Source: optionsXpress

Then there is the S&P 500 with its upside target at the Aug. 2 gap. That one occurs at 1286.94 in the cash. Also not far away.

SPX: Heading for its Aug. 2 gap.
Source: optionsXpress

Speaking of the S&P 500, recall that in Tuesday's column I said I would add to bullish positions on a pullback to the 50% retracement level at 1222.67. Hopefully, you noticed that yesterday's pullback bottomed about 1.5 points below that level at 1221. Apparently it just needed to pull back to the 50% level after tagging (almost tagging) its .618 level at 1257.58. That, by the way, is now support. I will be looking for a pullback to that 1257 level at a minimum.

SPX: The prior high at the .618 retracement is now support.
Source: optionsXpress

Finally, the euro is front and center in all of this. Its Fibonacci .618 retracement level weighs in at the 1.424 level (in the December futures). That is only 3/1000 from the current high of 1.421 (that current high is not shown in the chart below from earlier today). That warns of a top in the market because when the bloom comes off this rose and the euro begins to back off, the greenback will bounce and that will be the end of this rally.  

Euro: Popping up to its .618 retracement.
Source: optionsXpress



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