Navigating the Road Ahead

 | Nov 18, 2011 | 8:55 AM EST  | Comments
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"A stumble may prevent a fall." --English Proverb

Once again, after a very ugly day on European worries, we are gapping up strongly on news that some new European solution has occurred. This morning the news is that the European Central Bank is buying sovereign debt of "peripheral countries," which is driving up bonds and supporting the Euro.

The actual news driving this action is irrelevant. Psychology and emotion are what's important from a trading perspective. The fact that we consistently come back so quickly after being hit hard by worries is evidence that market players are underinvested and worried about missing out. Buyers tend to rush back in at the first sign of anything positive since so many are lacking long exposure. This causes the bounces to be big and quick and leaves many underinvested bulls on the sidelines.

While the pattern of selloffs on some new worries and then quick recoveries on new headlines is quite obvious, that doesn't make it easy to trade. If you are disciplined and use stops, it was very hard to avoid making sales on a day like yesterday, when we broke down so hard. Even if we have been leaning bullish lately, as I have, disciplined trading requires that you take some defensive steps when we start to fall like we have the last two days.

Rather than dwell on that, set aside the frustration of being jerked around by Europe every day and contemplate the overall market trend from here.

Much has been made of the triangular pattern that has formed in the indices over the last few weeks. Many are now saying that after two weak days that pattern is being resolved to the downside and that we should anticipate the downtrend to gain momentum.

I look at the situation a bit differently. First, the move to the downside hasn't gone far enough yet to do major technical damage. We did fall out of the area of congestion, which will serve as overhead resistance now, but we are still above the 50-day simple moving average of the S&P 500, and at the upper-end of the trading range that was in place for so long. I don't like seeing us below 1220, but at the open this morning, we won't be any longer. The next big step is to regain the 1250 level, which is going to require some effort.

A second thing to keep in mind is that the consolidation pattern in the indices was so well recognized that it is an ideal setup for a fake-out. When you have a big crowd trying to anticipate which way we will break, we will often see the initial move reverse because too many people embrace it too fast and are suddenly out of position when it doesn't gain further traction.

The breakdown yesterday likely attracted some aggressive bears who are looking for downside momentum to build. The bounce this morning is going to cause them to reassess, especially if it the bounce doesn't fail right away. If the bulls hold and start pushing back up, all those newly minted bears will have to reverse their positions and add to the upside pressure. Before you know it, we have a fake breakdown and the hunt for long exposure begins anew.

My thinking lately has been that downside should be contained because there is a big supply of underinvested market players who are anxious to rack up some relative performance into the end of the year. Those folks are going to feel some anxiety again on the quick reversal this morning. It took real guts to buy into the teeth of the decline yesterday, and those who didn't are now going to be worried about missing out on a quick recovery.

It definitely is a challenging market to navigate. Not only do we constantly have to deal with news out Europe, but we have some very strong emotions in play that quickly jerk us around as we navigate the news flow.

We'll see how well the bulls do at regaining upside traction this morning. The key will be the level of buying on the first pullback following the open. If the dip buyers are still hungry, they should provide quick support.

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