Why We Felt Comfortable "Clicking Down", Opening More Bull Put Credit Spreads and Bringing in Additional Premium During the Market Correction in May 2010

As the market pulled back hard over a 13 day period starting on May 6th, we felt comfortable to move in reserve cash and "stay ahead of the wave" by clicking down our strike prices and opening more bull put credit spreads to bring in additional premium.  We felt comfortable in doing this because the US economy, along with corporate earnings are expanding, not contracting as they were in 2008.  Below are snippets of the advisories that we sent out during the correction as we made the case that a bottom was forming and that we were not in a bear market.  For more on "staying ahead of the wave" strategy, please visit the Learning Center and read entries #12 and #13 - "What if the market surges, how do we protect ourselves?  and "What if the market drops, how do we protect ourselves?"

On the contrary, though, if the economy were deteriorating as it was from early 2008, (And we watch the macroeconomic data on a weekly basis) we would not have recommended to "stay ahead of the wave" by clicking down and opening more bull put spreads since the market could be posturing for a much larger fall, as it did in October 2008. 

Wednesday, June 2, 2010 (10:30 AM ET)

The market was stable through most of the day yesterday and then sold off in the last 30 minutes.  Sentiment remains extremely negative and just about all news, even if it's good, is being spun negatively.  The next big piece of news will be the jobs report that comes out this Friday.  Economists are expecting the US economy to add 450,000 jobs, and let's cross our fingers that the number hits or exceeds expectations....and then we'll see how the markets react.

Below is the DOW.   So far, it's holding above 9900, which is good.  Right now the market is trying to find a bottom, and as long as the DOW holds above 9900 the market should start to trend UP from here.

Below is the SPY.  So far, it's hanging tough and attempting to find a bottom.  As long as it holds above 106, what we are seeing today should represent the bottom of this correction. 

The Qs shown below is still above the Feb low and is holding above the 200 day SMA, which is demonstrating reasonable strength.

Below is the IWM.  It had a nasty sell off today in the last 30 minutes of trade, possibly starting a trend where investors are now trimming unnecessary small cap exposure out of their portfolios.  We'll need to watch this for a few more days to see if this is the case.  So far, the IWM is holding above the Sep/Oct highs and above the 200 day SMA, which is good.

The volume-based and advance/decline line charts are not providing any new information from yesterday's advisory, and right now they are choppy.  Thus, we are not showing any of them here.

Per the underlying health of the US economy, the ISM index came in today beating expectations and reinforcing the fact that manufacturing within the US continues to expand.

Construction Spending came in strong today blowing out consensus.  Even after digging into the report in more detail, the numbers looked good according to the Briefing.com analyst.

Below are sentiment indicators from a service called Sentimentrader.com.   This service monitors  "smart money" and "dumb money" types of sentiment indicators, consolidates them and then looks for extremes, which usually predicts when the market will make a trend reversal.  We'll talk more about the components later, but we'll throw a few things out here. 

Per the different categories that they monitor, most categories are showing extremes which signal an upcoming bottom and trend reversal to the up-side.  All charts below are intermediate-term at 1 to 3 months out.  The short term prognosis of 1 to 5 days is neutral.

Most of the intermediate-term sentiment indicators shown below are in the bullish territory. (near the green line)

Below is a list of most of the sentiment based indicators that they follow and we can see that all of them are at extremes putting them in the "Bullish for Market" column.  We'll talk more about all of these components later.  If you wish to understand some of them now, please visit sentimentrader.com.

Are we in a bear market?  In the big picture, no, we're in a 10% to 15% correction that is healthy for the markets after a strong run-up. Could the market go lower in short term?  Yes, and we wouldn't be surprised if the major indexes re-test the recent lows.  However, the 17/43 EMAs on the weekly chart do a good job of keeping us in during bull markets and out during bear markets and currently we are in a long term bull market.  At the present, we are in a correction, but because the world economies are now expanding there is a high probability that we'll continue to remain in a long-term bull market.

Conclusion:  We are getting close to a bottom.  However, we wouldn't be surprised if the markets re-test the lows one more time before reversing trend back to the up-side.

Monday, May 31, 2010

The market continues to be choppy and volatility remains elevated.  From the analysis that we show below we believe that the market is bottoming out, but more time is needed to confirm this.  We look at the volume and advance/decline based analysis in more detail below to help us determine when a trend reversal will be coming.

Below are the charts.  As we can see from the daily DOW chart shown below, the market corrected almost 15%.  Technicians are pleased since this was the % decline that they were looking for to deem the market "healthy".  We are now probably going through the bottoming process, so we'll just have to give the market more time to confirm this.  Because the 9900 level was already penetrated 3 times, noting the long shadows on 3 recent candlesticks, there is a good chance that this is the bottom.  In order to give us the best prediction if we are at the bottom we don't rely on the traditional price based indicators, but rely more on volume and advance/decline based indicators that is covered below.  In addition to volume and advance/decline based indicators sooner or later giving us a "go long" trigger, we would also want to see the 8 day EMA cross above the 22 day EMA, giving us further confirmation that a new UP trend is in place.  Right now the 8 day EMA is still below the 22 day EMA, which continues to confirm a DOWN trend.  Per downside potential, the 9900 level so far has held as support, representing the February low.  Because corporate earnings and the economy continue to grow, and assuming that the European mess won't impact US earnings too much, we believe there is a low probability that investors/traders will let the DOW stay below the 200 day SMA too much longer and they will drive the DOW back above the 200 day line.  If investors keep the DOW below the 200 day SMA, then this will be a concern and we'll need to reevaluate our analysis.

Below is the daily chart of the SPY, an ETF that tracks at 1/10th the value of the S&P 500 index - SPX.  Like the DOW, it is currently below the 200 day SMA, and investors recently sold when the index attempted to overtake the 200 day line.  We need to watch this a little longer to see if the SPY can overtake the 200 day line.  If it doesn't then we will need to reevaluate our analysis and this will be bearish.  In general, the big caps are getting hit hard since 30% to 50% of their revenues come from overseas, and European countries represent a reasonable % of their overseas revenue.  A trend reversal will possibly be confirmed when the 8 day EMA crosses back above the 22 day EMA.  Per downside potential, so far the 106 level has held as support three times, representing the Feb low.  Because this level was already tested three times, there is a good chance that we are going through a bottoming process.

Below is the daily chart for the Q's, an ETF that tracks at 1/40th of the NASDAQ 100 Index - NDX.   The Q's is now back above its 200 day SMA, which is good news for this index and for the market overall.   The next big hurdle will be the 46.5 level, representing the Jan high and the 100 day SMA.  If/when the Qs overtake the 46.5 level, this will be bullish for the Q's, and it will help the overall market.

Below is the daily IWM, which is an ETF that tracks at 1/10th of the Russell 2000 index - RUT.  Like the Q's, the IWM also held above the 200 day SMA, which is good.  Moreover, the IWM is back above the Jan high, telling us that there is a good probability that this index has bottomed.  The small caps are showing more strength than the large caps since most of the small cap's revenues come from the US, thus having less exposure to Europe.

Macro-Level, Fundamental View of US Economy's Underlying Health

Below are a selection of macro-economic indicators to give us a big-picture, fundamental view of the health of the US economy.  If/when the US economy begins to weaken we'll be able to monitor the gradual deterioration of the economy and this information will help us:  1) reduce our downside exposure by opening fewer bull put spreads; 2) trigger us to open a long term hedge to protect our bull put spreads; 3) alert us to possibly start opening bearish directional trades; and 4) tell us when it's time to move to the sidelines. 

Implied Volatility on the S&P 500 Index (VIX) -  We watch implied volatility (IV), also known as the "fear index", on the S&P 500 Index to help us gauge investor sentiment and to give us an indication of the strength of the prevailing trend, if there is one.  Moreover, if the VIX starts to climb, especially if the health of the US economy is gradually deteriorating, it could be a warning that a major storm is coming and that we might want to consider closing our bull put spreads and move to the sidelines.  Regarding the prevailing trend of the market, if the VIX drops far and fast in just a few days, for example where it moves 1 or 1.5 std. deviations in a short period of time, this is an indication that the trend could be strong and last a while.

Conclusion for IV on the S&P 500 Index:   IV climbed to levels not seen in Feb/March of 2009.  The European debt crises definitely sent shock waves around the world.  It doesn't help that this most recent negative catalyst hit when the US market was overextended and ripe for a pull-back, so this is why the market pulled back so hard.  We need to watch the market a little longer to find out if this is the bottom.

The Chicago Purchasing Managers Index that measures economic activity in the Midwest region pulled back a little in May but is still solidly above 50 telling us that economic activity in this region continues to expand.

Personal Income came in last week rising 0.4%, achieving consensus, and showing that income for US workers is gradually increasing.  As income rises, people will spend more.  However, personal spending disappointed and was down, and month over month it came in flat.  Personal spending is important because 2/3rds of GDP comes from consumer spending.

Personal Consumption Expenditure Inflation, which is one measure of inflation, matched consensus at 1.2% year over year growth, telling us that inflation is low and the Federal Reserve will be in no hurry to raise interest rates.  The Fed's targeted range for this indicator is 1.5% to 2.0%.

The 2nd estimate of Q110 gross domestic product (GDP) came in weaker than expected dropping 0.2% down to 3.0% growth.  Overall, the recession is over and the economy is growing, but it's growing slowly.

Durable Goods less Defense and Aircraft continue to rebound telling us that businesses are spending again and investing in capital equipment.   However, when completely stripping out all transportation related orders, the "general" durable goods number was down 1%, missing consensus by a wide margin.  Overall, the trend is UP, but we could see some intermediate term choppiness and a pull back in general durable orders, especially through the Summer.

The S&P/Case Shiller National Price Index came in last week and showed that on a year to year basis (dotted line) 7 of 20 markets covered by the report were either flat or increased in value, which is good news.  Per the negative view, 13 of the 20 markets declined in value over the last year, so it looks like we are not quite out of the woods.  Note the US National Housing Price Index (solid line) - it shows that home prices increased for 18 consecutive years peaking at 189, and then reversed in 2006 pulling back to 133, representing a 30% correction. 

Even though that home prices seem to be stabilizing, "months of inventory" for existing for-sale homes is still high near 8.5 months, telling us that it would take 8.5 months to sell all existing for-sale homes that are currently on the market.  This is going to remain high for a while because each month additional foreclosures hit the market increasing the number of existing for-sale homes.

Conclusion from the Macro-level Fundamental View of US Economy's Health - The macro economic data show, along with solid Q110 earnings results, that the US economy continues to grow, but we could see a intermediate-term slowdown in growth.  Regardless of the shorter-term weakness in the macroeconomic data, and barring a total collapse of Europe, we believe that the indices will stabilize above their 200 day SMAs and start to gradually trend UP and/or trade sideways through the Summer.

Intermediate-term (2 to 8 weeks) Sentiment-driven Trend & Trend Reversal Analysis to Help Time our Entries and Exits

Below are a selection of Volume and Advance/Decline-based indicators to help us gauge the prevailing trend, where the trend is primarily driven by sentiment, and to predict the timing of an upcoming trend reversal.

The Big Picture from Investors Business Daily (IBD) -  IBD continues to maintain a "market in correction" rating.  In addition to counting the number of accumulation and distribution days, the IBD analysts monitor the behavior of the "IBD top rated 100 stocks" and this provides them insight into the current trend and possible trend reversals.  Per the behavior of their top rated stocks, in the last week these stocks held solid, which is an early signal that we are probably at a bottom with this recent 15% correction.

Volume and Advance/Decline based indicators -  Below is the 1.5 year chart with 1 day volume bars on the S&P 500 index.  The main SBV Oscillator and the accompanying oscillators are improving and as a whole will probably signal to "go long" in the next 5 to 7 trading days, as long as the market holds somewhat steady.  The S&P 500 index is a good index to monitor since it is a proxy for the entire US stock market.  As we show to the right of the chart, the oscillators are mixed where some are bullish and others are bearish.  In addition to the below volume and A/D based indicators, we will need to see a bullish crossover on the 8/22 day EMA on either the DOW or S&P 500 index to further confirm a new UP trend, and so far the 8/22 day EMA's on both of these indexes, as shown above in the charts, is telling us to "stay short".   For more on how to read the below chart please visit Primer on Trend and Trend Reversal Analysis using Volume Based Indicators.

NYSE Advance Decline Line with MACD -  Let's look at the Advance/Decline line in more detail on the NYSE Composite Index along with its MACD.  The A/D Line provides uncanny insight into the strength of the prevailing trend and provides powerful prediction into the timing of a trend reversal.  We monitor the 12 day SMA (blue line) on the A/D Line looking for a positive slope (bullish) or negative slope (bearish), we monitor the MACD histogram for each, and for MACD bullish or bearish crossovers (red MACD line crossing above or below the zero line).  We can see that the last "go long" signal was on February 16th where the red MACD line crossed above the zero line and the slope of the 12 day SMA line was trending upward; and the last "go short" signal was around March 26th where the red MACD line crossed below the zero line and the 12 day SMA was trending downward.  Currently, the slope of the 12 day SMA is sloping upward, the MACD histogram has gone positive, the slope of the red MACD line is also sloping upward, but the red MACD signal line has not yet crossed up over the zero line.  Along with the volume based oscillators above, this is one of the earliest predictors of "growing strength" or "growing weakness" in the stock market that eventually leads to a trend reversal, and right now it's starting to show growing strength.

Continuing with the Advance/Decline line, the below chart looks at the volume behind the advancers less the volume behind the decliners.  The volume behind the A/D Line offers additional predictive insight into the timing of trend reversals.  Note how the MACD histogram is showing even more strength, thus providing an early indication of "growing strength".

Looking at the McClellan Oscillator on the NYSE Composite in more detail, we can see that it's improving and is almost neutral.  However, as long as the McClellan Oscillator is in negative territory, the market is not quite healthy and sell-offs could continue to happen.

Conclusion from the intermediate-term, volume and advance/decline based analysis:  The data show that we have probably found a bottom and a trend reversal is approaching, but we'll continue to see higher volatility as the market progresses through a bottoming process.

Tuesday, May 25, 2010 (Before the Open)

The correction continues and the Futures market is pointing to a strong DOWN open.  This correction will be bottoming soon per the below observations:

1) Fundamentals of the US economy look relatively strong and continue to improve.  Every week we monitor the health of the economy through macroeconomic indicators and they all show that the economy is growing, not deteriorating.  As a comparison, in early 2008 the macroeconomic indicators looked very different where they were deteriorating on a monthly basis.

2) Corporate earnings are growing rapidly.  Companies are lean and any top line revenue growth will translate to higher earnings.  The European slowdown will probably impact earnings some, but we won't know for sure until late June when analysts sharpen their pencils as they predict earnings for Q210.  Currently, S&P 500 companies are on track to generate $82 of earnings per share that translates to an S&P 500 index in the range of mid 1200s to low 1300s.   This probably will be revised down due to the European issues, but it's still pointing to an S&P 500 index that is higher than what it is today.

3) The VIX is revisiting levels not seen since the March low.  Is the US economy similar to what it was in February and March of 2009?  No, not even close.  When we see the VIX spike and approach past extreme levels, this tells us that fear is probably getting close to a maximum, it's shaking out weak share holders, and we are probably getting close to a bottom.

4) The Advance/Decline Volume line gives us early indications of new buying.  We can see that the volume behind advancers less the volume behind decliners was trending down strongly per the negative MACD slope (green line) and the 12 day SMA of the A/D volume line (blue line).  But now we are seeing more choppy behavior where the A/D volume line is getting more volatile, and we recently got two positive spikes in the MACD histogram, telling us that volume behind the advancing stocks is increasing.

5) The Advance/Decline line (just looking at the number of advancers less the number of decliners - not taking into account volume) also provides us insight into extremes and possibly turning points.  We can see below that this month has been very volatile where we had an extreme of 2500 more advancers over decliners on May 10th representing the last bullish effort to take place before the market started to correct.  We then swung to the other extreme with 2500 more decliners over advancers on May 20th.  Per the action on May 20th, when we see a bearish extreme like this, the market is usually approaching a bottom.

6) The ISE Call/Put Ratio has hit an extreme low telling us that retail traders are buying more puts over calls and are extremely bearish.  When the call/put ratio hits these extremes, we are usually close to a bottom.  For more on the ISE Call/Put Ratio Index and why we use this instead of the traditional put/call ratio, please read entry #34 in the Learning Center.

7) Looking at volume based analysis, the 60 day chart with 60 minute volume bars is very close in signaling to "go long" on the S&P 500 index, a proxy for the entire US stock market.  Volume analysis is one of the few ways to get an early read on upcoming trend reversals.  This information, however, is still choppy so it's still too early to get a solid read.  For more on how to read the below chart please visit Primer on Trend and Trend Reversal Analysis using Volume Based Indicators.

8) The DOW is nearing 9900 the February low, which is a critical support level.  So far, during recent heavy DOWN days, buyers have stepped in at this level.  There is a good chance that this level will hold as support.

9) Like the DOW, the S&P 500 index is also at a critical support level of 106, and so far buyers have jumped in each time the index has pulled back to this level.  Many traders and money managers are probably waiting for the SPY to pull back to 106 before jumping back in.

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