Halting the Tide (for a moment)

Projection Update:

What projected: S&P 850 -> 956 retest (90% chance) -> 1020 

What happened so far: 956 -> 865 -> 956 retest (passed) -> 996   

Today: 993.18

Within 1 week: 1020 (+- 15)

Within 4-6 weeks: retest of the 910-930 range (75%), retest of the 850-865 range (25%)

Within 3-6 months: 870-1020 whiplash (75% chance), 1100-1200 retest followed by a guaranteed large crash (25% chance)

Analysis:

We are closing in on the 1020 projection. The momentum is still upward, but we have repeatedly tested the 1000 mark, and failed, signalling indecision. The economic data and earnings coming in aren't decisively bullish either. The only force driving the momentum now seems to be the weakness-by-design of the USD. You know as well as I how effectively fear tactics work on the fragile psyche of fund managers.

Signs that we are reaching the rally's top:

- The earning season is ending. Insider selling is temporarily frozen during earning periods, so another selling force will appear soon. I don't see insider buying picking up after earning season, especially at a peak.

- Volume is low. This is a reliable sign that the trend is turning. It is not a timely indicator, since we could whiplash and slightly trend up for quite a while with low volume, but it could be forward looking in light of other factors.

- Some good earnings are being ignored. If the momentum is still strong, daytraders will be more empowered to chase after good news. They aren't.

- We have tried to do a rally close for the last few days, but couldn't. Mid-day rallies have petered out very forcefully near the end. The momentum upward maybe still strong but somebody is also selling hard.

- Ample oil supply. This is again not a timely indicator of an immediate trend turn, but it shows that in the year term, the US economy is not going to recover quickly or smoothly. Remember that mid-summer is the peak of the driving season. Just like last year's oil peak, if people ain't driving NOW, they ain't driving more later.

- Last but not least, the behavioural finance indicator. Read around cnbc.com and thestreet.com, among other popular sites geared toward retail investors and you will see an onslaught of excessively bullish articles (Dow 15000! Here we come!) backed by dubious reasoning, my favorite being patriotism. That signals the "denial" phase of denial, anger, indecision, depression, acceptance. The big fishes must make money somehow, and they make that money by exploiting the psychology of self-conscious smallfries who can't influence the market with their firepower. I trust good men like you to have no such compunction.

Now, no two charges ever end the same, and we may be off by 15-20 points either way. We must prepare for this.

Start taking profit. From the last rotation we did (the last entry a few days ago), jumping out of basic material and into home builder and commercial real estate, those sectors have rallied quite a bit and beat the sectors we got out of. So we take 50% profit now, sell things like PHM, LEN, TOL, PLD, KIM, etc.

If you are still holding basic materials (X, STLD, NUE, AA, etc.), financials (C, BAC, JPM, WFC, etc), or big oil now, get out of them decisively.

We should be at 15% long now, and then aim for 10% long at 1020. Since our 3-month projection includes a small chance of a hyperinflated stock market and vastly devalued USD, we must always have a permanent long portion as an inflation hedge. 

And I repeat, we must not be shorting these days, even on downtrends. Every downtrends from here will be quick corrections, so shorting won't win much, and if the hyperinflation case happen, that might result in a complete wipe-out.

Quick Update

Hah! apparently my pilot readers (a.k.a. my close friends) say the blog needs more graphics. Sure, I'll come up with something soon.

Analysis:

The plan still stands. We tested 956 and breached it decisively. The next wave of earnings will have a lot of materials in them, so we might want to consolidate some of our gains in steel and alum.

I suggest doing so by selling some long term call options. Surely, I would be happy enough to lock in my stake in Nucor at $50 (current price is 44.3), knowing that I only left 25% profit on the table should the construction and car industry magically bounce back to levels before the crisis (which was the high for a good decade by the way).

So what I think will happen is the momentum carrying us toward 1020-ish still, regardless of the bad earnings from Nucor and Microsoft. That said, some sectors will win and some will lose. A common misconception is that the index rising drives individual stocks. No; the individual stocks drive the index. So the best performing stocks driving the index up to this point will eventually have to leave the spotlight for someone else as the index keeps rising. So we fight accordingly.

Sector Rotation

Take profit on basic materials (steel, alum, copper) and energy. Diversify within each sector. For example, Nucor, STLD, and X, If you have all three of them, take profit on Nucor and X and leave STLD alone for diversification's sake. STLD and Nucor uses arc furnaces, X and Bethlehem use blast.

Tech will be a mixed-bag, but generally we will be down from here after it has driven the S&P. Lower PC sale by MSFT can't mean good things for the likes of IBM, INTC, AMD (especially AMD), etc. AAPL might inch up a bit but I wouldn't buy such an overpriced stock unless I'm stuck on a desserted island with it.

Banks are the next things to run out of steam, so we watch out for them and start acting accordingly. Take profit if you hold them, short a bit of them instead to hedge. JPM and WFC look pricey right now, but we wait a few more days for the kamikaze buyers to die down a bit.

Buy some (more) home builders and commercial RE, since they are all still relatively cheap.

Buy some pharma/healthcare. Hmm, who made those swine flu vaccines again? ;)

Powder Keg

Projection Update:

What happened: S&P 956 -> 865

Today, July 16: 940

Within 1 week: 956 retest

Within 4-6 weeks: 850 retest (25% chance), 1020 retest (75% chance)

Within 3-6 months: 870-1020 whiplash (75% chance), 1100-1200 retest followed by a guaranteed large crash (25% chance)

Stars: Financials, Commercial Real Estate, Commodities and Industrial Materials, Tech
Cash Cows: Home Builders, Mall Operators, CAD
Dogs: Gold, USD 

Analysis:

Back in early June, I was almost certain that 950 was the temporary ceiling and there must be a retracement to the 850 range. Well, we did retrace but only to 865. But being in a battle, you must begin to return fire with increasing intensity as the conditions move more in your favor. I was able to fill out 80% of my purchasing quota on the way down, the majority acquired at the 870 mark. I am currently 40% on the long side; the remaining cash is kept in CAD, which is indirectly a long position in commodities.

Two possible bullish scenarios were proposed from there.

First, 950 (956, exactly) will be retested. If this retest fails then none of the bullish scenarios will happen and we will almost certainly hit 850 or lower, retesting the low of Oct 2008, where the credit seizure began in earnest. But 950 has a high chance of being broken, with sentiment being a mixture of inflation fear and recovery greed, both of these bullish for stock. The earning season also could turn out very supportive of the bulls, since analysts set the earning bar far too low compared to last quarter actual earning, and we thought last quarter's bar was low! Now...

1) Reflation: we retest Oct 2008 high of 1020-1050, then trade in a range with a lot of whiplash between 870-1020, we will slowly make higher highs and higher lows though, and the stock market recovers painfully but sensibly, matching the economy's prospect. This is if inflation is tightly controlled (by the Fed) at a positive but small level. It's not easy to control inflation in this speculator-dominated battlefield, so it is a certainty that the best the Fed can do is to keep things in a range, and this make for a hard-to-trade but reliably trending up market.

2) Inflation: we break out from Oct 2008 high and then proceed to violently surge toward a psychologically important milestone, S&P 1200, the technical beginning of the bear market. This scenario will happen if inflation is allowed to go unchecked, either by a planning mistake, or indeed, by design, to induce a quick recovery at any cost. This retest, however, is guaranteed to fail (and may fail as low as 1100), and will then precipitate another crash that could bring us right back to the 800 range or lower. 

Scenario 2 deserves further explanation. If for any reason that there is the slightest hint at hyperinflation in the near future, fund managers and idle money (sidelined or new investors) will fear for their cash; speculative traders will act fast to raise commodity and material prices up; business managers will buy, build, and produce... anything to avoid keeping cash. The Fed had deliberately shut people out of Treasury, and Gold is a fool's investment, skirting a 40-year high. The only thing with the most potential to go up are stock, real estate, and commodities, which are technically low on the 1-year term. This is a volatile, mutually supporting, brew.

However, such a violent speculative rally will only end in disaster, since it will get ahead of the true state of the economy. The damage done to the wealth and confidence of the common people by downsizing will not heal within 3-6 months. Jobless data might improve but not nearly as fast as the price of gas and everything else going back up. A massive surplus of inventory and production capacity and price pressure on the household is another volatile brew, but this time for the bears.

The Fed's talk (but not their action) so far signified that they want a slow but sure recovery with low inflation. They are moderating their tone to guide the psychology of others to this direction and hinted at a possible rate raise by year-end, however, they are not toning down the quantitative easing. The chance that their *actual* intention is high inflation is small but still possible. More likely to happen is that they may make a mistake and trigger scenario 2 by underestimating the powderkeg nature of market sentiment at this point and the amount of power large speculators wield compared to other, longer-term players in the market.

We will operate under the assumption of Scenario 1, and expect the year to end at 1020-1050 range, but we keep our eyes peeled for any sign that scenario 2 may develop, and we must always have a portion of our portfolio allocated to the long side to hedge against inflation, just in case.