Tuesday, August 9, 2011

More Upside Likely, Then a Re-test of the Low

At this point we have seen an initial sharp short-covering rally which was to be expected as discussed the last few days. They are breathtaking and seem like you better get in fast because the market is going up fast. It is not uncommon to see follow through the next day after a bottom reversal like this, so don't be surprised to see another big jump tomorrow.

However, let's go back to what I posted the other day. The initial sharp reaction off the low of these waterfall declines has often rallied to the high of the second candlestick prior to the day of the low. In our case now that would put the S&P 500 at around 1220. But after that we have tended to see a retest of the low. In our current case we have a large unfilled gap down from Monday that still needs to be filled, and based off of historical tendencies is likely to be filled soon. So we should see the market rally up to that 1200 level at a minimum, before retesting the low.

So the next short-term play here is probably to short the market as the sharp rally reaches those levels and loses momentum. In this position I would expect a flat or triangle type pattern to follow this waterfall decline. In either case we are likely to see a deep retracement of any initial rally attempt.

IBD suggests waiting till the 4th day of a rally to look for an increased volume large advance before trying to go long on growth stocks. And even then only in stocks with well formed basing patterns. How many nice solid basing patterns do you think you will find right now? Probably not many. So, this rally is likely to fail and allow some stocks to strengthen to form the right side of potential bases while the downside momentum wanes.

For those who don't have a good grasp on this, major declines don't typically bottom on peak momentum or fear levels. So right now we are seeing an end to an extreme momentum move. What are the odds it's the bottom of this decline? Not real good based on how most bottoms occur in history. So for an intermediate time frame looking to go long, wait for some divergence on the daily chart technicals (and probably put/call ratios and breadth etc) before taking a long trade. Assuming we get something like that a few weeks down the road, I still don't think it will be the bottom of this decline, but at least it may lead to a credible bear market rally.

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