We’ve entered a high-stakes election year, where the market should cycle into strength as those in power attempt to win the hearts and minds of the electorate…

The slow-burn of the Eurozone crisis is also beginning to fade. Negative headlines and poor economic data — the exact same information that paralyzed investors just a few weeks ago — just don’t seem to matter anymore…

Some analysts (including a few of my colleagues) are attributing recent market strength to the Facebook effect. But I’m not completely sold on this explanation at all. Your mom and her friends talking about the Facebook IPO does not trigger a broad market rally. Sure, stocks in similar sectors will see some buying. But no one is bidding up shares of Waste Management in anticipation of Facebook going public.

However, Facebook’s impending offering is a symptom of the market rally itself. The billionaires and soon-to-be billionaires behind the IPO weren’t going to float this stock to the general public while the rest of the market was having a fire sale. That’s not good business. Waiting until the market has its legs back will always trigger a rush of offerings that have been patiently waiting in the wings — this one just happens to be a biggie.

But it doesn’t matter who is right — it all comes down to this: the bears might win today or tomorrow, or even most of next week. But ultimately, they will suffer as stocks continue to rally, sparking short-covering that will push the market up even faster…

That’s the thing with early-stage market rallies. Buying is contagious. And when it spreads, those on the wrong side of the coin are unceremoniously slaughtered. The euphoria of stocks moving higher after months of declines lobotomizes traders. They will jump on the big move, shoving aside anyone who gets in their way.

Of course, this is not a friendly game. At the beginning of a new trend, there are winners — and losers. If you don’t properly position yourself in the early stages of a rally, you will lose. It’s a simple as that…

If you’re buying stocks that are the strongest movers off the market’s lows — with the intention of holding them — you could be setting yourself up for failure. These stocks that catch fire and outperform during an initial broad rally are usually the most heavily-oversold names on the market. Most of the time, it’s because these stocks don’t have the fundamentals to backstop any intense selling pressure.

To put this into perspective, take a look at this chart of Response Genetics Inc. from 2009:

RGDX is a micro-cap biotech with no earnings and very few assets. The stock jumped big in March 2009 as the broad market put in a bottom, but the rally couldn’t hold. Investors moved on to other stocks that offered a stronger financial cushion.

Fast forward to present day, and we’re seeing similar action in RGDX:

After a sharp selloff in 2011, RGDX is roaring back to life. But while this stock might make a fine day-trade, I don’t see it holding up as a viable medium- to long-term investment. History could very well repeat itself here — with RGDX ending up back at $1 before the market runs out of steam.

On the other hand, the stocks you can find that will ride this emerging rally will have the backing of solid fundamentals and tangible industry trends. You’ll still have the upside of an in-favor stock — but your risk will be mitigated by revenue and earnings growth and the powerful economic conditions that drive the particular sector or industry.

The week before Christmas, I laid out three major stock trends that I believed would shape the market in 2012. The first major trend revolves around a slew of pharmaceutical patents that are set to expire this year. That means Pharma stocks that are favorably positioned in the generics business should easily outperform the market.

Here’s one of the fastest-growing, profitable small-caps in the generic drug industry:

Akorn Inc. (NASDAQ:AKRX) might not be one of the best performing stocks so far this year. However, the stock continues to build on its market-beating trend from 2011 while the business consistently grows its profits and raises guidance. That’s why I recommended this stock to my readers last year — and why we’re still holding the stock today.

If you continue to seek out stocks like AKRX that have strong fundamentals and a steady, rising trend, you should have no problem avoiding the garbage stocks that sucker in so many investors during the early stages of a bull market rally…

Sincerely,

Greg Guenthner
for The Penny Sleuth

Finding an Edge When the Market Moves Higher was originally featured in the Penny Sleuth.

Often, the momentum can be traced back to an obvious catalyst — fundamental improvements within the group or a well-publicized buyout in the sector. But sometimes, investors and traders trigger a furious rally pinned on nothing but the simple fact that a stock has started to move in their favor. The buying triggers even more buying — and the rally begins to feed off itself.

I’ve chronicled several interesting rallies over the past few years, ranging from coffee stocks (slightly absurd) to semiconductors (a great cyclical growth story). Eventually, these rallies run their course, and momentum traders move on to the next best thing. That might be happening right now to “The Great Pizza Rally of 2011-12.”

This pizza rally has been interesting for a couple of reasons. First, it has been largely contained within a subsection of the fast-food industry that would rarely be classified as a growth market. Also, I can see how a buyer might justify the rally in his mind. After all, the economy isn’t in great shape, so the average family might be buying more pizza. It’s a weak argument, but it makes sense to those who don’t trade using technical indicators. It’s tangible, easy to understand and act upon, and reinforced by the media.

Today, we’ll take a look at a couple of pizza players — and a few other high-flying stocks — and try to predict what the future holds for each…

Pizza Inn Inc. (NASDAQ:PZZI): This small pizza chain saw a big rally in its stock, taking shares from $3.50 in October to almost $7 by the beginning of December. Now, it looks as if the stock is stuck in the $5.50 range and possibly heading lower. The sharp uptrend that began in the fall is broken, so you shouldn’t expect more upside from this name anytime soon:

Domino’s Pizza Inc. (NYSE:DPZ): The king of pizza delivery is showing us a very similar pattern. Once again, we have a nice fall rally, lifting shares from $26 to $35 in a matter of weeks. However, 2012 has not been as kind to Domino’s. While the broad market has rallied to post-correction highs, DPZ has fallen out of favor. You can clearly see the trendline break right at the beginning of January:

BroadVision Inc. (NASDAQ:BVSN): After failing to catch a bid for most of 2011, BVSN proves that you don’t need a reason for an unannounced, triple-digit rally. This unheralded microcap started the month as a $10 stock, only to top $44 by yesterday afternoon. Not bad for a few weeks work — and absolutely no news other than the sheer power of the rally itself.

But that’s the thing with moves like this: they have to end eventually. And when they do, look out below. Check out the chart below for a very clear picture of what an unsustainable rally looks like. You should expect further downside action from here:

Apple Inc. (NASDAQ:AAPL): Finally, we turn to last night’s earning surprise from Apple. Even without vaunted leader Steve Jobs at the helm, Apple reported record earnings on stronger than expected iPhone sales. Spurred on by a 6% move this morning, Apple once again overtakes Exxon Mobile Corp. as the biggest company trading on the U.S. markets, with a market cap approaching $417 billion:

Sincerely,

Greg Guenthner
for The Penny Sleuth

Today’s Market Movers: AAPL, BVSN, and the Great Pizza Rally was originally featured in the Penny Sleuth.

Penny Momentum Trader editor Jonas Elmerraji notes that earnings were a crucial factor in the S&P 500’s recent breakout. With just over half of the S&P 500 has announced their earnings numbers, 76% have met or beat Wall Street’s expectations. “Expect corporate earnings to continue to be the biggest catalyst for stock performance in November,” Jonas said.

We’ll hear more from Jonas in a minute. But first, here are three earnings season tips that should help keep you from making any decisions that could put an unexpected dent in your brokerage account:

1. Trading on earnings is gambling — No matter what you know (or more accurately, what you think you know) buying a stock ahead of its earnings announcement in the hopes of making a quick buck is a 50/50 bet. You might as well hitch a bus ride to Atlantic City and put all your money on red at the roulette table. If you’re a swing trader, know when your potential trade candidates are set to report earnings — and avoid trading these stock until the market has digested the news.

2. Earnings are potential trend-breakers — Once a trend is in motion, it is more likely to continue than to reverse. This basic rule is the foundation upon which many successful traders have built their systems. However, unexpected announcements during earnings season can derail even the strongest trends without warning. Don’t assume that an announced conference call or press release won’t have a profound effect on sentiment.

3. Guidance is critical — The market is always looking ahead, so it’s important that you don’t get caught staring in the rear view mirror. Yes, revenue, margins and earnings from the past quarter are all critical pieces of information. If you assume stock in a company that just beat earnings — but lowered guidance — will continue to outperform, you could be in for an unpleasant surprise.

“Project X” Details Finally Revealed

My fellow small-cap analyst Jonas Elmerraji is once again at his desk this morning. He’s back from an unannounced business trip where he was contributing to Addison Wiggin’s “Project X”. I pressed him for details regarding his contribution to what has become a top-secret operation — and he did reveal some intriguing information related to his role in the project…

Before I get into the details, I must admit that I do know a little bit about “Project X”. I know that it’s not a new newsletter. It’s not a book. It’s not a conference, or a symposium. But that’s about all I could tell you. For what I’ve gathered, “Project X” not like anything that’s ever come out of Agora Financial HQ.

But with the information I’ve gleaned from Jonas today, I can say with confidence that if you are a small-cap trader or investor, “Project X” should be on your radar. This morning, Jonas told me his role in the project involves market timing strategies. One of the toughest tasks an investor faces is when to buy a particular stock — which is why Jonas is lending his expertise in both fundamentals and technicals to help a select few pinpoint the perfect time to enter a new position.

Whether you have a short-term or long-term market outlook, Jonas’ simple timing techniques should be a part of your investing toolbox. I can tell you from experience that proper timing is one of the main factors that separates the novices from pros who record consistent gains year after year. Even if you’re only thinking about getting involved in the stock market, I urge you to keep “Project X” — specifically, Jonas’ contribution — on your radar.

I know it isn’t much, but that’s the extent of what I know right now. Addison will soon be unveiling additional details to a select group of interested subscribers.

Greg Guenthner
for The Penny Sleuth

Avoid These Earnings Season Mistakes was originally featured in the Penny Sleuth.

Surge-and-sell market turbulence can be translated into a quantifiable property known as volatility. Once we “map” volatility, we can trade it more effectively. The trick is that there are a lot of ways to measure volatility.

I won’t bore you with all the technical aspects of it. But I do want to clear up a common misconception. Some people believe that the opposite of volatility is no movement at all. That is not true. Consider the human heartbeat. If it’s steady at 65 beats a second, then the volatility is zero. That doesn’t mean it’s standing still!

No, volatility is when the rate of change in movements becomes extreme.

For a look at what that means for technical charting, check out the chart below. It shows the co-movements of the AUDUSD’s one-month volatility against the AUDUSD spot.

They are in tandem, with peaks and troughs in volatility pointing to reversals of the price direction. So when a volatility spike shows up, it’s a good time to bet on the underlying investment going the other way.

For a more focused reading of volatility, we can use volatility smiles.

Volatility smiles are a type of charting that provides a shape for investor fear and greed. It represents the volatility of options at different distances from the spot price. If market volatility were neutral, charting the volatility values for puts and calls would form a shape like a smile.

In reality, however, volatility smiles are few and far between. Most of the time, sentiment favors one side or the other. When one side is being favored, instead of a smile in the volatility curve, there’s a skew or smirk.

Lately most option market are NOT smiling.

For instance, last week a chart for crude oil showed a big skew on the put side. Premium prices for puts were more expensive than calls at the same distance from the at-the-money spot price. It was a clear signal of very bearish conditions. Volatility levels for options were in the 50% range. It wasn’t parabolic, but it was sufficient to warn that it was time to look at the calls side of oil.

Last week the three-month volatility surface shows a change.

Notice the shape has begun to curve up on the call side. It is no longer purely bearish. Traders are beginning to shift their sentiment away from extreme bearishness on oil. This tells us to not be afraid to look for buying opportunities in oil.

Now take a look at the USDJPY volatility smile.

The volatility of the calls is balanced by the volatility of the puts — nearly a perfect smile. For the same distance from the spot, the volatility of oil is five times the volatility of the USDJPY. This clearly provides evidence that investors have ambivalent sentiment on the direction of the USDJPY.

If you’re still not convinced about using volatility smiles as a measure of market sentiment, look at the volatility smile of the Chinese Renminbi.

Does the market sentiment expect it to strengthen or weaken? There is a clear and very steep skew to the call side. But the put side is also coming alive. Take notice — this may mean that bets on a stronger Renminbi in the near future are not that certain!

The trading action implications in following volatility smiles are clear. They are signatures of the war between bullish and bearish sentiment. When there is a skew to one side, it’s not a predictor of a reversal — but it is a warning of a potential reversal. When the volatility surface moves away from a smile, the conditions are ripe for betting the other way.

Ultimately, the market tries not to be skewed in one direction for too long. You can and should bet on that.

Sincerely,

Abe Cofnas
Currency Analyst for The Penny Sleuth

Measure and Invest in Market Fear With a Smile was originally featured in the Penny Sleuth.

Tuesday offered an important lesson: before you begin celebrating, it’s important to realize when you are not yet out of the weeds. No matter how good one moment may seem, you need to be prepared for the exact opposite reaction the next day (or even the next hour). Today, I’m going to explain how taking a significant position in this market — whether long or short — could be a huge mistake.

There is a reason Tuesday’s rally failed. There’s simply too much uncertainty for stocks to post a game-changing rally or hold significant gains. Despite recent bailout news, Europe’s financial woes continue to haunt domestic markets. Volatility is squashing what little edge afforded to traders since the August correction began.

Breaking down the recent market action, you’ll find that aside from quick flips, almost any trading edge has all but evaporated. Making aggressive bets — whether bullish or bearish — on any of the market’s recent moves would have left you stopped out (or worse) 99% of the time…

Turning to the Russell 2000, you can see that the recent market action has left our small-cap index open to multiple interpretations:

On Monday, I warned readers of my premium trading service that socks could lure longs with a push back toward the bottom of the blue line, only to eventually fall to new lows. Not only did stocks break away into the previous range — they also retested the 20-day moving average before getting knocked back to reality.

Usually, this type of retest is common when a pattern is completed — so we must view any short-term rally from these levels with a skeptical eye. Also note how the top blue resistance line is beginning to point lower. It’s a muddled pattern at best — so your best bet is to assume volatile trading between the two big red lines of support and resistance. Approach any major market moves (of 2% or greater) with a skeptical eye. If you do this — and avoid trading in size — you will have a much better opportunity to come out of this period of volatile sideways action with your brokerage account virtually unscathed.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Don’t Trust This Market’s False Starts was originally featured in the Penny Sleuth.

The first installment covered some big commodities and indexes. Today I’ll apply that lens to currencies, showing what my research of the past year has uncovered and general information on how to interpret it.

The Euro (EURUSD)

For the EURUSD. Reflecting the market turbulence of the continent’s ongoing sovereign debt crises, the euro / U.S dollar pair moves through almost all percentage change gradients.

We can see 18 weekly closes at 0%; 18 weekly closes at plus or minus 1%; five weekly closes at -2%; seven weekly closes at plus or minus 3%; and two weekly closes of 4%.

If we visualize each week’s movements as a horse race, the strategy of betting on several different horses makes sense. The EURUSD provides an excellent statistical support for several one-week option trading strategies including at-the-money, out-of-the-money and deep-out-of-the-money!

The Yen (USDJPY)

The U.S. dollar / Japanese yen pair does not have a high population of frequent moves beyond 2%. Between August 2010 and the end of August 2011, the currency pair closed the week nearly unchanged 13 times. It ended the week up .5% seven times, and down .5% an additional seven. There were eight weeks where it closed up 1% and 14 where it closed down 1%.

The big moves are there, but they are rare. It ended the week down 2% on three occasions; up 2% just once; and more than 3% in either direction a single time.

The lack of big moves means that trading yen binaries requires a lot of patience and political insights. I look for important “event-risks,” such as key Bank of Japan meetings, to trigger movement. In general, it’s best to consider bounce plays using at-the-money positions.

Australian Dollar (AUDUSD)

The Australian / U.S. dollar pair is not a big mover, showing just 14 jumps or falls over 2% within the past year. And moves of 3% or greater occurred just six times!

Instead we see 15 weeks where the currency experienced a near-zero change and 21 weeks with only a 1% change in either direction.

With few big moves, it makes sense to trade weekly AUDUSD with at-the-money strike prices.

In reviewing the weekly percentage moves of the indices and the key currency pairs, the impression that markets are volatile is correct.

But from a trading perspective, that volatility isn’t a negative. In fact, binary options are the perfect tools for profiting from these weekly moves, not to mention protecting your portfolio.

The specific strategies are based on surfing market movements, detecting sentiment waves, and — when appropriate — going against the crowd!

In fact, last week we saw the value of betting against the crowd. On Monday, everyone was in despair over the prospects of a Greek default. By Wednesday, that despair evaporated.

If you haven’t already, I urge you to set up a free demo account with the Nadex here. Try playing some of these currency movements yourself.

And we would love to know how you do. Please feel free to tell us about your trades by emailing editor@pennysleuth.com.

Sincerely,

Abe Cofnas
Currency Analyst for The Penny Sleuth

Currency in Focus: The Biggest Movers in the Currency World was originally featured in the Penny Sleuth.

The answer is, more often than you think.

And today I’d like to share my in-depth research that proves it. The charts below show you the number of weeks that a commodity or index has moved a percent or more over the year.

This lets us see which markets have a tendency to make the biggest moves. And that information can help guide us to winning binary plays.

Today let’s take a look at how often big weekly swings occur in some of our favorite markets, along with some general thoughts on how to use this information.

S&P 500

Between Aug. 6, 2010 and Aug. 26, 2011, the S&P 500 has seen a weekly move of 1% in either direction a total of 17 times. It moved 2% in either direction nine times. It moved 3% in either direction four times. And the biggest moves, jumping or losing 4-5% in a week, occurred just four times in total.

That means we can generally expect 1% moves to happen frequently, which favors at-the-money binary options. On the other hand, it also shows that bigger swings aren’t out of the questions, which can make deep-out-of-the-money binaries smart bets.

Gold

The weekly closes support the sentiment that gold can move big in either direction. From Aug. 6, 2010, to Aug. 26, 2011, gold had 11 weeks where it closed up more than 1%; 12 weeks where it closed up more than 2%; six weeks where it closed 7%; one week where it had a close of 4%; and two weeks it had a close of 5%.

So in general, you’d be better off buying deep-out-of-the-money binaries than selling near- or out-of-the-money gold binaries.

WTI Oil

West Texas crude oil is one of the most interesting in this bunch. It really shows a capability for big moves. There were nine weeks where it closed 1% in either direction; nine weeks where it closed 2% or more; 10 weeks where it closed 3% or more; three weeks of 4% moves; and an extraordinary 11 weeks where it closed 5% or more

That is movement! And it proves that crude oil binaries can have some of the most surprising outcomes of all!

Perfect Conditions for Trading Binary Options

The implications behind this data are huge. It shows we have market conditions where we can “expect” big moves during the business week. The Monday through Friday life of binary options fit perfectly with these market conditions.

A 2% move in these markets during any week, in either direction, with the right binary option strike price, can translate into gains of over 100% returns again and again.

If you haven’t already, I urge you to try a Nadex demo account. It’s an easy and risk-free way to get a real-world feel for binary options.

Just go to www.Nadex.com. It only takes a few minutes to get started.

Sincerely,

Abe Cofnas
Currency Analyst for The Penny Sleuth

Currency in Focus: Big Market Swings That Could Lead to Giant Binary Wins was originally featured in the Penny Sleuth.

• Europe’s sovereign debt crisis
• U.S. debt negotiations

These issues have created powerful sentiment forces that are trumping longer-term fundamentals.

In other words, there is a lot of fear out there.

Investors who cave to fear risk missing large profit opportunities.

On the other hand, being overly optimistic can lead to massive losses.

To find a happy middle, you need to define some boundaries.

One way to do that is with scenario analysis— asking “what if” questions to frame big issues. Thinking about what would happen in a worst-case “doomsday” situation helps you develop a strategic mindset that can help you even if things never get that bad.

Let’s take a look at the three biggest worries investors have today.

Doomsday Scenario #1: What will happen if Greece defaults on its loans?

Obviously a Greek default will be bad for the euro — but at first it won’t be as bad as you’d think.

For one thing, the eurozone is beginning to understand what’s on the other side of default. In fact, European policymakers are already saying that a partial default may be necessary.

So it won’t be a sudden-death event. It is a phased approach, with each failed deal taking Greece a step closer to “doomsday.” The currency markets are anticipating a default, with each wave of pessimism weakening the EURUSD.

The interesting side effect is its positive impact on non-eurozone currencies. The British pound, the Norwegian krone and Swiss franc look a lot better in a default scenario.

For instance, the euro is significantly weakening against the British pound.

It’s also important to consider the impact of a default outside the currency markets. There will be a spillover to the equity indices. Germany’s DAX index is highly correlated with the EURUSD.

The European banking sector will take a big hit, too, with institutions holding Greek— not to mention Italian and Spanish— sovereign debt becoming vulnerable to great losses.

Things will only get worse before they get better, and V-shaped turn around is very unlikely. You can use binary options to target the inevitable bounces, but don’t expect those bounces to last.

Doomsday Scenario #2: What will happen if the debt ceiling isn’t raised in time and the United States defaults on its loans?

Washington’s game of political brinkmanship has a lot of investors scared. But unlike the euros stair-step descent, fears of a default aren’t baked into U.S. market expectations.

After all, Washington knows what’s at stake… and it’s easy to believe that politicians will hash out some kind of deal to keep the government solvent.

On the other hand, that also means a U.S. default would be a surprise. And much more traumatic to the markets.

In this kind of event, the biggest beneficiaries would be the safe havens: the yen, the Swiss franc and gold.

But there is an important caveat— the chances of an intervention. A crisis in U.S. confidence may trigger a massive coordinated effort by central banks to buy dollars.

A short-squeeze on the dollar is a very possible post default scenario.

Doomsday Scenario Scenario #3: What happens if Greece and the United States default at nearly the same time?

This is the ultimate doomsday scenario— and therefore the least likely. But as I said earlier, considering the worst case can help you consider the less-than-worst case.

Surprisingly, if there’s a big shock and a joint Greek and U.S. default emerges, gold might not be your best bet. A liquidity crunch could actually create a sell-off in gold.

In that case, the yen and Swiss franc become the big beneficiaries…

I’d also consider the Norwegian krone. It is considered one of the most stable and safest currencies.

In the short-term binary world, I expect needing a lot of espresso to monitor currency moves. It’s crunch time, and deep-out-of-the-money (DOOM) trades are now looking like the best approach… especially in gold.

Sincerely,

Abe Cofnas
Currency Analyst for the Penny Sleuth

P.S. If you haven’t already, I suggest you give binaries a shot. They’re exciting, fast paced one week plays. And potentially very profitable. For a great tutorial, check out the Nadex binary exchange. You can find its step-by-step, interactive guide right here.

Currencies in Focus: 3 Ways to Profit from the Worst Case Scenario was originally featured in the Penny Sleuth.

The dollar index, the Dow and the S&P all swung wildly.

On the surface, Bernanke’s message was pretty clear—the latest round of quantitative easing (QE2) will end as scheduled, but interest rates will remain low.

As a trader looking for profitable opportunities, what does that mean for you? Let me show you…

First, we can use a word cloud (a fancy name for a visual representation of the words used in his speech) to dig deeper into Bernanke’s remarks. The more times a particular word is used, the bigger it appears in the cloud.

Here’s how it looks. The result is very revealing…

You can immediately see that the two big words are “inflation” and “growth.”

Evidently that reflects the core challenge before the Fed, which is to stimulate growth without causing inflation. With the Fed’s historic record of being unable to do either well, we are in for a wave of disappointment on both grounds.

In the medium- to long term, that is bearish for the dollar.

In the shorter term, however, things are a lot more interesting…

The end of QE2 is coming in the middle of the U.S. government’s debt ceiling and deficit debates. So there is a lot of uncertainty in the air—the perfect climate for intraday dollar swings… and big currency and index moves!

As you may know, my favorite way to trade currency and index movems is to use what’s called a “binary option,” or “binaries.”

Binaries let you speculate on currencies with known and limited risk. Better yet…  they expire in under a week, meaning you won’t have to wait weeks, or even months, for a play to pay off. And if you’re right about the direction of the movement, they offer huge profit potential.

If you haven’t checked out binaries yet, see my tutorial here.

The binaries I suggest looking at this week are on the S&P 500. With fears that China’s economy is slowing down and the U.S. congressional tug-of-war over federal spending, the markets are very edgy. Anything can trigger a sell-off in the U.S. stock markets.

The best way to play this trend is to look at deep out-of-the-money binaries on the S&P 500—or, as I call them, DOOM binaries.

Being so far out of the money means they react sharply to big news or a surprise move. They cost less than $15–$20 to get into. And when they work out, they pay $100 even.

That means up to 500% returns… if you get the market move correct.

I suggest you give binaries a shot. They’re exciting. Fast paced. And potentially very profitable. For a great tutorial, check out the Nadex binary exchange. You can find its step-by-step, interactive guide right here.

Sincerely,

Abe Cofnas
Currency Analyst for the Penny Sleuth

How to Trade Bernanke’s Speech… For Up to 500% Gains was originally featured in the Penny Sleuth.

I’m just getting back into the office after spending a few days in New York last week for a conference at the NYSE. One thing that’s always telling about any trip to Wall Street is the tone that’s exhibited by the market participants I interact with.

It’s painfully clear right now that trading is tough across the board – and that fact is showing up in major banks’ quarterly results this earnings season. Trading units simply aren’t posting the kinds of profits that they’ve been known for in the last few years…

For retail investors, the most pressing question should be why.

Ostensibly, the market has been throwing out signs of bullishness lately. The S&P 500’s break above 1,344 at the end of last month, for example, was a bullish move that suggested buyers were in control of the market. At the same time, solid economic data and earnings numbers on Wall Street indicated that those buyers had reason to be bullish. But that wasn’t the whole story…

Even though the S&P was moving higher, those moves were “easy”. In other words, they’ve been moves within ranges – not moves above resistance levels. We know that because of the lack of trading signals we’ve gotten from the technicals. Breakouts are a sign of market strength because they represent buyers overcoming challenging levels where sellers want to sell, not just share prices moving higher through neutral space.

Remember, major indexes like the S&P 500 are averages are the sum total of the price action of their constituent stocks. So even though a breakout may take place in the S&P itself, the bullish signal isn’t impressive unless it’s accompanied by breakouts (and not just weak-handed moves higher) in its stocks. The lack of breakout signals hasn’t gone unnoticed.

And the weakness is beginning to show itself in the marketplace: According to data from Bloomberg, 72% of the 417 S&P 500 companies that reported earnings results since April 11 have beaten analyst expectations. That’s a staggeringly bullish metric – one that doesn’t even include firms that merely met estimates. But at the same time, the S&P 500 has only increased in value by less than 1%. There’s a big disconnect there.

That’s hardly the only instance where the market is showing shakiness. From a technical standpoint, a big concern is the negative divergence in volume since the 2009 bottom – while early stage bull markets should see increasing prices on high volume, trading volume has actually been declining as the S&P makes its way higher.

A Strategy for May

It’s times like these when discipline is more important than ever. When trading gets tough, it’s tempting to make changes or force trades. But that’s how otherwise good traders lose money and miss important moves.

Generally speaking, markets trend. When they range (as the S&P is doing now), it’s temporary. In the meantime, don’t forget that being allocated to cash is a trade. By sitting out of the market when risk-reward doesn’t synch up, traders not only take advantage of small gains from interest rates, they also increase their risk-adjusted returns by decreasing their market exposure. That’s a crucial element to longevity in the market.

While I’ll be the first to admit that it’s frustrating to sit on your hands and wait out trading signals, it’s necessary to avoid getting stomped in this market. That’s why avoiding stocks could be the best trade you make this week. Wait for a decisive technical breakout signal before taking on new stock positions for your portfolio – holding out for that sort of objective buy trigger could end up significantly improving your gains in May.

I’ll be sure to fill you in as the trading environment continues to evolve…

Sincerely,
Jonas Elmerraji
Managing Editor, Penny Sleuth

May 17, 2011

Why Avoiding Stocks Could Be the Best Trade Right Now was originally featured in the Penny Sleuth.