A Rough Start

John Nyaradi — Sun, 18 Jan 2009 21:35:00 GMT

Green Flag Flying
We expect higher prices ahead

The markets continued their retracement back to the bottom of the recent trading range we've been in, and 8,000 on the Dow seems to be a solid floor with 9,000 at the top.

This is the range we've been in for the past two months and now everything is once again oversold and the volatility is returning with the VIX back up in the high 40s.

Short term signals are all on "buys" while long term signals remain negative.

The uptrend of late last year and early January ran out on our positions this week as we were stopped out of several positions in both portfolios for losses.

This drawdown puts us in the unfamiliar position of facing losses and underperforming the general market. Since the start of this bear market, we have conserved our capital and outperformed the market, and I think the key here is to maintain our discipline with the goal of working our way back into positive territory.

As I wrote last week and the week before, risk management remains paramount. In my opinion, the best way to manage risk is to maintain the full portfolio and reduce position size so that you are comfortable with potential losses.

This remains a treacherous market.

The View from 35,000 Feet

For the week, the Dow was down -3.7%, the S&P -4.7% and the NASDAQ down -2.7%.

Seven out of ten sectors are forecasting negative 4th Quarter earnings growth and the government continues throwing water on the flames with a $118 Billion safety net for Bank of America and another $20 Billion infusion of cash.

The Obama team is talking about a new government bank, an "aggregator," to buy up bad loans with the remainder of the TARP funds, and, of course, the markets are eagerly awaiting the inauguration and the promised "change."

Trapped in a Trading Range

Since the opening bell of 2009, the Dow has taken a quick 1,000 point trip down to what seems like solid support at the 8,000 level.

Since November, we’ve been locked in a trading range of about 8-9,500 on the Dow Jones Industrials.

The extent of this range can clearly be seen on this chart courtesy of BigCharts.com.

We entered this range shortly after the panic low of late November and since then have not been able to escape. The bulls made several attempts to breach serious resistance at the 9,000 level, only to be beaten back by the bears who repeatedly have taken the average down to approximately 8,000.

And this pattern was repeated again beginning on January 7, 2009, as the Dow was beaten down to below 8,000 until its recovery to close this week at 8281.

What causes trading ranges?

Simply put, trading ranges are caused by a lack of conviction on both the part of the bulls and the bears. The bulls don’t have enough force to push the market higher and the bears don’t have enough power to break into new lows.

This makes for an interesting environment because if you can trade these ranges you can profit, but it’s also extremely easy to get on the wrong side of these moves and get whipsawed back and forth, particularly with the velocity of recent moves.

So what’s an investor to do?

There are only a couple of choices. You can try to trade the range and hope to be on the right side of the moves or you can stay in cash or you can hang on and hope that if you’re long that we finally break out to the upside of this static place in which we find ourselves stuck.

When will we break out?

That depends on a number of factors.

A break to the upside could be cause by an Obama rally, by an improvement in earnings or by a return of some semblance of confidence in the US financial system.

The market is eagerly awaiting the stimulus plan to emerge from Congress, and if it likes what it sees, a powerful rally could ensue. Any improvement in earnings outlooks going forward could be a powerful catalyst for a rally as billions have left the market and are parked in the safety of cash. Sooner or later that money will be deployed in the markets and when that happens, demand will certainly push prices higher.

A break to the downside would most likely be caused by the realization that the second half of 2009 won’t be better as the conventional wisdom says it will or by a continued revision downwards in earnings forecasts by the Wall Street analysts. Further declines will cause more investors to throw in the towel and go the stick it in the mattress philosophy of investment.

What to watch for.

If the Dow breaks the old November lows of 7700, it would indicate lower lows ahead. Some analysts forecast we could go as low as 5-6,000 on the Dow based on depression like earnings.

If the Dow convincingly breaks and can hold above 9,000, then there’s a high likelihood that a new bull market, or at least, sustainable bear market rally is in place.

Either scenario will require different strategies to be successful.

An upside break will provide opportunities in Exchange Traded Funds with high relative strength relative to the rest of the market. In my work at Wall Street Sector Selector, relative strength is a big factor in my ETF selections and the sectors with the highest relative strength will outperform the general market going higher and offer investors a chance to “beat the market” even in a climbing trajectory.

A downside break will require a flight to cash to preserve wealth, going to the safety of treasuries, even with their negative rates of return, or inverse ETFs which move opposite to their underlying indexes.

So, while nobody has a crystal ball, there are ways to read what’s happening and adjust one’s portfolio to take advantage of whatever market conditions we find unfolding as we move farther into 2009.

The Week Ahead

Wednesday: January Homebuilders Index

Thursday: Weekly Jobless Claims, December Housing Starts

Sector Spotlight:

Weekly Leaders: Consumer Staples, Utilities

Weekly Laggards: Financial, Oil, Emerging Markets

The markets are closed tomorrow for Martin Luther King Day which is fitting symbolism for Mr. Obama's historic inauguration on Tuesday.

Mr. Obama will stand on the Capitol steps and look down the Mall to the Lincoln Memorial on the opposite end. There he'll be reminded of the spirit of Martin Luther King who stood on the steps of the Lincoln Memorial on August 28, 1963, and delivered his "I Have a Dream" speech to 250,000 supporters of the civil rights movement.

I can only wonder if Dr. King could have possibly dreamed that 44 years later, another young African American would be sworn in as President of the United States.

In so many ways we're living in truly historic times, and I look forward to our work together during these challenging days.

Wishing you a great weekend wherever you may be.

Your partner in prosperity,
John
John Nyaradi
Publisher
Wall Street Sector Selector

P.S. Current market conditions promise to remain challenging. Click on the Wall Street Sector Selector link above for a special report, “How to Avoid the Buy and Hold Trap,” that offers potential alternatives to “buy and hold” investing.

Wall Street Sector Selector : John Nyaradi

A Rough Start