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October 28, 2009

Bear With Me

I am going to harp tonight about a point which is a core tenant of my technical analysis: the fact that conventional moving averages are useless and one must determine, subjectively, which moving average works for each price series. As regular readers know, I am quite keen on the 65DMA for the S&P 500. I nixed my shorts just before the close today, and I'll show you why.

s&p 500 daily chart

How many suckers do you think got drawn into the long side as the SPX touched the 50DMA around SPX 1050, thinking deep oversold readings would produce a pop at that point? How many do you think are looking at their charts tonight thinking, "Crap! the SPX lost the 50DMA! It must be time to short!" My guess is they panicked out of their longs late in the day and will get suckered out of their cash on the short side, as well. The 65DMA is quite reliable at reversing moves... or at least halting them temporarily. Factor in the huge $444M of buying-on-weakness which accompanied today's session along with the aforementioned extreme oversold readings, and we have the recipe for a bounce.

The question is whether the bounce will be sustainable or simply a head fake before a larger move lower. First, the dollar continued its strong move off the recent low. As long as the DX holds above the 76 pivot, I will operate under the assumption that the dollar is unfolding a countertrend rally and hence, stocks should work lower. Second, banking shares lost an important support level:

bank stocks

Perhaps the lower break will prove to be a head fake as were a couple of the upper breaks, but why take chances? Until the level is regained, we should read it as it is.

Now, assuming the 65DMA is going to hold, there are two ways the bearish scenario can play out. Either we see a failed attempt at the SPX 1100 high or we see a trend line crawl along the 65DMA followed by a severe break lower. The latter setup is much easier to trade, but, of course, the market doesn't always do what's easy. We'll just wait and react to whatever develops.

You may, quite intelligently, ask why I bother to cover shorts if I still have a bearish read on the market. The answer is simply one of risk control. For starters, there is no guarantee my read is correct. I would rather stay flat until I see one of the bearish setups mentioned above. At that point I will have a higher-probability play in hand and will take an even larger short line. Also, it is highly unlikely price will slice right through the 65DMA and keep plunging. If the moving average does yield tomorrow (which, by the way, is actually a third and more potent bearish scenario... so much for my counting skills), the MA will likely be back-tested in a few days, and I'll just short the back-test.

Let's close with a look at GDX. Gold miners lost the trend line highlighted on the daily chart in yesterday's post. The ETF is now approaching an important trend line on the weekly chart.

gold mining stocks

A violation of the weekly trend does not kill the bull case... it only makes the waiting period more painful! For a volatile asset class such as precious metal miners, a retreat to the mid-30s... about 30% or so... would not be so unusual. Unpleasant, but not unusual. As long as a trader is not leveraged to the point of not being able to weather such a correction, the next move higher should be explosive enough to reward one's patience.


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