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April 25, 2009

Topping Off a Rally

There is a scribble on the white board in my old office that reads, "Trade the system. Everything else is just noise." Such sage advice (thank you) comes in handy at times such as the end of the current week when it is particularly easy to doubt one's position. With a short line that can be described as more than arbitrary, the strength mustered by equities over the last two session is disheartening. The key to holding one's position... and doing so for a reason, not just stubbornness... is to step back, look at the reasons the trade was entered, and determine if any of those reasons have been violated.

stock index chart

Whenever I open a short line, I keep an eye out for the type of move we saw on Monday... a solid sell-off on increasing volume that creates a swing high. This candle sets the cornerstone for any larger move and also allows stops to be adjusted. I would have closed my shorts Friday if the market managed to close above Monday's high. Note that the four subsequent days failed to match the volume posted on our cornerstone day. Also, the two weeks which have passed since I initiated the short position have seen heavy selling-on-strength, including $171M yesterday.

There are additional data supporting a topping process:

stock market indicator

stock market indicator

Equities are also sitting in a zone of heavy resistance:

stock index chart

So, the bulls are looking for an imminent explosion higher above SPX 875. Even if equities were able to somehow muster such a move, I'd have to believe it would fizzle quickly. Stocks are already facing extreme overbought readings and some fairly hefty SoS data. The current setup offers one of the occasional opportunities where selling OTM calls has a favorable risk/reward.

Thus far, I see little reason to be panicked out of my position. The only worrisome point is action in the dollar:

dollar chart

If the 200DMA cannot contain the dollar's decline, it may be a sign that the government's attempts at reflation are more successful than any prudent economist (oxymoron?) would like to believe. It would also mean that the stock market might continue nominally higher. In any case, I expect my stops will have me out of shorts before that point.

The dollar also has implications for precious metals. I've noted expectations that gold and silver will continue higher regardless of the dollar's relative strength to other currencies. Nearly every currency in the world is being trashed, so gold will rise against all of them. However, if the buck weakens against other paper trash, precious metals will rise even faster in dollar terms. Let's look at the charts.

gold chart

If this pattern resolves higher, we're looking at a minimum target of $1,240.

silver chart

It would be nice to see a 2-3 day crawl under those downtrend lines. Such crawls tend to act as coils for breaks higher and would offer a cue to augment positions.

Apart from mining shares, my precious metals position consists purely of silver simply because I expect silver to vastly outperform our little yellow friend.

gold/silver ratio

Besides the fact that the liquidation anomaly should be unwound, silver should also eventually run toward historic price ratios. Before the age of fiat currency, the ratio stood for decades at around 15. During the 20th century, the gold/silver ratio fluctuated wildly, frequently finding its base between 20 and 40. Now I'm going to pull two figures out of a hat for lack of a better methodology. Suppose gold eventually hits $3,000/oz and the gold/silver ratio reverts to a mid-point at 30. We will end up with $100 silver!

At risk of sounding like Gary... which, after all, may not be a bad thing... I have no intention of selling my core silver or mining positions until those extremes are met. If I am wrong about the impending breaks higher, any sell-off will be warmly met with further purchases for my portfolio. I wonder how many people got shaken from their holdings during this 2-month consolidation? If (when) prices break higher, they are likely to do so violently. How many shakeout victims will re-purchase at significantly higher prices? 'Nuff said.

A few other miscellaneous notes...

Based on the look of the Treasury chart, I'm really liking my TBT position here.

Treasury bond chart

My favorite mining stock is holding up quite well:

stock chart

Penn West offers a similar consolidation target:

stock chart

And I certainly have no complaints about the performance of my Precision Drilling shares:

stock chart

A final look at the S&P 500 before I sign off:

weekly SPX chart

Laissez les mauvais temps roules.


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