Short-term oversold seeks a bounce

Equity markets sure have a penchant for correcting quickly.

Unfortunately for bulls, this sharp correction and oversold market is overshadowed by a confirmed downtrend. So while a bounce is anticipated, selling into rallies will be the preferred strategy.

Some positive signs include positive seasonal timing, recent outperformance of financials (certainly as compared to technology), and oversold technicals. Better-than expected GDP growth (5.7%) and brisk replenishment of inventories have historically allowed market rallies (off recession troughs) to continue at least into a trading range (following gains similar to what we have seen from the March bottom).

Therefore, we believe that the market is more likely to undergo a 10-15% correction from its top as opposed to making a significant (i.e. 2/3) retracement of its recent gains or new lows.

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Swift correction: bounce watch begins

Telling signs of market weakness manifested itself this week in the equity market's correction. While the intermediate-term remains up, a sharp, high-volume sell off underscores fear. VIX, which had exhibited complacence as price fell significantly below its EMA 34 (an indicator we watch closely), exuded warning signs of a market top (along with a Put/Call ratio in the .60-.80 range, which in the past had been accompanied by market sellofs).

Now, bullish percentage readings, NYMO and stocks trading above their 50-day moving averages, all have corrected sharply. A little further to go, and these indicators will settle at levels that in the past have preceded market bounces. With the damage done in equities, we will look to add to short positions on a bounce, and may switch to long (for a quick trade) should we see a selloff early next week accompanied by an intraday recovery. We expect volume to be heavy.

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Market hanging tough

While price is key and we don't fight the trend, positive sentiment, low put/call and VIX readings suggest a cautious although bullish stance. Weakening momentum suggest a pause (minimally, a consolidation of recent gains); hedging with partial shorts and covered calls.

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Correction in motion

Signs of a relapse in economic weakness coupled with mediocre quarterly results has weighed on this market. The extremely positive sentiment as measured in bullish metrics as well as low put/call and low VIX support a correction of this overbought market. Time will tell whether this correction is part of a trend reversal following such strong market gains since March 2009.

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Can't ignore the positive signals

Market uptrend bias continues, with renewed strength in NASDAQ and small caps. Continued weakeness in financials overhangs the markets, as does a firming in the dollar. Many foreign ETF's have begun to downtrend; they were early leaders in the recovery and benefited from a weaker dollar. Their tiring uptrend (see EFA, EMA, EPP, EPI) and the dollar's bounce may represent a leading indicator of a waning US equity market in the new year.

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Bullish Stance Persists

Indices continue to trend upward (IWM has recently shown renewed strength). Market Breadth (NYMO, NYAD, etc.) are improving. A shift in the dollar/gold trends represent some risk to equities based on their inverse relationship since March 2009.

Cautiously Bullish

Strength in strong revenue-growth equities (typically captured in the IBD 100) and improvements in market breadth suggest continued opportunities to gain on the long side. The looming threat is resistance, which has been foreboding. One refreshing sign is the new high achieved by the Tranports, re-affirming a Dow Theory buy signal. Our strategy is to add strong stocks in basing patterns and to protect profits with trailing stops. We remain cautious, as a potential shift in the trend in Gold and the US Dollar bode potentially negative to equities, which have travelled inversely to these two asset classes.

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