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July 8, 2010

Ok I admit—I got lucky with calling the turn of the market in the last post.  Don’t expect a repeat of such calls going forward.  These accidents of fortune occur more often than chance would suggest when you bet with historical probabilities. Still–the odds of being at the point of minimum adverse excursion are slim at best. I guess that is what hedge fund legend Jim Simons likes to talk about walking into work and hoping “he gets lucky.” Certainly I won’t have any reporters calling me up for future opinions.  So with that qualifier, I will present my own thoughts on developing an S&P500 intermediate term trading game plan for the present market conditions.  To borrow a caption from the last president–George Bush Jr. (whom I’m sure many now wish would be the president instead of Obama and his socialist parade) I would like to talk about “strategery.”

Everyone is focused on what to do now, and really to me it comes down to creating an optimal strategy based on an assessment of the possible scenarios. Personally I think its obvious to say that the S&P500 is at a possible inflection point that will define 2010 and possibly 2011. All of the trends are pointing down, yet at the same time the market is showing signs of life -finally- following a sizable pullback.  The 50-day moving average recently crossed below the 200-day moving average–the so called “Death Cross” which ostensibly is an ominous sign. A good article  by Woodshedder on this long-term trend indicator and some stats worth reading through the various links: I think that one key fact that I have found in a lot of my S&P500 research is that short trades have a much lower probability of being correct then long trades. This is especially true for longer-term trend systems. While some might argue that this is because the market has an upward bias over time (which is true) I also found that short trades worked poorly even in protracted bear markets. This is because of the increase in volatility that arises when the market goes down This increase in volatility and accelerated change in the return/risk dynamics makes explosive rallies in downtrends a fundamental reality. The basic implication is that you should take profits on shorts as conditions become increasingly oversold—such as when the RSI14<30.

As a consequence, I would rate the odds of a sustained downward move as being low. Furthermore, if this new bounce is going to be the actual bottom of this swing-point, I would argue that the recent swing low (1010 on SPX) marks a significant support point that must be violated before a short trade should even be contemplated. Given that most long-term short signals are unprofitable (over 60%), it seems that getting short with evidence of strength coming off of deeply oversold conditions is probably the most common situation where trade losses often occur for the “Death Cross.” Seeing current support broken would “confirm” that this downtrend might actually have a chance to succeed. In this case, if  the short-term support was violated, it would be wise to think about a stop and reverse signal above the current swing high (1060 on SPX)-or the highest high that is achieved before an eventual pullback that violates support (at 1010 on SPX). Once again you will have the capacity to adjust your strategy  if “Mr. Market” decides to change his mind. Flexibility is key because the market is a crazy beast–especially these last few years.

While my intermediate bias would be long, in the short-term however (read 1-3 days) I would bet on a mild pullback due to overbought conditions. The two most likely outcomes in my opinion tommorow are the formation of a small up-bar with a narrow range, or a medium down bar with a medium range and a close slightly lower than today’s close. We may also see the market have a few small up-bars on weak volume before seeing a short-term pullback. In either case, the current point is not an idea spot to be adding to longs regardless of your outlook. It is best to wait for a short-term pullback to enter more units long or a new unit.  One might place a stop 1/2 of an ATR unit below the low of today’s bar or the previous day’s bar.

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