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contraction




The market started weak in the morning and spent the whole afternoon trying valiantly to paddle back upstream. It was futile as the stream of positive earnings news was not enough to scare away the bears. On that note, while the majority of companies have reported and of those many have brought in positive surprises there is reason to be skeptical.

According to a recent study covering 500,000 firms over 27 years, there is ample massaging of the numbers to "beat" expectations. According to one of the co-authors, Joseph Grundfest:

"Managements will exercise accounting discretion to try to make their numbers look better for Wall Street... in a number of subtle ways"

While accountants are usually portrayed in popular culture as nerdy and about as creative as a celery stalk, the reality is very different. Having taken advanced accounting in university, I can tell you that the discipline could easily be moved under the auspices of Arts Departments.

The surprising part of this is just how little money is required to be shuffled around to provide a nudge over estimates. According to the study, just $31,000 in quarterly net income is enough to beat estimates by a tenth of a cent (per share). See complete article at the WSJ: Afflicted by Quadrophobia.

Again, this should not surprise anyone familiar with the extreme pressure imposed by Wall Street on quarterly performance and the cat and mouse game involved in managing their expectations. Also not surprising is the corollary of the findings: that companies which engage in such shenanigans repeatedly have a higher probability of "having an accounting issue". I suppose that's what Enron had, "an accounting issue".

Putting aside such fundamental concerns, after catching the market's bounce from the recent correction, I don't really feel like pressing the long side. Especially since a simple market momentum gauge like the annual rate of change is hinting that we are headed for either a pause or possibly another tumble:

Click to open larger version in new tab:
S&P500 index comparison 250 day rate of change

As you can see from the chart of the S&P 500 compared to its 250 day rate of change, when we hit a high like we have (twice) recently, the market either plateaus or corrects. By the way, I chose the 250 day rate of change because that is approximately the number of trading days in a year (give or take a few days for leap years and holidays and such).

What the graph is showing visually is the concept that is inherent in all organic systems. To use an analogy, while a very fit person can sprint for a few hundred meters, they can't keep the pace up in the long term. They would need to pause and refuel before setting off again. So with the market. It has periods of expansion and contraction in all time frames.

Earlier this month I already touched on how momentum is waning as the market loses its afterburners. I think this is another indication of the same theory.

It also dovetails with what we've learned from Lowry Research, in that we are entering the last stages of this cyclical bull market. The momentum thrust, which lifted the market with a ferocity to befuddle almost everyone, is now over. The S&P 500 is now sputtering and while it may still have a few points left in it for the bulls, I don't think this is the time when you want to press it.

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Could The Recession Be Over?

More than a year ago I called it: We are in a recession!

It was rather foolhardy to go out on a limb like that but with the help of hindsight we now know that that was quite a prescient call. What I didn't expect was that we would be entering one of the most serious recessions we've seen in recent history.

Since the National Bureau of Economic Research has been keeping track of them, we've had 22 recessions (including this one). However, only 4 have been longer in duration:

length of US recessions chartoftheday
Source: Chart of the Day

It may be just as foolhardy to now do an about turn and declare that the 'Great Recession' is over. But we are seeing some indications of that. The bad news is that the sharp contraction in inventories that we've seen has been unprecedented in recent economic history. The good news is that such drawdowns have historically signaled the end of recessions:

US manufacturing wholesale inventories recessions
Souce: Doug Kass at theStreet.com

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Utility Stocks Snap Back


Yesterday I wrote about utility stocks being on sale. Today most of them gapped up in a technical snap back but finished the day poorly.

Still for nimble traders there was ample opportunity to take advantage of the short term oversold condition in this sector. Here are two charts from FPL Group (FPL) and Entergy (ETR) which are representative of what happened in this sector today:

entergy utility stock ETR.png

FPL Group utility stock FPL 5 min chart.png

We still have quite a ways to go to fully work out this oversold condition. Eventhough it won't be straight up to new highs, this sector bears watching. Especially the high prices stocks which present good low risk opportunities when they contract in range and volatility.

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I find the fractal nature of financial markets fascinating. You can look at a minute chart, a 30 minute chart, a daily chart, a weekly chart and you will see basically the same formations, the same elemental forces of support and resistance and the same setups.

As a trader, you can use this to your advantage. Switching time frames can help you avoid a "noisy" market. It's also a great trick to avoid looking at the same charts that everyone else is looking at. It can, in fact, be an edge if everyone is looking at the 15 minute chart, for example, and you're looking at the hourly chart or the 40 minute chart. You will see things that others will simply miss.

To illustrate what I mean, let me show you an example of a trade executed following the basic rules of the dummy trading setup: look for a thrust (expansion in price), then a contraction or pullback and hop on as the contraction is taken out by the continuation of the trend. The dummy trading setup is meant to be executed intraday but knowing the fractal nature of the markets, there is no reason we can't trade it at a higher time level. This example is a swing trade using daily charts.

Metalico Inc. (MEA) is in the hot metals sub-sector. It put in a stable, long base for over 4 months. Then in early April it broke out with unusually high volume. It consolidated a little around the $5.25 breakout area and continued higher. If you missed this first opportunity, the next one came on April 18th 2007 as price pulled back significantly. It formed a hammer like candlestick with a very long tail. This was a tell that price was being supported as a second wave of buyers saw their chance to get in on price levels they had missed before.

Metalico Inc MEA April 24 2007.png

The next day there was a contraction as it printed a narrow range, inside candle. This is what a "dummy trader" looks for! The break-out of this contraction (green line) then took price to the previous swing high and beyond. Notice also that the volume shrank significantly as price pulled back in mid April. This was another tell that people really weren't interested to part with their shares but rather to accumulate more (blue rounded box).

How you trade this setup is really up to you. You can wait for a tightening of the price range or you can wait for a real pullback. Traders like Tony Oz only get in on a deep pullback, preferably all the way back to the break out price. But as you can see with Metalico's example, you may not get such a deep pullback when faced with a strong trending stock.

I don't think anyone can say one entry setup is better than the other. Ultimately it is up to each trader to fine tune the setup to their liking and temperment. But keep in mind that such setups are merely starting places. Take them and build on them with your own ideas.

In any case, getting back to the point about different time frames... take a look at M&F Worldwide Corp. (MFW) on a weekly chart. Yes, weekly. And then count how many "dummy spots" you notice!

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Last week I wrote about the emergence of solar stocks and the solar sector as a white hot (pun unintended) area of the market. You should always pay attention when a group of stocks in a sector acts alike - like a school of fish or a herd of gazelles darting in one direction. This is a strong signal that has a terrific track record in pinpointing tremendously powerful thrusts in price action.

After I wrote that review, Shane sent me a note over the weekend pointing out that I had missed out on JA Solar (JASO). I was thankful but shocked! I still can't believe I missed this one because it is one of the few that have recently come public and I made a special note to pay extra attention to recent IPO's in this sector.

This is something I've learned from William J. O'neil's class "How to Make Money in Stocks" (I know, cheesy title, but brilliant book). O'neil says that new stocks (IPOs) are 'fresh' and have a new constituency. The fact that an IPO has 100% happy holders is a very important element of a sustained uptrend.

So which stock do you imagine rocketed higher? Yup, the one that I somehow missed:

JASO JA Solar Holdings.png

JASO went public just a few months ago in February 2007 and since then it went into a tight trading range between $20 and $16. Then late last week it broke through resistance with a wide range bar and massive volume. The next few days saw even more extreme price expansion with run away gaps and wide range candles as momentum players piled on. As far as I know, there is no news. This is a pure technically driven move.

Look at that intraday price action! You can't get any more beautiful than that chart. There were so many contraction areas that offered a low risk entry. If you've missed the move so far though I think the prudent thing is to wait for a pullback. There will be one as some of the longs will want to ring the cash register. Even if there isn't one, you never want to chase a parabolic move.

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