Today as you all know is Independence Day and markets are closed for the holiday. Tomorrow we will be receiving the June Jobs Report around 5:30am pacific time, so be prepared for some volatility in the markets. Especially after a day off, traders will be looking to use tomorrow's job's headline to make up for the lost trading day this week.
Basically what we will be watching for will be a resolution of the downtrend either higher and breaking through resistance or a continuation move lower. As we have been discussing over the past few weeks, the markets seem to be in a transitioning phase after the 8 month rally. The major indexes have all put in a lower high and a lower low within the past month and that is the first signal of a downtrend. While it appears that the market should trade lower from here technically, would it really be a surprise if it just continued to move higher throughout the summer? It would seen illogical for it to move higher, but the market is one place where logic holds little sway. So we need to be prepared for the likely outcome (continuing lower short term) AND also being mindful of where the downtrend becomes invalidated should it move higher from here.
Lets take a look at the anatomy of the rally from a 6 month daily chart:
You can clearly see the string of higher lows and higher highs from January though May. But then you can also see how a lower high was made and then followed by a lower low. We may be seeing a second lower high here as price has gotten stuck below the 20 and 50 DMA's.
Our primary focus needs to be on how the market handles this short term down trend and whether it can break above its resistance line and make a higher high.
For the downtrend to be broken and making us bullish on stocks here again we need to see a few things:
First, the market needs to trade back above both of its key moving averages, the 20 and 50 DMA's.
Second, we need to see price break, close and follow through above the downtrend resistance line.
Lastly, we want to see the follow through move take out the prior "lower high" at 1,654.
With those 3 conditions in place I would be convinced the downtrend is broken and it would be time to get bullish on stocks again.
Until that happens however, we have to assume that the market is undergoing a deeper correction and we need to protect the majority of our capital. There are some opportunities out there to be had now, but they should be treated cautiously and with one foot out the door on your stops. Generally its dangerous to be buying when the market is shifting into a down trending cycle, so make sure, if you are doing some buying here to keep purchases to only the strongest individual names and with only a small portion of your available funds.
In a down trending market I like to put on "Pair Trades". Basically you buy an outperforming asset and short an under performing one against it. For example I bought some small amounts of HD, F and TWX earlier this week and then shorted the SP500 against those positions. The way this trade works is I buy a stock or ETF that is outperforming the SP500 and then to hedge (protect) my bet I then short the SP500. If the market trades higher I then expect to make more on my outperformers than I lose on shorting the under performer. If the market goes down I expect my stronger holdings to hold up better than the market and lose less, while my short position makes money, lessening the blow to my account.
Its a fairly basic concept and by following our model portfolio we already do half of the trade. We already buy outperforming stocks and ETF's, so basically one easy way to protect against the down market is to short the under performing asset while still keeping your strong holdings. Pairs can come from any two assets you choose to compare. You could buy Europe and short China, that is a popular trade that All-Star Charts has been mentioning (fantastic blog btw). You could buy Discretionary's (XLY) and short Staple's (XLP) against it. These are just a couple examples of how a Pair Trade can be put on. The basic gist of the concept is to be long the winner and be short the loser. That way if the market rallies, your winner makes more than you loser and if the market goes lower, your loser loses more than your winner. This is just a hedging strategy however and should only be used when the market is transitioning and you are trying to reduce overall market exposure. With a pair trade you will never make as much as you could picking only one side of the trade, but it reduces your risk of a big negative move by the markets if you anticipate trouble ahead.
Heading into Friday, our blog portfolio is still roughly 50% invested as that is invested on the longer time frame. We had one more casualty this week as I sold the XLE when its bounce into resistance seemed weak. It is currently trading just at the underside of the 20 WMA and I was simply not pleased with how it was attempting a rally. As for my personal accounts I am only net 25% exposed to the long side of the market. I have roughly 50% of my funds invested, but as discussed above I am holding a few pair trades that are balancing and reducing my overall exposure. I have a feeling tomorrows report will set the tone for the next leg here as we move back into earnings season. The next couple weeks should be largely dictated by the reaction to tomorrow's news event. Make sure you don't miss it.
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