Take a wait and see approach

Man, I can't stop eating cherries. I just picked a bunch from my tree and it's stopping me from typing this post. OK first of all, last week....wow. Nobody, neither bull nor bear expected that degree of a pop. So, did we see the bottom? Well, I have my doubts. There was plenty of doom and gloom as I was noting at the time, but there wasn't panic. I also don't think the market "reset" enough as I talked about in my previous post. This rally had short squeeze written all over it. It looks like the bears were overzealous "shorting strength". It seems as if the entire trading community went short at 1300 "resistance" and got their asses handed to them.

Now we have a market that is as overbought ST as I have ever seen seen it. During the first thrust out of a correction bottom or new bull market, you tend to see such behavior which is actually bullish longer term but in a bear market or a still ongoing correction phase, such conditions represent a great selling opportunity. We're gonna find out which one it is. During last summer the market got this ST overbought in late July. What happened later was a small dip followed by a higher high and then the market tanked the whole month of August. So, even when ST overbought conditions do occur in bear/correction phases it can still be tricky for bears to capitalize on the short side if they try to play the day to day action using tight stops.

Looking at the bigger picture it still suggests taking a wait and see approach. It looks as though the effects of China's tightening are finally starting to be felt wth a key manufuacting guague showing a slowdown for the month....and yes I know it's just 1 month. Will there or will there not be a "hard landing" in China and emerging markets in general? Commodity related investments are obviously at risk here and they have been in a declining trend this year in response to global slowdown fears. I just read an article on bloomberg that said net long positions in 18 different commodities has been reduced to the lowest level since July 13, 2010. If you remember, that's right where the market and commodoties bottomed last summer. So from a sentiment perspective, this is good news for commodity bulls and equity bulls too. However, I should point out that regarding oil, arguably the most critical economic commodity, there is still a rather large net long position of about 153,000 contracts. At the July lows of last year it was only about 50,000. So, all in all, the hot money is being flushed out of the commodity space but there's still room for more flushing. This is part of the "resetting" that I think the market needs. Unfortunately, last week's rally prevented this reset from being fully completed.

So, is the slowdown in global growth going to be temporary like last summer or will it result in a reccession? I think the answer will lie in between. The Economic Cycle Research Institute (ECRI) is an economic forecaster that I respect the most. These guys have a superb track record of calling major turns in the economic cycle. Last summer they predicted a slowdown and some permabears like Hussman were using this call to justify their double dip predictions. ECRI was quick to respond by saying that they were only predicting a temporary slowdown not a reccession. This time around ECRI is more bearish. Although they aren't calling for a reccesion (at least not yet), they are calling for a slowdown that will likely persist throughout the remainder of the year. They also made it clear that this forecast had nothing to do with Japan. Bernanke thinks this "soft patch" will end by the summer. This goes against the forecast of the ECRI which has the better track record.

So then, what to do? My belief continues to be that this bull market has not fully played out because monetary conditions and public sentiment towards the market/economy suggest it is still in tact. But having said that, bull markets will tend to have large consolidation phases where the market goes sideways or moderately down for several months, even up to a year or so. I think this is where we're at for the time being. If you play the bigger swings like me and have been riding the run since September, then it's time to step back, harvest profits and take a wait and see approach to see how this shit plays out. This implies having a large cash balance and reducing exposure to growth sensitive stocks (preferably on strength). There's a time to press offense and there's a time to play defense. From a 2-6 month perspective, it's time to play some D here.

I always emphasize focusing on the bigger picture. Weeks like last week will make you very tempted to do just the opposite. I for one will not get sucked into the casino of daytrading and ST trading. So, what do you do then? Just sit in cash? Well, not entirely. I would still be willing to have some exposure in names that have a good story that aren't strongly correlated to the general markets. What about shorting? Well, in bull markets I am reluctant to do so, even during times like this when I feel the trend will be down/sideways for a while. I have to admit though, I get very tempted. But what if this is not a bull market anymore? Well, in that's case it's best to wait for the market to truly roll over with the fundamentals (earnings) in a decisive deteriorating trend, not just a downshift from positive to less positive. If the permabears end up being right and we're going back to SPX 700, there will be plenty of opportunity to make money on the short side....there's no need to pick tops. Top picking bull markets will destroy you. Just ask an elliot waver who went 200% short as per the recommendation of Prechter in November 2009. I wonder if that loser ever apologized for that call.

One trade I'm considering is long TLT December 90 calls which I suppose is similar to a short bet against the market since bonds have been negatively correlated to the market as of late. Why this trade? A few reasons. 1) There is so much hatred towards bonds from both equity bulls and bear alike
2) Given the data, it's quite unlikely the fed is going to raise rates until at least some time next year
3) The recent peak in commodity prices suggests that inflation pressures will be abating
4) Taking a look just at the chart ignoring any news, biases or predispositions, it sure looks to me like a bottom has been recently formed and the recent dip in bond prices looks like a pullback in a new uptrend which is ideal for an entry point.

If I go ahead with the bet, it will be an "all in" type trade meaning that I'm willing to lose 100% of any capital I commit to this trade. To me, this is the way to play option trades like this....you gotta swing for the fences because the day to day noise volatility with option trades like this is far too great to use stops effectively. So, if you're gonna risk losing 100% if you're wrong, you ought to be aiming for at least a 100% gain if you end up being right and that's the case with this trade. I think TLT hitting 100 before the year is over is quite doable and that would translate into at least a double for TLT Dec 90 calls.

It's been well over a year since I've made an option trade. Here are my rules

1) the trade must be with the trend
2) give yourself at least 3 months until expiration
3) Use in the money options with at least 65% intrinsic value
4) go all in, no stops aiming for at least 100%

If you are going to be aggressive like this going "all in" you must never risk a large amount of your capital. For me it's going to be in the 5% range if end up pulling the trigger.