Be Patient – Wait For A Breakdown – The Get Short!

When oil inventories and the Beige Book are the two primary economic releases, you know it's going to be a slow news day. Yesterday, the market pulled back sharply after establishing a new relative high Monday morning. The selling pressure was persistent and the market closed near its lows of the day. Commodity stocks were hit particularly hard. They have made astronomical runs in the last two weeks and they are overbought. Cyclical stocks also retraced and they are priced for a full recovery. Any hiccup in economic activity will force a swift decline as bullish speculators head for the exits. Yesterday's decline was partly due to excessive optimism. Last week, call buying reached levels we haven't seen in over four months. Almost every analyst I see on CNBC is bullish and over 80% of newsletter writers are bullish. Option implied volatilities are falling and they are at 18 month lows. This means that traders are not hedging and they are not buying puts for speculation. When sentiment gets this lopsided, a quick reversal often results. Year end seasonality is behind us and the market will have to find another catalyst. It won't be interest rates since they are as low as they can possibly go. Economic news has started to soften and the gradual improvement could stall in the next two months. Small businesses account for 50% of the employment in the US and they are not hiring. Large corporations have scaled back and when they do add staff, it is overseas where the growth is stronger and the wages are smaller. Health care reform is another variable that will keep firms from hiring in the US. States will also be laying off workers to balance budgets. Now that the holidays have passed and the stimulus money has been allocated, businesses will want to see if the economy has legs of its own. I believe consumption will be slow to recover. The catalyst for the next rally will have to come from earnings. Stocks are priced for great results and we are likely to see optimism over the next two weeks. Once we get past the financials, I believe stocks will decline on the actual earnings releases. Profits will be fantastic, but revenues will be flat to slightly higher. A real trade war is brewing between the United States and China. It escalated two weeks ago when the US imposed duties on Chinese steel. Today, Google announced that it might pull operations from China. There are too many obstacles and restrictions for them to compete effectively. If this battle does not end quickly, it will fester and escalate. Tomorrow, initial jobless claims will be released. If the number is soft (greater than 440,000) the market will decline. Last month's Unemployment Report is still being viewed as a fluke, but if mounting evidence suggests a jobless recovery, traders will get nervous. Retail sales are likely to come in strong according to MasterCard's estimates. However, that news is priced in and stocks have room to pull back. Friday's CPI number could be very interesting. Last month, it showed a .4% increase and that was much hotter than expected. Upward pressure on interest rates would not be good for the market. Buyers have stepped in and the market looks like it will be able to hold a rally today. The Beige Book should show decent economic activity and it will support higher prices this afternoon. I don't believe we will erase yesterday’s losses today. If the market breaks below SPY $113.40, I will buy puts. If the market breaks below SPY $112 I will add to the position. At this stage, I only want to play a breakdown. I sense that we are close. I do not want to sell call spreads because the premiums are small. It’s tough to be on the sidelines, but that is where I am most comfortable right now.

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