This Decline Will Set Up A Buying Opportunity. Let It Run Its Course

January 31, 2011
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last Friday, the market opened on a positive note. It was able to shrug off a dismal initial jobless claims number, weaker than expected durable goods orders and a “soft” GDP. By midmorning, buying dried up and profit-taking set in.

Japan’s debt rating was lowered by Standard & Poor’s and unrest in the Middle East spooked investors. As I’ve been mentioning, bullish sentiment has been off the charts and the market was overdue for a correction. Speculators need to be flushed out before the market can push higher.

I don’t want to downplay the significance of what is happening in Egypt, but these events should not disrupt the global economic recovery. The market can deal with wars, terrorism and recessions. It cannot deal with a credit crisis.

The new European financing facility that has been established gained support last week. The initial €5 billion bond auction was greatly oversubscribed and credit markets have calmed down. Japan and China are supporting those auctions. This condition can change rapidly if PIIGS countries fail to make structural debt changes in coming months. For now, these seas are calm.

Corporate profits are on the rise and 75% of the companies that have reported have exceeded estimates. Another 12% have hit estimates. Companies have increased profits by 35% year-over-year.

Most sectors have reported earnings and we should not see too many surprises. This will be another busy week of earnings releases and we will start hearing from retailers next week. This morning, we learned that consumer spending increased .7% last month and that was better than the .3% analysts had expected. We know that December retail sales were a little weaker than expected and bad weather was to blame. I am expecting a positive reaction to earnings this week.

The focus will shift slightly in the next few days. Major economic releases like ISM manufacturing, ADP employment, initial jobless claims, ISM services and the Unemployment Report will be released. Jobs are the key to a sustained economic recovery and initial claims have been creeping higher the last two weeks. We need to see decent employment numbers this week if the market is going to hold its current price level. Last month, ADP employment showed 300,000 new jobs in the private sector. They process payrolls for small and medium-size businesses and we need to see that strength again this month. If the number comes in weak (less than 150,000) we could see a negative market reaction.

From a technical standpoint, I mentioned that a second major decline off of a new relative high would signal a temporary top. We have that formation and I believe stocks will test the downside before they rebound. Support at SPY 126 should hold. If it does not, major support at SPY 123 will be tested. I don’t believe it will be breached. In fact, one of these two levels will set up an excellent buying opportunity.

I have been selling out of the money call credit spreads and those positions look excellent. Once support is established, I will start selling out of the money put credit spreads on commodity stocks. This sector looks very strong and it has weathered the decline nicely.

Look for the downside to be tested today. I believe the selling will be rather contained. A “soft” jobs number this week could spark the next leg of this decline and it should flush out the remaining bullish speculators.


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