Last week, the market finally showed signs of improvement. Previous rally attempts have been squashed immediately and “selling the rally” has worked well. This time around, we are actually seeing some follow-through and the market is cautiously grinding higher. There have been a few intraday declines where the bears have tested the bull’s fortitude. Those declines have been contained and we’ve witnessed buying into the bell.
This morning, ISM manufacturing came in weaker than expected. National factory activity fell to 38.9 in October from 43.5 in September. This is the lowest reading in 26 years and a number below 40 indicates exceptionally weak activity. As I noted last week, I don’t believe that this number (or any other released before Friday) will spoil the rally.
Foreign markets were positive. The Nikkei was up 5% and Europe was up 1% on average. This has provided a positive backdrop and the market has been able to overcome early weakness.
In order for us to see a decent snap back rally, we will need to break out above SPY 100 today. That will force shorts to cover and we will have decent momentum. From Tuesday through Thursday, we could rally to SPY 110 and fill in the gap. This needs to happen soon because Friday’s Unemployment Report will cast a dark cloud on the market.
I like the bid to the market and for the time being, the path of least resistance is higher. In the back of my mind, I know that long-term conditions are very weak. Trading against the longer-term downtrend is a dangerous proposition. The best current option strategy is naked put writing. You can distance yourself from the action by selling out of the money puts on an unleveraged basis (keep half of the strike price in reserve so that you can always buy the stock on margin). This strategy takes advantage of time decay and declining implied volatilities. This is not a time to spread your wings, we have to be very careful and we need to keep our size relatively small.
Once this rally exhausts itself, we can get more aggressive with bearish trades. At that juncture, the premiums will be less expensive and we will be on the “right side of the market”.
Focus on stocks that have firm support levels and have been leading the recent market rallies. Place a stop to buy back the puts if those support levels are breached.
I expect the market to stage a nice afternoon rally, but I don’t know if it will have the strength to get through SPY 100.