Option Traders – Warning Shot Fired – Take Profits Into This Rally.

May 12, 2008

Last Wednesday, the market hit heavy resistance at SPY 142 and it fell by 30 S&P 500 points. It has struggled to tread water ever since and I believe a warning shot has been fired.

The market has rallied from a level where worst-case scenarios were priced in. Thanks to aggressive Fed action, a full-blown financial crisis was avoided. Without question, the market was oversold during its capitulation low and retest in March. Now, the pendulum has swung the other way.

Financial stocks looked tired last week and traders have become numb to the write downs. New capital has been raised, diluting existing shareholder value. I believe this sector will struggle to hold recent gains.

This morning retail stocks are up on positive comments from Ann Taylor and an upgrade in Wal-Mart ahead of earnings this week. Any rally from this point on will present a shorting opportunity for this sector once it stalls.

Economic numbers have been meeting expectations, but they have still been weak. Unemployment continues to rise, inflation is moving higher, consumer confidence is low and debt levels are very high. Consumers are losing their purchasing power and they are getting hit on a number of different fronts.

I am not bearish; I just believe that we need to trade the range. Buyers have become more passive and they demonstrated that last Wednesday. When they put their wallets back in their pockets, the market dropped like a rock. This is a good time to be in cash and to wait for a pullback. Aggressive accounts can short the financials, casinos and durable goods.

This morning, oil is down and the dollar is moving higher. That has set a positive tone for the market. Overseas markets were also positive and that provided a springboard.

It will be interesting to see where the CPI comes in. It takes time for higher prices to filter down to the consumer level. We have already seen big PPI numbers and I think this month we will see and a hot CPI number as well.

Lower oil prices could mitigate a big CPI number and hopefully, today’s drop in energy prices is not a one-day event. If we get a hot inflation number and oil holds this level, traders will be expecting an interest rate hike from the Fed when they meet in seven weeks. The notion of higher interest rates could spark a market pullback.

Today’s rally seems to have stalled and quiet trading is likely to set in for the rest of the day. The path of least resistance is up and the market will hit resistance at SPY 140.50 today.

I’m not expecting it, but an afternoon decline would be a bearish sign.
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