Fight or Flight?

We are in the midst of a market pullback. That has been obvious from just the news. Long term investors are used to riding these out. But short-term traders have decisions to make. Is this just intermission or is it time to head for the exits?

The pullback has lasted 10 trading days. The S&P 500 has retreated only 1.8%. It has set a slightly lower high and a slightly lower low. Volume on down-close days has been slightly above average. Each average so far has respected its 50-day moving average.

The NASDAQ has been slightly stronger, the Dow Jones Industrial Average and the Russell 2000 have been slightly weaker. In painting a picture of this pullback, I have to skip the bold colors and go with the pastels.

I do not have a crystal ball that works well (turning it upside down I see it wasn't made in the USA. That's what I get for buying one from QVC). But I can list the pros and cons of the current environment to help decide whether ‘fight' or ‘flight' is appropriate.

The markets move in cycles. They always have, it's human nature. Looking at the S&P 500's chart, over just about any time period I pick, I see a roughly 1-1/2 to 2 month cycle. Sometimes the cycle lows occur 1 month apart, sometimes 2-1/2 months apart, sometimes it is hard to identify a low, but overall, short-term cycle lows average a little less than 2 months apart. Using that reasoning, and the Stochastics indicator to help confirm actual and likely lows, I feel that nothing is unusual and I can expect another short-term low to be set within the next week or two.

I continue to add up the pros and cons for thinking the market will soon reverse and resume an upward trek.

Pros

There is no evidence of widespread panic selling.

There may be a positive market reaction if the proposed two-year budget deal is approved. See House passes budget pact by wide margin.

The Fed is still indirectly pumping billions into the stock market each month, and contrary to the ‘taper' talk, that is not likely to decline much in the near future. A good summation of the situation is expressed in an article by Matthew Lynn on Marketwatch.com titled Central banks will move goal posts to keep QE forever.

This is the time of year where historically, buying shows up from new money coming in (from year-end contributions to IRAs for example) and institutions look to polish up their portfolios. In fact, the seasonal chart for the S&P 500 shows a steadily increasing average return over the next six months:

(Note: The NASDAQ's seasonal chart is slightly stronger for the next 2 months, the Russell 2000's chart is slightly weaker. Whether or not it plays out this year, tech stocks are usually strong gainers this time of year and small caps on average are not big movers).

Cons

Recent earnings reports and guidance have been weakening.

Interest rates are headed over 3%, and possible geopolitical events could cause a sudden change in attitude. Art Cashin at CNBC sums this up at Here are the 3 biggest risks to stocks.

Many stocks have Stochastic indicators that have been stuck at the top for some time, reflecting the upward pressure on stocks in recent months. Statistically, we are well overdue for a good pullback.

So what is my decision and what approach will I be inclined to take?

Until the situation changes significantly, I will wait for a short term cycle low to look for new long stock/bullish option trade possibilities. Current positions can be protected with trailing stops.

I would consider small positions in inverse market ETFs with a trade plan to exit them quickly upon a strong upside reversal in the market. My favorites in the past have been SDS (ProShares UltraShort S&P500, an ETF that seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the S&P 500), SKF (ProShares UltraShort Financials, an ETF that seeks daily investment results, before fees and expenses, that correspond to two times the inverse (-2x) of the daily performance of the Dow Jones U.S. FinancialsSM Index.), and FAZ (Direxion Daily Financial Bear 3X Shares, an ETF that seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the Russell 1000® Financial Services Index).

Do not use inverse ETFs for medium to long term investing, only very short term trading. Also, since they use derivatives and leverage to achieve 2x or 3x performance, make sure you understand how they work and what their tax implications are.

Right now, all 3 inverse ETFs have the same pattern – a recent high that they are currently challenging. If SDS (or SKF or FAZ) break above the recent high, AND the overall market has a very negative tone, then a small position in one of these inverse ETFs, targeting a 5-10% gain within a couple of weeks, and exiting quickly if the market turns strongly positive, could make a good trade.

But remember that seasonal chart I showed you. The historical odds are in favor of further upside going into the January earnings reports, otherwise known as the “Santa Claus rally”.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, type in www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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