Reward and Risk Increasing

I believe being positioned correctly over the next couple of weeks will have a great impact on 2010 returns. I believe that both the reward for being right and risk of being wrong is elevated right now (I’ll make my point below). I’m starting off today by doing a summary of the moving averages and taking a look at certain sector ETFs.

MOVING AVERAGES

Notable changes in the moving averages are as follows:

1. Commodities: SLV, NIB (Cocoa), BAL (Cotton) are now trading below their 200 DMAs. JJN (Nickel) is trading below its 100 DMA.

2. Bonds: LQD, JNK and HYG are now trading below their 100 DMAs.

3. Currency: EUR/USD (FXE) remains in bear mode. My target for FXE is in the $132 range. It is quite oversold right here, so I would expect a bounce before we hit the target. However, the break through horizontal and MA support makes it unlikely that we’ll see a reversal. I must admit that I am having less confidence in my 2010 prediction of a sideways USD based on the FXE chart as well as some of the other currency pairs.

Other notable currency observations:

GBP/USD (FXB) is also trading below its 300 DMA and is now solidly in bear territory with EUR/USD.

4. Volatility: $VIX is trading above its 200 DMA after breaking out from a bull flag. Note that we have not seen volatility above its 200 DMA since March-April 2009. Volatility is expanding.

INDEX ANALYSIS

On Friday, the market was down over 10 S&P points the entire day and reversed during the last hour. It is not surprising to see the bounce based on many of the weaker ETFs hitting their 200 DMA.

The following indexes bounced off their 200 DMA: XLE, XLF, SMH, XLB, XLU, XME and EEM.

Some might read this as a pivot point. After all, the market was down and the market reversed strongly once these indexes hit support. My argument against this being a buy point is that it would be pretty unlikely for these indexes to not find some support at the 200 DMA. With that in mind, I don’t put much weight in the fact that the decline found support. I would have been surprised if they didn’t bounce here. But how significant will the bounce be and how long will the duration be? I don’t see anything that makes me believe this bounce is more than just a short lived support bounce.

If we look at the major indexes (DIA shown above), I also see that the major indexes bounced of the infamous “Lehman gap” (see Oct 2008). Again, not a surprise that the indexes did not simply cut through such a strong support level.

CONCLUSION

EUR/USD (FXE) is getting crushed and is in bear mode. Moreover, GBP/USD (FXB) is also in bear mode and appears to be headed to $152 (another way of saying the dollar is in rally mode). As we might expect, commodities are getting crushed. Whether it is agriculture or precious metals, the currency reversal has deflated commodities. Additionally, the bond funds (LQD, HYG, JNK) are all breaking down below their 50 and 100 DMA and look poised to test their 200 DMAs. Volatility is also expanding (the $VIX) and now above the 200 DMA.

We’re getting close to a juncture whereby both reward and risk are increasing. The reward is timing your buy off the 200 DMA. If it holds, you get a fantastic entry point. It becomes the perfect “buy the dip” opportunity. Of course there is no free lunch. That reward does not come free. As I have written previously, the largest declines often come when volatility is elevated with the market indexes trading around or below their 200 DMA. So if this European  sovereign debt crisis actually does have teeth, it is possible that you might be buying right before a deep selloff.

For now, I think it is best not to buy this selloff. Here is what I don’t like:

1. Bearish Euro an Pound. The currency markets tend not be as fickle as the stock market. If these charts are in bear mode, I don’t want to bet on them quickly reversing. This means I expect a strong or sideways dollar. This is bad for stocks and commodities.

2. Bond Funds. Everybody has been calling a bond bubble, and we’re finally seeing these funds breakdown. Weakness in the bond market often precedes weakness in stocks. Or in this case perhaps more weakness in stocks.

3. Volatility. Volatility appears to be breaking out. While extreme volatility can be a contrary indicator, I would not call the VIX at 26 to be hitting extremes. Rather, I would say that we’re seeing an expansion of volatility. This is when things can get dangerous.

My plan would be to reevaluate many of the indexes discussed above when the main indexes (SPY, DIA, IWM, QQQQ) hit their 200 DMA. I would be surprised if Friday turns out to be the low. We’re simply too close to the 200 DMA on the main indexes and I would expect the 200 DMA to act as a price magnet.

I mentioned that XLE, XLF, SMH, XLB, XLU, XME and EEM hit their 200 DMA on Friday. Let’s see if the indexes hold here. If the market is going to continue higher, these indexes should hold while the stronger indexes should trade down (that’s how the main indexes will get down to the 200 DMA). Put another way, we’ll see a mean reversion where the weak indexes flatten out and the stronger indexes (e.g, IAT) trade down.

If these weaker indexes breach their 200 DMA, I would expect them to be leading indicators that the market will continue its slide. Let’s see if they hold. In particular, let’s see if FXI finds support off the 300 DMA. Remember, I don’t think this market is going anywhere without a healthy China.

(FXI nearing the 300 DMA)

Ultimately, playing the market at this critical juncture should mean scaling into it. If I do see conditions that make me believe that support will hold, I would start by entering a position of 10-15% of my total capital. I would only add to it once profits started to accrue. Adding a large position size on this pullback is tempting because of the potential reward but it is a risky proposition for the reasons referenced in my post hyperlinked to above.

Meanwhile, if I start to see confirmation that the market is heading lower, I would wait several weeks to get short. If this is something bigger, there will be plenty of time to get short. I don’t want to be early because the move lower through critical support will undoubtedly be sloppy in both directions. I would rather wait for a definitive break to let me know we are in bear mode. Trading through that slop would be very very difficult.