We’re currently in the midst of an overbought rapture of retail investor effusion, one that will send markets unpredictably higher in the very near term before an inevitable stall brings it all to a halt.


At that point we’ll have to see what happens.


It could take a few days, a few weeks, or a bit longer, but there’s little chance it won’t occur.  The trajectory has been set, the momentum is building and the masses are enthralled.

What’s less predictable is how the rest of the investment world will respond.  In particular, we’ll be looking to the bond market and select commodities for our cues, but equally important will be the emerging markets and local high yield securities, all of which offer a meaningful gauge of where the next big moves are going to take place AND what volume of selling we can expect from equities.


As we’ve remarked repeatedly in this space over the last couple of years, we do not believe the final market top is at hand.  There’s still a measure of hubris that has to be attained before the ultimate heights are reached, and the current mood is nowhere near where it has to be.  Moreover, even the sentiment indicators we watch, while relatively stretched in terms of the last few years, are nowhere near the absolute levels we would expect in order to become outright short sellers of equities.



We have long suspected that the final blow-off top will be a jagged affair that sees extraordinary swings in the major averages before they attain their final highs.


The only thing we might compare it to, is the final moves of the silver market back in 1980/81 – a series of zigzags that not only signaled an all-time high in the precious metals, but also the birth of a bull market in stocks that has yet to look back for close to forty years.


Have a look –

Frequent moves of 50% or more in both directions regularly occur on the way up.


Projections and Expectations


To repeat, the coming stall in equities will not mark an end to the bull, but it will trigger action in other areas we deem significant.  While nothing is perfectly clear at this stage, we already see the trend in the commodities forming, and it’s higher.  Energy and precious metals will both see gains and industrial metals should also pace higher.  The latest action in markets has seen an almost 1:1 inverse relationship in the action between equities and commodities.  Look for it to continue.


As far as bonds go, we’ve seen a bout of weakness recently, and many big names in the fund camp have called for a bond bear to begin henceforth, a development that – if it transpires – could send great sums flowing very quickly into other domains – and then back again, as the requisite reaction takes place.


In short, it’s no time to look back. We’re in for bumpy ride in the near term.

Pass the salt!


One of the immediate triggers on the sell horizon is the month-end portfolio balancing incumbent upon pension, hedge and other funds as their investments trend higher and lower.  A fund that, for example has opted for a hypothetical 50-50 equity/fixed-income allocation has to maintain that balance.  And because the month just ended saw a strong surge in equity prices (and a slight drop on the bond side), a commensurate selling (and buying) of those assets is due to take place.


According to numbers offered by Credit Suisse, there’s roughly $12 billion worth of selling that should hit the U.S. market in the coming days from funds that rebalance, and an additional $12 billion from pension funds that invest overseas.


And that, says Credit Suisse, is “a relatively large amount relative to recent history for a month that does not coincide with quarter-end.”

Will it Ignite the Spark?


Our trade for the day is predicated on the notion that, yes, we’re about to see some weakness in equities.


And the equities that we’re choosing to focus on for the trade are generally the leaders of the stock pack – the Transports.


As you’ll see below, the rise in the trannies over the last two months has been phenomenal, a better than 20% surge that culminated in an important Japanese Candle formation that we’ll now show you.


Have a look –

Take a look first at the move that began in late November (in red) that added 21% to the index.  It resulted in an overbought RSI condition for a full week (red circle at bottom).


At the same time, price was tracing out a textbook bearish engulfing pattern that marked the highs for the move (blown up, in black).  This pattern is a very reliable reversal indicator.


At this point, we’ve had a test of the former highs at 11,400 (that failed), a breakdown in RSI (below the 80 line), a cross lower on MACD, all of which point to weakness in the immediate future.


The bulls have to hope for a break above former highs at 11,400.  The bears gain momentum with any and all closes lower than yesterday at 11,184.


We believe the transports will decline to longer term support at roughly 10,000.


On the other hand, the above mentioned strength in the commodities has been due, in large part, to ongoing dollar weakness.  The dollar has been absolutely pummeled of late.


Here it is –

Despite a dreary technical picture, though, RSI indications are pointing to a near term bounce.


And therein lies the other side of our trade.


We’re using the iShares Transportation Average ETF (NYSE:IYT) for the trannies and the PowerShares US Dollar Index Bullish Fund for the dollar (NYSE:UUP).


And it looks like this –

- Content protected for Normandy Executive Lounge, Option Trader Elite, Executive Lounge members only]

And the UUP CALLs are already three bucks in-the-money!


Many happy returns,


Matt McAbby

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