PM: Close above 1500

PM Update

The S&P500 continues making new highs, but who is buying and why are they buying?  That is the key to understanding where we go from here.  After some reflection I realized why I blew the AAPL call and hopefully this will keep me from making the same mistake in the future.

MARKET BEHAVIOR

The S&P500 finally closed above 1500 and finished near the day’s high.  Volume was slightly above average as a decent number of traders show a willingness to buy stocks at these levels.  But are they buying stocks here because they think the market is headed higher, or are they buying for other reasons, such as covering an index short as part of unwinding their hedged AAPL position?  Understanding motivation is an important part of figuring out where we are headed.

MARKET SENTIMENT

Stocks are making a strong move after breaking resistance at 1470 and have come 30-points in six-trading days.  The last down-day of any real significance was 13-trading sessions ago when the market dipped a measly 4-points.  To find a more meaningful sell-off you have to go back to the final days of last year during the Fiscal Cliff gridlock.

It is amazing how calming a smooth rally is on the nerves and there is far less fear in the market than the closing weeks of 2012.  But as a contrarian trader, I feel more comfortable when everyone else is nervous.  It is nice to think the market can rally for dozens of days without selling off, but typically the real world isn’t so easy.  There is no reason to expect a major pullback, but some selling would be normal after rallying 100-points in less than a month.

One of the more interesting dynamics at play is the market’s strength in the face of AAPL’s collapse.  I wrote why hedge funds are buying the index as they unwind their AAPL potion in this morning’s blog post.  The concern for traders is this short-covering is not an enduring phenomena and without new buyers expecting higher prices, we risk running into a ceiling real soon.  But that is a good thing, pullbacks are a health and normal part of moving forward.  When we go too-far, too-fast, it doesn’t end well.

TRADING OPPORTUNITIES

Expected Outcome:
There is no reason the market cannot rally 14+ consecutive days without a minor pullback, but the further we go, the more we push our luck.  Knowing how the markets work, it would be foolish to suggest people rush out and buy after so many up-days.  Can we go higher?  Sure.  But is that a high-probability trade?  Of course not.

The bigger challenge is figuring out how far the inevitable down-days will go.  Will it be another 4-point dip before rallying the next day?  Or will we pull back to support at 1470?  We tend to go down faster than we go up, so we could easily retest 1470 over a couple of days next week.  But don’t short the market expecting a lot more selling than that.  Take profits early and often in any counter-trend trade.

Alternate Outcome:
If the expected outcome is a down-day after 13 up-days, then the alternative is another dozen up-days.  That surely would surprise market participants as they watch in awe as the market leaves them behind.  While the contrarian view says we should expect the unexpected, we also need real buying to propel a move like this.  If new buyers develop a fear of heights, the market peak will be a self-fulfilling prophecy.  Can we rally for a month without any real selling?  Sure.  It is likely?  No.

INDIVIDUAL STOCKS

AAPL gave up another $10 as hopeful traders waited in vain for the expected rebound.  But I can’t be too critical, Wednesday afternoon I was an AAPL bull too.  As part of my blown call, I’ve done some reflection on why I got it so wrong.  It turns out I fell for one of the things I often warn other people about and that is thinking the contrarian trade is going against trend.  AAPL’s decline had clearly gotten a little out of hand and that obviously meant traders were overly bearish in the name.  But what I forgot is contrarian is going against the crowd, not the trend.  If I dug a little deeper I would have realized most traders felt there was real value in AAPL and it was only time before the stock bounced back.  The crowd expected a bounce, not a $50 selloff, and that is why we ended up with the plunge lower.

Contrarian trades work because people trade their conviction.  People own what they think will go up and sell what they think will go down.  If everyone expects AAPL to bounce, they already own it in anticipation of the bounce.  But if everyone already owns AAPL, who is left to buy?  That is exactly what happened on Wednesday and Thursday, AAPL put up good numbers, but the stock plunged because everyone who wanted AAPL already owned it and no one was left to buy.

I know better, but that still didn’t keep me from developing a blind spot when I was convinced of the value in AAPL.  The saving grace is I limited my losses by keeping my position size reasonable and cutting my losses quickly.

Stay safe