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“You’re gonna need a bigger boat.”

Equity Put Call Ratio

Well, at least I hope we’ll need a bigger boat if everyone jumps on board the rally that these two technical indicators say is coming.

The graph above shows you the Equity Put/Call Ratio. You can see that we are clearly in over-sold territory with the ratio of Puts to Calls at a 2-year high. This is one of those contrary indicators that tells you since investors are buying so many puts (insurance against prices falling) compared to calls (a gamble that the market is going higher) the bad news is already priced into the market and it should go up.

You can see that our current level is extremely high, and generally when the crowd all goes in one direction, the market goes in the other.

Percentage of Stocks Trading Above

This graph shows you the percentage of stocks trading above their 50-day moving average. The 50-day moving average is a key trend line to watch for equity investors – on the graph above you can see that I’ve annotated it to show you the extreme levels. When a significant number of stocks are trading below their 50-day moving average (you can see the green line that denotes the significant level) the market is generally set for a move higher.

On this graph, I’ve over-laid the S&P 500 index in purple so you can see the movement in stock prices compared to the indicator. I’ve also circled in green the over-sold levels (below the green line) and the corresponding low in the market. I’ve also annotated the over-bought levels (above the red line) and included red circles to show you the highs in the market that correspond to the indicator.

These are obviously short-term indicators. They can indicate simply a bounce higher in stock prices that corrects an over-sold condition in the indicator before a return to a downtrend or it can be the beginning of a more significant move higher. And naturally the opposite can also be the case relative to short-term selloffs and more protracted moves lower.

Earlier this year, I wrote on the blog that this year we’d trade in a range of 1200 to 1375 on the S&P 500 Index. As the year has progressed, 1250 has become a key level for the index.

S&P 500 Index

You can see that 1250 is roughly the current level of the 200-day moving average (the red line on the graph above). The market indicators above coupled with the 200-day moving average moving up to converge with the market price gives us a pretty critical situation. If this is just a bounce and the market can’t move toward the 50-day moving average (the blue line on the graph above) we have a fairly significant technical problem. A break below the red line would indicate the market would be in for a serious correction potentially back to 1050. A move above the blue line would mean a move back toward the 1375 level.

The fundamentals will give us the magnitude of the move. Right now, the market is shaking off the perceived impact of the end of the Fed’s program called QE2 (their most recent episode of printing money to stimulate the economy). Some smart people say that QE3 is already set to be unveiled with the name Operation Twist (in this program, the Fed will target either the 2-year or the 10-year treasury bond and not allow the yield to go above some pre-determined level, buying as many bonds at the treasury wants to issue in order to keep that yield below target).

If equity investors see that the Fed is continuing to stimulate the economy with Operation Twist (as Bill Gross says in inevitable) then look for stock prices to move higher. If Operation Twist is not in the cards and the economy continues to soften while unemployment continues to rise, then look for stock prices to move lower.

Our current strategy is to take some of the cash we’ve cash we raised in client portfolios and put it to work in some areas that look more oversold than other areas. As the bounce moves stock prices up, we’ll start to sell off some things that look like they have seen their best days. The 1250 level on the index will be key for us – if the market moves below there, we will raise additional cash in client accounts as the 1050 level will be in play.

We had 6% to 8% cash levels in accounts but have been putting some of that to work in the past few trading sessions. If we can move up toward the 50-day moving average, this will turn out to be a successful tactical move for our clients.

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Since one of my favorite movies was released on this date 36 years ago, I had to find a way to tie it into today’s post. Oddly, this movie came out before many of the critically important people that work on my staff were born, yet I can clearly recall sitting in the theater 36 years ago seeing it for the first time and being scared out of my socks when the shark came out of the water.

Sorry its been several days since the previous post – I was dealing with a case of kidney stones and was out of commission for a few days.

Thanks for reading, and keep checking back here for more analysis of the market at this critical juncture.