Keep your pants up!

As the saying goes: “Don’t get caught with your pants down!”

Last week the market broke to new highs on the Fed’s announcement of QE2. I am in the camp that the installment of another QE program isn’t necessarily good news in the long run. Regardless, the markets rallied nicely at the end of the day on Wednesday and then again on Thursday. In addition, financials finally got up “off the mat” and took part in the rally. So, does this mean the markets are embarking on a renewed up trend?  It would appear so, but it’s definitely not a forgone conclusion.

I have to admit that I was just as surprised as anyone when the markets hit new highs last week. Actually, I never even thought we’d be able to get back up to the April highs, let alone exceed them. As I began to re-evaluate this market’s latest move, this “surprise” reminded me of some other times I have been surprised by the markets hitting a new high.

Please review the following charts of the S&P 500:

The first chart is from the all time market top in 2007. I remember thinking that a bear market had probably started in July and August only to have us hit new highs in October. Hitting the new high surprised me, but it turned out to simply be a fake-out and the start of our current bear market.

The second chart is less than a year later. The 1400 area had been a very important price level for the S&P. So, breaking above it in May once again surprised me. As it turns out, this was a fake-out as well and down we went.

Now, am I saying that our recent breakout is a false one? Who knows? Interestingly enough, the markets have yet to follow through on Thursday’s breakout. If we pullback over the next week or so, which I fully expect, I will be curious to see how the volume pattern unfolds. If you look at the previous fake-outs and the selling that followed, volume accelerated on each move lower. If volume does not increase on any pullback, then I would expect that it is just a pullback. However, if we break back below our April highs and volume starts to pick up, I’d have to ask myself if something bigger has started.

Lastly, if you review my previous “Chart School” articles, you are aware of the link between commodities, the dollar and the markets. I would highly advise watching the currency and commodity markets as well as the stock market.

The Tale of the Tape: The markets have broken out to new highs. It would appear that the markets are heading higher. However, sentiment is high and the environment is ripe for a pullback, if nothing else. Watch the April highs. Watch the volume on any pullback. Look for breakdowns in gold/silver and to what extent they occur. Don’t get complacent and use your stops.

Waiting for the most opportune times that I have outlined above could provide you with higher probability entry points. No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.

Good luck!

Christian Tharp, CMT