Three Obstacles to a Summer Rally

Thanks to a multitude of factors, it's prudent to play the market from trading range to trading range -- and not be shy of locking in profits.

While it seems like the European Union and U.S. government are stuck in a never-ending game of Whac-A-Mole, it’s also apparent that more moles are popping up more quickly, needing more force to be subdued.

Some of the more stubborn and persistently recurring moles have been a weak housing market (as tracked by the iShares Down Jones U.S. Real Estate ETF), declining home-building activity (SPDR S&P Homebuilders ETF), high unemployment, weakness in the financial and banking sectors (SPDR Select Sector Fund-Financials and SPDR KBW Regional Banking ETFs), and potential country defaults. The Greek mole has been whacked over the head enough to bruise the mallet.

For right now, however, the mole that’s holding the stock market captive is the stalemate deficit situation. But regardless of if, how and when the deficit mole gets whacked, this summer (or late summer) may turn quite ugly.

Here are few reasons why:

Poor Seasonality

In terms of seasonality, August is one of the worst months of the year. A silver lining is provided courtesy of the presidential election year cycle. Pre-election year Augusts tend to perform much better than the average August.

While the government’s thumb may keep the scale tilted towards the bullish side in August, the months of September and October tend to be bearish, even in pre-election years.

A Looming Market Peak

The S&P is laboring on a 10-plus year bearish M formation. “The ETF Profit Strategy Newsletter” has been tracking this pattern for several months and wrote on April 3:

(Click here to enlarge chart)

“There is strong Fibonacci projection resistance at 1,369. In terms of resistance levels, [this trading level of around 1,370] is a strong candidate for a reversal of potentially historic proportions.”

The S&P 500 (tracked by the iShares S&P 500 Index ETF) spiked to 1,370 on May 2 and reversed sharply. However, for a confirmed bear market, the S&P would have had to drop below structural support of around 1,250 in June.

The “June 15 ETF Profit Strategy Update” outlined this support and pointed out that as long as it doesn’t get violated (in fact it recommended to go long), the possibility of new highs remains on the table.

Since then, the Nasdaq-100 (QQQ) has rallied to new all-time highs. The Nasdaq Composite, S&P 500 and Dow Jones got close to new highs but reversed before (the newsletter recommended to close out long positions at S&P 1,345 and went short at 1,325).

Even though things look bleak, I wouldn’t write off the possibility of new highs just yet. If the S&P rallies after a potential debt deal, it would offer a good opportunity to short the market. If it doesn’t, it may fall straight into the summer doldrums.

Weakening Demand

The Dow Jones Transportation Index (IYT) provides two possible clues for investors:

1) Transports rallied to new highs on July 7, while the Dow Jones Industrial Average was unable to better its May 2 high. According to Dow theory, that’s bearish.

2) IYT has fallen nearly 10% in three weeks. What do transportation stocks know that we don’t?

One thing could be that UPS, FedEx and Union Pacific only ship what you and I order. If we don’t order, they don’t ship. The weakness in transportation stocks may be reflective of weakening consumer demand.

The Howe Robinson Container Index fell 9.3% since the end of April. The index tracks rates for container vessels that ship everything from pens and sneakers to flat-screen TVs and DVR players.

Over the same period last year (it’s not like we had a great economy last year), the index surged 56%. Retailers are restocking now for back-to-school and holiday shopping, so this weakness during peak season is troublesome.

Because of the lack of peak season demand, leading shipping companies had to delay the introduction of the usual peak-season surcharges on Asia-U.S routes.

Ignore the Mole

If you’ve read my articles before, you know that I used to write more about economic indicators and fundamentals. But quite frankly, I think following economic indicators and spoon fed news is a waste of time.

For the past two years, the housing market has been getting worse, yet stocks were going up. The government is unable to rev up hiring, yet stocks were going up. Greece has been getting bailouts, yet stocks were going up (I’ll stop here).

The one time economic indicators were really pointing towards a sustainable economic recovery was in April 2010.

However, I view economic indicators as lagging indicators. They lag behind stocks and stocks had been going up. For that reason I wrote in the “April 2010 ETF Profit Strategy Newsletter” that: “the message conveyed by the composite bullishness is unmistakably bearish.”

That was the last time I used economic indicators to make a market call. My focus has been on technical indicators accentuated by sentiment and a healthy dose of skepticism towards Wall Street and the media.

Elephant Hunting With Safety Net

There is no doubt that at one point the mullet will break and the whole house of QE-glued cards will collapse. Until that collapse is confirmed, it is prudent to play the market from trading range to trading range and not be shy of locking in profits.

This may not sound as glamorous as selling at the top and buying at the bottom but that’s basically what it is, just at a smaller level. This approach assures nearly all the profit potential of a massive move without the risk of the unexpected. I call this the incremental trading range approach.

Prior trades recommended by the ETF Profit Strategy Newsletter include: Go short at S&P 1,369 (May 2) and cover shorts at 1,325 (May 17). Go short again at 1,298 on June 7 and cover shorts and go long around 1,259 (June 15). Sell longs at 1,345 (June 7). Go long at 1,298 (June 18) and sell longs at 1,330 (June 27). Go short at 1,325 (June 28).

It may be surprising, but throughout much of this chain of trading, it didn’t really have any idea what stocks are going to do. I simply allowed the market to guide the way. Failure to move above resistance is a sell signal, while failure to move below support is a buy signal.

Of course a bit more work goes into the process than this, but in a nutshell, that’s it. This simple but effective approach allows you to go elephant hunting (big profitable trades) with a safety net. It also sets investors free from having to dissect every economic release or news report.

The ETF Profit Strategy Newsletter converts complex technical analysis into easy to understand forecasts and actionable trades. Last night's special update suggested that the S&P will test and bounce from support at 1,284. It also highlights why this support is crucial (it's more than just the 200-day SMA) and what the potential up side target is.

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