A Look Inside

Daily State of the Markets 
Monday Morning – October 25, 2010  

On one hand, days in which data input is limited or nonexistent can be viewed as a waste of time as these sessions are about as interesting as watching paint dry. On the other hand however, when traders are left to their own devices, we get a rare look at what’s really going inside their heads. Cutting to the chase, it would appear that in looking at Friday’s action, those in the trenches at the corner of Broad and Wall are still leaning the bulls’ way.

By most counts, one might have expected to see stocks pull back by now. After all, the S&P is up about 13% from its late-August lows and the DJIA finds itself just 73 points away from the high water mark for the current bull market. The indices have been overbought for the better part of two months, market sentiment has become fairly rosy, and the current joyride to the upside is based primarily on hope. As such, a pause that refreshes would be normal right about now.

However, much to the chagrin of anyone thinking that Wall Street is a two-way street, a pullback of even -1.5% has proved elusive and the S&P hasn’t spent more than a day below its 10-day moving average in the last 37 trading sessions. Thus, it is easy to see that this has indeed been an impressive run.

What about that overbought condition, you ask? Doesn’t that tell us to be careful and that a correction is imminent? Well, one of THE most important lessons I have learned over the past 25 years is that there are two kinds of overbought conditions. The first is the kind that most investors are familiar with – a sign that a pullback is likely. This type of overbought condition occurs when the market is in what we’d call a two-steps-forward-one-step-back type of mode. In this case, the market rallies for a while then pulls back a bit in order to give the buyers a rest. And this is how most traders I’ve come in contact with over years interpret the various oscillators used to identify an overbought condition.

However, it is important to recognize that there is another kind of overbought condition. When a market becomes overbought (or oversold) – meaning that an indicator such as your standard stochastic (%K: 14, %K: 1, %D: 3, with 80/20 bands) is above the upper band – and then stays overbought for an extended period of time, it is actually a sign of strength. In other words, a market that can’t move away from an overbought condition is clearly bullish. And the best way to play such a move is to either get in and stay in, or buy any dips that come along.

Let’s face it; buying any and all dips since the beginning of September has been a profitable venture. The question, of course, is how long the current run for the roses will last. While my crystal ball is MIA at the moment, my view is that Friday’s action suggests traders have not given up on the heads-stocks-win, tails-stocks-win-too trade as just about everything except the DJIA was up handsomely – and without any news to drive prices higher.

So, whether or not you agree with the thinking behind the move (blue skies are ahead thanks to Bernanke & Co and the mid-term elections), it does appear that traders and fund managers (remember, a big batch of mutual funds have 10/31 fiscal year-ends) are still thinking that it is best to run with the bulls.

Turning to this morning… Stocks are looking to open higher on the back of the G20 meeting and the corresponding drop in the dollar.

On the economic front… We do not have any data to review before the bell, we will get the report on Existing Home Sales at 10:00 am eastern.

Finally, be sure to take time to breathe today…

Pre-Game Indicators

Here are the important indicators we review each morning before the opening bell…

• Major Foreign Markets:
  • Australia: +1.29%
  • Shanghai: +2.57%
  • Hong Kong: +0.47%
  • Japan: -0.27%
  • France: +0.42%
  • Germany: +0.62%
  • London: +0.60%

   

• Crude Oil Futures: + $0.68 to $82.37
• Gold: + $20.20 to $1345.30
• Dollar: higher against the Yen, lower vs. Euro and Pound
• 10-Year Bond Yield: Currently trading at 2.520%

   

• Stocks Futures Ahead of Open in U.S. (relative to fair value): 
  • S&P 500: +9.32
  • Dow Jones Industrial Average: +62
  • NASDAQ Composite: +13  

* Report includes items that make comparisons to the consensus estimate questionable

Wall Street Research Summary

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