What astutue traders will do here

As anticipated, stocks followed
through on the previous session’s reversal day, enabling the major
indices to post solid gains across the board. The S&P 500
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Composite
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gained 2.0%. Small and mid-cap stocks, which typically lead the market in both
directions, outperformed. The Russell 2000 Index surged 3.0% and the S&P 400
Mid-cap advanced 2.4%. Each of the major indices finished near their intraday
highs, indicating the bears had no interest in selling into strength.

For the second day in a row, volume rose in both exchanges.
Total volume in the NYSE was 8% higher, while volume in the Nasdaq was 16%
higher than the previous day’s level. The gains on higher volume marked the
second consecutive “accumulation day,” pointing to institutional buying
interest. Market internals were also firmly positive. In the NYSE, advancing
volume exceeded declining volume by a whopping margin of more than 12 to 1.
However, the Nasdaq was positive by a ratio of only 3 to 1. The divergence in
the market internals indicated broader-based strength in the S&P than the Nasdaq.

When the market rallies sharply off the lows, as it did
yesterday, many novice traders and investors make the risky assumption that the
market has bottomed and begin buying stocks. But doing so without taking a look
at the “big picture” is a dangerous proposition. It’s true that Tuesday’s
reversal day indicated a high probability that the market would follow through
and rally the following day, but only traders with a very short time horizon
would be wise to initiate new trades on the long side of the market. A lot of
overhead supply remains and each of the major indices are still well below
resistance of their primary downtrend lines. If the indices eventually break out
above those downtrend lines, it would be less risky to be positioned net long,
but that is not the case for now. The S&P 500 is still below both its primary
downtrend line and its 200-day moving average, as the chart below illustrates:

If the S&P holds onto yesterday’s gains and breaks out above
the downtrend line illustrated above, we will begin testing the waters on the
long side of the market, but astute traders will patiently wait for confirmation
that would occur from a break of the downtrend line. In fact, many traders are
viewing yesterday’s rally as a chance to sell short on a bounce into resistance.
Consider also that the Nasdaq Composite is still below its 20, 50, and 200-day
moving averages. Obviously, each of those will act as major areas of resistance.
Take a look:

We are smack in the middle of quarterly earnings season, which
tends to make stocks more volatile than usual. After the close of trading, both
eBay and Apple Computer reported earnings. Both were trading higher in the after
hours market, which could help the major indices to build some upside momentum.
But until we get confirmation, we are content to be positioned mostly in cash,
waiting for the market to prove that it can sustain the gains that is has racked
up. Professional traders know that the key to consistent long-term profitability
is not found by being in the market all the time. On the contrary, most
profitable traders will tell you they are out of the market more than they are
in it. Remember that we are not in the business of gambling on which direction
stocks will go. Rather, we simply react to price and volume patterns as
they present themselves. If yesterday’s rally is for real, there will be plenty
of time to participate. However, jumping the gun without confirmation can be a
costly proposition.

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