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The Shorting Opportunity of a Lifetime

by Michael Nystrom
Thursday November 2, 2006
Arlington, MA

The shorting opportunity of a lifetime is near. You can see it in the growing divergences between the stock market and the actual economy. The Dow is precariously perched near its all time high, having cruised effortlessly to 12,000 and beyond, but its gangbuster growth has stalled of late. While it is normal for a market to consolidate after a run like we've seen over the past three months in the Dow, the meaning of this pause is yet unclear. Is this is a consolidation before a further push higher, or is this market simply churning as ownership changes hands from strong to weak, leading to an inevitable plunge?



It is impossible to say, but we have ample clues. The Dow's new highs remain unconfirmed by the Dow Transports, the S&P500, as well as the once high-flying Nasdaq (chart not shown), which remains down more than 50% from its record high in 2000. Ominously, the Dow has already crashed in terms of real money - gold - as the chart from the October EWT Special Report shows.



The non-confirmations extend to economic indicators as well. Peter Schiff's "Denial is more than a river in Egypt." gives a succinct summary: GDP is slowing, housing is slowing, housing prices are falling, US manufacturing is crumbling, but the Dow makes new highs. An article released today makes it even more clear: the yield curve has been inverted for several months and now the inversion is worsening, increasing the odds of recession. And check the source of this information: Fed Model Shows Recession Odds Growing.

In spite of the deteriorating fundamental picture, the emotional impact of the soaring Dow has turned many of the staunchest bears into reluctant bulls, thereby magnifying the disconnect. The yawning gap between the news and the market is confusing. Such divergences can last a long time, and it is impossible to pinpoint when they will be resolved. "The market can stay irrational longer than you can stay solvent," goes the old saying.

Fortunately, we have a recent precedent of a market that became wildly divorced from its underlying fundamentals, which can be used as a handy reference: Nasdaq 1999-2000. Although I have written about this recently, I think the lessons presented are relevant and well worth reviewing again: From mid 1999 to early 2000, the Nasdaq became completely disconnected from reality, rising over 100% in a span of less than one year. The tremendous move was powered by increasing Fed liquidity leading into Y2K, a massive short squeeze and excessive optimism at the arrival of a "new era" economy. That rise exhibited an aggressive, almost a militant denial of reality, destroying bears on the way up. Day after day, week after week the market rose with barely a pullback. It just didn't make sense. When it finally did exhaust itself on March 10, 2000, there was nothing special to mark the occasion. The top was made quietly, without fanfare.



Oh sure, the market made a new high and closed at the low for the day, below even its open. It was a bearish key reversal - a suspicious sign - but the market had disregarded so many similar traditional topping patterns on the way up that they were rendered all but meaningless. Even the selloff that followed wasn't much of a clue. Compare the actual top in March 2000 with the similar but false topping formation just two months - and 20% - prior. Like today, the Nasdaq 1999-2000 market had conditioned investors to believe that dips were nothing but buying opportunities.

The Nasdaq's final "buying opportunity" in March 2000 was the sucker's bet of the millennium. Following the March 10 top, the market tried to rally but couldn't quite muster a new high. When the market failed at the previous low, the top was confirmed. In spite of that, how many investors held on, riding down the slippery slope of hope, unable to believe that the once powerful bull was now dead? Many steadfast bulls lost loads of money holding onto the erroneous belief that stocks only went up. Some that I knew personally lost their life's savings.

Should we look for the Dow's new high to play out the same way? Unfortunately history is not that kind. But there are some commonalities to watch for. The Nasdaq's near breakdown in January 2000 should have been taken as a sign that the bull was weakening. Likewise, the action of today's Dow around 12,000 should yield valuable clues. Is this a consolidation or a reversal? Only the market knows the answer to that question. I had expected the market to move sharply higher after crossing 12,000, as I alluded to in Jesse Livermore on Dow 12,000 But what I expect is irrelevant. Only the market knows which way it's going, and it will reveal its answer through price. There are five principles that I have developed over time to listen for such answers in my trading:
  1. Simplicity -The single definitive indicator that tells which way the market is moving is price
  2. Objectivity - No matter how good or bad the news is, price can always go either way for extended periods of time
  3. Humility - Regardless of what I think might happen, the market is always right
  4. Flexibility - Be willing to stand aside or reverse if price proves you wrong
  5. Patience - Setups take time to develop, and price moves take time to play out - usually (much) more than you expect. Don't try to anticipate or rush the market (you can't)
How do I apply these in practice? The Dow has had a strong run, and is either building a base for a further move up, or churning and changing hands from strong to weak. (#2). While I think the market is due for a selloff, I'm not going to be surprised or paralyzed by a move higher, and will remain in position to take advantage of it (#3, 4). This basing action could end tomorrow, or it could go on for several weeks (#5). A move below 12,000 or a bounce off that level will give me the answer I need to take action (#1)

I've been trading various vehicles now for over 10 years - stocks, mutual funds, options, and index futures. Each vehicle has its own particular advantages and disadvantages, making the array of vehicles like a toolbox. For this trade, my vehicle of choice is the Dow e-mini futures. Why? One reason is leverage. I get more leverage from futures than from stocks or bear funds: $5 for every Dow point move, at roughly $2,400 in margin per contract. I could potentially have more leverage with options, but only if the move is big enough, and my timing is exactly right - two variables that I am not at all sure about (see #2). Because these futures contracts are electronically traded and very liquid, it is easy to establish and close positions quickly - something that is impossible to do with mutual funds, which are better suited to long-term investing than trading.

Obviously, futures are not for everyone and I don't mean to suggest anything of the sort. Because they are so leveraged, they are very risky and they bring out an incredible gambling urge that must be avoided at all costs. Gambling with these things is a quick way to the poor house.

Back to the Dow. We have a major catalyst in the upcoming Congressional elections on November 7. Every media outlet seems to be predicting a Democratic victory in the House, and possibly in the Senate. The only ones who so far don't believe it, or don't want to believe it, are President Bush and the Dow. It is possible that both are in for a rude awaking on Election Day. Either Mr. Bush is in denial or he's got a "November surprise" up his sleeve. If there is a November surprise that can sway the election, it will most surely sway the market - in one direction or the other - as well!

Using the 12,000 level as my key - short below and long above - there is the possibility that I'll get whipsawed as the market bounces around, groping for direction. Not only is it possible, but quite likely. When the great trader Ed Seykota was asked how to avoid such whipsaws, his answer was simply "don't trade." This was not a sarcastic response, but a recognition of the fact that whipsaws and losses are an inevitable part of the game of trading, in the same way that outs and strikeouts are part of the game of baseball. There is no way to avoid them. The best you can do is to minimize them. In the greatest season of baseball's greatest hitter, Ted Williams got a hit just over 40% of the time. A disciplined trader with the same batting average is - believe it or not - doing just as great! A few small whipsaw losses of several hundred dollars per contract are worth it for the potential thousands of dollars gained by being on the right side of the market for an extended move.

If this market continues to move higher, it just means that there will be more downside profit when it does finally top. However, it could also mean that we have finally actually entered the hyperinflationary blowout phase in the American economy that has long been anticipated and dreaded. This is something that unfortunately must be considered. This would obviously be a much more serious event that will require completely different strategies that go beyond mere trading.

I will be keeping very close tabs on the Dow between now and election day, and will continue to monitor the inflation/deflation situation over the coming months. Gold looks like it may have broken out of its multi-month downtrend, and the dollar appears poised to break its multi-month uptrend.



If this is truly the case, these developments would have larger significance for the US economy global financial order. If you are interested in being further updated on these topics, or are an experienced trader interested in learning more about the nuts and bolts of futures trading, please sign up to my low volume announcement list.

Comments on this story are welcome.

Turn off the TV and think!






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