Market Overview

It's nearly Christmas and the markets have taken a slight pause today (some are up a little and others are down or flat). I thought it would be a good time to look over the markets in general and see where we stand. There's a lot of chatter about the annual santa claus rally, lets see what the markets say.

To kick it off, lets look at the S&P via SPY. As you can see from the chart below, the S&P has been stuck in a trading range since early November. The top of the channel has been tested several times in December but we still have not seen a meaningful break. I want to see it break and hold before getting too bullish on the market.

The recent break out in tech (qqqq) is good news for the bulls. Tech is looking incredibly strong and it will help move all the markets higher if it remains strong. I will be looking to enter a long position in either the nasdaq etf or the semi conductors (smh) if the S&P breaks out. Here's the chart for the Q's, note the break out:Okay, S&P is range bound, Q's are breaking out, what else should we be following for an indication...the small caps (IWM). The small caps have been the laggards lately but now they seem to be playing catch up. The Russell 2000 (IWM) is sitting (barely) at fresh highs which is another good indication for bulls. Here' s the chart:We'll go ahead and file the small caps under bullish for now, but this will change if it falls back into its prior range. Next lets take a glance at the VIX. The VIX has just fallen to some fresh lows and it actually closed below the 20 level yesterday...something that it hasn't done for some time. What does this mean? It means that worries are easing, at least for now. This is also a bullish sign for the short term outlook of the stock market.

So far, we have a neutral S&P that might break out (neutral), a breaking Nasdaq (bullish), a breaking Russell (bullish) and a falling VIX (bullish). That's 1 neutral and 3 bullish signs. Where's the case for the bears? Here it is, the financials.

Financials (XLF) have been a huge laggard and they will weigh down the S&P and the market in general if they don't perk up. Here' s the chart:There's the obstacle for bulls and fuel for bears. I don't know which way it will go and I'm certainly not smart enough to figure out how big of a mess the banks are (or are not) in. Furthermore, I can't even try to figure out the effects of the stimulus plan and whether that will provide enough cheap money to raise the market in general and make banks profitable, but there are lots of people out there that think the stimulus is merely going to provide profits to banks. I just watch the charts and try to determine which direction "order flow" is moving and then ride along.

One indication that can provide insight into whether banks will do well (and the economy in general) is the yield curve. The yield curve is currently steep, meaning short term rates are much lower than longer term rates. This is good for banks which in turn is good for the economy and markets in general. This is why the feds want the rates to remain low. Here are the current treasury rates and yield curve that are pulled straight off of Yahoo Finance's Bond Center. As you can see, longer term rates are much higher than short terms rates. This should help banks quite a bit and is indicative of good times ahead. However, there's always the concern that this time is different, especially considering that enormous stimulus plan and the worries of future inflation. We'll see how it plays out but for now I'm counting it as bullish.

So what else is there? The Dollar. The dollar has been in the headlines and has been talked about quite a bit lately. Most of the chatter has been about how bad the dollar is and that it's falling and going to lose half its value...blah, blah, blah. The dollar has actually been strong as of December and it appears that a reversal of some kind is under way. Here's the chart of UUP:Until recently, the dollar had shown an inverse correlation to the stock market, but that relationship seems to have changed as the dollar has been climbing with the market. I particularly like the long play in the dollar and I'm currently in it. One reason that I like it is that the dollar has been rising with stocks, but, the dollar also serves as a good flight to safety instrument that the world buys it when things start looking bad. Therefore, the dollar will likely keep rising in its current trend, and then if things get bad in the equities markets, the dollar will rally even harder. That's my current theory and like I said, I'm in this one.

Last but not least, Gold (gld). Gold has been on a bullish tear for quite some time, but now it seems to be falling back to earth. Why is gold a good short right now? Here's 3 reasons: 1) gold is likely in a bubble and bubbles break hard when they pop, 2) historically, gold has sharp climactic tops and long rounded bottoms and Dec. 3 sure looks like a climactic top to me, 3) the strong dollar will put pressure on gold prices. All of these things tell me that gold is a good (note not a sure thing) short right now and I'm currently in it. Here's the chart:Alright, here's a quick recap. The S&P is still range bound (neutral) and needs to break out, the Nasdaq is trending higher (bullish), the Russell is perking up and printing new highs (bullish), financials are lagging (bearish) but the yield curve is steep which makes it easier for banks to make money (bullish). The dollar is showing strength and gold is weak. These are neither bullish nor bearish (IMO) but they are very tradeable and I'm in both.

So what now? I'll be looking for a break out in the S&P with confirmation from small caps, financials and bonds (lower bonds). If this happens, I'll be looking to go long tech (QQQQ, XLK) and semi conductors (SMH) and short bonds (TBT). I'll also be adding to the long dollar position and the short gold position if they continue in my favor.

If the S&P doesn't break higher, watch out because we might see a substantial drop in the markets. For the bearish scenario, I'll be looking to short financials and emerging markets and look to go long utilities (xlu) and bonds (tlt). There's the game plan for the rest of the year and the beginning of 2010. We'll see how it plays out.

Have a merry Christmas and a happy new year!

TLT