Mr. Market Shows His Horns

A few weeks ago when I was getting ready for the S&P 500 to fall through 1,100 on its way to 1,050, I was building a position in the bearish 3X leveraged ETF SPXU. Here's what I said in "No Recession Scenario" on September 16:

"Mr. Market is guaranteed to fool most participants into selling bottoms and buying tops. Though I have played this summer correction very well, my time to be fooled could be right around the corner too."

Staying short was tough on the break of support between 1,140 and 1,120 on Sep 22 and then the subsequent reaction rally back to 1,190 over the next three sessions. But I hung in there and was rewarded in the past week with a heavy market that finally closed below 1,120 on Monday and then punctured 1,100 on Tuesday.

Then a funny thing happened on the way to 1,050 yesterday in the final hour of trading. The market roared back to close 50 points off the low. It must have been a thing of beauty (for bulls) to watch.

Trouble is, I wasn't watching. I gave up nearly 3 points on 1,000 shares of SPXU as I was giving a lecture about the financial crisis to a junior college sociology class. Almost $3,000 of my open profits evaporated in the last 45 minutes as the S&P surged from 1,080 to 1,125.

Fooled, But Ready

I like to take the best from every experience. I am naturally a glass half-full kinda guy because I always learn more that way. And with that attitude, I'm always putting myself in a position to benefit from new opportunities that I would otherwise not see.

I was already this kind of optimist before becoming a trader over 15 years ago. And trading only reinforced the practice. To succeed in markets, your mind has to be able to recover quickly, learn from mistakes, and re-focus on principles and rules that help you win in the long run.

The lessons here could be numerous, revolving around having limit orders in place for minor profit targets after a big move (I've done this often with smaller positions) to using trailing stops to avoid profit give back. Whatever I finally learn or implement, I'm okay with having captured part of the move, following my basic plan, and not taking on excessive risk.

There could also be lessons about paying closer attention to the closing hour on days like this. We say that the open is "amateur hour" where buy and sell orders from retail customers are gifts to the market makers. Well, the close is for the pros. Believe me, I'm paying attention now.

Lessons learned in progress, this morning I took my lumps and sold my SPXU shares at $20.75, recovering what profit still existed from an average long position near $18. And I went long the opposite ETF, the bullish 3X leveraged UPRO at $44.75.

Why Bullish Now?

So why have I taken yesterday's late day bullish reversal as a signal for further upside? Because it was so powerful -- 45 S&P points in 45 minutes! -- it can only be the result of one thing: institutional money managers looking around and concluding "barring a recession that looks worse than what is priced in, this move is overdone and stocks are really cheap here."

Yes, there was lots of short-covering by bears. But that is part of the chemistry in rallies like this too. Not only do the bears push stocks and indexes higher in a panic to rein in their profits (the smart ones, that is... not me), they are forced to rethink their existence as bears.

Plus, we are getting follow-through today. Mix in the persistent doubt of the wounded bears, and everybody else still on the fence, and the stage is set for further levitation. The beginning of bull markets -- and of vicious bear market rallies -- occurs when very few believe it possible.

Bear Flag Capitulation Over?

So is the bottom in at 1,075 now? Still hard to say. From a technical standpoint, the bear flag I've been talking about (see the video Bearish Signposts) should have a bottom target closer to S&P 1,000. But I can't argue with Mr. Market right now when he is yelling so loudly that we are going higher, at least in the short term.

Fundamentally, lots of economic data points are pointing to a much lower probability of recession. And portfolio managers are not going to run to cash in this environment. Their job is to invest in equities and outperform the S&P benchmark. Interest rates, earnings forecasts, and valuation metrics are making their models flash with green lights. Their risk has now turned back to the upside.

With today's close above 1,140, what looks most likely is a rally that really tests resistance levels on the S&P near 1,200 and 1,220 -- especially with positive earnings reactions in the coming weeks.

I wrote last Friday about earnings season being the more important catalyst (vs. Europe) to take us out of the trading range, one direction or the other. I didn't think it would be a 3-day event though. Now we are back in the trading range. And that tells me the bulls are in charge... and the bears must be getting exhausted.

By the way, I'm not showing an S&P chart here that I usually do with that range because I don't want to get too "technical" today about the levels, pardon the pun. As I try to explain to the diehard fundamental guys here, a chart is simply a picture of market psychology, a snapshot of sentiment, a window on supply and demand.

Right now, the bulls are speaking about their demand for stocks and their lack of worry as they cruise back up through the broken support levels.

Kevin Cook is a Senior Stock Strategist for Zacks.com

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