T2108 Update – August 15, 2011 (It’s Like It Never Happened…)

(T2108 measures the percentage of stocks trading above their respective 40-day moving averages [DMAs]. To learn more about it, see my T2108 Resource Page. You can follow real-time T2108 commentary on twitter using the #T2108 hashtag.)

T2108 Status: 19% (Day #8 of the current oversold period).
VIX Status: 32.
General (Short-term) Trading Call: Only add to bullish positions on dips. Hold any remaining bearish positions as small hedges.

Commentary

And just like that, it is as if last week’s drama never even happened. The S&P 500 soared 2.2% and closed on its highs for the day to put an exclamation point on a week that will leave many wondering “what was all that about anyway?” (click here for a daily, year-to-date chart of the S&P 500). If you followed T2108 throughout this ordeal, you should be better off than you were going into last week…or at least I hope you did not sell anything. If nothing else, perhaps you have a better appreciation for why I purposely ignored the headlines during these T2108 updates.

T2108 soared along with the S&P 500. My favorite technical indicator increased 6 percentage points to 19%. It is right on schedule for exiting oversold territory this week. Barring any significant negative catalysts overnight, I suspect we will experience a gap up tomorrow morning as the market seeks to issue maximum pain to those who followed the oversold momentum too far to the downside. Next, another mental challenge presents itself to us…

Once T2108 exits oversold territory, I have no standard set of rules for exiting short-term trades. Trying to hold until the S&P 500 hits overhead resistance at the previous intraday low of 1250 makes sense, or even the converging 50 and 200DMAs. Waiting for the next overbought reading seems like a huge stretch at this juncture although it could (ideally) occur at overhead resistance. Regardless, we must continue to respect the ferocity of selling we just witnessed. A lot of eager and relieved sellers are going to show up at ever rung of the ladder going up from here. Moreover, as I have mentioned before, T2108 could easily descend back into oversold territory. Granted, such an event will represent an opportunity for those who did not take advantage of the last one, but it could prove painful for anyone who held on to short-term trades too long.

Your exit criteria will depend on two things: 1) your risk profile, and 2) your assessment as to whether we remain in a bull market or a bear market (or even a sideways market).

If you are conservative, you may not have purchased any short-term trades and are waiting for that first day out of oversold territory as stated in the options for trading during oversold periods. This choice would be unfortunate in this case, because the market will have already made a substantial move from the bottom, creating a much higher risk entry point than usual. If you chose to buy once the volatility index, the VIX, increased 20% from the first oversold day, then you have profits you are likely eager to lock in. I will not hold it against you.

If you are aggressive, you started buying on the first oversold day and continued to add to positions throughout the selling. Your profits now could be substantial and taking at least 1/3 off the table makes sense to me.

More important than the risk profile is the assessment of the bias of the market. If we are still in a bull market, or even a sideways market, then traders should hold steady and be patient. If we are now transitioning into a bear market (do not forget that the S&P 500 just nicked the point of a 20% loss from recent 52-week highs), then you want to be as aggressive taking profits as you were in building positions.

I am currently in the aggressive camp. While I think we are at a high risk of getting a bear market next year, I also think there is an excellent chance for a strong rally going into at least October (see “T2107 Flashes A Major Bearish Warning“). I have chosen to take a small amount of profits here – especially with options that expire on Friday! – but I intend to hold steady with as much of my trading positions as possible. For example, a break below today’s low may encourage me to hit the reset button.

As I said, we have a mental challenge ahead of us. Sorry I do not have a set of simple suggestions…so let’s keep taking this one day at a time…

(Note another nice validation of past analysis I have done on oversold conditions: once again, the intra-day and closing bottoms on the S&P 500 occurred within one day of the top in the VIX. While we can never know just how high the VIX will go, this observation suggests that treating a large spike, like 20% or more, in the VIX, is a high-probability bullish signal during oversold periods.)

Weekly T2108

*All charts created using TeleChart:

Related links:
The T2108 Resource Page
Expanded daily chart of T2108 versus the S&P 500
Expanded weekly chart of T2108

Be careful out there!

Full disclosure: long shares and calls on SSO, long VXX puts