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Market Rally Over-extended - Here Are the Warning Signs - We Are In Cash

Posted by Pete Stolcers on June 9

Posted 9:30 AM ET – Yesterday the S&P 500 rallied above its opening price from January 1st. That seems incredible given the largest market drop since the Great Depression. We are within 200 S&P 500 points of the all-time high and Asset Managers are leaning on a safety net provided by central banks. Tomorrow the FOMC statement will be released and we can expect a dovish tone. If the economic recovery is sluggish they will provide additional monetary easing. As I’ve been noting for the last week, stock valuations are stretched and I believe we could see a market pullback. The S&P 500 is down 25 points before the open and some of yesterday’s gains will be raised.

In the last two weeks we’ve seen the laggards rally and there has been a rotation out of tech stocks. This event typically signals the end of a rally and swing traders need to be cautious. I don’t know what event will spark selling, but once profit-taking sets in the momentum will build and bullish speculators will get flushed out. Bullish sentiment has surged to the highest level in more than two decades among option traders and not one stock in the S&P 500 is down for the past 10 weeks. The market has poked through the upper end of a trading channel and that suggests that we could see a bullish climax.

The FOMC statement tomorrow would normally be a big event, but dovish comments are already priced in.

Last week’s economic data sparked optimism and many analysts are now predicting a “V” shaped recovery. ADP and the Unemployment Report both suggested that hiring is brisk. ISM manufacturing and ISM services are forward-looking indicators since they survey businesses. China’s services and manufacturing PMIs reflected economic expansion in May. The news has been good. Backlogs and pent-up demand should fuel the first leg of the recovery.

AstraZeneca announced that it will produce 2 billion doses of a vaccine that has yet to get FDA approval. The drug is still in clinical trials, but the pharmaceutical company must be extremely optimistic to justify taking this risk. It will start distributing doses as early as September and it will wait for the clinical trial results and FDA approval. Texas was one of the first states to reopen and the number of hospitalizations due to Coronavirus hit a new peak yesterday. This virus is stubborn and it will not go away quietly.

Swing traders should have very little risk exposure. We do not have a position in SPY and our current bullish put spreads are trading for pennies. At the end of the week we will only have one open position and we will stay on the sidelines. Option implied volatilities are extremely low and we have to go close to the money to get the credit we want. A massive market rally has led to extreme bullish sentiment and we will wait for those speculators to get flushed out. Option implied volatilities have been inching higher the last few days even when the market has been on a tear. That is another warning sign. We will not swing trade from the short side. This is been a powerful market rally and we won’t fade central bank money printing. The best trading opportunity will come when the market drops and it finds support. I believe that SPY $300 could be tested. The last time we had a cash position was in the middle of February and we all know what happened after that.

Day traders need to watch for market support this morning. Don’t buy early. We need to make sure that buyers are still engaged before we get long. Look for stocks with relative strength and wait for that support. If the market makes a new low after two hours of trading, focus on the short side. There will be good opportunities to buy and to short today. Some of the laggards are overextended and they will be excellent shorts. I will evaluate market conditions during the first half hour of trading and I will use the 1OP indicator to determine market direction. Down gaps have been our best day trading set-up and this should be a good day for us.

Resistance is at SPY $323.40 and support is at $319.60 and $317.

This has been a low-volume rally and we need to be cautious. I also consider this to be a low probability trading environment. Hopefully, we will see some volume today.
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