CTMPR

With only a couple weeks of QE2 remaining the S&P 500 ETF appears to be headed to test the 200 day moving average in the $125 area (1250 S&P Index). The bullish commodity trade that ran wild after the initiation of QE2 also appears to be deflating as one by one the commodity ETFs roll over lead by Silver and now joined by the agricultural commodity etf and Coal ETF.

The fact that we are in summer also adds to the doldrums with many investors taking the “Sell In May” approach. This approach looked particularly attractive to me this year, so I’m holding a 30% cash position at the moment. If the S&P 500 holds at 1250 I may cut that cash in half, but it doesn’t feel like we are at a stock market bottom.

The strangest thing about the decline thus far is the total lack of volatility that has accompanied it. This makes me believe there might be something bigger on the horizon. Volatility ETF volume continues to swell as investors seek protection, but volatility has remained very subdued. Normally things don’t turn around until after you have a significant spike in volatility and inject some fear into the market.

Looking at the Leveraged Volatility ETF below you can see that the deflation of volatility has be a very persistent trend over the past 6 months.

If the 200 day moving average fails to contain the market, the major support comes in at the 20 Month SMA which is currently at roughly 1185-1190. As you can see in the following chart this average is tested most years in the summer time, with all the headwinds in the market it would not be surprising to see a test this year as well.

A drop into the 1185-1190 area that was accompanied by a nice spike in volatility would set up a perfect buying scenario. It might also be a good time to buy a leveraged financial etf since the financials are one of the most beaten down sectors in the market. Oil services is another area that might be appealing again if it takes part in the sell off.

In the meantime, I don’t think there is any rush to buy stock as the negatives (Greece,End Of QE2 etc) far outweigh the fact that the market is 7 1/2% cheaper than the recent peak.

Basic materials stocks have been in a strong uptrend ever since the beginning of QE2 reaching a peak at the end of April. Now they have been selling off along with the correction in commodities. The Basic Materials ETF IYM is approaching the lower end of the range and is within about $5 of reaching it’s 200 day moving average.

The industrial economy has been strong lead by agricultural, mining and construction equipment. We have noticed even in our skid steer attachments business that activity has been picking up steadily since the lows in 2009. It seems we are at an inflection point in the economic cycle where the markets are going to have to take over from the fed and government stimulus. It seem to me there is still a major hangover effect where people are reluctant to spend and are still in debt paying mode. It will be interesting to see if this trend can change in the next 6 months or if there will be a need for Ben to come along with QE3 next fall.

Financials Remain Weak

Another area that remains very week are the financial stocks and they are still at valuation levels that rival the lows in 1991. The government, FDIC fees and invasive regulatory requirements are the primary drags on this sector but again in this economy there is also still a lack of loan demand. It seems like we are stuck in a similar situation that occurred in the late 70’s and early 80’s where consumer confidence remained low and demand remained sluggish. I’ve been watching to see if the XLF
Financial ETF could hold support at the 200 day moving average, but it broke down through it yesterday and is trading lower again today. It may be one of those times when an undervalued sector just continues to get cheaper until there is a major change that spurs investor interest.

Everyone (except Ben Bernanke) has been so worried about inflation the past several months, it will be interesting to see if asset and commodity prices can remain strong as the fed backs away. If there is anything Bernanke understands it’s how demographics and debt trends can cause long periods of deflation and that is what he’s been trying to avoid. He was a vocal critic of how Japan handled their economy the past 20 years so don’t expect him to follow their lead.

Investors seem to love stories, give them a exciting story about the computer revolution (1987), the internet revolution (1999), the real estate boom (2006) or silver replacing the dollar (2011) and individual investors come piling in with fistfuls of dollars. Don’t get me wrong, all investors buy into stories but the small investor tends to take it “hook, line and sinker” and never changes their view.

The latest Silver Bubble is a perfect example. Back when I started buying silver at $12.50 no one was paying much attention to it. In fact, I’ve been trading silver since 1988 and until the past few months I never knew anyone who invested in silver except for a couple clients. In fact, over the past few years since the advent of the silver ETF I had been telling friends of mine they should add a little silver to their portfolios.

It wasn’t until the recent parabolic move however that I began hearing about people putting large chunks of their IRAs into silver. Stories of people doubling their money in a matter of months tend to get everyone excited. As silver moved from $38 to $50 in 2-3 weeks I knew it was going to end badly. Parabolic moves like that are not caused by professional investors or hedge fund managers, they are caused by a stampede by the general public.

So many people had seen the “End Of America” type videos or fell victim to the hype in the Blogosphere and had to get into silver because it was going to $100 or even $250 per ounce! This is all fine as silver is such a small market that it could go to $100 or $250 if the dollar ever collapses for real. Right now however, there are an endless number of newbie silver investors “sweating it out” because they bought at 31 year highs only to watch it fall off a cliff.

Even when we were in the high $40s and people were saying things looked toppy, the silver fanatics were commenting on every article talking about how only idiots would sell silver. Well, I sold silver at $48+ and right now I’m not feeling at all like an idiot.

In order to make money in the markets, you need to learn a couple basic lessons. You can be involved in any market and have belief in a trade but NEVER fall in love with an idea. When the market presents you with a huge profit, take your original investment off the table and play with the profits.

Greed is your enemy, most people tend to buy more when they have made money but this is exactly opposite of what you should do. When a trade has moved your way there is often a higher degree of risk, using your paper profits to buy more is a prescription for disaster.