Playing the Rotations at the Bottom

Today I am sharing with you some of my recent experiences in "playing the rotations". While I don't have any evidence that the current market is typical of a deep market selloff, like we just experienced (I would need to research in detail 2002-03 and 1991-92 to make a proof), it is logical. At the bottom of a deep selloff, the typical pattern is a "smiley face". The price action decelerates from the selloff into a long "basing" pattern where there is much treading of water. Traders will just move between sectors to get some action during this sideways trend. The market will consolidate behind typical early stage leaders as the market moves up the right side of the smiley face, which might be 2009 or even 2010 given the depth of this selloff.

A good example of the "Smiley Face" basing pattern is the US Currency vs. other world currencies. There is an ETF with ticker of (UUP) that allows us to chart this pattern. Notice how the declining trend is broken by the right corner of the smile. The breakout above the declining trend line at around $22.70 on July 17 (same day as Financials bottomed) was the buy signal.

So, for those who want to stay active in the market, a shorter term trading mentality is required, for at least part of the portfolio. A close eye on individual sectors and their trends along with well defined buy limits and sell stops (at chart bottoms and tops) are a must.

Today I made a couple trades that reflect this concept. I have been playing the basing of the Financials sector, as expressed by XLF or its levered cousin, UYG on the long side from $20 on up. But when UYG gets to $23, I jump back into SKF, the inverse ETF fund for the Financial sector (goes up when financial stocks go down). This pattern has been very solid since late July and I have participated in each direction each time, using sold put options on the near month, making profits on both the up and downside. This trend could continue much longer. If the financials bottomed on July 17, it will take some time before they regain their earning power so that the stock prices can advance significantly. In between, the price will just gyrate in a fairly narrow zone, as it has for a month.

I have created a "Prophet Chart" on the UYG to illustrate this action and the potential buy and sell levels based on the short term trends (usually only a few days long each). It is easy to see the pattern than is now established between $20 and $23 on this chart. This sideways action can continue for some time, until fundamentals change significantly one way or the other.

Another chart that shows promise for the sideways action is the Tech index, XLK. There is a levered version of this sector as well, the ROM which will provide a lot of volatility in its near term options. Because the Tech sector was not as overpriced in 2007 and so was not as damaged by the selloff, it is possible, even likely, that the XLK will break out sooner rather than later. Tech is typically an early cycle sector. As soon as the economy looks to recover, the Techs will break out. See the flag pattern on the chart? This is the narrowing funnel trending the highs and the lows. If the price action breaks out of a "flag" pattern, it will have quite a bit of momentum. Watch to see if XLK breaks out to the high side, at around $25.

Finally, let's look at the Energy sector, XLE. Here is a sector that has had a large correction, but looking over a one year time frame, it can be shown that the correction may have just run its course, as it approachs the bottom from January this year. There is definite trading support for oil at $100 a barrel. So, unless we are entering a deep global recession that shuts down demand, the trading action shows that we are nearing the bottom of the materials / commodity selloff and are getting ready to bounce (and may have done so today). The price line today is just moving above the downward trend line of the recent highs. The best way to play this sector is to the upside, but with very tight stops to get out if the economy does change the fundamentals of the commodity boom, drying up demand.

See you soon.