Portrait Of A Short Squeeze

09/09/05 01:21:03 PM

by David Penn

From Cindy to Katrina, piggish bears have overplayed their hand in September.

Security: $SPX
Position: N/A

The depths of every bear market have their signature. The bigger the bear market, the more pronounced the signature, to be sure. But traders who know that the news can be as much ally as enemy are able to spot these signatures and, rather than being overwhelmed by the tempers of the time, can often exploit these moments to their great profit.

Bigger bear markets often have multiple signatures. The 2000-02 cyclical bear market concluded with a number of horrific events--the Washington, DC sniper attacks, the Russian theater hostage crisis and, of course, the Congressional authorization of President Bush's determination to invade Iraq.

Most recently, the August downturn in 2005 had its ill tidings. Anti-war protestors, led by Cindy Sheehan--a mother whose son died fighting in Iraq--camped out at the President's vacation retreat in Crawford, TX. This was a function of the growing social polarization in the country, a polarization that culminated in the fury of recrimination that exploded in the wake of Hurricane Katrina.

This is a key point. Social polarization and negative mood didn't cause the hurricane. But it did condition the way people responded to the objective facts of the hurricane. Social mood doesn't change the facts--it simply suggests how we will "color" the facts, in bright tones or drab ones.

FIGURE 1: Rising MACD histogram troughs and rising stochastic troughs were clear warnings that the bear market in August was running out of both fear and loathing.

Graphic provided by: Prophet Financial, Inc.

Humans are resilient beasts (no offense intended, all you intelligent designers); otherwise, we wouldn't have stuck around for so long. As such, things can only get so bad before we become, in the immortal phrase of the bear market of the 1970s, "mad as hell and not going to take it any more." And that is just what happened in late August.

Note in Figure 1 how the moving average convergence/divergence (MACD) histogram troughs form higher and higher lows over the course of August. Note also how the stochastic is also making higher and higher lows--especially in mid-month. These higher lows show that the bearish momentum was (understandably) growing weaker as the market moved lower. The question, of course, is when would that weakness become weak enough to allow the bulls to seize control of the market. This is important--and shown in the fact that the MACD histogram peaks were forming lower and lower highs over the course of August.

The first sign of bullish strength came with the first higher high peak in the MACD histogram on August 29. Shortly after this peak, the market slipped lower to test the lows of the month. Late in the trading day on August 30, the Standard & Poor's 500 did make a lower low. But that lower low actually turned out to be a bear trap--or at least an effective 2B test of bottom insofar as there was no follow-through in the last 90 minutes of trading on August 30. On the following day, the market moved higher and has been doing so impressively ever since.

Confirmation of the new direction came on September 1, with an MACD histogram peak that was higher than any such peak in the past month and more. In fact, the last MACD histogram peak that was as high as the one on September 1 was the one on July 11. Not coincidentally, that peak on July 11 was also confirming the end of a bear phase--that phase being the correction in the second half of June (the ill tidings of this correction, you might recall, included the terrorist bombings in London).

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Portrait Of A Short Squeeze

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