Reader Steve Poses a Short-Selling Puzzler

I got a great comment this week from reader Steve on my post about why the appointment of new Fed Chair Jay Powell just doesn't matter.

Steve wrote:

Lee your commentary is always intended to be fact based and well informed. Thanks. It does appear at the moment that your shorting call based upon liquidity is too early. You originally discussed having a small short position and we have had the short-term LAMP red for weeks. Further, your commentary discussed huge financing requirements for the US Treasury based upon TBA advice. And - diminishing foreign demand for U.S. treasuries. Therefore, where is commensurate the liquidity crunch and the pull back in stock prices.? So far, just seeing record high after record high. For now, it appears that the liquidity crunch is non-existent and at best temporary - if the markets significantly retrench, the Fed will again go back to Q/E. Look at the BoJ - they have expanded their bank balance sheet to 70% of GDP. The US can do the same. Grateful for your view. Thanks.

I read Steve's comment just before Thanksgiving, and I knew right away I wouldn't be able to enjoy Turkey Day until I had addressed it. Steve's comment touches on a number of important issues - some of which I've alluded to in recent posts, but others not.

First, I can't stress enough that shorting stocks or indexes must finally be based on technical analysis. Liquidity establishes context, but the charts rule. If you are not a chart trader, then I would suggest finding a good technical charting service to guide you before you even think of trying short-term trading.

There are several experts right here at Money Map Press, including D.R. Barton, Jr., and Shah Gilani, who can help you with that. You should be comfortable with their approach before you start trading. It's a risky, high-intensity business that requires some time and attention.

I also offer a short-term trading service at my site, The Wall Street Examiner, if you are interested.

Let Me Be Clear - This Market Is Running on Speculative Fumes

The short-term LAMPP signal does look wrong, but there's some nuance that at least excuses that mid-September signal a bit. Since that time, my trade setup screening algorithm has produced almost as many shorts as longs, until the last week. During the mid-September to mid-November  period, trades on the short side did just as well as long-side picks. The market averages rallied, but cyclical momentum and breadth weakened sharply, allowing profits to be made on the short side in the right stocks. The shorts actually outperformed the longs for a couple of weeks. That was not the case before September, when only longs were profitable.

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Over the last week, there has been a massive shift back to the long side. Whether that will prove to be a false start remains to be seen, but we should know within the week after Thanksgiving. The period from then until Christmas is normally strong. If the market falters instead, it could be a sign that the jig is up.

There has been an enormous increase in Treasury supply since mid-October. I expected that to depress the markets. It has not. That appears due to a couple of things. One is a massive influx of cash from Europe and Japan, as their central banks continue to print money and then punish it for staying in their home markets with negative interest rates. That drives the big institutions to instantly shift cash to Wall Street by purchasing U.S. Treasuries and U.S. stocks. That adds to liquidity in the U.S. market.

The second factor is an increased use of margin and other types of leverage as the rally proceeds. That's dangerous.

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Meanwhile, the Fed has only begun to pull cash out of the banking system. That draining activity will increase dramatically over the next 12 months. And in January, the European Central Bank will cut its QE purchases in half.

As a result of these factors, my target for the market's peak has been January. The looming revisiting of the debt ceiling crisis is a wild card, but that will only be a short-term effect. Ultimately, they'll do a deal that will take that issue off the table for the foreseeable future.

In the meantime, my conclusion is that the market is running on speculative fumes. My technical work, using the cycle theory of J.M. Hurst, has for a long time projected a long-term top in the 2,600 to 2,650 range. We're there. The probability of a top in this area over the next three months is high. I would short the market when the charts tell us that the turn is under way - not before.

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Sometimes rule No. 2, "The trend is your friend," or "Don't fight the tape,"  supersedes rule No. 1, "Don't fight the Fed," for a few months. Since the Fed has barely started draining funds from the system, this is one of those times.

The short-term LAMPP has looked wrong (with some nuance), but the long-term LAMPP hasn't gone red yet. There's no long-term sell signal. But it will happen, soon. When it does, the market will be primed for a downturn. We'll look to the technical charts for specific timing.

I may have been guilty of being less than clear about the issue of timing short sales in past posts where I talked about the issue. I hope that this clears that up.

In the meantime, from an investment perspective, I'd continue to systematically sell small portions of your portfolio to raise a significant cash cushion by the end of the first quarter of next year, if not by the end of January. I'm shooting for 60% to 70% cash. Your requirements will differ depending on your personal circumstances. Only you can decide what's appropriate for you, but having a lot of cash will provide protection from loss and will give you the opportunity to pick up bargains over the next several years.

Just not right away. I would avoid buying anything at these levels. We are getting very, very close to the final top.

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The post Reader Steve Poses a Short-Selling Puzzler appeared first on Lee Adler's Sure Money.

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Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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