Investors Should be Suspicious of False Hope

Take a look at the chart below and you can’t help but wonder if this bounce is doomed to fail like the previous four September/October fake-out rallies.

Since the Aug. 9 lows, the S&P 500, along with the Dow and Nasdaq, has staged four seemingly powerful rallies. Each time, the S&P 500 gained about 100 points. Each time, the S&P 500 erased all or nearly all the gains and ultimately fell to new lows.

Just last week, stocks rallied on Monday and Tuesday (Sept. 26 and 27). The media got all giddy, and after Monday’s (Sept. 26) close, the Associated Press claimed that “Stocks jump on hopes for a Europe fix.” On Tuesday (Sept. 27), Reuters reported that “Stocks pop on Europe hope.”

The S&P tumbled 120 points from Reuters‘ hope-filled Tuesday headline to this week’s lows.

Yesterday, once again, the AP exclaimed that “Stocks rise on hopes for European banks.” Is this bounce just another fake?

Hopium Doesn’t Work

Hope is not an investment strategy, and those “smoking hopium” a week ago were in for a big bad Greek surprise. Sunday’s (Sept. 25) ETF Profit Strategy update clearly stated that “Following this bounce we are expecting a new low and will re-enter short positions against 1,148, 1,173 or after a break below 1,121. It is prudent to scale out of short positions between 1,100 – 1,088″.

Fake vs. Real Low

The chart above shows why the Aug. 9 low at S&P 1,102 was unlikely to be the real low — sentiment was simply too bullish. The Aug. 14 ETF Profit Strategy update stated that “When the dumb money feels now is a buying opportunity, we should be suspicious. In fact purely based on sentiment, we should probably expect a reversal to the downside.”

Real bottoms occur when investors are deeply bearish, not bullish. As the chart shows, investors were much more bearish at this week’s low.

The Aug. 14 and Aug. 21 ETF Profit Strategy update featured six other reasons why new lows are likely and how such a low can be recognized. Here are two (quoted from the newsletter):

1) “The VIX high generally does not coincide with an S&P bottom. As the chart below shows, neither the Oct. 23, 2008 nor May 21, 2010 VIX highs marked an S&P low. There was a 21-trading day lag time between the VIX high and the S&P bottom in 2008 and a 28-trading day lag time in 2010. Based on this pattern a new price low may occur in 17 to 24 trading days.”

The Aug. 8 high for the VIX was 48. This week’s secondary VIX high was “only” 46.88, which is exactly the same pattern we saw in October 2008 and May/June/July 2010. It occurred 40 days after the primary VIX high.

2) “RSI doesn’t answer whether the S&P will bounce right here, but it shows that there tends to be an RSI and general breadth divergence whenever significant lows are reached. It would therefore make sense to see a new price low unconfirmed by a new RSI low.”

RSI (Relative Strength Indicator) at the August low was at 20, and this week’s low is at 37. The non-confirmation in both RSI and VIX suggest this week’s low at S&P 1,075 will remain intact for more than just a few weeks.

Support, Support, Support

The Oct. 2 ETF Profit Strategy update said in no uncertain terms that 1,088 is important support and outlined the ideal bottoming scenario: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”

The actionable trading strategy was articulated as follows: “It’s prudent to scale down short positions around 1,100 and exit most short positions around 1,090. Regarding getting into long positions, either 1) Buy against 1,088 with a fairly tight stop-loss below or 2) Buy after the S&P registers a new low (around or below 1,088) and comes back up above resistance at 1,088.”

The S&P dipped below 1,088 briefly and soared to close above 1,088 and even higher. In short, the S&P did all the right things to consider a bottom in place.

A Double-Edged Sword

Before getting too excited about a possible rally there are two things to keep in mind:

1) The S&P already has spiked 90 points in three days, so it wouldn’t be smart to chase stocks right now (in fact, we have a tight stop-loss on our long positions). It would be prudent to wait for stocks to revisit important support� before buying into this rally.

2) All U.S. indices have fallen below major support after reversing right against important resistance. This means a major top is likely in place. From a technical perspective a rally was likely, but technicals strongly suggest it will only be a counter-trend rally.

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The ETF Profit Strategy Newsletter provides a detailed short-, mid- and long-term outlook along with the target level for this rally and the support that should serve as buying opportunity.