The Gilmo Report

May 25, 2011

May 25, 2011

A light-volume gap-down on Monday took the NASDAQ Composite Index and the S&P 500 Index down below their 50-day moving averages in what has so far been a shallow short-term correction that has taken each index down 4% and 3% off their recent price peaks, respectively. Monday and Tuesday each added another distribution day to the mix, but with the market already in a bona fide correction these just add weight to the negative tone of the market. As we see in the NASDAQ’s daily chart, below, while we did get a bounce in the indexes today, the NASDAQ was unable to make any progress back up into the gap and towards its 50-day moving average as it remained in what is so far an expanding three-day range. Volume picked up today but the indexes did not exhibit any decisive upside thrust as they sold off into the close, cutting their gains by a third or more by the close, depending on the specific index. Objectively, today’s action counts as day one of a rally attempt, although it would not be necessary to see a follow-through in order to call a resumption of the market’s uptrend given that 3-4% down in the indexes constitutes little more than a short-term correction.

NASDAQ Composite Index Gilmo Report Chart

As I wrote in my report of this past weekend, gold flashed a pocket pivot buy point as measured in the SPDR Gold Trust (GLD) last Friday, and the yellow metal has in fact continued higher since then. The question that comes up given the current market action is that, if QE2 ends, what happens to the market and precious metals? Well, we know from May 2010 that the market went into a nasty tailspin after QE1 was terminated at the end of April 2010, which you can see in the yellow-highlighted area of the one-year daily chart comparing the GLD (red/black line) to the S&P 500 (black line). When the market tanked after the end of QE1, gold in fact rallied until the latter part of June. This short-term peak in June also roughly coincided with the low of the summer correction of last year. This is one possible outcome of the end of QE2, but not the only one. The Fed knows what happened last time when we got the brutal sell-off that featured the infamous “Flash Crash” of May 6, 2010, so there is always the possibility that they will come up with some creative way to create not necessarily a “soft” landing, but perhaps a “softer” landing for QE2 than they did for QE1. In the meantime, we can simply use the 50-day moving average as our selling guide for the GLD, which could continue to perform well whether QE2 ends altogether or not, and it would also likely drag silver up with it.

SPDR Gold Trust (GLD)  Gilmo Report Chart

If gold does go higher and ends up dragging silver up with it, can we expect silver’s climax top to pan out something like we see in silver futures 2006 daily chart from 2006 where the sharp breakdown after the climax top resulted in a sharp rally back up to higher-highs before finally collapsing?

silver futures 2006 Gilmo Report Chart

Or does it simply collapse in a little double-top like we saw in silver 2008, below, and stay down for a while? So far silver is tracking along its lows and remains under its 50-day moving average currently, and the key to figuring out silver will be to watch what gold does, in my view.

silver 2008 Gilmo Report Chart

Silver may also not mimic what it did in 2006 and 2008 and do its own thing, so to speak, in 2011. In the short-term a lot of this is going to depend on what happens with QE2 and the potential for a type of QE3. Perhaps the Fed will let QE2 end and then see how the markets react, or they may deliberately try to engineer their way around and away from an outcome that is similar to April-May 2010 by keeping some sort of QE variation in play. There are a lot of different possibilities, and while we can’t predict the exact outcome of QE2 ending we can simply allow the price/volume action of the precious metals to guide our handling of any positions in either. For now the SLV has been staging a low-volume bounce as it makes a run for potential resistance up at its 50-day moving average at around 38.11. Volume has been light down here on the silver futures, so it appears that silver is at least trying to build a bottom here. This, of course, could take some time, so any kind of backing and filling from here would not be unexpected.

SLV Gilmo Report Chart

Over the weekend I discussed the three-weeks-tight (3WT) flag I was seeing in Green Mountain Coffee Roasters (GMCR) and lo and behold, the stock was added to the NASDAQ 100 on Monday, causing it to pop out to all-time highs, as we see on the daily chart below. The stock has since continued higher, and Monday’s breakout, while not exhibiting the standard O’Neil volume requirement for a new-high breakout buy point, was an easy buy based on the fact that it was indeed a pocket pivot buy point as the stock emerged from the 3WT formation and catapulted off its 10-day moving average. The stock has been up every day this week so far, lending testament to the fact that pocket pivots will get you in on a proper buy point when a new-high breakout without the “textbook” requirement of having to trade 150% or more of average daily volume won’t. Vive le difference!

Green Mountain Coffee Roasters (GMCR) Gilmo Report Chart

It was with a fair bit of amusement that I watched Netflix, Inc. (NFLX) move to all-time highs today on heavy volume, given that I had written over the weekend in my May 22nd report that “With so many becoming skeptical of NFLX’s future prospects, it would not surprise me to see the stock break out of this ladle-with-handle formation and go higher.” The move was sparked by news that Facebook was allegedly discussing “social features” with NFLX. I pointed out the stock’s ladle-with-handle base formation over the weekend, which provided a nice launch pad for the stock today. Can NFLX go higher from here, even if the market correction continues? I would say that is definitely a possibility since leading stocks can often continue higher after the general market has topped. If you like buying new-high breakouts, then NFLX is still in range of its 252.22 buy point, as I see it, using that price level as your nearest and lowest-risk selling guide.

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Taking note of Monday’s pocket pivot buy point in NFLX that led up to today’s breakout to all-time highs in that stock, we might also take notice of Chipotle Mexican Grill’s (CMG)
pocket pivot buy point on Monday as well, as we see in the daily chart below. Short-sellers have continued to lean into the stock’s recent uptrend, as the stock still has 2.6 days of short interest which multiplies out to 2,901,600 shares, or just under 10% of the stock’s 30-million-share float sold short. Notice as well on the chart that two small black “ants,” signifying that the stock was up 12 out of 15 days or better at that point, showed up five and six days ago as the stock approached its all-time highs. It’s easy to doubt CMG, but the bottom line is that this stock is not a short until it breaks down materially, and those who try to short it on the way up, like those who have tried to short NFLX on the way up, may not find themselves rewarded any time soon. Based on Monday’s pocket pivot buy point, the stock is potentially buyable here using Monday’s low as a selling guide for a quick exit should the stock fail from here.

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In the past two reports I’ve discussed several stocks that are on my watch list given their constructive action during this market correction that is now 18 days in duration off the peak. All of these stocks continue to act reasonably well, including AMZN, which continues to hold above the 190 breakout level; CRM, which has continued higher from last week’s buyable gap-up move and is pushing towards all-time highs; VMW, which is exhibiting decent action within the handle of a cup-with-hande formation; and TIBX, FTNT, LULU, and FOSL, all which continue to hold up near their highs. The one exception is rare-earth metals miner Molycorp, Inc. (MCP), which I have discussed as potentially building the lows of a possible new base. Today MCP announced that they have filed to offer 11.5 million shares from selling shareholders, which the media is citing as a sign of a “rare-earth metals bubble.” Sure. Let’s be realistic here – insiders sell for any variety of reasons, and the insiders at MCP have done well with the stock since it came public last year at $14. Why not sell more shares? What I think is very interesting here is that despite this announcement of an additional 11.5 million shares hitting the market, the stock only sold off $1.6 or 2.7%, on light volume. Keep an eye on how this acts when the secondary is finally priced in the coming days.

Molycorp, Inc. (MCP) Gilmo Report Chart

On the short side of the market, we’ve seen LVS and FNSR remain weak but extended to the downside from optimal short-sale points. Another stock I’ve discussed as a short-sale target per my report of May 15th, F5 Networks (FFIV), has also been weak since Monday’s gap-down which took it below its 65-day exponential moving average. Overall volume in FFIV has been weak, but I noted that today’s upside move right back up and into the 65-day exponential line occurred on the weakest upside volume yet. While it is not entirely clear whether FFIV is building another right shoulder in what so far looks like a head and shoulders type of formation, one clue might be found in the action of cloud-computing network stocks as a whole. Stocks like RVBD, ARUN, FNSR, APKT, and CAVM, all related more to the network side of the cloud phenomenon, have been acting quite weak as of late, and among these FFIV appears to provide the only actionable set-up, using either the 65-day exponential moving average at 105.17 or the 200-day simple moving average at 110.81 as your guide for a stop, depending on your risk tolerance.

F5 Networks (FFIV), Gilmo Report Chart

Despite the fact that we are in a correction, there is some buyable technical action in this market, such as we’ve seen so far this week in NFLX and GMCR for example. If one does choose to take positions in this market then the best approach is to revert to viewing the market not as a stock market but as a market of stocks, handling each potential situation on its own merits and risk parameters. Thus, for example, if one did decide to buy into the breakouts in NFLX or GMCR, maintaining stops at the breakout points would appear to make sense given the fact that the market remains in an overall correction. Remember that even if the market continues to correct, leading stocks can continue to go higher, and as examples I would point out First Solar (FSLR) continued going higher in late 2007 going into 2008 after the general market topped out in October 2007, as did a number of agricultural names like Mosaic, Inc. (MOS), Potash, Inc. (POT), and Agrium, Inc. (AGU), for example. Therefore, if one is adventurous enough and maintains proper stops, it is possible to continue to play leading stocks that continue to act well, although this is admittedly more difficult when the general market is correcting or in a bona fide downtrend.

The few ideas I’ve discussed in recent reports have offered some profit opportunities, at least in the short term, and I will continue to flag what I see as offering potential in this market, either long or short, while the market remains in this mushy state of affairs. With QE2 coming to an end, it is not clear how this will affect the markets, and with recent economic data pointing to continued softness in the U.S. economy as well as rumblings of defaults coming out of Europe, the Fed may not be in the mood to pull the plug too quickly given what happened last year when QE1 ended and we had a sell-off that resulted in the unnerving “Flash Crash” of May 6, 2010. In the meantime there is no reason to act on anything other than the most optimal set-ups.

Gil Morales

CEO & Principal, Gil Morales & Company, LLC

Principal and Managing Director, MoKa Investors, LLC

At the time of this writing, of the stocks mentioned in this report, Gil Morales, MoKa Investors, LLC, and/or Gil Morales & Company, LLC held positions in DGP, NFLX, and FFIV, though positions are subject to change at any time and without notice.

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