The Gilmo Report

August 15, 2010

September 15, 2010

The NASDAQ Composite Index suffered a sharp gap-down break this past week but was able to find what is for now at least temporary support at the mid-July lows. The magnitude of the three gap-down moves was significant, with the second gap-down day on Wednesday of this past week taking the NASDAQ Composite Index below its 50-day moving average for the first time since mid-July. Yet the absolute level of selling volume was not overwhelming, as we can see on the daily chart below. In general, since the early May breakdown and the now-infamous “flash crash” on May 6th, selling volume during this correction has steadily declined despite the fact that each sharp break in the NASDAQ’s pattern since early May has been accompanied by higher volume relative to the days preceding each of these breaks. While volume remains indicative of the “summer doldrums,” for the most part, when volume has increased it has come in the form of selling volume. With the market finding a brief respite on Friday as it held above the intra-day lows of Thursday’s trading range, the market might be in a position to bounce here, faking out late short-sellers. However, the situation here is fluid, and a break of this little support area here at the mid-July lows with volume picking up again would likely mean that a retest of the early July lows, also the absolute lows of the market’s May-July correction, is in the cards here.

  Gilmo Report Chart

After taking a little hit on my long positions early in the week, shifting quickly to a very concentrated 100-150% short position in Research in Motion (RIMM) helped to recoup these losses as RIMM immediately cooperated by pushing lower on Thursday and Friday down to this rising trendline off the early July lows in the stock. I’m looking for RIMM to bounce off this trendline, just a bit at least, and up into its 50-day moving average one more time as an opportunity to come back into the position on the short side, particularly if the general market stages a reaction bounce from here. However, this is not guaranteed, so you can get a sense of how I handle RIMM from here, using the rising trendline and the 50-day line as my guides for re-entering the position. If the market bounces, RIMM will likely try and bounce off this trendline, setting up a potentially optimal short-sale opportunity. If the general market continues lower, RIMM will likely break this rising trendline, and so I am happy to re-enter the position on the short side as the stock starts to break down through the trendline, as I’ve drawn it all on the daily chart of RIMM, below. Recognizing as well that this market is a bit strange, and we could see the bizarre emergence of some sort of QE2 reaction rally in the market, I have preferred to play it safe over the weekend, moving to cash as I decide exactly how to play any trend that develops here.    

Research in Motion (RIMM) Gilmo Report Chart

When I’m running large, concentrated short positions, just as when I’m running large, concentrated long positions these days, I seek to keep my risk to a minimum by using the nearest guides I can find for my stop-loss or trailing stop points. A 150% short position in RIMM that results in an 6% drop in the stock results in a 9% gain in my portfolio, which can work in reverse if things don’t work out. Do this two or three times correctly and you are up big – do it wrong and you can expect to take some pain. For this reason, I maintain two types of stops on my concentrated short positions: a time stop and a price stop. Based on what I’ve studied in my own trading recently, I use a new rule I call the “20-cent Rule.” In May, when I was able to make over 100% on the short side in my own account, I achieved this by working concentrated short positions and keeping very tight stops while at the same time using the liquidity of the market to quickly move in and out of short positions until they finally broke down for me. What I found in studying my own trades is that in the vast majority of these trades, using a 20 cent “quick-stop” on large, concentrated short positions works very well as long as I am willing to re-short the stock as it moves higher, gaining the advantage of putting out most of the position at a more favorable, higher price. I should emphasize here that such a rule is one I came up with as a result of studying my own trading, not yours, so it may not work for you the way it works for me. I have noticed that I trade best when I trade fluidly, and adopting a rigid stance tends to work against me and my particular trading psychology.

I would encourage each of you to study your own trades carefully to pick off your own weaknesses and develop little rules to correct these tendencies. Identifying patterns in your own trading can often result in extremely useful trading rules that can improve your results by putting the odds more in your favor and keeping you out of trouble. You may notice that you too often buy too high or short too low, and developing rules that can put the odds further in your favor is quite helpful, as I have learned since making my comeback from a pathetic 2009. Know thyself!

In any case, for myself, taking some quick short profits that helped to put my psychology on an even keel here and then moving to cash to engage in a significant “big think” session this weekend without any bullish or bearish bias that might be engendered by any pre-existing positions in my portfolio, was the thing to do. This market is going to have to show me some strong upside evidence before I am willing to believe that this “uptrend” is merely “under pressure,” as a break to new lows remains a distinct possibility while we move towards the end of summer and into September, when investors supposedly all return to business.

All three of my “Power Trio” stocks, F5 Networks (FFIV), (CRM) and VMware, Inc. (VMW) took a hit this week and broke sharply off of their previously well-contained uptrends. VMW, shown below on a daily chart, was the only one that followed up a logical bounce off its 50-day moving average on Thursday with some above-average volume on Friday as the bounce continued. Frankly, I would prefer to see volume higher on the up days as the stock bounces, while the pullback to the 50-day line occurs on lighter volume. All that Thursday’s action tells you is that enough market participants pay attention to the 50-day moving average to move in and buy VMW at that point, resulting in a decent short-term bounce. I would watch to see whether VMW or any other leading stock retest their 50-day lines for a second time, but with volume drying up, which I would view as constructive. One thing I would not do here is to try and short these stocks. This is often a popular thing to do since the leaders in any environment where the market is running into some speed bumps often look “too high.” If you are shorting VMW here, you are asking for trouble, since if the market turns and rallies for a few days, VMW, FFIV and even CRM could all turn and head back to their recent highs, running in shorts.

VMware, Inc. (VMW) Gilmo Report Chart

VMW is showing some above-average volume as it bounces right off of its 50-day line, while F5 Networks (FFIV), shown on a daily chart, below, is bouncing from a position above the line but with little upside volume thrust. As I said, any of these stocks could make another run at their highs, depending on the action of the general market, since they are still in uptrends as defined by their 50-day moving averages and they are still leading stocks in this market, even if it is wobbling a bit. If the market breaks they may hold and simply go about the business of building all-new bases while the rest of the market, including the laggard former leaders, heads lower. The problem here is that FFIV was looking as if it was coiling up in an ascending flag and from my perspective it should have moved up and out of this formation. The second that it proved this scenario wrong, it was out of my portfolio. Remember that I strongly advocate printing out charts of all your positions every day or every other day and marking up different hypothetical price moves in your positions, asking yourself what you will do in each case. You can also just do this on your computer monitor if you have a drawing program that allows you to annotate charts, which “saves trees.” By “experiencing” what might happen to your stock and going through this exercise, if and when a particular situation arises you will already know what to do, and the emotion or “heat of the moment” is hopefully eliminated from the equation.

F5 Networks (FFIV) Gilmo Report Chart

In FFIV’s case, once it broke the 10-day moving average with volume picking up sharply, it was negating the flag formation – a simple sell. Now the volume on this bounce is a bit weak and it may eventually test the 50-day line, but that will largely depend on the action of the general market from here.

Not all leaders are in trouble here, however, as Netflix, Inc. (NFLX) demonstrates in its daily chart, below. Last weekend I flagged NFLX as a pocket pivot buy point two Fridays ago as it came up through its 50-day moving average on volume that was higher than any other down-volume day in the pattern over the prior 10 days. NFLX then held its 50-day line and surged through the declining tops trend line I’ve drawn on the chart, which defines a standard new-high base-breakout buy point at around 124. The stock is showing a lot of strength because of a significant change to the “N” or “New” in their story, which is the new distribution deal with EPIX, Inc. to distribute movies from Paramount, Lionsgate, and MGM studios over the internet. This brought in a lot of buying as the market assessed the positive impact of this agreement on NFLX’s business. If the general market remains weak, NFLX might pull back to the breakout point, and if it did so constructively it could either a) build a new base during a market correction or bear phase, or b) continue higher again if the general market firms up. Keep an eye on NFLX as it is a de facto “big stock” leader.

Netflix, Inc. (NFLX) Gilmo Report Chart

The best short-sale targets are stocks that have weakened considerably, have lower relative strength ratings, and which are in bona fide downtrends. Stocks like VMW, FFIV, and CRM, while getting whacked pretty good off their recent peaks, are still in uptrends, and may just spend time building bases here even if the market goes into a deeper correction or bear market. Back in 1997 I used to try and short these types of situations, thinking that the first test of the 50-day line would surely result in a break down through the 50-day moving average, but this is getting the cart before the horse – these stocks are still leaders, pending further evidence, and violate the principle of only shorting those weak, laggard stocks that were former hot leaders in the prior bull phase. In this case, we prefer to pick on stocks like RIMM, shown earlier, and Visa, Inc. (V), shown below on a daily chart. V is currently working on what looks like right shoulders in an overall head and shoulders pattern that you can see on a weekly chart, but not on a daily chart, below. Here I focus on the “head” and its sharp downside break along its right side, followed by this series of right shoulders with successively lower peaks that form a “descending triangle.” What I’m looking for here is a breach of support at around the 71 price level, so I view weak rallies up towards the 50-day and 200-day moving averages in the 74-75 price zone as potentially shortable if the general market remains weak or gets weaker.

Visa, Inc. (V) Gilmo Report Chart

Notice, however, that V did not pick up any real selling volume on Friday, which leads me to believe an upside bounce here is likely, and could coincide with a bounce in the general market, which as I indicated at the outset of this report is a decent possibility here. Apple, Inc. (AAPL), which I mentioned as a short-sale idea in my mid-week report of this past Wednesday, has dropped below its 10-week/50-day moving average, as we see on the weekly chart below. However, this past week showed light selling volume, so I find the action to be somewhat inconclusive. Also, last weekend I noted the positive aspects of the three-weeks-tight (3WT) over the three weeks preceding this past weeks, but upon closer examination I note that the second and third weeks of the 3WT were actually wedging up along the lows. Now this pullback down below the 10-week moving average may simply be serving to “correct” the wedge. There are a lot of high-volume downside weeks in AAPL’s pattern, the biggest of which occurred in January of this year. This is still in flux, as there have been signs of distribution in AAPL, but it has yet to decisively break down. If the general market goes, so goes AAPL, in my view, so this will bear watching. My tendency here is to think AAPL has the potential to bounce back up towards its 10-week/50-day moving average at around 257-258, and a weak-volume rally might be a clue to lay out the shorts on AAPL.

Apple, Inc. (AAPL) Gilmo Report Chart

What we know from last Wednesday’s Fed announcement is that another round of quantitative easing is stirring, better known as QE2, which has nothing to do with Queen Elizabeth and big ships but everything to do with the rush of paper liquidity into the system headed for who knows where. We already have been acquainted with what QE-influenced “Fed fumes” markets are capable of, and to this end I would point members towards the chart of the NASDAQ Composite Index September 2009 to March of this year. Note that when the market looked liked the end was in sight and heavy selling volume began to knock it down during the three highlighted periods in the chart, the selling suddenly stopped and the market would then turn around and head right back up to higher highs. In each case, these three periods of heavy selling action were followed by periods where the market rallied back to new highs on volume that was not equal to the selling volume. Maybe this is what a QE market is all about. So with the market faced with heavy selling at the current time, and QE2 possibly in the air, I would not let any short positions get out of hand, maintaining tight stops if that’s what you choose to do. On the other hand, there is nothing wrong with sitting in cash if the market begins to behave erratically, which I believe is still a possibility.

NASDAQ Composite Index September 2009 Gilmo Report Chart

The reality is that I don’t see a lot of fantastic short-sale set-ups right now, and the long side looks somewhat dicey to me. But a rally here by the general market, given that it is in a position for such a “logical” bounce attempt, might help to clarify the situation a bit more. For example, if a bounce here were characterized by weak buying interest and volume, then it may be worth aggressively looking at the short side as stocks like AAPL, ISRG, V, MA, and RIMM potentially rally up into logical areas of resistance at 50-day or 200-day moving averages and then roll over in a continuing general market correction or new bear leg. Of course, all this is dependent on the market evidence that is presented in the coming days and weeks. QE2 might fail, or it might just create an environment where the market chops and slops all over the place, creating for investors the classic situation of “death by a thousand cuts” as one gets whipped about. This is why we can always back away from trying to be bullish or bearish and treat the market less as a stock market, and more as a “market of stocks.” Positive action in stocks like NFLX here was playable on the upside, as its recent pocket pivot and subsequent new-high breakout has proven. (PCLN), which I first discussed as a buy just above its 50-day moving average in my reports of July 14th and August 4th, has also moved to new highs, hitting the $300 level for the first time, as we see below on its daily chart. Jesse Livermore would like this as he once said, “It was an old trading theory of mine that when a stock crosses 100 or 200 or 300 for the first time the price does not stop there but goes a good deal higher, so that if you buy it as soon as it crosses the line it is almost certain to show you a profit.” So far, PCLN has crossed $300, but it hasn’t closed above it yet. (PCLN) Gilmo Report Chart

Livermore would also use this rule of his in reverse when Anaconda Copper failed at the $300 price level in 1907 causing Livermore to unload the stock, “Anaconda opened at 298 and went up to 302¾ but pretty soon it began to fade away…I made up my mind that if Anaconda went back to 301 it was a fake movement. On a legitimate advance the price should have gone to 310 without stopping. If instead it reacted it meant that precedents had failed me and I was wrong; and the only thing to do when a man is wrong is to be right by ceasing to be wrong.”

Back in late 2007, when AAPL first tried to get through the $200 price level, it failed miserably, and this signaled the end of the 2007 market rally. In light of Livermore’s thinking, it will be interesting to see how PCLN acts around the $300 level as it potentially tries to punch through – or not. I love this Livermore quote precisely because it shows how he simply lets the market tell him what to do, and he does so in full acceptance of the message. There is a certain type of logic and fluidity in his approach, and it comes through in this quote, in my view.

The bottom line for me here is that we could be looking at further downside, and certainly another leg down in a continuing bear market would likely provide a very nice window of opportunity on the short side, and sometimes you have to sit around doing less as you wait for this to set up correctly and commence. Until it actually commences, you can get whipped around a lot and short-sale trades become very short-term as you end up only playing the little downside jerks within patterns. But you also have to have at least one foot in the water when it does commence, so short-selling becomes a laborious affair if one wants to work at it.

The flip-side off another leg down is probably choppy and sloppy movement to the upside. Underlying conditions remain somewhat uncertain, but the market may begin to discount something potentially positive in the coming November elections, so anything could happen. Throw in QE2 to add to the strangeness, and until I see something decisive happen here I prefer to play light, if at all, while remaining vigilant for a window of opportunity to open, which could be tomorrow, next week, next month, or longer.

Gil Morales

CEO & Principal, Gil Morales & Company, LLC
Principal and Managing Director, MoKa Investors, LLC

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