Momentum Returns, But Is it Here to Stay?

In my May 8 column, While Bulls and Bears Snooze, Mules Are Holding the Market, I discussed my theory of herd-market mentality. I described what I called a mule market, in which our two main momentum players, online traders and institutions, had been turned into mules -- stubborn and impossible to get moving.

In the last few weeks after several false starts, the herd has finally started moving. The Nasdaq bottom on May 24, at 3042 was the first rock thrown to get the herd moving, or at least get its attention. The second was well-known market commentators like Bob Brinker calling the market "oversold" and anticipating a short-term rally. The third rock, and the real fuel to the fire, was the release of economic figures throughout last week.

News of the economy and inflation slowing, as well as the general feeling that the Federal Reserve will raise rates no more than one more time in the near future, sparked a fresh round of momentum and really got the institutions off and running. On May 26, I noticed key indicators that the institutions were again joining the party and starting to accumulate. Heavy selling in the morning was not met with a large market downturn. This indicated to me that institutions were beginning to soak up the selling and accumulate in anticipation of a rally. As the government figures were released last week -- confirming the slowing of the economy -- the market took off and institutions went into high gear.

Although news was released all week indicating that inflation was slowing, the real test will be when the Producer Price Index and the Consumer Price Index numbers are released on June 9 and June 14, respectively. Until then, we are playing with what we anticipate the numbers to be. But no matter what the reason, the market is off and running again. If this is a short-term rally or a change in the general market direction, only time will tell.

When I see major moves in the market, especially one that has sold down so far, I tend to play stocks a bit differently. The momentum can be prolonged, and I tend to ride the trades a bit more into the longer-term momentum, riding out the smaller waves.

Whenever I make a trade, I weigh the risks and potential rewards, then make my decision to execute the trade. Last Thursday was a classic example of why I do this. For the past several weeks I have noticed that the market had consistently been opening up with strong buying for about the first half-hour before its first selloff.

Another round of economic numbers were to be released early Friday, June 2. There were two possibilities: that the numbers would be bad, causing the market to react negatively; or that the numbers would be good, causing the market to react positively.

Cisco (CSCO Quote) is fairly representative of the Nasdaq as a whole and is also a key indicator of what institutions are doing. Whenever you hear the word institutions, you usually hear Cisco mentioned in the same sentence. In the case of bad numbers: if I bought Cisco just prior to the close on Thursday, I would expect it and the market to gap down (open lower than the previous day's close) about $3, then climb at the open at least $2, as it had been doing the past few weeks. So my risk was about $1.

If I bought Cisco just prior to the close on Thursday and we had good economic news, I would expect it to gap up about $3, climb at the open, then drop as it had been doing. Looking at the risk-rewards -- in the case of bad news -- my downside was only about $1, but the upside was well worth the risk.

I purchased Cisco at 60 3/4 a few minutes prior to the closing bell on Thursday using this risk-reward formula. The government figures were positive, and Cisco gapped up on Friday morning 3 13/16 points from my purchase price to 64 9/16. I rode the momentum to 65 where I exited the trade for a cool 4 1/4-point gain.

I used the same risk-reward decision process with Ciena (CIEN Quote) -- a stock that had been moving alongside Cisco all week. I purchased Ciena just prior to the bell at 130 on June 1 and sold at 145 1/4 the next morning. If this isn't a testimonial for meticulously tracking specific patterns and playing only the high-percentage trades, I don't know what is.

OK, so is this a bear market rally or a real-deal market reversal? Only time will tell, but we momentum traders welcome volatility either way, up or down. Now that the volatility is back, don't make the mistake of shooting at everything that moves. Continue to pick and play only the high percentage trades. Remember, capital preservation is the key in fast markets just as it is in slow markets. Good trading!