Play the Pattern Until It Breaks

It is strange how many rational beings believe the ultimate truths of the universe to be reducible to patterns on a blackboard.
-- Frederick Pollock

On Wednesday the S&P 500 managed the unusual feat of jumping almost straight up for the seventh day in a row to make a new high for the year. This is the third month in a row that we have seen almost the exact same pattern. After we make a new high, the tendency has been for us to stall out at the new high for a week or so and then roll over and close the month poorly before we repeat the pattern again.

It is fascinating that the market has been so consistent in producing these "V"-shaped bounces, but the problem is that they aren't particularly easy to trade, especially when volume tends to decline as we go higher. The quick shift from a technical near-breakdown to a new high just isn't very typical market action. I'd be very surprised if we have ever had this pattern repeat itself almost exactly for three months in a row.

So where do we go from here? If the pattern holds, we might have a few more days of upside but then we'll churn for a while and then see selling as the month winds down. Of course, trying to catch the exact point when we turn down is extremely difficult and tends to lead to short squeezes if the bears are overly aggressive too early. We saw a good example of this yesterday when we gapped up and surprised those who didn't believe another "V"-shaped bounce to new highs was possible.

What is so frustrating about this market is that it just doesn't lead to the creation of good chart patterns, and they become even worse the longer the rally continues. So the folks who hesitated to buy extended charts become anxious to buy any dip at all. That mindset keeps the dips extremely shallow and never allows for any of the healthy consolidation that technicians look for.

The other tricky thing about this market is how strongly the action is tied to any movement in the dollar. Any pressure on the dollar automatically triggers the buying in gold, energy and various commodity-related names. The "short dollar, long commodity-related equities" trade is so obvious to everyone now that we have to watch for any sign that it is unwinding. When it does reverse, the market reaction is going to be very ugly, very fast, but for now no one seems to be at all worried about that.

Although it has been a tricky trading environment, above all else we have to respect the fact that this market is acting very strongly. Many traders are tempted to keep on trying to short this rather illogical action, and it just isn't working very well. Ironically, the more they try, the more likely the market is to continue to act in an unusual fashion.

Our job here is to monitor the action closely and react as conditions change. If the typical pattern holds, we should have some flat action and then a couple of days of sharp down action, but we can always count on some surprises from the market beast.

Wal-Mart (WMT - commentary - Trade Now) is out with earnings this morning that are slightly ahead of expectations, but the stock is trading down on light guidance for the fourth quarter. Weekly unemployment claims are coming up, and we'll likely see a reaction to that data. Asia was weak overnight and we have a little softness in premarket trading.

No positions.

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James "Rev Shark" DePorre is the author of Invest Like a Shark: How a Deaf Guy with No Job and Limited Capital made a Fortune Investing in the Stock Market. He is founder and CEO of Shark Asset Management, an investment management firm, and he also operates sharkinvesting.com, an interactive online community that serves and educates active investors. DePorre holds business and law degrees from the University of Michigan, is a member of the Michigan Bar Association and a former tax attorney and CPA. He lives in Anna Maria Island, Fla., with his wife and two children. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Rev Shark appreciates your feedback; click here.