Too Early for Santa, Too Late to Buy

There were plenty of reasons to buy into last Monday's (Dec. 1) meltdown. But now? Now it's tougher to make the bullish case for the short term.

Yes, we are already hearing all the misguided talk about the fabled Santa Claus Rally, as many analysts mistakenly talk about the Santa Claus Rally already being under way or coming early, or other screwy notions. Fact is, the Santa Claus Rally is about a specific time frame, and it doesn't mean just any rally in December. It specifically refers to the last five trading sessions of the year and continues through the first two sessions of the new year. As such, it cannot begin till around Christmas at the earliest. A rally that takes place now till Dec. 20 may be a good rally, but it ain't Santa.

In fact, between now and then, during mid-December, there is evidence of a fairly consistent pattern of weakness, especially in the tech sector, going back to the mid 1990s. This may not be a deal-breaker this time around, but it's worth keeping in mind, and it's another reason I am becoming increasingly cautious for the short term.

The intermediate term is a somewhat different matter. I don't mind holding some bullish positions in anticipation of a further recovery over coming months and even later this month. But for the short term, I wouldn't consider buying here with the S&P above 900 and still up more than 20% off the recent lows. Then add to this, the satisfaction of upside objectives (notably the filling of a bunch of gaps over the past two sessions) and an extreme overbought condition, and you have all the earmarks of a near-term top.

So why hold long in here at all? At least one reason of note -- several bullish island reversals were created during Monday's gap-up opening. As the market collapsed into the close Tuesday, those islands remained intact, and accordingly I added to my bullish bets -- but just for a trade.

In the chart of the S&P Futures below, you will see what I mean.

S&P Futures Monday's bullish island reversal is still intact

Click here for larger image.

Source: Lind-Waldock

Note the bullish island reversal created on Monday morning as the S&P Futures catapulted over the previous Monday's gap. Then late Monday, the S&P almost made it up to fill its Nov. 11 gap at 921.50. Not quite, but close. For now that's resistance.

On the downside, the critical level is the bottom of the island at the 880 level. As long as that level holds, the bullish implications of the island remain in effect, so I don't mind buying weakness toward that level.

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S&P Cash (SPX) Stalling at the Nov. 11 gap

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Source: Lind-Waldock

A better illustration of the gap filling pattern is evident in the cash S&P, the SPX, as this index came within a fraction of a point of filling its Nov. 11 gap on Monday and died there. Yesterday after making a lower high, the SPX collapsed.

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Nasdaq 100 (NDX) Turning the market back at the Nov. 11 gap

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Source: Lind-Waldock

But probably the best example of the pivotal role played by gaps in recent sessions is seen in the Nasdaq 100, the NDX. Here, note the unusual dual island reversal pattern on Monday. Very rare -- the NDX gapped above two recent gaps on Monday.

Then look where the index topped out: right at its Nov. 11 gap (1251). Well, it actually went about half a point above it before selling off almost 50 points into yesterday's afternoon lows. Here the retracement pattern to the upside appears complete, as the decline from the close of Nov. 10 was perfectly retraced.

The good news is that the island gaps remain in effect. As long as they hold, I will nibble on the long side, but only during pullbacks -- preferably toward 1180-1200.

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Russell 2000 Filling the Nov. 14 gap and selling off

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Source: OptionsXpress

Finally, we come to the Russell 2000, which also had an overhead gap in its sights yesterday. Here there was no gap from Nov. 11, so it did the next best thing -- it traded up to the top of its Nov. 14 gap at 491.23, also exceeding its gap by about half a point, and then from there sold off almost 6% to the afternoon lows. Here as usual, the filling of the gap telegraphed a near-term top.

If you can't take advantage of a 4% to 6% pullback, you probably shouldn't be trading in this market. At OptionsXpress, I placed orders to buy puts (or cover short puts) as those gaps were being probed. That is how to trade these gaps.

Though the market is rallying back up today, for now, this has the look of another complete retracement (of the decline from the close of Nov. 13) and probably another short-term top.

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Know what you own: Schiller mentions the indices. ETFs that track major indices include ProShares Ultra Dow 30 (DDM - commentary - Cramer's Take), ProShares Ultra S&P500 (SSO - commentary - Cramer's Take), ProShares Ultra QQQ (QLD - commentary - Cramer's Take), Diamonds Trust (DIA - commentary - Cramer's Take), ProShares QQQ Trust (QQQQ - commentary - Cramer's Take), SPDR Trust (SPY - commentary - Cramer's Take) and iShares Russell 2000 (IWM - commentary - Cramer's Take).

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At the time of publication, Schiller was long Dow, NDX, SPX, Russell 2000 and Financial Services funds up to 45% levels. Long bull spreads in the DJX and QQQQ options, although holdings can change at any time.

Dr. Harry Schiller is a Registered Investment Advisor with the California Dept. of Corporations. He holds a Series 7 General Securities license as well as a Series 4 Options Principal license. He has been owner and editor of the Short Term Consensus Hotline since 1988. For more information, see www.harryschiller.com. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.