New Ways to Make Money in Early 2007

I may be hanging out with the family this week, but my trader's brain is working full-time, jotting down ideas and observations about January's market. Last week's selloff threw a monkey wrench into the powerful uptrend off the summer lows and made it crystal clear we'll need to find new ways to make money in early 2007.

Let's start with the growing divergence between the S&P 500 and Nasdaq indices. The S&P 500 held up relatively well in last week's decline, closing above short-term support at the 20-day moving average. But the Nasdaq 100 and Composite got pummeled with selling pressure that carried prices toward their 50-day moving averages.

The strongest fourth-quarter performers did the most damage in all exchanges. Big-cap tech stocks, like Apple Computer (AAPL - commentary - Cramer's Take) and Google (GOOG - commentary - Cramer's Take), got hit especially hard during the ugly event. The wholesale distribution dragged the Nasdaq 100 index well below early December support, where it closed out the week.

Call it profit-taking or a disorderly pullback. In either case, the selloff feasted on shareholders trying to hold on through year's end in order to reduce their tax bills. Perhaps that was the whole point, with today's predatory traders and trading machines feeding on the innocent just before the holidays. In any case, the damage has been done.

Notably, the transportation sector has been getting ripped apart since mid-November. The group had a terrible week, with the DJ Transportation Average (TRAN) cutting through long-term support at the 200-day moving average. While we might see a tradeable bounce set up shortly, this violation could herald the start of an active bear market for the sector.

The decline of the Trannies reflects growing speculation about a major business slowdown in 2007. These are the stocks that haul around the raw materials and finished goods that drive the American economy. Dwindling demand for all this "stuff" equals lower profits for transportation companies and many other industries as well.

But it's a mistake to jump on the short side too quickly. Downtrends take time to form, and the S&P 500 divergence suggests that early short sellers will get their heads handed to them with a quick spike that retraces a path back to the December highs. So my advice if you want to short this market is to take a chill pill, at least for now.

But it would be just as foolish to stay a mindless bull here. The depth of selling pressure likely marks the start of a topping pattern that eventually yields a first-quarter correction. Note my use of the word "eventually." Tops take time to form, and we just aren't there yet. So I recommend that longs use any remaining rallies to lighten up on positions.

Last week's selling pressure was broad-based but also displayed encouraging signs of rotation from second-half performers into potential value plays. This makes sense because January wipes the slate clean, giving last year's losers an opportunity to become the new year's winners. But it's important to choose wisely when bottom-picking.

Health care stocks -- which got pummeled after the elections on speculation that the new Democratic Congress will enact industry price controls -- rose almost 3% while the broad market was selling off last week. The emerging rotation into the group might continue for another two or three months.

UnitedHealth Group (UNH - commentary - Cramer's Take) pulled back sharply after the December 2005 high. The stock bottomed out in May and tested the low in November. It's been moving higher since that time on solid accumulation. Last week's rally above the September high at 52.80 sets the stage for a run back to the 2005 high in the first quarter.

How will energy stocks perform in January? The jury is out after the sector's mixed performance this December. The Oil Service HOLDRs Trust (OIH - commentary - Cramer's Take) rose to a five-month high midmonth but sold off hard last week. However, the decline didn't break the three-month series of higher lows, and support at the 50-day moving average could hold up.

Falling natural gas prices are holding the group back right now. So far, this winter has been warmer than expected, despite attention-grabbing blizzards and a few cold snaps. As a result, it will be tough for oil services to move higher as long as nat gas can't find a decent bid. Of course, that might change quickly with a steamrolling Alberta Clipper or Polar Express.

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At the time of publication, Farley held no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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