Playing the Correction

Every year, I half-expect the predictable year-end rally not to happen. Well, it nearly always does. Through the years, I have come to respect seasonal patterns of strength and weakness. For instance, it's now quite widely known that the May-to-October period is unhealthy for stocks, but the other six months are very good.

This week (Oct. 27 to Nov. 2) is historically the single strongest five-day period of the year. Not one down week for the last 22 years! So what happens? Right out of the gate, the market falls flat on its face. I'm reminded of Yale Hirsch's dictum: "If Santa Claus should fail to call, bears may come to Broad and Wall!" In other words, if the market doesn't rally when it normally does, watch out.

I think the market will correct its sharp post-Sept. 21 rally by declining into an early- to mid-December low. When the market has a big bottom in October, it often follows that course. (One exception was in 1998, when the market was brought low by the Long Term Capital Management panic from August to October, and then exploded upward, with no pullback at all, in November and December. But that was still in the bull market, and I don't think the market has such power these days.)

One put/call indicator calling for a correction now is the "option premium ratio" which appears only in Investor's Business Daily -- as far as I know. It has been recording high levels as late as this Monday, and this is bearish. Further, in the stiff decline on Monday and Tuesday of this week, there were no high levels of put trading recorded. Higher levels of put trading are expected at the next low. It would seem the correction into a December low has begun.

Here's how I am playing this situation in some individual equities. Followers of the RealMoney.com Trading Track know I shorted Lockheed Martin(LMT Quote) on Monday. I did this because of the big news of the fighter contract that up-gapped the stock at the opening, and for several other reasons: 1) Defense stocks appear to have topped out; 2) Lockheed Martin's chart shows that it hit a sharply rising channel line at Monday's high; and 3) Monday's trading for the stock also created a very high-volume one-day negative reversal. It looks like an important top was made on that day. I am short Lockheed Martin stock and calls too.

I also shorted Merrill Lynch(MER Quote) today for the following reasons: 1) It has been much weaker than the XBD (broker-dealer) Index; 2) short interest is only 2.51, which means that all shorts can be covered in 2.51 days of trading; and 3) traders have opened over 10,000 calls at the 45 and 50 strikes, against only small put open interest.

Finally, I shorted Lexmark (LXK Quote) because: 1) it is extremely weak, barely off its lows; 2) option traders have bought lots of calls, even though the stock is weak; and 3) the ratio of call open interest to put open interest is more bearish now than in 99% of the weeks in the past year.