Waiting for a Catalyst, Watching the Fed

This column was originally published on RealMoney on Oct. 31 at 12:12 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Most investors know that October is housecleaning month for the mutual fund industry. With the fiscal year-end at Oct. 31, fund managers prune their portfolios, dumping their losers. The recent selling pressure on the broader market can be partially attributed to this. With that behind us, the market should gain some room to move to the upside.

I am looking for a catalyst that will get the market out of its doldrums. Perhaps it will come from the Federal Open Market Committee meeting Tuesday, additional declines in oil prices or evidence that inflation is benign.

For anything other than very short-term moves, it is important to understand the underlying conditions that are affecting the market. After all, if you don't have a good thesis for your positioning, every little jiggle in the market will elicit a reaction from you. Rather than go down that bumpy road, focus on understanding the bull and bear arguments. If you know both sides and then choose, you are better able to control your own destiny by making a conscious choice based on more complete information.

I believe the current volatility in the market is due in part to the absence of clarity with respect to some very fundamental economic conditions. There are several questions that I'll need answered before I'll feel any degree of commitment to the bull or the bear side:

Does the Fed even try to distinguish between commodity-based inflation and inflation derived from pure pricing power in a very strong economy?

If rates keep rising, will the real estate market gently flatten, or will it turn out to be a bubble that pops?

And when real estate slows down, to what extent will this affect the average consumer's spending habits? If, for example, we sustain a deep pullback in real estate values, will the resulting "poverty effect" reduce demand so much that that inflation fears just fade away?

I suspect we'll get some clarity from the FOMC on Tuesday, which should help answer some of these questions. And if we don't get clarity, I suspect November will go the way of October.

Let's get to the charts.

Last week, the Dow Jones Industrial Average bounced off established support. Take a look at the bigger picture and you'll see that the Dow has actually been consolidating its 2003 gains for the last couple of years. Right now, the most upside I see is around 500 points, to 11,000. If the Dow hits that level, we'll probably see the same selling pressure that has kept a lid on the Dow for quite a while.

I also see a downside of around 500 points. If the Dow falls back to around 10,100, dip-buyers will likely halt the downtrend. Before I'd adopt any kind of commitment to market direction, I'd have to see the Dow break out of this channel.

On Friday, my friend Fari Hamzei of HamzeiAnalytics.com mentioned to me that his indicators were quite bullish on the S&P Select Financial SPDR Fund (XLF Quote). A quick look at the chart shows that the fund is at the top of its range, with steadily rising lows. An RSI within the top half of the clip and rising on balance volume are two bullish indicators that support a breakout. However, notice that the peak in July was accompanied by the same combination of indicators -- resistance held back then. I'd like to see more evidence of strength before jumping in.

Wells Fargo (WFC Quote) accounts for 4% of the holdings in the Select Financials SPDR. This stock is at midchannel. It's moving higher, so the bulls have the edge now, but until the bulls push through resistance at $62.50, I'd just stay on the sidelines. On a $60 stock, a $2 upside prior to resistance isn't my kind of trade.

REITs have been on fire for a number of years, but every once in a while they really take a hit. We saw a sharp pullback during the second quarter of 2004 and during the first quarter of 2005. Over the past several weeks, the Dow Jones Equity REIT Index has pulled back by more than 10%; however, this chart shows price action that is indicative of a bounce. The thrust beneath $225 a few weeks ago was rejected by the bulls -- they finally bought the dip. The lows over the past couple of weeks have been successively higher. That is illustrative of increasing aggressiveness by the buyers.

Remember that REITs tend to be made up of rental properties, so you're not buying Pulte Homes or Toll Brothers. Many REITs also have fairly good dividend yields, so this increases their attractiveness on dips. If you've got a place in your portfolio for real estate, I'd suggest considering REITs such as Equity Residential Properties Trust (EQR Quote) and Aimco (AIV Quote).

AmerUs Group (AMH Quote) has been consolidating over the past couple of months, with $57.50 defining the excess supply level. Each time the buying takes the price up to present levels, sufficient supply halts the price advance as buyers soak up the supply. However, at some point this supply will diminish and buyers will chew through the $57.50 level. If this occurs, the uptrend will resume as stockholders start demanding higher and higher prices.

Be careful out there.

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