Capitulation? Or a Bounce to Sell Into Now?

NEW YORK (TheStreet) -- Flat. That is how I am positioned over the weekend. I see no edge in either direction at this juncture. The short term trend is down, but we are getting oversold based on some measures. This is a market for those who embrace volatility and not for those looking for longer term trends.

Quick one to two-day trades make the most sense until a clear trend presents itself.

Last week in my piece "This Is Not Your 2013 Snapback Market Anymore," I wrote:

To simplify, the path of least resistance right now is down. Don't over think it. Yes we will see bounces, especially when we get oversold, but until the path of least resistance turns back up, using 2013's playbook will likely be a losers bet. This is no longer your 2013 BTD (Buy the Dip) market. This is your 2014 "failed breakout" STR (Sell the Rip) market.

Today I explore those ideas more, via technical charts.

Assessing the Current Situation 

Since the end of the first Fed induced Quantitative Easing (QE) program in March of 2010, all QE endings have been accompanied by volatility measured by the CBOE Market Volatility Index (VIX.X). Thus far, this latest taper is proving no different, but also could go a lot further to match more closely the volatility levels reached in 2010 and 2011.

We could be considered oversold based on 20-day new lows on the S&P 500 Index   if we were using 2013's playbook. But looking back three years, oversold can get much worse -- as it did in 2011 and 2012.

Furthermore, the market often takes a couple of spikes back-to-back before finding a bottom (as denoted by the red lines in the chart below).

Similarly, we are nearly at oversold readings because of S&P 500 stocks above their 20-day moving average -- if we're going by the 2013 playbook. But the S&P isn't as oversold when measured against a longer period of time. 

The S&P 500 is hanging onto its lower bollinger band (BB band), a place that often sees snap backs rallies. In 2013, the market rarely stayed at the bottom of its BB for too long. However, during a correction (not just the small pull-backs to which we have become accustomed), the market can stay oversold, dragging the BB band down with it.

That's exactly what the market did in February of this year. That's what it has done with the PowerShares (QQQ), which tracks the Nasdaq 100 Index, and that's what has happened with the iShares Russell 2000  (IWM), which tracks the Russell 2000 Index. But this isn't a reason to go long in and of itself.

Last week the S&P 500 has finally begun to show the same weakness that has been exhibited for over a month in riskier asset classes such as the biotech and small cap sector.

After last week's selling, it is becoming more probable that the S&P will drop to its 200-day moving average in the near term. Currently that figure stands at 1,761.43. However, bear in mind if it does happen it likely will not occur in one straight line down. 

With a break of that double bottom on the Nasdaq at 84.11, we likely visit the 200-day moving average, currently at 82.60. 

The Russell 2000 closed slightly above the 200-day moving average. If it fails to hold, the next level of support is around 107. 

The iShares Nasdaq Biotechnology Index  (IBB) is emblematic of a risk-on environment, and closed below the 200-day moving average for the first time since 2012. The next level of support is around the 200 level.

A further breakout in the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) would signal a continuation of a risk-off environment, as investors flock to safer instruments, pushing yields lower.

What to Look For When Determining Whether You Should BTD or STR

We will very likely get a bounce at some point in the next week. The question is, how do you know if it is just a bounce or if we have instead hit a short-term bottom and a new upend will emerge with staying power? Here are some signs to look for when searching for a bottom:

  • A distributive day based on breadth indicators as well as extreme volume would give credence to potential capitulation.
  • An up day that shows follow through and can sustain itself for more than two days.
  • Money coming back into biotechs as well as the Nasdaq and small-cap stocks.
  • 20-year Treasury bonds fading.
  • CBOE Market Volatility Index sliding back below 14.
  • A spike in the put/call ratio

Not all of these variables are necessary, but the more that do occur, the better the odds that a bottom is in before resuming a new uptrend.

The important thing to remember is that what worked in 2013 is not working this year. If you have not yet adapted your trading strategy you are likely struggling. But you can change that.

During the current backdrop, the best trading strategy is to either stay in cash until a less volatile market presents itself or to trade tactically and not overstay your welcome in any one trade. As I mentioned last week, the short term trend is down, but the bigger picture is a healthy consolidation period after a five-year bull run.

Take a look at the S&P 500 over the last five years, and that trend is clear.

At the time of publication, the author held no positions in any of the stocks mentioned.

Follow @Sassy_SPY

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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