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Counter Trend Rallies

Posted By Barry Ritholtz On November 23, 2004 @ 2:36 pm In Markets | Comments Disabled

The relatively simple concept of the counter-trend rally is generating a disproportionate degree of confusion amongst nervous traders and fund managers. Allow a brief clarification of what these retracements mean to a variety of differing but interrelated asset classes: Oil, U.S. Dollar, Stocks and Bonds.

All asset classes traded in free, liquid markets tend towards eventual over-extension. Commodities, fixed income, currencies, equities, and options all must retrace their prior gains or losses after an emotional move in either direction. As traders press their bets, they eventually reach the point where the temptation for profit taking becomes overwhelming. That’s often the initial move counter to the previous trend.

Or, consider what happens when a trade becomes too crowded: the path of least resistance is the opposite direction, as everyone who could lean one way already is. The next move is the unwinding of that excess enthusiasm.

What makes the most recent activity so complex has been a series of simultaneous counter trend moves in Oil, interest rates, currencies and equities. It is no coincidence, as the chart nearby shows, that as Oil pulls back, equity markets rally. Concurrently, the U.S. dollar has bounced after ongoing weakness. Short term, a weak dollar helps multi-nationals by making their exports cheaper. Longer term, the effects are deleterious. Not only does the weak dollar pressure Crude prices higher, it discourages foreign purchases of U.S. assets, i.e., fixed income and equities.

The complexity of all these moving parts was revealed during last week’s Tuesday and Friday sell offs. This holiday-shortened, light-volume week has equities particularly sensitive to any twitch in the price of Crude. But the thinness of trading suggests that the markets can be easily pushed around, on Wednesday and especially the short session on Friday.

We continue to advise using these pullbacks as opportunities to add to long positions. Look for the Nasdaq to pull back toward 2040. I hope the S&P500 sees 1150, but since I suspect it won’t, I would start adding as the SPX approaches 1160. Perhaps the Dow pulls back to 10,350, but on the chance it doesn’t, use 10,425 to start scaling into that index.

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