Gabe Velazquez is a professional trader with 14 years of experience. His focus is intra-day and swing trading the ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has managed both stocks and futures accounts as well as conducted educational seminars on technical analysis for the past ten years. He is a frequent guest on Biz radio, where he shares his market knowledge and utilization of technical indicators. Gabe also teaches the 5 day E-mini course for Online Trading Academy.

A Quarter's Not Enough

The market reacted harshly to the quarter point cut by the Fed on Tuesday. Earlier in the day, the market had been trading higher, as anticipation for half-point rate reduction gained traction. That soon changed as the announcement of the less than desired move was made public. Traders quickly showed their displeasure with the Fed's action (or lack thereof) by aggressively hitting bids. The brunt of the selling was directed towards the usual suspects: Banks, brokers, lenders and homebuilders. All in all, the major averages had their worst sell-off in over a month, down over 2% for the day.

The bemoaning about Bernanke and Co. not being forceful enough in their policy or their language was evident throughout the media. The berating of the Fed became a regular occurrence in a lot of the post-analysis interviews. I personally applaud the Fed for standing their ground and not caving into the demands of the market. After all, the dual mandate of the Fed is to promote price stability and full employment. To this end, I believe that they will act as needed in coming months.

In truth, the S&P had rallied almost 120 points in the two weeks leading up to the FOMC meeting. This upward move can be attributable to the discounting or "forward-looking" mechanism that markets continuously go through. The pace of such a rally is unsustainable, so it should come as no surprise, that the market is pulling back; the Fed decision just happened to be the catalyst.

From a technical perspective, the markets had indeed become a bit overbought, as measured by several indicators (which we'll touch on in a bit). The sentiment gauges that I've covered in past articles, namely the ISE index (shown below), had readings above 200 early Tuesday. Note the numbers in the "all Equities" column on the bottom. This high number was telling us that small option players were overly optimistic in front of the Fed meeting. As I've written in the past, when this group of speculators becomes overly weighted to one side of the market, it is generally a good bet to trade against them. In this instance, it paid handsomely, as the market dropped more than 2%. I must be very clear on this: Although sentiment measures can be helpful in spotting turning points in the market, the final arbiter in making trading decisions is always PRICE ACTION.

Let's examine some charts to see where we stand technically. The first chart for review will be that of the ER2 daily (below).

There are two noteworthy points here. First, the ER2 had become overbought as measured by the slow stochastic. What added more validity to the overbought measure was that it also coincided with a resistance level. That level being a 50% Fibonacci retracement of the October peak to the November trough.

In looking at the daily chart, we can say that the recent rally was a corrective move in an ongoing longer-term downtrend. In Fibonacci analysis, a market is not considered to have reversed a trend until it closes above the 61.8 retracement level.

In the shorter-term time frame, our focus will shift to the hourly chart (above) of the ER2. Here we can really appreciate the velocity of the sell-off. It took 3 hours to undo a week's worth of rally. The next area of support is around 756. I suspect at some point that level will be tested.

In summary: With only a few trading days left in 2007, the obvious question is, how do we end the year? I believe the market hangs on to register a positive year. The year 2008, however, will be the dicier. The pervasive ills of the last nine months will still have to be dealt with. As I write - early morning Wednesday - the trading on Globex indicates a very nice recovery. The S&P's are up 30 points on word the Federal Reserve is coordinating with other central banks to deal with the credit crisis. Maybe the Santa Claus rally just needed a pause before resuming. The lack of follow-through to the down side will be key, if the bulls are to remain in control.

So until next time, I hope everyone has a profitable week.

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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