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Stock Market Santa Claus: Rally or Lump of Coal?   (December 17, 2007)

Santa seems to be wavering about delivering his annual stock market rally to Wall Street. Little wonder, given the tapped-out consumer and the resulting inevitability of a consumer-real-estate-bust-global-overcapacity recession. But before we write Santa off completely, let's look at some charts:

The VIX (Volatility Index) moves inversely to the markets; when volatility spikes up to a peak, that usually marks a market bottom. When it drops to a low, that corresponds to a market top.

And just to confirm the wedge/pennant formation, here is the Nasdaq:

These wedges or pennants are rather obvious formations, and they typically break up or down in a big way. There are certainly may fundamental reasons to believe the market will break down--recessions usually bring declines in corporate earnings, etc.--but there are technical reasons to believe Santa gave the market a head-fake last week and is loading the sled with a rally.

You can see the market wavered in a very similar wedge in September, and even offered up a similar head-fake, i.e. MACD appeared poised to roll over into a "sell" signal. Yet the stochastic is oversold, suggesting the down move of last week has run its course. MACD is neutral, suggesting the market could move up or down.

One factor which is occasionally worth considering is how the options market is reflecting the overall market's sentiments. The cliche is that 80-90% of all options expire worthless; many options are purchased as hedges, and their expiration was expected.

With that said, the market rarely rewards bets held by 80% of the players. Right now there is a huge imbalance between puts and calls in the financial stocks like Citicorp (C), Washington Mutual (WM) and Countrywide (CFC). There are 3 or 4 puts (bets the stock will decline) for every call (bet the stock will rise). This tremendous imbalance suggests to me--and please note this is merely a wild opinion-- that the financials are poised to explode upward, rendering all those puts worthless.

Why? No reason; just that's the way it usually works. When four punters line up to bet that "these wretched financials are doomed to huge declines" for every punter gambling that the financials' demise is somewhat premature, the market typically takes the four punters' money and rewards the sole punter.

Since wedges generally break big up or down, it should be an interesting week.

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