Will Wednesday's 5% Surge Kick Off a Year-End Rally?

Wednesday's surge was impressive. A quick thumbnail technical analysis allows for only one conclusion: Stocks will rally further.

The Dow soared nearly 500 points, the S&P and Nasdaq finished up 4.2% and small caps led the charge with a 5.8% gain. The VIX is 27% lower today than on November 1.

Trading volume on the NYSE clocked in at 1.66 billion, over 60% above the 10-day average. Up volume accounted for 97% of that day's trading. Assuming that this rally has further to go seems like a slam-dunk.

But a little bit of perspective is never bad. We saw a similar price and volume surge on October 27 when the S&P pushed as high as 1,293, and the Dow as high as 12,284. NYSE trading volume that day was almost 40% above the 10-day average.

The October 27 explosion lifted 94.5% of stocks above their 10-day average while Wednesday's squirt propelled 93.6%, but (and that's a big but) stocks tumbled more than 10% following the October 27 performance (more about what that means in a moment).

High Probability Profits

When it comes to trading, it's all about identifying high probability entry or exit points. There are always new trading opportunities, but the best opportunities are those where all stars (indicators) are aligned for a profitable trade.

The three best indicators, in my humble opinion, are a composite of technicals (support/resistance levels, Fibonacci analysis, trend lines, patterns, buy/sell signals, etc.), sentiment and seasonality. A high probability trade sees all three indicators pointing in the same direction.

Along with a few minor setups, we've gotten two major high probability signals this year. A sell signal in May and a buy signal in October.

In April, the S&P was closing in on major technical resistance, investor sentiment was outright bullish (which is bearish from a contrarian point of view) and seasonality was turning bearish (sell in May and go away).

The April 15 ETF Profit Strategy Newsletter warned that: 'A major secondary market top is forming. It would simplify our forecast if the S&P would be able to reach the ideal 1,369 - 1,382 target for a major secondary market top before the summer doldrums.' The S&P topped on May 2 at 1,371. The rest is history.

Exactly the opposite was true at the October lows. The September 23 ETF Profit Strategy Newsletter provided this outlook: 'From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter trend rally. Any drop below 1,088 may mark the end of the 2011 bear market leg. Such a drop may be only on an intraday basis.'

The S&P exploded 20% from its 1,075 intraday low on October 4 to its 1,293 high on October 27.

It's A Bit Murky

Based on a number of technical indicators and patterns (such as the 2008 decline), stocks were supposed to decline thereafter. Sentiment was also bullish enough not to prevent any further declines.

Seasonality however didn't agree. Pre-election year strength and a seasonally strong November/December/early January pointed towards higher prices.

A developing triangle in November also could have led to a breakout to the up side, but it didn't. I stated in the November 18 ETF Profit Strategy Newsletter that: 'Due to bullish November, December and early January seasonality, I would have preferred a bullish triangle breakout. This would have kept prices afloat for another few weeks, sparked further enthusiasm and ultimately aligned 'the stars' for a nasty January decline. Seasonality remains an issue, so we'll look to profit from lower prices but we'll be cautious and won't buck the trend if stocks decide to rally past important resistance levels.'

Courtesy of the Wednesday rally, we are above those resistance levels now and won't buck the up side trend.

But not bucking it doesn't mean we can't try to figure out what stocks will do next.

Short-Term Outlook

At the onset of the article I compared Wednesday's seemingly bullish spike with the October 27 spike, which turned out bearish (see chart below).

I don't want to make a big deal out of a sample size of one, but it will take some follow through buying to get excited about Wednesday's bounce, at least over the short-term.

The technical picture remains long and mid-term bearish even if we get enough buyers rushing in. Additionally, the bullish seasonality won't last too much longer and higher prices will turn sentiment bullish, which will be bearish for stocks.

Despite the possibility of higher prices, I believe that the next big profit opportunity will be to go short. The key is to get the right entry point and not prematurely swing the bat before the ball is thrown.