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A description of the content follows : We've got a lot to get to today, so we'll do so without any fanfare. On tap for this mid-week edition of the Micro Cap Press newsletter.... From the Editor: Swapping Out Some Stocks - We're adding one to it, but subtracting two from the editor's 'sandbox' portfolio. Which one is being added? One of the...

 
 
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Wednesday, October 27, 2010 @ 11:26 am PDT Volume IV : Issue 41
In This Edition...

We've got a lot to get to today, so we'll do so without any fanfare. On tap for this mid-week edition of the Micro Cap Press newsletter.... 

  • From the Editor: Swapping Out Some Stocks - We're adding one to it, but subtracting two from the editor's 'sandbox' portfolio. Which one is being added? One of the four discussed on Saturday, 
  • A Special Offer for Micro Cap Press Fans - More, better, and faster. If you thought the free Micro Cap Press newsletter was good.... 
  • Another Bearish Red Flag - Add a contrarian interpretation of sentiment (with a twist) to the growing list, as if today's selloff wasn't bad enough. 
From the Editor: Swapping Out Some Stocks 

In this past weekend's edition of the newsletter, I posed four possible new additions to the sandbox portfolio. I'm pulling the trigger on one of them, though I'm more than offsetting my risk by pulling the plug on a couple of existing positions. Let's just work through them one at a time. 

What I'm Buying 

You may recall American Equity Investment Life Holding (NYSE:AEL) was the insurance stock with lots of momentum and even more value, with single-digit P/E ratios supported by very reliable earnings. Though it's off a little bit today, of the four names I mentioned, this one just seems to have the most resilience..... which will be important if the brewing pullback (see below) hits us as hard as I expect it to. 

So why buy any stock when you think you're headed into the wind? A couple of reasons. 

One is, the best of the best stocks can and often do overcome marketwide bearish tide's. The other reason - this is one of those quirky industries (insurance) that has a knack for trading independently of the rest of the market anyway. 

That said, above all else, I'm adding AEL to the sandbox portfolio not because I know what's going to happen, but because nobody knows what's going to happen, and we need to optimize our risk/reward proposition for that unknown. American Equity Investment Life Holding shares have the best shot at going up in the near future whether the market sinks or rallies from here. 

What I'm Selling 

I'm pulling Transcend Services (TRCR) out of the portfolio, not because I've changed my mind about the company, but because I see TRCR as one of those stocks that's highly vulnerable to a marketwide selloff. We've held it through a pretty big runup, and actually have an 18% gain left to protect. Better to take what we've got and reduce our risk, than let ego and sloppiness get in the way. Who knows? I may buy it back later. 

I'm also making an exit of Triangle Capital (TCAP). Like Transcend Services, we've got a profit to protect (a small one of 9%, but still). And, given the height of the recent daily bars, I've got a feeling we're seeing the torch being passed from the bulls to the bears; a string of tall bars often comes at the beginning of a rollover. Today's lower range - and open and a close under yesterday's low - makes me even more suspicious that TCAP is going to be one of the selloff's heavily-punished victims. 

If my math is right, we're about 50% invested right now and about 50% cash in the sandbox portfolio right now. 

My allocations to each trade have been 5% of the portfolio's value, which gives us room for 20 individual trades.... not that I have to own that many at any point in time. I know I don't want to own 20 trades and be 100% invested here at what seems to be a short-term top, but it would be a mistake to be left completely empty-handed if for some reason the market continues to roll higher. 

That being said, if you like following my sandbox portfolio, you're going to love this special offer just for Micro Cap Press readers.... 
 

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The same analytical team that brings you the Micro Cap Press is now offering the complete trading/investing solution you've been asking for. Rather than getting one sector outlook, one stock pick, or one market call one time (or even occasionally twice) per week, you can now get all of these several times per week, as these trends are unfolding! 

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You've seen glimpses of the kind of commentary you'll receive with the Rhino Report here in your subscription to the Micro Cap Press newsletter. Now take it to the next level. 

Best of all... you can test drive it risk-free. Try it today, by going to www.rhinoreport.com.
 

Another Bearish Red Flag 

Though it's been a while, we've looked at the ISE Sentiment Index before. Just to refresh everyone's memory though, here's the crash course (which you'll need to understand if the outlook below is to make complete sense)

The ISE Sentiment Index - obviously - falls into the sentiment index category, along with the CBOE Volatility Index and the put/call ratios for all the exchanges that trade options. In fact, the ISE Sentiment Index is the ISE's put/call (option) ratio. 

What's not as obvious is that these three indices, along with a few others, also fall into a category of tools called contrarian indicators. Quirky 'contrarian' interpretations of conventional data sets allow their followers to (1) spot extreme bullish or bearish opinions, and (2) take on trades or positions that are very much in the minority at that point in time. 

Or said in simpler terms, when the sentiment tools suggest the market is very bullish, contrarians see it as bearish. When sentiment indices say investors are stunningly bearish, contrarians start thinking and trading bullishly. Indeed, in the past when put/call ratios spiked to extraordinary levels because fear was rampant, contrarian traders viewed it as capitulation. Conversely, when complacency and confidence was high and put/call ratios reached unusually low levels, contrarians viewed those periods as short-term market tops. 

Oh, and one more thing.... skilled and experienced contrarians have made small (and sometimes huge) fortunes, because they're right - and perfectly spot the market's pivots - a great deal of the time

While an excessive number of followers and incredible market volatility have somewhat negated the effectiveness of using spikes and plunges in sentiment indices as contrarian clues, another methodology is emerging that is proving to be quite helpful. 

This is where today's 'bearish red flag' comes in. 

Like we said, the raw daily data of the ISE Sentiment Index isn't all that helpful any longer.... it's just too erratic. The TREND of that daily data, however, can tell you quite a bit about the market's true undertow. That's what the nearby chart illustrates. 

To take the erratic daily data and smooth it out onto a trend, we simply need to add a moving average to it. Or in our case, we've added two - a faster one and slower one (sorry, the settings are proprietary). And just to cut down on the chart's clutter, we've grayed out the actual daily data so we could focus on the two moving averages. 

The arrows are the points where the two moving averages crossed one another. The blue arrows are bullish crosses (short-term under long-term average), and the red arrows are bearish crosses (short-tern over long-term average) See anything incredible

It wouldn't be accurate to say it was a perfect tool - we saw a couple of fakeouts. It caught the majority of the big swings though, and usually right at their beginning. 

Though this type of contrarian interpretation spots the 'move towards a strong opinion' rather than the apex or trough of an opinion, it's still clearly a valuable premise. And more important to us right now, we just saw a bearish cross of the ISE Sentiment Index's moving averages. Add this to the list of bearish evidence. 

Here's a full-screen shot of the S&P 500 versus ISE Sentiment Index

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