Trading Strategy for the S&P 500

Trading Strategy for the S&P 500With all of the negative market sentiment in the markets and in the newspapers every day, one index that has bucked the trend is the S&P 500. The S&P 500 has been an extremely strong performer so far this year. In the face of a slowdown in China, Europe continuing to implode, and a general market sentiment that isn’t resoundingly bullish, the S&P 500 has continued to move higher.

Is the market insane or does it know something the general public doesn’t? It is true that the economic data has been quite poor over the last few months. The U.S. is certainly experiencing a slower level of gross domestic product (GDP) growth as compared to the earlier part of 2012. Market sentiment has remained poor with many short-sellers quite active, betting against the S&P 500. What happens for short-sellers is that, at some point, they end up being forced to cover. I believe part of the rise can be attributed to short-sellers covering in the face of a strong S&P 500.

Another partial reason is that many investors are anticipating additional monetary stimulus by the central banks of the world, including the Federal Reserve. Will market sentiment change if the Federal Reserve does not add more stimuli? That’s a difficult question to answer. Obviously, no one can predict how the market sentiment will change and how the S&P 500 will be impacted by this dynamic shift in the psychology of the market. What we can do is look at the technical analysis of the S&P 500 to understand the current market sentiment.

S&P Large Cap Index Chart

Chart courtesy of www.StockCharts.com.

The S&P 500 has been in a bullish channel since early June. While the media has maintained a negative market sentiment over the past couple of months, the S&P 500 has remained strong. We are currently approaching the highs of the year, and a break of this point will surely result in further short-sellers being forced to cover their positions. If this forced covering is larger than the outstanding supply, the S&P 500 will continue higher, at least in the short term.

In technical analysis, trendlines are extremely important. Until the S&P 500 breaks out from either side of this range, it would be impossible to predict the next move. Especially ahead of the next Federal Reserve meeting in September, which could be a catalyst for the S&P 500 to break this well-defined path. Such a momentous meeting will surely impact market sentiment and drive the S&P 500 for the rest of 2012.

At the end of the year, we also have the fiscal cliff issue. If you believe that the politicians will pass a resolution and extend the budget at current levels, this would be a bullish result. Perhaps some of the buyers in the S&P 500 are already anticipating such an outcome. In either case, I would be more comfortable waiting for a breakout from either side of this range before thinking about initiating a position in the S&P 500.