Despite the fact that growth is slowing in the largest economic sector, traders are clearly buying something

Buying the Rumor and Selling the News on FOMC

Prices often run up before a major news event and then come back down once the new information has been released. This frequently happens before an earnings report, and this week Restoration Hardware (RH ) and HD Supply (HDS ) were good examples. This phenomenon is referred to as buying the rumor and selling the news. It can be a little frustrating for investors trying to determine whether a bullish breakout has legs, or if its just pure speculation. However, there are some signs that can provide advance warning.

The Big Rumors for this Week

There are two big events will be watching over the next week. On Sept. 18, the Federal Open Market Committee (FOMC) is slated to host their press conference and reveal details of the much anticipated taper. That is definitely the biggest announcement of the month and will likely introduce plenty of volatility. However, this Friday is also a big day for economic news, with the release of both the University of Michigan Consumer Sentiment numbers and the monthly retail sales report for the United States.

Retail sales are important because the U.S. economy is largely driven by consumers. Over the last two years, the rate of change of retail sales has been declining much like it did in 2007 as the real estate crisis began to heat up. You can see the rate of change of retail sales on a year-over-year basis in the chart below.

As you can see, the rate of change in July just peaked above the recent trendline before turning lower again in August. But was this a positive sign that growth is looking a little better? Probably not, as the spike in July looked disproportionately good due to the fact that the numbers from July 2012 were a complete debacle. However, despite the fact that growth is slowing in the largest economic sector, traders are clearly buying something. Is it optimism that retail sales will turn around this year like they did in 2012…or are they buying because they are pessimistic about the report?

The Fed Claims to be Data-Driven

It may sound strange that investors would buy because they anticipate bad news on Friday, but it makes more sense when you think about what is driving the Feds actions. The Fed claims that they will taper (or not taper) based on improvements in unemployment or adverse changes in the inflation rate. Retail sales are a reflection of both of those factors. The terrible July 2012 report didnt slow equity growth because traders knew that bad news was good news for the September FOMC meeting. They were not disappointed. Two more rounds of quantitative easing (including QEternity) were subsequently launched.

Are traders hoping for bad news this time around as well? The retail sales report reflects employment and income through the level of spending. It also helps us understand inflation through the price level. If inflation is low and spending disappoints for the month of September, it will put pressure on the Fed to slow down its tapering plans. We dont think they will skip tapering altogether, but they could reduce the total amount.

We already know that Wal-Mart (WMT ), Target (TGT ) and several other major retailers reported bad sales data in August. It doesnt seem like a stretch to use that information to anticipate that retail sales will disappoint this month. It seems logical that this will pressure the Fed to reduce the amount by which they may taper in the short term and traders may like that. That is the rumor we believe the market has been buying over the last week and a half.

 Sell the News

We have assumed that the rumor is being priced in, and (like last September) the actions of the Fed will precede some profit taking. In 2012, retail reports began to look a lot better by the late-August timeframe, while this year they have stayed low. It does make it more likely that the Fed will be motivated to keep stimulus levels high, but the relatively-worse retail performance may accelerate the subsequent selling as well.

This puts short-term investors in a very difficult situation. On the one hand, the market is overbought and near resistance. If traders decide to sell the news, then bears could make a lot of money to the downside in a very short period of time. That sounds good, but how long do we have to wait for the market to correct? Precise timing is impossible, but here are a few factors we are watching right now that will help identify when the selling is imminent.

1. Asian and Emerging Markets Tend to Drop First: Lower consumer spending in the U.S. may make it more likely for the Fed to keep stimulus up, but it hurts emerging and Asian markets. There was a small hiccup last night in Asia, but nothing serious so far. We are looking for a larger drop like what we saw on May 13, 2013 before U.S. markets started selling off on May 22.

2. Bond Prices Start to Rise with Stocks: A trend in stocks is considered very weak when it starts to correlate with bonds. For example, through most of August bonds dropped with stocks indicating a higher likelihood for a rally. However, from March until May, stocks rose with bonds indicating a higher probability for a decline.

3. Volume Drops as Stocks Near Resistance: This is the factor that is most obvious right now. Prices are rising, but average volume is well below levels seen during the last strong bull market in the first quarter of 2013. Low volume doesnt mean sellers are in the market yet, but it does indicate that buyers are running out of capital. Low volume is an important sign of weakness.

All three factors discussed so far can turn around very quickly. This is a tough market to navigate, but volatility creates profit opportunities. We will have to simultaneously prepare for day-to-day volatility that pushes prices back and forth between resistance and support. That will make time-value erosion a more significant problem. In an environment like this, you should limit your trading, and remain balanced between bullish and bearish bets in the positions you do have.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader , a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here .

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