Yesterday’s market activity reminded me of the classic Clint Eastwood movie titled “The good, the bad and the ugly,” only in reverse.

The major indexes started out looking very ugly, then looked bad and ended up looking pretty good, as most of the losses were recovered by the end of the day.

Earnings misses were one reason, while disappointment with durable goods were another. Commodity prices headed south while the dollar rose.

Technically speaking, the S&P; 500 is struggling to break through the glass ceiling in the 1,184 area. But the mother of all concerns was the Fed and how big of a move it will make next week.

A WSJ story casts doubt on the magnitude of the planned QE-2 intervention. It seems like the markets have priced in a major sum, something along the lines of $2 trillion.

The story suggested it may not be a shock and awe effect as hoped for, but the amount could very well be limited to a few hundred billion dollars to start with while measuring its effect over time. That indeed would be a disappointment to the markets as much more was expected.

Again, it’s just a story, but it shows the uncertainly not only in the markets but in my view also at the Fed. We are entering unchartered territory, and no amount of monetary injection can interrupt the trend (economic slowdown) that is currently in place, and we will very likely not prevent a double dip from occurring—at least in my opinion.

It’s anybody’s guess how much volatility we’ll be seeing next week. Depending on the election outcome, there could be a huge relief rally and then a reaction to the Fed announcement.

My suggestion? Be sure you know where your sell stops are.

There was nothing straight forward about yesterday’s trading session. The major indexes bobbed and weaved within a fairly narrow range but managed to close at the unchanged line to slightly up despite a weak opening.

The reason was a combination of punches thrown by the current heavyweights, the economy and earnings. While a report on home prices was disappointing, it was offset by a gain in consumer confidence. That should have pushed the markets higher, but weak earnings kept a lid on any attempts to move to a higher level.

The dollar was up, as were interest rates, while gold was down slightly and crude oil was higher just a bit. The net result translated into tiny market gains.

It appeared that investors were simply cautious ahead of next week’s double whammy: The elections and the Fed announcement regarding QE-2. Short of any unforeseen major events, I expect this slow and directionless trading to continue over the next few sessions.

It was a rally right from the start after yesterday’s opening with the S&P; 500 heading straight for the 1,200 level.

Support came from the G-20 meeting, which ended as all of those types of meetings end: long on talk, but short on results. I guess the positive twist was that nothing was really decided other than a call for more sustainable current-account deficits. That sent the dollar south but helped metals, gold and crude oil move higher.

After an initial jump, the major indexes slowly retreated for the remainder of the session, but managed to close up. It seemed like every attempt to higher levels was met with selling, which may have been a case of computer-generated trading as we were approaching the 1,200 milestone.

Existing home sales came in better than expected, although the median price was down from a year ago. Distressed sales, either via foreclosed homes or short sales, made up 35% of the market.

Bank stocks continued to weaken because of the continuing saga involving errors and omissions in the foreclosure paperwork. The Fed announced that it is investigating foreclosure practices, which means this ordeal is far from being over. If surprises are uncovered, there is bound to be some effect on stock market direction.

Chart courtesy of YahooFinance

With interest rates near zero, income investors have been pouring money into junk bonds at an alarming rate.

JNK, see above chart, is one of the more popular ETFs and has grown to over $5 billion in assets. With an average daily trading volume of almost $90 million, it’s a snap to get into or out of the market with lightening speed.

The current juicy annual 10.8% yield makes this a tempting proposition. Given the fact that the Fed is lurking in the background with its QE-2 gun cocked and ready to fire, low interest rates are indeed here to stay for a while, at least until the comatose economy starts to show signs of life.

This should bode well for prices of junk bonds for the time being. However, do not become complacent and prepare yourself now for an eventual exit. This may be some time down the road, but it only takes a few minutes a day to set up and track your trailing sell stops. Once interest rates start to head higher, and bond prices head south, you will thank me for having a plan in place to deal with a sudden change in trends.

The use of Sell Stops was a hot topic on this blog last year. In case you missed the Q & As, I have compiled them in a free e-book, which you can download here.

Disclosure: No holdings

I am leaving Germany this morning and will be heading back to California, so I won’t have a chance to write Sunday’s musings. Regular posting will continue on Monday.

Reader Roger had these comments regarding an article he submitted with the title “Is the market ready to roll over?”

The above article makes a pretty strong case indicating the market is about to reverse direction based on a large number of technical indicators.

The above link is very technical in nature, so I will hone in on only a couple of points. One of them that was made in the S&P; 500 chart is that the recent uptrend has been “extreme,” which means the angle of ascent has been much steeper than normal.

I have observed the same thing when reviewing my Domestic Trend Tracking Index (TTI), which has risen just as steeply over the past few weeks. As a long-time chart watcher, I can say that extreme up moves not supported by volume are floating on hot air and can be subject to fast and furious corrections; the question is, when?

While markets can remain irrational for a long time, there are other factors to consider. The article mentions developments like Eurozone debt issues, currency wars and the foreclosure mortgage crisis.

I would like to add the main driver of this rally to the above list, which is the Fed and its promise not to let the economy slip back into a recession by lending an assist via QE-2 (Quantitative Easing) when necessary.

While in my view no amount of intervention by the Fed can avoid another recession from occurring, given current circumstances, it has at least appeased Wall Street via the assumption that QE-2 will be good for the markets. It will be for a while, if the economy in fact will recover (slim chance) on its own thanks to the initial boost of QE-2.

If QE-2 fails, as it will in my opinion, the market will roll over and collapse like a piñata, since it has been only propped up based on false hope and premises. I have been pounding the lack of economic recovery theme for over a year. Obviously, the economy is like the Titanic; it moves very slowly and it takes a while to turn it around or affect it in any way; much longer than I had anticipated.

If and when QE-2 gets implemented, other factors can still play a role in derailing the current market up trend. To me, it’s very likely that an outside event, such as a European debt default, or the bursting of the Chinese or Canadian real estate bubble, will affect market direction and reverse the current trend.

This may coincide with technical analysis, or not, but there is no certain way of telling when a trend comes to an end. The only way you can have some control is if any of your holdings in your portfolio reverse and trigger your trailing sell stop. That is as close as you can come in determining that this rally may be over.

You can never forecast these events, you have to wait and let the market tell you when it’s time to get out. Anything else is simply guesswork.