Confidence and A Conditional Reprieve Amid Oversold LowsAT40 = 11.7% of stocks are trading above their respective 40-day moving averages (DMAs) (hit an intraday low of 9.4%, oversold day #3)
AT200 = 32.3% of stocks are trading above their respective 200DMAs (intraday low of 30.0%)
VIX = 21.3 (a decrease of 14.7%)
Short-term Trading Call: bullish
Commentary
AT40 (T2108), the percentage of stocks trading above their respective 40-day moving averages (DMAs), fell as low as 9.4% on Friday. AT40 dropped as low as 8.6% intraday during the February swoon (February 9, 2018 to be exact). Since 1986, AT40 has closed below 9.4% only 92 trading days, and AT40 last closed below this level on January 21, 2016 at 8.3%. The day before that, AT40 closed at 7.4% and traded as low as 3.8%. AT40 obviously cannot trade much lower than these levels.
AT200, the percentage of stocks trading above their respective 200DMAs, is very important now as an oversold gauge. AT200 closed the week at 32.3%. In January, 2016, AT200 managed to get as low as 9.0%, a level last seen around the historic March, 2009 bottom. In other words, while AT40 suggests the market is set up for a sustained bounce, AT200 reminds me that these oversold extremes can get yet more extreme if panic gets a fresh heaping of fuel.
Trading action around important technical levels also remind me that the market could go lower. The S&P 500 (SPY) is essentially back to flat for the year but is still 7.2% above this year’s double bottom. A retest will be in play if the index fails to win what is perhaps the stock market’s most important battle: a test of 200DMA support. During the February swoon, the S&P 500 only ONCE closed below its 200DMA. The index closed below its 200DMA on Thursday and set up Friday’s drama. The index gapped up just above its 200DMA in an effort to clear out bearish sentiment. Sellers quickly closed the gap and then failed to take the index lower. Buyers fought off a test of the intraday low and managed to churn the index toward the day’s open for a 1.4% gain on the day. It was a messy way to demonstrate the importance of the 200DMA! If buyers can follow through early this coming week, the technical pattern will look like a (short-term) washout of the market’s most motivated and panicked sellers. I call this a conditional reprieve in the middle of oversold conditions because of the criticality of this 200DMA pivot.
{The S&P 500 (SPY) closed right on top of its 200DMA support after sellers almost ruined an opening gap up.}
The NASDAQ had a battle similar to the S&P 500’s; the main difference came with an intraday pullback that did not create a complete reversal of the gap up. The Invesco QQQ Trust (QQQ) did not fully reverse its gap above the 200DMA. Its 2.8% gain on the day has the look of a successful, and bullish, reversal of a 200DMA breakdown.
{The NASDAQ gained 2.3% with a gap up and then close just below its 200DMA.}
{The Invesco QQQ Trust (QQQ) made a convincing leap with the reversal of the opening gap up only touching 200DMA support. QQQ ended the day with a 2.8% gain.}
While the big indices fared well at the end of the day, other indices did not. Their poor performance underlined Friday’s conditional reprieve. Some of these sectors need to wake up to help the stock market mount a credible and sustainable bounce out of oversold conditions.
The faders managed to keep these indices plastered with bearish sentiment. The iShares Russell 2000 ETF (IWM) closed flat after sellers completely reversed the opening gap up. The Financial Select Sector SPDR ETF (XLF) suffered a similar fate. This disappointment was even more critical given the wake of bank earnings from the likes of JP Morgan Chase (JPM). The iShares US Home Construction ETF (ITB) held no pretense of recovery as its fade resulted in a 1.0% loss and fresh 17-month low. ITB has dropped 17 of the last 18 trading days in a sign of a near complete market retreat from home builders.
{The iShares Russell 2000 ETF (IWM) ended the day flat as it clings to the starting point of the big May breakout.}
{Bank earnings failed to save Financial Select Sector SPDR ETF (XLF). Sellers faded the opening gap up to a flat close on the day. At least buyers were able to bounce back from a fresh 2018 intraday low.}
{The iShares US Home Construction ETF (ITB) continued its epic slide with an 18th straight down day. The 1.0% loss closed ITB at a 17-month low.}
As suggested by the breadth indicators, the sell-off is causing broad damage. The Health Care Select Sector SPDR ETF (XLV) had a solid uptrend coming out of the February swoon. XLV even broke out to a new all-time high in late August. Last week, XLV broke down solidly below its 50DMA support and nearly reversed all its gains from the breakout.
{The Health Care Select Sector SPDR ETF (XLV) gained 1.5% in a return to the lower Bollinger Band. A 50DMA breakdown is not confirmed.}
The volatility index, the VIX, dropped 14.7% to 21.3. The intraday high failed to top Thursday’s intraday high: a small positive for volatility faders. Still, the VIX is still considered elevated given its perch above 20.
{The volatility index, the VIX, remains elevated despite a 14.7% pullback.}
The VIX typically serves as a gauge of fear on the high side and complacency on the low side. If we had an equivalent for government economic policies, say a “GIX”, the GIX might be at record lows. Confidence is of course half the battle of economic performance and confidence is tangibly oozing from D.C. (from one side anyway!). With consumer confidence at record levels, unemployment down to historic levels, and economic growth impressively strong, the rhetoric accompanying policymakers represents a euphoria perhaps only matched by the complacency of the “Great Moderation” when the Federal Reserve (mostly under Chair Alan Greenspan) was heralded for ushering in a time of lasting economic prosperity…just ahead of the Great Recession. If you knew nothing about economics, you might conclude this time around that the U.S. really has figured out how to repeal the laws of economic cycles.
In particular, Larry Kudlow, the leader of President Trump’s National Economic Council, is beating a steady drum of unapologetic and triumphant confidence. In a CNBC interview, Kudlow issued a sound bite that *I* am confident will one day in the not-so-distant future sound cringeworthy to those of us who follow economics. Kudlow declared: “We are in a hot economic boom. There’s no end in sight.”
Other key points from this interview…
Not worried about the Fed killing the economy. It has staying power. {Me: This message is consistent with Treasury Secretary Mnuchin’s reassurances about monetary policy. Contrast these claims with President Trump’s worries over rate hikes.}
Biggest blue collar employment boom since the 1980s.
In 2018, U.S. entered an economic boom that no one thought was possible.
Loves the skepticism. Proved the skeptics quite wrong. Don’t think that’s going to change.
I fully understand why Kudlow is blowing the trumpets and beating the drums. For example, the display is an “eye-for-an-eye” response to the shrill skeptics who denounced the policies that helped kicked the economy into a higher gear. However, as an investor and particularly as a trader, I cannot help but think about the contrary implications of important government officials claiming that the economic good times will continue as far as the eye can see. Such claims defy experience and the laws of economic/business cycles. Such claims help form a foundation of hubris which can lead to policy errors. My unavoidable wariness feels even more poignant when in parallel I stare at charts showing a stock market violently and sharply falling off its all-time highs. I am not worried about over-optimism today or this quarter, but it is something that makes me stand up and take notice. (At the end of the chart review, I include a link to a Bloomberg Politics video for more context on Kudlow’s economic triumphalism).
For now, I am keenly focused on my strategy for trading oversold market conditions. The stock market is on day #3 of oversold conditions. The average oversold period lasts about 5 days and the median is around 2 (50% below 2 and 50% above 2). At the current oversold depths, it could easily take another 2 or 3 days to climb out of trouble. The longer an overperiod lasts, the more bearish the implications. Similarly, the more frequently the market returns to oversold conditions, the more bearish the implications. The drama at the 200DMAs is extremely important context for these bearish implications. A stubbornly oversold market with an S&P 500 and NASDAQ below 200DMAs is a recipe for fading rallies.
{Mean and Median Duration Below Given T2108 Threshold}
The drama at the 200DMAs made me a little less aggressive. I sold my S&P 500 call options immediately after the open. I added to my Caterpillar (CAT) put options. I took profits in other bullish positions. I selected two small fades with a short on Roku (ROKU) which was up as much as 10% at one point, and I bought shares in Direxion Daily Russia Bear 3X ETF (RUSS). On the bullish side, I doubled down on put options on the ProShares Ultra VIX Short-Term Futures (UVXY) and opened a calendar call spread on Nvidia (NVDA). I become an aggressive buyer of SPY and QQQ call options on a combination of indices trading well below their lower Bollinger Bands (BB), volatility surging, and AT40/AT200 reaching toward historic oversold lows. Again, with earnings season coming up, I am leery of taking on a lot stock-specific risk as part of the oversold trading strategy.
