by Andrew Adams CFA, CMT, Saut Strategy LLC
Charts of the Week
As mentioned in Jeff Saut’s report on Monday, legendary oil tycoon T. Boone Pickens recently passed away at the age of 91. I was lucky enough to have a front row seat a few years ago at a Raymond James conference where Jeff and Mr. Pickens entertained the audience during a fireside chat touching on oil and other investment and non-investment topics. It was a very memorable experience and even well into his 80s, Mr. Pickens was sharp and always ready with a witty quip. By now, I’m sure many of you have seen his farewell letter making its way around the interwebs, but I wanted to highlight some of the principles he left behind explaining how he built his wealth (the majority of which has been pledged to philanthropic endeavors):
Learn to analyze well. Assess the risks and the prospective rewards, and keep it simple.
This advice is the essence of trading and investing but it’s also worth trying to weigh the risks (costs) and rewards of most everything we do in life. There are many different methods for analyzing the market, but at the most basic level it comes down to balancing the estimated risks against the estimated rewards. If you stick with trades or investments that have the potential to return many times your risk, in the long run you will probably do ok.
Follow Me @DayTraderGator on Twitter for Additional Thoughts
That risk vs reward relationship, perhaps more than anything else, is why I am drawn to technical analysis since it helps visualize and estimate those projections. Whether with individual stocks or the broad market, my focus is on determining the perceived upside and downside and the probabilities of each occurring.
Simplicity is also crucial. People are often surprised by how few indicators and technical methods I use in my analysis. Adding more and more lines and indicators to a chart does not necessarily help one make better decisions, and a more complicated approach usually only leads to “analysis paralysis” as the signal gets lost in the noise. If something helps you make better decisions then use it; if not, throw it away.
Be willing to make decisions. That’s the most important quality in a good leader: Avoid the “Ready-aim-aim-aim-aim” syndrome. You have to be willing to fire.
One of our goals in these commentaries is to provide actionable guidance — something you can actually use to help navigate the markets. Now, sometimes that’s easier said than done considering Mr. Market doesn’t always cooperate by providing the clearest of signals (and it’s hard to provide advice that applies the same to everyone), but we do make it a priority to say how we are approaching the markets at any given time. No amount of analysis matters if you cannot pull the trigger and make a decision on what to do, both when writing market commentary and when putting money to work.
Learn from mistakes. That’s not just a cliché. I sure made my share. Remember the doors that smashed your fingers the first time and be more careful the next trip through.
One of the few things I actually remember from inside the classroom during my college days was one of my professors saying, “Do more of what works and do less of what doesn’t work.” I think that’s good advice for life, in general, but it certainly applies to playing the markets. It’s impossible to invest or trade without making mistakes. It’s a hard business and the ones who last in the long run are the ones who minimize their mistakes by learning from them and not making the same bad decisions over and over again.
So, Rest in Peace, Mr. Pickens, as well as legendary technical analyst, Justin Mamis who also recently passed away. These men are irreplaceable.
Now, even though there’s no good segue to do so, let’s turn to the markets since I’m sure that’s what Messrs. Pickens and Mamis would want to talk about; and what a wild session yesterday turned out to be!
The major U.S. averages began the day by gapping up and looking as if they may take a shot at challenging the recent highs; but after sputtering and failing to build on the gains heading into the 11:00 am hour the losses started to accelerate once the day’s gap was filled and Monday’s closing levels were taken out. I posted a “trading flash” to our website and my distribution list around midday to voice my near-term concern with the reversal, and the S&P 500 responded by trading all the way down to the September 10th low of 2957 soon afterward (a 1.67% drop from the intraday high). Then, just as it looked as if the index was preparing to fall even further and take a shot at filling the noticeable 2940-2957 gap from September 5th, President Trump tweeted that he’d authorized the release of the “complete, fully declassified and unredacted transcript” of his phone conversation with the President of Ukraine. Like clockwork, the S&P 500 shot up 20 points in minutes on the news since I’m told by Twitter that releasing the transcript lowers his impeachment chances (it’s hard keeping up with the D.C. circus). The rest of the session was then spent chopping around within the afternoon’s range.
Overall, the technical action is a bit concerning since it’s eerily familiar to other near-term trading tops we have experienced over the past year.
A quick double-top, followed by a subsequent failed rally attempt has been the market’s way of showing its exhaustion recently and so far that pattern is playing out again. What’s more, now that we’re down at these levels it’s hard to believe the S&P 500 doesn’t trade at least a little lower to fill the gap created on September 5th. As I’ve written before, gaps in the charts don’t necessarily HAVE to be filled before an index or stock can move on, but most are eventually closed based on my experience. In fact, I would actually feel better about any subsequent breakout to new highs if that gap is filled first since that would take care of that potentially lingering red flag (the NASDAQ closed its own 9/5 gap yesterday). Alternatively, if we come in today and start to rally early in the session without filling the gap, I will probably be skeptical of the move since that gap remains so close nearby.
My ideal path from here, then, is we see further weakness today or later this week that fills the gap by taking the S&P 500 down to at least 2938-2940 but then stocks are quickly bought back up. I really don’t want to see us trade for too long back within the 2820-2940 range that dominated the month of August since that will be taking a noticeable step backward if we retreat back into the range so soon after breaking out.
Yet if we do trade down to the top of that range and then start to bounce I think that could offer a very nice opportunity to get aggressive on the long side since at that point the market should start to see demand pick up based on the charts and it also provides a clear zone in which to define your risk (i.e. plan to exit trades if the index fails to rally and falls back within the August trading zone).
Once back in that zone, however, it’s tough to make a case for buying stocks again until a clearer setups forms.
So, that’s the way I’m thinking heading into today’s session. In the bigger picture, I still think it’s too soon for longer-term investors to raise massive amounts of cash but it is worth watching closely over the next few days in case we do retread back into that August trading range since that would be a red flag to me and would up the chances of getting something more substantial. Breadth readings have actually been decent, with the NYSE Advance-Decline line making another new high as recently as Monday, so this isn’t a case when weakness has been noticeable under the surface while only a handful of stocks are participating. Moreover, the market has already been given every opportunity to decline over the last month and yet has not, which makes me wonder just what it would take to produce another significant decline after 20 months of sideways markets with no shortage of political, geopolitical, and economic concerns.
Maybe it’s a possible Trump impeachment but he’s survived this long which makes it hard to bet against him (and a 2/3 majority in the Senate to have him removed from office seems unrealistic in my inexpert opinion and he’s unlikely to pull a Nixon and resign). And while the situations are obviously different, it is worth noting that during Bill Clinton’s impeachment proceedings back in 1998- 1999, the S&P 500 actually went up almost 9% from low to high so it’s not a slam dunk that the market would tank on the news (after all it might like the thought of fewer intraday policy tweets).
The other big topic of interest we’ve been getting asked about is what’s been going on in the repo market (repos, or repurchase agreements, are a form of short-term borrowing mostly for dealers in government securities). My take is that the smart people I follow don’t seem to be worried about it, Jay Powell didn’t seem to be worried about it, the stock/bond/credit markets don’t seem to be worried about it, and the only people I’ve seen commenting that it’s a reason to worry are those that say basically everything is a reason to worry. I see little evidence then that it’s anything like 2008 when there was a lack of faith in the entire financial system, which is supported by the fact that the stock market is still near all-time highs and credit spreads appear to be improving rather than getting worse.
Remember, back in the fall of 2008 when there were similar concerns in the money markets, we were months into a recession, the S&P 500 was already down more than 30% beneath its 2007 high, and credit spreads were already blown out to relatively high levels. If there is reason for concern, it doesn’t appear to be showing up yet in the markets. Like with many topics of possible concern, I throw repo rates into the large bucket of stuff I’ll worry about once the markets give me a reason to worry. Until then, I’m not going to take any direct action because of it.
That said, it’s probably a good time to bring back my regular reminder that if you are worried about the market’s reaction to a potential Trump impeachment or if you’re worried about the repo market or if you are worried about anything else that’s out there to worry about THERE IS NOTHING WRONG WITH TAKING STEPS TO MANAGE THE POTENTIAL RISK AS LONG AS YOU ARE OK WITH THE COSTS OF
DOING SO. If you want to sell positions to raise cash or hedge with options or take other similar defensive actions then that might make sense for YOUR portfolio (i.e. sell down to the level where you’re able to sleep comfortably at night). I would not recommend going overboard with it at this time based on what I’m currently seeing in the market, but that is ultimately a call each individual has to make based on his or her risk tolerance.
S&P 500 Sector Snapshot
S&P 500 At Critical Area
With the weakness yesterday, the S&P 500 has now pulled back to the top of the breakout point from the August trading range. The area between 2940- 2950 should, therefore, act as added support, though the gap from the 9/5 breakout (green shaded region) is an obvious target to be filled. After that, things get more unpredictable once the S&P is back within that 2820-2940 trading range. There are some more minor support levels around 2915, 2890, and the diagonal line connecting the recent lows (green dotted line), but the more major support doesn’t enter until the bottom of the trading range around 2820, which is why I’d rather not see the index trade for too long within the former range because it increases the odds of 2820 being tested once again.
Double Tops Have Been Common and Worth Taking Seriously
One of the main reasons I’m being extra vigilant at the moment is because we have seen similar “double top” (or double top-esque) patterns lead to more substantial weakness over the past year. Not only does the current formation look similar to what we got around this time last year (that resulted in a 20% drop), but when combined with the late July peak it has created an even larger potential double top. This is why I really want clear support to enter in the 2940-2950 gap zone and bounce the index back up to make the charts look better. Under 2940, I will turn even more cautious just in case a more substantial decline does form.
More Reason for Extra Caution…Potentially
As I have written before, I am not a big believer in technical price projections. Technical analysis teaches that we can use the size of chart patterns to project price targets, but I have had limited success with it in my own experience. That said, the size of the POTENTIAL larger double top that would form if the S&P 500 kept falling here is worth paying attention to because it implies a minimum target of 2625 if all went according to the textbooks. To be clear, though, the double top is only a potential pattern right now and won’t be confirmed unless the index breaks below the recent support zone around 2825. So, like the market in general, it’s worth monitoring closely but hasn’t yet done enough to warrant major defensive action for most readers.
And for Good Measure
Here is the longer-term look for the S&P 500 and where we currently stand. I didn’t actually intend for this report to be so negative, but, here too, I think some extra caution will be warranted if we continue to fall because the S&P 500 risks breaking down through a large rising wedge pattern, a pattern that can lead to some sharp down-moves. Again, no clear sell signal has been given yet, but the situation demands watching closely just in case.
Alternatively…
I think I’ve adequately covered the downside potential and why right now is such a crucial moment for the stock market, but I want to stress again that I still think that severely negative outcome is a lower probability event. Alternatively (and ideally) we could also see support enter in the 2940-2950 zone, as expected, and take the S&P 500 right back up to challenge the all-time high. At this point, that still seems to be the likelier of the two setups. Successful investing and trading requires envisioning possible scenarios and then adjusting to how they play out in real time. If expecting guarantees, you’re going to be disappointed.
NASDAQ Filled Its Remaining Gap
As noted, the NASDAQ Composite did fill its own gap yesterday before slightly bouncing. Now we hope the S&P 500 does the same.
Small Caps Still Rangebound
The Russell 2000 exploded off its August low after falsely breaking down below support, outperforming the S&P 500 on its way up. Since then, however, the small cap index has returned to its disappointing ways, finishing lower six sessions in a row and underperforming large caps. It is back to the middle of its larger trading range and, ideally, will find some support around 1510-1520. Only a break from that trading range will give us a real indication of its next big move, but if the broad market can find some support soon small caps might be worth a second look since they did outperform during the late August/early September rally.
VIX Back into Caution Territory
I continue to have success with using a VIX above its 20-day exponential moving average as a caution signal. Over the last year, the most significant losses in the S&P 500 have only come AFTER the VIX was already above its 20-EMA. It’s just another reason for extra caution at the moment unless it quickly drops back down beneath it.
No Red Flag from NYSE A-D Line
One positive thing the market has going for it is that the NYSE Advance-Decline line was just at a new all-time on Monday. Typically, the A-D line tops out in advance of the S&P 500 prior to a substantial sell-off, as it did back last year around this time when it topped out in August but the S&P 500 topped out in late September/early October. Breadth has actually been pretty strong lately, which is good.
NYSE % Above 50-DMA Retreating
Not surprisingly, the percentage of stocks on the NYSE above the 50-day moving average has fallen along with the major indices. Prior to that, though, the indicator was back up above 70% where it has routinely been during this bull market. That in itself is a positive and reflects market strength, but it is worth noting that the indicator has been making lower and lower peaks throughout this year, which suggests fewer stocks have been participating in each subsequent uptrend. The current indicator level also implies that the market would likely have much further to fall before this indicator hits the levels below 25% that typically coincides with a significant trading low.
Still More New Highs Than New Lows
Another positive is that even with the weakness yesterday, there were still 87 more new 52-week highs across the NYSE, NASDAQ, and AMEX compared to new 52-week lows. Usually, it’s only when this indicator is negative (more new lows), that we get the worst declines.
Credit Spreads Not Indicating Concern
Credit spreads are a useful indicator of how much concern is in the financial/economic system. To oversimply a more complex concept, when spreads are widening and this indicator is rising, it reflects more concern and when they are tightening and the indicator is falling it reflects that the market believes conditions are improving. Despite some talk about conditions in the money markets bringing back memories of the fall of 2008, the worry does not yet seem to be showing up in credit spreads.
Credit Spreads Not Indicating Concern II
The previous spread was the US High Yield Master II Option-Adjusted Spread. Here is the US Corportate BBB Option-Adjusted Spread, which shows similarly low levels of concern. These spreads are at some of the lowest levels of the year.
Trade Ideas
As mentioned earlier, I’m not really seeing any attractive long setups in the kind of individual stocks I track. Like in August, I expect we’re either going to see stocks bottom together shortly, which would mean you should be able to take your pick on what to buy, or the market will experience more pain and short setups should be abundant. There’s nothing sticking out to recommend at this time, but if we do get a bottom soon and it plays out like in August, small caps might do better on the way back up.
When I look for trades, I am looking for stocks I think can move in the direction I want them to go quickly while limiting my downside if I am wrong. I expect to be wrong a decent amount of the time given the tight stops, but the idea is that the winners should more than pay for the losers. There is an opportunity cost to holding a position, as the capital allocated to it prevents you from using that capital in another position, so if I enter a stock and it doesn’t quickly do what I think it should I may cut it even though a stop or profit target isn’t hit. Likewise, I usually move my stop up to my breakeven point once the trade starts to go in my favor in order to prevent a winning trade to turn into a losing trade. Understandably, my trading strategy might not fit your trading/investing strategy, but the trades highlighted in this report are the kinds that I typically look for.
Current Open Positions in Personal Accounts (this changes daily): Long BIDU, Short MES Dec20’19 (micro S&P 500 futures contract)
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