Tuesday, August 11, 2015

Trading Notes: Week Of 8/10/2015

Friday, August 14th

*  For me, the standout observation for today's trade is that the yuan stabilized at the overnight fix, we got a small pop in stocks, and then there has been no follow through and, as I write, that small pop has been entirely reversed.  Meanwhile oil and copper continue to languish near their recent lows.  The need for devaluation in China is a response to economic weakness and perhaps the best real-time gauge of that weakness is in commodities pricing.  I have trouble seeing any sustained bull move in stocks until the deflationary pressures reflected by commodities weakness abate.

*  My various breadth measures have been peaking and, recently, bounces in stock market breadth have not been sufficient to lift the index to new highs (see chart of Intermediate Strength above).  I'm content, given the dynamics above, to have a small swing position for a move to oversold levels. The models are neutral, and it would not take a huge amount of weakness to turn them bullish, so at this juncture I'm not anticipating a full-on bear market move.  Too, as the above chart shows, we've seen a drying up of the number of stocks making fresh lows.  Should we get near-term price weakness and fewer stocks making new lows, I will use that as a tactical opportunity to take profits.  If the weakness hypothesis is correct, we should not take out the overnight highs in today's trading session.  With models not lined up, I'm happy to have a relatively short leash for position trades.

*  The breadth volatility measure referenced yesterday is at the lowest levels seen since late February/early March.  Such low levels have been associated with weak returns over a next five-day basis.  Pure volatility has also moved below median levels, also associated with weak forward returns over a swing basis. 

Thursday, August 13th

*  Yesterday's note about caution chasing oversold levels when pure volatility is high turned out to be more right than I expected, as we reversed the recent weakness and rallied strongly in SPX.  We dropped all the way below 2050 in the ES futures early in the day, a two-week low.  Interestingly, we only saw 1058 stocks across all exchanges make fresh monthly lows vs. 1078 on 8/6 and 1862 on 7/27.  Note a number of sectors that held up with relative strength, including the yield-sensitive utilities and consumer staples shares.  The commodity-related stocks have also held up.  This told us that the early drop was more about sector rotation than full-on risk-off--a valuable tell.  Market breadth has not been weakening with the recent China related selloff.

*  Pure volatility remains unusually elevated even with yesterday's rebound; when this occurs, there is usually more upside left in the move, as the combination of volatility and strength leads to near-term momentum.

*  The 3-5 day models are mixed:  one is neutral, the other mildly bearish.  The next day model is neutral.  These are the kinds of signals you get in the middle of trading ranges.  I could be persuaded to buy intraday weakness that holds above the overnight lows for a short-term trade higher based on the strong pure volatility, but otherwise don't perceive a strong edge.

*  My breadth volatility measure is hitting multi-week lows.  That's a measure of the volatility of day to day breadth and it's been a helpful measure.  When breadth volatility has been in the lowest half of its distribution since 2014, the next five days in SPY have averaged a loss of -.01%.  When in the highest half of its distribution, the next five days in SPY have averaged a gain of +.34%.  If we were to get other volatility readings dropping, the models would likely turn bearish.

Wednesday, August 12th

*  China devaluation continues as major driver of stocks globally.  While developed market equities have traded in a range over the past several months, emerging market stocks have been in a consistent downtrend (see EEM chart above).  This suggests that a major engine of recent global economic growth is no longer a contributing factor.  It is this weakness and not the stimulus value of the weaker Asian currencies that is driving stock and commodity markets lower and stimulating a flight to the safety of quality yield.

*  The 3-5 day models for SPX are neutral; the next day model ended Tuesday very modestly bullish.  The models cannot factor in idiosyncratic market factors such as the devaluation, so I am not relying upon them for signals at this time.  Sometimes this time really is different.

*  My measure of "pure volatility"--the average price movement per unit of trading volume--has become elevated, which means that we could see outsized moves (including countertrend ones) as volume picks up.  This has important implications for the setting of stops and targets on trades and makes it particularly dangerous to chase overbought or oversold price levels.

*  General game plan is to continue to sell bounces in SPX that terminate at lower highs.  If the devaluation truly is contributing to an ongoing risk-off trade, we should not trade above the levels seen just prior to the most recent yuan fix.  I continue to harbor doubts about any kind of sustained Fed hiking in the face of what is increasingly looking like a currency war of competitive devaluations.  

Tuesday, August 11th

*  China devaluation key piece of overnight news; USD rises vs. Asia; stocks give back a chunk of Monday's gains.  China devaluation affirms government concern over economic weakness.  Difficult to see much in the way of Fed hiking with Asian goods becoming cheaper in U.S. and dampening inflation.  Also difficult to see Fed hiking in any sustained way in the face of what is increasingly looking like a currency war.  All in all, this is consistent with the macro themes recently outlined and should be supportive of U.S. stocks offering yield.  Economic benefits of lower inflation/lower prices are tempered by headwinds from higher USD.

*  My 3-5 day models for SPX turned modestly bearish at end of day on Monday, but reaction to the China news swamps model effects.  Next day model for SPX turned from modestly bullish to neutral.  

*  General game plan is to sell bounces in SPX that fail to take out Monday highs.  Commodity markets have been a good proxy for the Asia weakness theme, and it is difficult to see stocks sustaining a rally if that theme is dominant.