Monday, December 14, 2015

Trading Notes: Week of December 14th

Friday, December 18th

*  Thursday's action during New York hours completely reversed recent strength, with price weakness evident essentially from the opening bell.  When we did get some decent buying flows in the second half hour of trade, those were unable to push the market to new highs.  Meanwhile, we saw a resumption of weakness in oil and high yield markets and strength in the U.S. dollar.  From that point forward we traced out a trend day to the downside, as selling flows took over.  When you get meaningful buying that cannot push prices to fresh highs (or vice versa), that is often a great tell for intraday trading.  Those buyers are trapped on subsequent weakness and contribute to the continued decline.

*  Per my plan, I bought the early weakness, went green on the trade with the morning buying, and then proceeded to lose that gain and go into the red.  "That shouldn't be happening," was my response to the price action and I stopped out with a modest loss on the position.  When good trades (trades based on historical tendencies) go bad, there is information there.  Quite simply, the idiosyncratic influences of  the oil and credit weakness, dollar strength, and market maker selling to hedge put option losses in the face of quadruple witching overwhelmed any historical tendency for an oversold market to continue higher.  This is why flexibility in following the tape is paramount; getting locked into a market view blinds one to those unique influences that can turn markets.

*  That being said, I'm not convinced that yesterday's weakness (and some weakness so far in pre-opening trade) is a one-off that we can simply attribute to options expiry.  The weakness in emerging market stocks is real; the weakness in commodities is real; the weakness in high yield bond markets is real; and the number of stocks making annual lows vs. highs has been expanding.  All of this leaves me open to the possibility that we work off the recent oversold condition in a low Sharpe manner, ultimately making lower highs in the major indexes, and setting the stage for a meaningful decline.  The weaker and choppier any bounce from this latest weakness, the more open I become to that hypothesis.

*  I find the weakness in AAPL to be noteworthy.  It's one of those bellwether issues that bears watching.  Notice also how small and midcap stocks (IWM) are further from their 2015 price highs than large caps.  Microcaps (IWC) are similarly relatively weak.  On the other hand, the more defensive consumer staples shares (XLP) touched a new high recently.  Not exactly a pattern of relative strength that speaks to broad and strong economic growth expectations.

Thursday, December 17th

*  Once again we saw strength in stocks coming out of recent oversold conditions, with the strategy of buying weakness that stays above overnight and prior day's lows working well.  We've continued strong in overnight trading, which keeps the basic strategy alive.  Early in an upward phase of a market cycle we tend to see momentum, which means that strength builds on recent strength.  That's what we've been seeing recently.

*  Per the chart below, my basic overbought/oversold measures place us nowhere near overbought yet.  We have over 80% of SPX stocks trading above their three- and five-day moving averages, but that number can stay elevated for a while in early phases of market rallies.  I'm especially interested to observe the correlation between stocks and the oil market, which had been quite high and now seems to be breaking down.   

Wednesday, December 16th

*  Many traders try to predict what will happen next when they don't understand what is happening now.  Here's an article that addresses that situation.

*  Yesterday's post noted the oversold situation in the market and cited bullish expectations.  Those played out well in yesterday's trade and now in the overnight session.  Today's trading will be dominated by the Fed meeting announcement in the afternoon.  With traders focused on recent turmoil in high yield markets and the drop in oil, some are anticipating dovish messaging from the Fed.  It is not clear to me that this will be the Fed's primary focus, which could leave room for a "hawkish"/bearish surprise.  That being said, given the queries cited yesterday, buying weakness that holds above overnight and prior day's lows continues to make sense.

*  Note that we've bounced nicely in short-term breadth, given yesterday's rally.  If this is the start of a bull move higher, we should see the "overbought" condition stay overbought for multiple days, as the early phase of an upward cycle typically features momentum.  Where we're at in cycles helps determine whether we can expect short-term momentum versus mean reversion.

Tuesday, December 15th

*  I found yesterday afternoon's trading in ES to be very constructive.  We had significant bouts of selling pressure (high negative TICK readings) but price held above its morning lows.  Since that time, we've seen a nice rally in stocks in European hours.  The inability of selling to push prices lower and the inability of buying to push prices to new highs is often a good tell for price reversals.  (Interestingly, the NYSE TICK readings for much of the day were much more negative than the TICK readings I look at that cover all stocks, including small caps and transactions on regional and electronic exchanges.  That all-stock TICK is tracked via e-Signal.  I will be monitoring divergences between these measures closely to see if there's consistent information there.  As one savvy trader pointed out, the NYSE TICK is probably more dominated by bonds and bond-related shares trading on the exchange).

*  Meanwhile, we're in pretty oversold territory as the chart below indicates.  This tracks the number of SPX stocks making fresh highs vs. lows over a 5, 20, and 100 day time frame.  (Data from Index Indicators).  In the past couple of years, returns have been favorable when we've reached such oversold levels.  Since 2010, when this measure has been in its most oversold quartile, the next five days in SPX have averaged a gain of +.63%.  When the measure has been in the other three quartiles, the next five days have averaged a gain of only +.04%.

*  In a future post, I'll be talking more about my research into market cycles.  For now, here's a look at one of my cycle measures.  It, too, shows us at quite oversold levels.  Since 2012, when cycles have been in their most oversold quartile of values, the next ten days in SPY have averaged a gain of +1.05%.  The remainder of occasions have averaged a ten-day gain of only +.33%. 

Monday, December 14th

*  When markets knock you down, do you:  a) stay down and back away; b) grit your teeth and stick with what you're doing; or c) figure out what went wrong and try to adapt?  How we respond to adversity makes all the difference in our long-term success.

*  A truly weak market is one in which oversold conditions give way to even more oversold conditions, and that is what we saw on Friday.  The number of stocks making fresh new lows, which had moderated in recent sessions, exploded on Friday, following the weakness in oil and high yield bonds.  Across all exchanges, we had 60 new three-month highs against 694 new lows.  That's the highest level of new lows since late September.  With oil prices weak overseas, we're having difficulty sustaining an overnight rally.  Failure to bounce meaningfully from oversold conditions is a warning sign; I'd rather let the bulls prove themselves and buy the first pullback than try to catch knives.    

*  Note how small (IJR) and mid-cap (MDY) stocks have broken below their November levels; also note that emerging market stocks are closing in on their September lows.  Wide swaths of the equity markets are weak; this is not how bull markets behave.

*  VIX closed above 24 on Friday.  Volatility has picked up and that can lead to painful short covering rallies as well as violent downside moves.  It's important to take volatility into account when sizing positions and deciding upon holding periods for positions.