Monday, January 04, 2016

Trading Notes, Week of January 4th, 2016

Friday, January 8th

*  We finished Thursday with very weak breadth, as over 2000 stocks across all exchanges registered fresh monthly lows.  Moreover, fewer than 10% of SPX shares closed below their 3, 5, and 10-day moving averages.  In a correction, such oversold levels generally lead to relatively quick bounces.  During bear moves, weakness can beget further weakness before any bounce materializes.  Early August, 2011 was a notable case in point.  We saw buying enter the market with the China fix overnight and then again with the strong payrolls number.  Still, we're registering lower price highs and so I can't conclude we're out of the woods simply because we're oversold.

*  My primary cycle measure is in oversold territory, but not yet at levels that have recently corresponded to intermediate-term market lows.

*  Note the rise in VIX; my pure volatility measure is also elevated, which means that we are not only likely to see heavy volume, but also more movement per unit of volume.  That has important implications for sizing of positions, stop placement, etc.

Thursday, January 7th

*  Yesterday's post noted the macro headwinds from China/EM/commodities and pointed out that intermediate cycles had not yet bottomed for stocks.  Overnight we're seeing more of the headwind dynamics, with another day of weak trade in China and oil trading sharply lower.  That has dragged stocks down significantly.  Selling bounces remains the operative strategy; my cycle measures are in oversold territory, but not yet at levels associated with recent market bottoms.

*  Because of the China dynamic, important market moves are occurring outside of U.S. trading hours.  That has important implications for both day-traders and for those holding positions overnight.  Day-traders operating during U.S. hours are finding markets already extended by the time trading starts.  Traders holding individual stocks overnight are subject to gap risk.  It's a classic example of a change in markets that requires traders to adapt.

*  In yesterday's trade, new three-month lows expanded, ending divergences that appeared to be showing up among breadth figures.  With today's weakness, I expect further negativity of breadth.  While my intermediate cycle measures are not in bottom territory quite yet, short-term we're quite oversold (see chart below) and my measure of pure volatility (volatility per unit of volume) has once again spiked.  That combination raises the odds for short-term, sharp short-covering rallies.

*  The collapse of oil hurts commodity producing countries, hurts major growth areas of the U.S. economy, and reflects a situation in which demand from weak economies overseas cannot overcome increased supply.  Below is a chart of the past year in WTI crude.  The bear in oil has become the bear in stocks.

Wednesday, January 6th

*  After an indecisive session yesterday in which bulls could not mount much follow through to the strong bounce late Monday, we've continued the downtrend in overnight trade, with oil notably trading weaker.  I continue to see China/EM/commodity weakness as major headwinds for stocks.  My intermediate cycle measure is not yet in bottom territory, per the chart below:

*  Interestingly, thus far we're not seeing as many stocks making new lows as we did at similar levels in December following declines.  I'm particularly impressed with how utilities stocks and energy stocks have held up reasonably well despite the Fed rate hike concerns and falling oil prices, respectively.  My base case expectation is for a break of the December lows and an expansion of breadth weakness, but I am very aware of the alternate scenario in which weakness cannot expand new lows.  That would be more consistent with a trade in which we're closer to the bottom of a range than poised for a true bear correction.

Tuesday, January 5th

Great post from Bella on the kind of self-observation and diligence it takes to be a consistently successful trader.

*  We continued the sharp decline in early trade Monday, but per yesterday's observation re: volatility, we saw a ferocious late-day rally that wiped out the day's declines.  The intraday advance-decline line had been showing strength into the afternoon, leading to that late day rally.  When we're oversold and selling can't push the market to new highs, that's when we're most vulnerable to the sharp short squeezes.

*  The weakness has continued in overnight trade and, per the intermediate overbought/oversold measure below, we're not yet at oversold levels that have historically led to sustained bounces.  This measure is based on 5, 20, and 100-day new highs versus lows among SPX stocks only (data from Index Indicators):

*  That being said, we're quite short-term oversold per the measure of the percentages of SPX stocks trading above their short-term moving averages, per the chart below.  When we're oversold like this on a short time frame, my leaning is to play make-it, take-it with short positions and not necessarily count on moves to extend over longer time horizons.

*  Right now, it's just a one-day observation, but I do notice that despite yesterday's broad weakness, fewer stocks across all exchanges made fresh new lows than at the December low points.  It would be very significant if those downside divergences were to hold up on further weakness in stocks.

Monday, January 4th

*  With the sharp decline in China to start the new year, stocks have sold off sharply overnight.  The decline on the heels of an already short-term oversold market confirms yet further that the intermediate-term cycle has turned downward, per the chart below:

*  My measure of "pure volatility"--the volatility that we see per unit of market volume traded--has exploded higher with the overnight move.  Spikes in pure volatility commonly occur near market bottoms, but the cycle measure above is nowhere near a bottom level.  My concern here is that we're starting 2016 at a higher volatility regime, where we'll not only see high volume and volatility, but higher volatility for each unit of volume traded.  That means we could see large moves even on relatively short time horizons.  Short-covering rallies can be painful when volatility regimes explode.

*  China and emerging markets broadly have underperformed U.S. stocks for a while now.  This trend may be accelerating, as concerns about global weakness in the face of a strong U.S. dollar take hold.  Such a global trend would make it difficult for the Fed to engage in further tightening and could weigh on the U.S. economy.  These are themes I'll be tracking early in 2016.