I’ve said it here many times now. If it’s bad for stocks, it’s going to be bad for just about everything. Well, you can now add a corollary statement: The Fed is the most dangerous variable for the markets and the MELA system, as its threat of raising interest rates in early 2022 has accelerated the recent selloff in stocks.
Last week, citing a persistent market breadth divergence, I noted that I was “pulling back my horns just a little, which is not to say that I’m turning outright bearish.” This week, I’m going on record stating that I am increasingly concerned about the stock market, especially given the general tendency of any “Buy the Dip” rally to fail in the last few days. Moreover, because the stock market is the most important component of the MELA system (Markets, Economy, Life decisions and Algos), as the stock market goes, so will likely be the cascading effect throughout the economy and daily life.
That’s because, as familiar readers know, large numbers of people depend on their stock trading revenues and the state of their 401 (k) plans to make important financial decisions. As a result, if and when we enter a bear market in stocks, the ripple effects will be felt through the economy as spending will decrease proportionately.
That said, it would not be surprising if all of this blows over with some kind of boffo announcement regarding the Omicron threat suddenly disappearing. Sure, it’s folly to expect, as it would make little sense. But that’s how the algo-driven market works.
Welcome to the Edge of Chaos:
“The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder.” – Complexity Labs
The Fed Sank Bonds, Which in Turn Sank Stocks
Stocks were holding up fairly well until January 5, when the FOMC minutes unveiled the fact that the Fed was way more willing to not just taper QE, but to actually raise interest rates as early as March 2022. The net result was three-fold and nasty, with the U.S. Ten Year Note yield (TNX) leading the way as bond sellers factored in the Fed’s newly revealed intentions. In addition, as the New York Stock Exchange Advance Decline line (NYAD), the CBOE Volatility Index (VIX), the S&P 500 (SPX) and the Nasdaq 100 (NDX) charts directly below show, the ensuing selling in stocks and the volume in put option buying were both persistent.
I’ll discuss the stock situation in some detail below. Sticking to bonds, for now, we see that TNX breached the 1.7% yield area. And yes, if this persists, we are likely to see a test of the 2% yield area. Worse, if that level is breached, expect some very bad things to happen not just to stocks, but to all markets, as CTA (commodity trading advisor) algos will have to make changes to their asset allocation.
On the other hand, with TNX closing outside its upper Bollinger Band on 1/7, we could see a short-term reversal in yields. This could buy stocks a breather, but it may or may not last.
For more on how to develop a trading plan and how to approach this dip, watch my latest appearance on StockCharts TV’s Your Daily Five.
Energy Stocks Such as EOG May Offer Short Term Relief from Stock Market Rout
When bears raid the stock market, aside from looking to preserve capital, it makes some sense to look for areas where there are positive money flows. This is especially useful if one keeps in mind one simple fact; if we are truly entering a bear market, most stocks will eventually fall.
That said, in this current market selloff, which is still too early it its development to allow a full discerning of a final outcome, the energy stocks such as Houston-based natural gas giant EOG Resources (EOG) may be worth a trade.
Certainly, we know that there are some mitigating factors that have led to tighter supplies of fossil fuels available for consumption — such as decreased investment in exploration and extraction over the last few years, restrictive federal regulations and a bumpy transition to clean fuels, especially in Europe; and ironically in Texas as we who live here learned painfully in February 2021.
And while we recognize that these factors could make the energy sector attractive over the long term, we also know that commodity stocks could turn at the flip of a coin, especially if it turns out that we are in a bear market for all stocks.
In other words, I am describing the potential for a short-term trade featuring EOG, based mostly on technical factors. Meanwhile, a quick review of the price chart shows a familiar trading pattern:
- Short sellers are nearly exhausted as ADI has bottomed out and is starting to move higher
- Buyers are coming back as On Balance Volume (OBV) is turning up after an intermediate pullback, showing signs of perking up
- The stock has broken out above fairly significant Volume by Price (VBP) bars which, as I’ve noted before, means that the algos are using intraday dips to nibble at the shares
So, do I think EOG is going to go up forever? Of course not. But right now, it looks a lot better than many other stocks in the market. I own shares in EOG as of this writing.
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VIX and NYAD Hit Crucial Red Lines Simultaneously
Keep a close eye on the 50-day moving average for NYAD and the 20 area for VIX. If the market continues to act as it did over the last week, further breaches of these two levels are likely to lead to more aggressive selling.
Let’s address the what is, for now, a short VIX reversal first — as it’s a bearish development, especially if it continues. That’s because a rise in VIX means that put option volume (bets that the market is going to fall) are on the rise. And when put volume rises, it means that put buyers are causing market makers to sell puts. When market makers sell puts, they have to sell stocks and stock index futures to hedge their put sales.
So what happens is that bearish put buyers essentially create periods of self-fueling downward price action – a self fulfilling prophecy of sorts – as the market maker’s hedging activity juices the down trend and leads to lower prices. In this case, VIX rose from 17 to nearly 20 over a few days, and this rise had a near 100% correlation to the NYAD’s rolling over and the fall in the major indexes.
The S&P 500 (SPX) is doing better than the technology stocks (see NDX, below) as it’s holding near its 50-day moving average. ADI and OBV are still quite negative here, though, which means that selling could well pick up steam.
The Nasdaq 100 index (NDX) broke below its 50-day moving average and is testing key support at 15,500 or so. A break below this area could well take the index down to a test of the 200-day moving average.
The S&P Small Cap 600 index (SML) is still muted after being the weakest area of the market during the recent rally. At the same time, SML is by no means showing any signs that it’s about to become the market leading index, although that may change.
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In The Money Options
Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com and now in its third edition, plus The Everything Investing in Your 20s and 30s Book and six other trading books.
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