The Sounds of a Reversal
"If you are going to panic, panic early..."
In this edition we will go over this weeks charts and events, as well as explain
why each section is important as an introduction to our market philosophy -
- The Spin - The news this week and how it was spun.
- The Charts - The Reversal, the damage, and the current bias.
- The Lesson - What you should learn from the markets this week.
* The Spin *
News stories, to the market, are kind of like fashion trends. At any point in time, there are always a handful of themes that the markets concentrate on, and in turn, the media centers chase. Major themes or 'focus markets' have been the euro, war in Iraq, inflation, deflation, employment reports, what have you. When a given topic is being 'spun', it needs to be followed closely (no matter how ridiculous it may seem) since although the underlying effects or movements aren't any different then they were before, the markets temporary interest often causes it to correlate highly with the developments in that topic or market. Then, just as quickly as it appeared, the interest is gone. What we try and do is separate the fluff issues from the real issues on the minds of traders. So what caught the spin factor this week?
- Europe - It seems that Europe has turned into a politician's worst nightmare. After the embarrassing constitution fiasco and the ever worsening economic figures, financial advisors have been asking themselves, "Why exactly did I think the Euro was a good currency?" Why indeed. This week Italy spouted off more rhetoric about its Argentina like debt problems with talk of switching back to the Lira. Other European nations are dealing with the growing debt problems as well and feel that the ECB is not being accommodative enough - that this isn't the right time to be enforcing a strong euro policy (read Mauldin's article for more thoughts on this.) Although Europe's problems run far deeper than just a highly valued currency, this sort of talk makes currency traders uneasy with the euro still hugging it's lows. To make matters worse, Britain's MPC minutes, showed two members with dissenting opinions wishing to lower rates because of weakening economies, which came right on the heels of Sweden actually cutting it's rates by 50 bp. These stories are causing quiet a bit of noise in the currency markets with big bets being placed ahead of the next ECB meeting. What's this mean to you? The usually uneventful ECB (European Central Bank) and BOE (Bank of England) announcements could cause some major currency swings this time around will be carefully watched - don't be caught by surprise.
- China - The usual suspect regained popularity this week as it roared onto the scene with a 18.5 billion dollar bid for UNOCAL, a large California oil & gas company with large holdings in Asia. This by itself is relatively un-important, but the protectionist uproar that it's causing in congress isn't. Hilarity ensued as Greenspan teamed up with Snow to try and calm the angry congressmen but they seemed to have little effect. The real anger here stems from the fact that the Chinese company that is 'making the bid' is being subsidized by the Chinese government, which is viewed as unfair. Read more about the specifics of the acquisition along with analysis here. The real irony, of course, is that China is beginning to use the mountain of extra dollars that it has acquired because of Americas relentless buying of cheap Chinese goods (trade deficit) to do some buying of its own. What does this mean to you? If the market gets any inclination that the trade war threats by congress could become a reality, they will undoubtedly get hit hard. Furthermore, don't be surprised if we begin seeing even more bidding from Chinese companies in a variety of markets - with the acquisition market already hot, traders will be bidding up potential targets.
- Oil - Oil hit 60$ this week and the news media made a big deal about it and blamed it for the markets decline Thursday with the Dow Transports getting hit hard. However, I think the markets will be getting more and more used to high oil prices, so unless they really start running away, I don't see the day to day movements of oil having too much influence on the broader markets here. I would also recommend that everyone take the time to read Henry C K Liu's extremely insightful oil article concerning the historical and likely economic effects of 50$ oil here.
* The Charts *
Although news should be kept in mind, especially because it can cause abrupt moves in the markets, most of the time, its just noise. Experienced traders can give countless examples of when the markets have rallied on negative news and in bad economic environments, and dropped on positive news and good economic indicators, all of which is very baffling to the news media and the average investor. Generally, the media is in the business of answering the classic investor question, "Why did the market go up/down today." Everyday they attempt to pick out an event that they feel must have put the market where it is at any given moment, so when the market is up, they will pick from the positive stories, and when the markets are down, they will pick from the negative - developing a sort of straw man bias in what is reported that day. What people must understand, however, is that the market is not news driven, but sentiment driven - because the markets are not driven by events, they are driven by emotional traders. The markets won't go up or down in response to anything but individuals buying or selling, and news is only as important as the traders in the market feel it is. Moreover, traders often try and anticipate and out-guess other traders which yields an overall market reaction that is often contrary to what is expected when the news arrives.
This is why we resort to technical analysis (TA) to analyze the current bias and sentiment of the markets. The problem with technical analysis however, is that there are as many ways to read a chart as there are analysts reading them. Although many have attempted to define strict rules and simplified methods of analysis, ultimately they all come up short. This is because the market is constantly changing and shifting, leaving many strict rules useless in future situations. The true usefulness of technical analysis lies in developing a feel for the market wherein you can detect changes in sentiment and react to them. TA to me is not about prediction, prophesizing, or forecasting, but figuring what the market sentiment, or market trend, is at that moment, and having the discipline to react to it when it changes.
- The Reversal -
The highlight of this week is undoubtedly Thursday's monster afternoon reversal. The week had been strong, with a lot of tech companies forming solid bull flags (bullish formation) and the semiconductor index on the verge of breaking out of a 12 month range. Volume had been very low with the index's spending most of Monday thru Wednesday chopping sideways in a slow grind. Many traders were happy about one thing however - after that strong rally, we weren't dropping.
The night before, CNBC's Jim Cramer was pumped up about a tech rally he felt was imminent, with MSFT and SHLD written across his knuckles - a practice that has always resulted in those stocks rallying instantly in the overnight session. Sure enough, the next day, MSFT was up almost 2-3%. After a generally positive jobless report, the markets leapt higher. Analysts on CNBC were practically crawling over there desks with excitement as if we were already up 160 points on the day. What no one seemed to really care about was the fact that the Dow opened down, and was drifting lower (notice the bearish break of the ascending triangle.) The finger was quickly pointed at the Dow Transports which were falling rapidly from a head-and-shoulders formation as oil danced around the 60$ level. However, none seemed too concerned since tech was the story of the day. Intel was up, Google was up, semiconductors were up - pretty much everything involved with technology seemed to be having a good day as they rallied up until about mid day which is when the panic began. NASDAQ began pulling back slowly as the Dow's decline began to accelerate, and it wasn't long before this so called pullback turned into a selling frenzy with the positive semiconductors making a complete reversal and plunging into the red.
The decline continued throughout the day with both the Dow and the NASDAQ finishing the day near their lows on massive volume. At one point the Dow ETF and Futures plummeted as they ran into a mountain of stops, pushing them down an extra 100 points in 2 seconds. The snap back was quick due to arbitrage, but the damage had certainly been done, and traders were quick to push the Dow down to that level again the next day.
Without a doubt, the NASDAQ is holding up much better than the Dow, and it also had a more impressive rally to it's highs. I am skeptical, however, of the NASDAQ's ability to sustain any sort of rally with a languishing Dow. Moreover, it would take a powerful rally to turn traders bullish on the Dow - drops like this aren't suppose to happen in a bullish environment and it will leave traders skittish for some time to come. I would also like everyone to notice the volume of this 2-day decline. The general rule is, that corrections should be on lower volume then the trend moves. A common trait of reversal days (trend change) is high volume move in the other direction. The NASDAQ is now sitting at a relatively strong support level - a previous congestion area, and the 38% retracement. This means that traders should not be surprised if they encounter chop or attempted reversals from these levels - which could make for a great short entry.
I was recently asked, "how can moves be this fast when everyone is bullish... these moves just appear out of nowhere." The answer to that is a classic reference to why and how the markets often run contrary to what seems to be unanimously expected. If everyone is bullish, then that means that everyone (or the majority) is long the market and has already exercised their bullish opinion by buying. If that is the case, then it follows that there are very few people left to buy. Therefore, everyone is sitting long stocks waiting for the others to push the market up for then. In situations like these, the markets can start to drift lower solely because of the lack of buying. Then the selling begins to trickle in, pushing the market even lower, and a sort of domino effect takes place with everyone who was long (the large majority) panicking to get out, along with very few people wanting to post bids. These cascades are hard to predict, but noticeable when they begin because of the pure velocity and somewhat surprising timing of the move. The only thing the average trader can really do when caught long in situations like these is to abide by the old saying, "If you are going to panic, panic early."
The markets taught a valuable lesson Thursday to all those willing to learn it. What separates amateur traders from the professionals is simply this : Amateurs look at the market and think to themselves were they think it should go. They form an opinion as to what would be the "right" thing for the market to do, and jump into a trade. Professionals are different in that they don't necessarily form an opinion on the market, as much as they just react to the market. In this sense, there is never a 'right' or a 'wrong' way for the market to go, it's just the market - and they stand at the ready to listen to whatever information the charts have to whisper. Forming opinions is dangerous for the simple reason that people hate being wrong. Once you make up your mind that the market should rise, you will unconsciously filter incoming information to conform with what you have decided. In a way, it doesn't matter what the market does because you will always adapt your expectations, find some technical indicator, or think of some reason that the market will come back and eventually prove you right. It isn't until it is hopelessly far away that traders will pound their desks in frustration and ridicule the stupidity of the other market participants as they dump their holdings.
There is an old saying that we live by, "Trade what you see, not what you think." Opinions are deadly, reaction is everything. Despite how simple it may sound, it can be extremely difficult to train yourself to think this way. Thursday morning, it was all but impossible not to be caught up in the bullish ebullience of the markets. The warning signals were there; everyone was convinced they were right. However everything was not alright. The Dow was in the red and falling, the Transports broke down from a head and shoulders, yet the bullishness remained. Excuses were created for the falling Dow, and why it would not hinder the coming tech rally that must surely develop. Then the decline began.
This is where the internal battle begins. When do you get out. When do you admit to yourself that you were wrong. For most participants, this point comes much too late, and near the end of the move. As a reactive trader / investor, you must recognize when something about a certain pattern is wrong. That no matter how good it looked, guaranteed it seemed, when the market shows you something different, you must make yourself available to see it, and not excuse it away. This same principle applies to longer-term traders on daily, weekly, and monthly charts.
We interpret the reversal as being decisively bearish and flipped short after the initial turn on Thursday. If the decline is to continue, the NASDAQ will need to accelerate it's decline to confirm the move in the Dow. Failure to do this should raise flags for the bears. Oil stocks have maintained their strength and will probably be most resilient to market weakness while the transports will probably continue bearing the brunt. Today's lesson, however, reminds us that we must stay vigilant and not get locked in a bearish mind set. Daily updates and ideas are blogged at www.runetrading.com.
Best of luck.