As we have traded both long and short since the beginning of December I started expressing increasing concern about trading the long side in the past week or so even as markets rallied again to marginal new highs. Yet the bullish cabal kept raising price targets again (many spoke of 1,860-1,900) and even going so far as to tell us why high margin debt is a good thing. Seriously. Self delusion is a human trait I know, but ignoring warning signs and making them a basis for arguing the opposite of what they indicate is a skill indeed.
A lot of people were caught very wrongly positioned on Friday and the end of the day had the smell of fear and forced liquidation to it. In fact, it was one of the largest two day slides in a long time and all those that bought the Thursday close and didn’t take profit overnight got hurt badly. This creates trapped supply. And the weekly overbought levels I have been harping about show that there is a lot of downside to be had still.
Now nobody knows what markets will do day to day and sometimes they outright surprise. Friday was such a day. Even getting the macro right and being properly positioned as I was it does not insulate me from being tossed by a market that suddenly changes behavior. Hence I keep pressing the issue of account strategy, discipline and process and having the flexibility of trading both options and futures (article to come this week).
After taking profits on remaining shorts I started scaling into longs into the carnage, slowly and small at first, but then added a bit more size, but never overexposing myself. As you know keeping fire power is one of the key rules to my trading. Lottery plays for a bounce did not work out and these small options positions amounted to nothing. I did scale into a couple call positions for next week & February and scaled into future long positions.
While identifying trade set-ups is mostly a chart and watching the tape based exercise for me most of you know I’m always keeping a keen eye on the political and economic macro.
And that backdrop is a juicy one for this week. The following considerations are on my mind:
1. Ben’s last meeting FOMC meeting as chair with Janet about to take over. Yes taper is an issue, but this sell-off now puts us tactically in the same place as in December: Oversold right before a Fed meeting. Shocking. My basic take: “They” won’t let his last meeting be a complete disaster and her transition be a crisis.
2. Month end on Friday. So far 2014 is off to a dreadful start for funds. Unless they want to see redemptions en masse in February my sense is they will want to smoothen things out a bit before the end of the month.
3. Friday $5B POMO. While POMO seems to have lost its firing power it would still be a powerful factor on mark-up day.
4. Friday’s carnage has left indices far disconnected from 5 EMA and 8MA and you know my standard rule on that: They always reconnect. The sudden drop below the 50MA also invites a re-test sooner rather than later.
5. Finally, while the larger trends look close to breaking they haven’t yet. That is not to say they won’t or couldn’t, but they haven’t yet. And while I have heard of the August crash and the October crash and the September swoon I haven’t heard of a January crash yet. $IWM in fact is so far showing a pattern that has coincided with previous bounce areas.
6. China default? I don’t know. As most of you know I’m highly skeptical as to the sustainability of this global debt experiment and the reliability of China’s economic numbers are part of this risk construct that may blow up at one point or another.
For now I view last week’s action as a first warning shot, but not a sign that we are heading straight down.
Bottom line: I’m leaning toward a hefty bounce this week which I aim to sell, but want to ride higher. The risk/reward has now shifted back to the long side. My expectation is that the recent action will bring out some more sellers and makes any rallies suspect as supply is trapped higher. Frankly the ideal scenario for longs is to see a gap down on Monday which will likely cause a reconnect bounce with basic MA’s.
My base scenario is to buy any open weakness and sell at the first MA reconnects. Based on FOMC action we may see another retest of lows before moving higher. A repeat of December’s FOMC meeting is a distinct possibility and anyone short should keep this in mind, in fact I suspect many folks will cover into FOMC.
My basic strategy this week then: Buy the dips and sell the rips. Volatility is back!
Keep in mind also that the analog continues to be a structural guide, and that guide calls for a major rally into mid February.
$ES: we are seeing a move toward the recent trend line. I added here on Sunday night.
$SPX: The monthly 5 EMA target I mentioned in the previous weeks is now in striking distance. Remember we do not have to touch it precisely as the chart will catch up, but it is a downside target to be aware of. As it stands I expect a test of the 50MA and 5 EMA this week at some point, hence this is what I’m positioning for. With futures I can be more flexible in terms of timing.
$IWM weekly. This trend line will break soon enough, but it hasn’t yet.
$GS: Goldman was leading the decline this week, but then started showing relative strength on Friday. The market decline was too violent to let it bounce, but I got calls for this week and will be watching it as a potential signal for a bounce.
$VIX: Standard sell the $VIX on spike set-up. Looking to play puts on $VXX on extreme spike action.