Thin ice

Markets moved lower in early trade, continuing recent weakness.  The question remains how much longer can this continue?

One thing to remember is the current price is a balance between bulls and bears.  Moves occur when a slight imbalance occurs between bulls and bears due to new information or changes in sentiment.  The result is prices adjust to relocate that precise point where exactly half the money is on each side of a trade.  So while you have an opinion one way or the other, 50% of the market has the opposite view and this disagreement is what makes markets work.  The challenge for a successful trader is figuring out which side to pick.

The interesting thing to ponder is if this sell-off has become too obvious as we clearly broke support?  Most often profits go to those who get on a trade early and those showing up late are stuck with the bill.  Keeping this in mind, can we continue assuming the upward bias and overbought condition remains in the face of these horrible technicals?

Using an analogy, it seems the market is on thin-ice.  Apprehension has been building as prices decline and renewed fear of headlines is haunting traders.  But the thing about thin-ice is you only get in trouble if it breaks.  The market could easily skate past this thin patch unscathed and come out the other side ready to rally.  If this is the case, we might see the market begin bottoming soon.  But the danger with thin-ice is we are one bad headline away from a plunge where everyone panics at the same time.

Last summer we found ourselves in a similar position with lots of storm clouds on the horizon leaving investors fidgety.  Then the one headline hit that sent everyone running, S&P downgrading US debt.  The downgrade was telegraphed for months and the actual result of the downgrade turned out trivial as the Treasury market rallied in the face of the downgrade.  But once the selling started in the equity market, it quickly spiraled into a two-week free-fall as the S&P500 lost 17%.  The market was in the mood to sell-off and it found its excuse.  Could this market be setting up for the same thing right now?

The silver-lining to our current sell-off is it has been fairly orderly and so nothing like the fall-off-the-cliff we experienced last summer.  Further, traders who saw the world did not come to an end due to Euro contagion last fall will feel a sense of been-there-done-that and won’t be as panicky this time around.

All of this is a long way of saying, I think we are one bad headline away from a material sell-off, but baring that, the market could find support soon.  But if the latter case plays out, the rebound won’t signal an all-clear as any rally still has significant technical and sentiment resistance to breakthrough before moving to new highs.

As for how to trade this, the short is a bit long in the tooth as it has become fairly obvious and the market doesn’t like being obvious.  Anyone putting on new short now is a late to the party unless their game plan is entirely based on a waiting for that backbreaking trigger to send the market tumbling.  But when comparing the risk/reward, the short continues to be the more attractive trade because on the long side you are currently risking ~$3 of downside to make ~$1 of upside.   With that skew, the best play continues to be waiting.