Strong rebound

S&P500 daily @ 2:05 EDT

The stock market is popping today after yesterday’s strong bounce from under the 50dma.  It would be highly encouraging for the markets if this bounce stuck because it continues a pattern of higher lows and higher highs.  The markets were helped this morning when the Euro gained almost one cent against the USD in early trade, a huge move in the currency world. The Euro has been selling-off for days and a relief day was inevitable.

But to be honest with you, the market is confusing me right now.  It feels like sentiment and pricing has disconnected.  Everyone is widely negative on the markets, but prices only fell 3.6% from the peak to the trough.  That doesn’t represent much selling at all.  How can we see such a dramatic swing in sentiment with nothing more than a 3.6% change in price to show for it?  There are few possible scenarios in a case like this.

First one, a lot of calm and collected value investors buying shares from the weak holders rushing for the exits.  These longer viewed investors see something the panicked crowd doesn’t and is willing to step in because they expect the market will head higher from here. With confident institutional money standing behind the market and propping it up, this is very bullish.

The second case is where investors are scared, but are still holding their long positions out of hope and desperation they’ll come back. This is driven by an emotional reluctance to admit defeat and give up on the chance of a getting their money back.  This is where the market becomes disconnected from reality and starts trading on hope, not fundamentals.  Most investors acknowledge the dark clouds circling the markets and this is why they are scared; China slowing, band-aids in Europe, stalling US employment, fiscal cliff, lowered earnings guidance, etc.  But the previous 6-day decline didn’t happen in a more traditional waterfall action that relentlessly punishes indecisive people until they are forced out.  It declined in steps, encouraging indecisive people to continue holding.

Typically people get flushed out when the market keeps moving against them and the losses continue to mount.  But the previous 6-day sell-off happened in steps where indecisive people were not punished for holding after the initial decline.  In some cases the indecisive traders were even rewarded as the prices rebounded from their early daily trading lows.

Given the step style decline and the modest size of the sell-off, I think a lot of weak holders are propping up this market through their emotional reluctance to admit defeat and sell.  What makes me most nervous about this prospect is the market becomes disconnected like this before a major collapse.  In August and September 2008, the market was disconnected from the fundamental headlines about banks’ financial stability.  In July 2011, the markets were indifferent to Europe’s debt crisis. We all know how those situations played out.

Now don’t get me wrong, I’m not predicting an imminent collapse, no one can see something like that.  But I am pointing out odd behavior that just isn’t jiving with me and it has potential ominous implications.  Let’s not jump to conclusions; the market gets disconnected all the time without crashing, so this could be no big deal.  It’s like skating on thin ice; you’ll be fine as long as you don’t break through.  In most instances you might not even know your life was at risk and everything goes on like nothing happened.  But unfortunately ignorance doesn’t change the risk profile.  The thing to keep in mind is while not all disconnects in the market lead to crashes, all crashes are the result of a major disconnect between pricing, sentiment, and fundamentals.  The crash occurs when the market can no longer hide from the disconnect and the gap closes in a very short period of time.  This almost always happens to the downside and is usually triggered by a piece of bad news that sets the whole thing off.

With disconnects, crashes are the most extreme resolution and only happen every few years.  Most disconnects are closed more gradually and market participants don’t even realize it happened.  That is most likely what will happen here, but it is worthwhile to at least acknowledge the risk for a big move down is here.  As it stands, I think we are one bad news story away from a 10-15% slide.  Given the limited upside from here, that doesn’t make for a favorable risk/reward on a long trade.

And of course the third possibility regarding the market is many of the normal traders are on vacation and less experienced traders are moving the markets in unexpected ways.

For me, the main takeaway from the above is the markets are acting odd and the most prudent course of action when this is happening is to just sit it out.  If I miss a nice rally, so bit it, I’d much rather miss the bus than get hit by it.  There are old traders, there are bold traders, but there are no old, bold traders.

Stay safe