Markets had their biggest down-day in several months, but don’t jump on the correction bandwagon just yet as the market hates being obvious and will most likely chew up both bull and bears with head-fakes before revealing its true intentions.
The markets opened higher, but started selling off in late morning trade and the slide accelerated under 1445 by late afternoon, violating previous support at 1450.
Does this mark the end of the run? Most likely not. Climax tops reverse quickly, so the 10-days of sideways trade at 1460 largely preclude this outcome. Even if the market is toppy at these levels, many reversals take the shape of a double-top or a head-and-shoulders, meaning we could easily make new highs in the near-term even if the ultimate resolution is lower. (Although we could be completing the head portion of a reversal if August is the left shoulder)
Selling or shorting today’s weakness is the obvious trade and often the obvious trade is the wrong trade. But today’s 1% decline is noteworthy because it is the largest decline in at least three months. This return of volatility could be the early signs of turmoil in the markets, which often precedes a reversal in direction.
As seen in the accompanying chart, the market continues to trade comfortably inside the previous uptrend channel established this summer. We broke above it briefly with recent Bernanke pop, but have clearly retreated back within the range. It is too early to write the rally’s obituary, but the warning signs are mounting.
It sure feels like the market is trying to selloff, but each time big money comes in and props it up. The million-dollar question now becomes, what is ‘smart’ money doing? Is it accumulating shares at each dip? Or is it quietly selling to the ‘dumb’ money chasing these new highs? People think price and volume magically give clues on this, but the truth is the market is always perfectly symmetrical because for every seller you need a willing buyer.
What ultimately determines the direction of the market is the depth of available buyers and sellers at a particular level. Will we run out of buyers at this level first, or sellers? Up to this point, the supply of sellers has run short and is why prices have been bid up to four-year highs. But this is a big move since the June lows and the higher we go, the harder it becomes to find new buyers.
I still sense there is slightly more skepticism than optimism in the markets, and as we all know, people trade their portfolio according to their opinions. The skeptics are light the market and the optimists are heavy the market. While this balance was far more skewed a few weeks ago and lead to the explosive upside we’ve seen, the scales have become more balanced recently and this is why the bears are finally able to exert more downward pressure on the markets today.
Lacking a strong sentiment skew, the market could break either way, but more often the market tends to overdo a trend before reversing and so far it doesn’t seem like this rally has been overdone from a sentiment point of view. But the probabilities are becoming more balanced and there is less of an edge to being long than there was a few weeks ago.
An interesting idea came from a WSJ article on Monday quoting several money managers who are allegedly thinking of closing their books at these levels and coasting through the 4th quarter. But here is the thing, big money managers are notoriously secretive in positioning of their portfolio because they don’t want anyone to front-run their trades, so why would these guys start gushing to a reporter about what they are about to trade? It doesn’t make any sense unless 1) they have already sold and closed their books for the year or 2) they are intentionally trying to spook the market so they can buy in at lower levels. Either way, this sentiment by several money managers shows greed has not overtaken the market and big money remains cautious and reluctant up here. No doubt the market could fall under its own weight if buyers fail to show up, but the fair number of skeptics remaining provides ample fuel for a continued move higher if a rising market forces them to start chasing.
The direction is a tough call here because of the recent run up, but I suspect there is more upside left in this move even if that includes a modest pullback to flush out all the weak holders who bought at the tail lend of the recent run-up. Remember, the market is never easy, so buying after the obvious rally was a mistake and most likely so is shorting the obvious start of the correction. I have little doubt the market will chew up both bears and bulls before this is all said and done, so wait a bit before jumping in on either side, unless of course your portfolio enjoys the feel of the market’s meat grinder.
As I’ve been saying every day for the last couple weeks, keep doing what is working, but don’t get greedy and be prepared to take your worthwhile profits off the table. It is far more profitable to sell into strength and buy weakness than the other way around. Sell when you don’t want to sell and buy when you don’t want to buy. That is the fundamental core of the contrarian trading.
Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.