The holiday lead to a tight, low-volume day, but given what happened last week we can count that as a victory. There is not a lot of hope left in the markets and many of the weak hands have been chased out as we crashed through key technical levels. The abundance of pessimism is making an optimist out of me.
The market is finding its footing, at least temporarily. We closed 1377 on Thursday, 1379 on Friday, and 1380 on Monday. Monday’s trade fell within a tight range, seven points between the high and low, on exceedingly light volume, no doubt due to Veteran’s Day. It is encouraging to see we made it through the weekend without compounding last week’s crisis of confidence.
We continue trading under the 200dma. All the stop-losses set under 1400 and the 200dma have already been triggered and that selling event has come and gone. From here it is harder to identify an obvious stop-loss underneath the market. This is good because it is far less likely the market will stumble through another large concentration of stop-loss orders, triggering a new avalanche of selling.
Between all the selling that has already occurred and the lack of a critical technical level underneath us, the bears are going to have to work a lot harder to extend this move lower.
It is challenging to find a positive news story in the financial press. Fiscal Cliff this, Euro Debt Crisis that….. The press is even reading body language and facial expressions of our politicians trying to figure out what is going on behind the scenes. The question for us is how do we trade this?
The first thing to recognize is we don’t trade news. News is largely random and unpredictable. In addition, the modern internet era made it next to impossible for the average trader to get ahead of the crowd before headlines become priced in.
But if we can’t trade the news, what do we trade? We trade other people’s expectations of the news. This is a small but crucial nuance. People, not events, create emotion-driven, asymmetrical trades and high-probability profit opportunities. For example, if everyone fears a Fiscal Cliff, then we assume these traders have already priced it in. Common sense tells you anyone expecting an imminent market crash would sell ahead of it and quite possibly short the market. Using that logic, we can infer anyone talking about the perils of the Fiscal Cliff has already reduced their exposure. Based on the chatter in the press and investor groups, the Fiscal Cliff risk is already largely priced in and much of the selling expecting this event has already occurred.
No doubt we could see more selling if conditions deteriorate, but what happens if the Fiscal Cliff is not as bad as everyone fears? This is where the asymmetrical trade kicks in. The market fears the unknown and often prices in a larger risk premium than the event deserves, meaning much of the downside has already been accounted for. If things did in fact get ugly, there isn’t a lot of downside remaining. But if on the other side, if things go as expected, the market will rally because the uncertainty, fear, and risk of the worst is removed. And if things go better than expected, the market will surge ahead.
This is what creates the asymmetrical trade. The market will selloff more if things go worse than expected. The market will rally if things go as expected. And the market will pop if things go better than expected. In one case the market moves down, in two cases the market goes up. And not only are the discrete outcomes in our favor by a factor of two to one, so are the probabilities and magnitudes of those outcomes. The expected and most likely resolution will lead to a rally because it removes risk and uncertainty. Only the low probability, worse than expected, will lead to further price declines. And even if we do see prices decline, a large portion of the selling has happened ahead of time, meaning there is less downside remaining.
In the markets there are no guarantees, but there are probabilities.
By no means is it completely safe to own stocks down here at 1380, this is the stock market after all, but without a doubt buying stocks today is far safer than it has been at any point over the last four months. In fact, the riskiest time to own stocks was back in September when we were trading over 1450. That is the paradox of the markets; it is safest when it feels the most dangerous, and it is most dangerous when it feels the safest.
We will know in a few days if the selloff continues or bounces. The market has already made two legs down and that is usually enough to refresh a bull market. If we are moving into a bear market, there are often three legs down, meaning we could see another bout of selling before the market temporarily bounces.
We have a chance for a strong rebound that takes out the shorts, or one more leg lower. Those are not horrible odds for owning stocks at these levels. My guess is pessimism has climaxed and we’ll head higher. As mentioned earlier, news is largely random and without a doubt we could have a headline take our legs out, but if things stay the same or improve modestly we should see the markets bounce back.
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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.