Stocks undercut prior support near 1,810 and slipped under the 50dma for the first time since October. The market is testing the lower bound of the recent trading range after failing to break above it earlier in the week.
Markets are nervous following recent Asian and emerging market weakness and this anxiety is flaring up among short-term traders. Stocktwits’ SPY sentiment survey has seen bullishness drop from 80% in December to 39% today. Last week’s AAII sentiment survey showed bullishness dip under 40% for the first time since November. What was record high levels of bullishness just a few weeks ago has cooled off dramatically and is a healthy sign.
When analyzing sentiment, it is helpful to segregate market participants by timeframe. We have day-traders, swing-traders, position-traders, and buy-and-hold-forever. Stocktwits is comprised primarily of active day and swing traders. This group has clearly grown bearish recently, suggesting many liquidated longs and some have even gone short as sentiment on those boards plunged. We can largely ignore the buy-and-hold-forever crowd since many of these 401k types don’t follow the market daily and a 3% dip over two days is unlikely to send them running for cover. That leaves medium-term position traders. How are these traders positioned and what are they think will go a long way to telling us what will happen next.
Many of position traders are fully invested following 2013’s monster run. Last year they flinched anytime the market showed weakness, but every dip turned into a buying opportunity and anyone who sold kicked themselves for being so foolish and weak. After getting burned a couple of times, these position traders learned to hold any and all weakness. When confident/complacent owners hold the dips, they keep supply off the market, making it easier to bounce. With fewer people hitting the sell button, markets don’t selloff as much, and as we’ve seen in recent months, volatility decreases.
The headline roiling global markets is Asian and emerging market weakness. Most short-term traders have either been shaken out as the market dipped under their stop-losses, or they used the violation of support as a signal to go short. No doubt a lot of the selling over the last couple days has come from this highly active group of traders. The buy-and-hold-forever crowd isn’t selling, so we can ignore them. The million dollar question is if weakness in emerging markets is enough to shake the confidence and resolve of position traders. These guys held through Shutdown, Debt Ceiling, and Taper as we bounced off those lows. If those significant headline issues that hit close to home didn’t make them flinch, why would a manufacturing index data point on the other side of the world all of a sudden turn them into scared sellers? That’s a good question.
Expected Outcome: Bullish – at lower end of trading range
Stocks dipped under support and the 50dma in early trade, triggering many stop-losses in the area and tempting bears to short the weakness. At this point either the selling accelerates as the weakness shatters the confidence and resolve of a wider pool of owners, or supply dries up as we run out of sellers and the market bounces like it has so many times before.
Who’s the sucker here, nervous sellers or excited dip buyers? Asian markets have been selling off since December, so why it became big news yesterday is curious. Most likely this was just an excuse for the nervous to sell and the cooling sentiment is a healthy part of moving forward. Dips wouldn’t refresh the market if they didn’t convince everyone this time it is real.
Nothing shatters confidence like a screen filled with red. It doesn’t matter why the crowd is selling, just seeing other people sell makes us nervous. This dates back to our days in the wild. When everyone else started running, those that waited around to see what all the fuss was about quickly became lion food. It doesn’t matter if these headlines are legitimate or not, price is truth and emotional selling often leads to more emotional selling.
If the recent trading range holds and selling doesn’t accelerate, this is clearly a buying opportunity. Continued carnage in the emerging markets is a real risk, but the best profit opportunities always feel risky. The conservative trade is to wait another day or two for this trade to play out. A trader with a higher risk tolerance can try picking a bottom if the selloff stalls this afternoon.
Plan your trade; trade your plan
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.