The Big Move Came. What Happens Next?

By Jani Ziedins | Weekly Analysis

Sep 10

screen-shot-2016-09-10-at-2-35-40-pmMy August 30th free blog post was titled “The Next Big Move is Coming“. By almost all standards Friday’s 2.5% freefall qualifies as that move. We’ve been lulled into complacency by this summer’s tight, sideways trade, but we knew it couldn’t last forever.

Friday’s volume was the highest we’ve seen since the Brexit, but certainly not over heated considering the size of the accompanying price move. The selloff crashed through all kinds of technical levels and triggered most automatic stop-losses, but the relatively constrained volume suggests we didn’t set off a frenzy of reactive and emotional selling. That can be good or bad depending on how you look at it. It is nice to see most owners remain calm during a painfully ugly period. That bodes well for a rebound if these owners keep their composure next week since confident owners keep supply tight. But the opposite argument is Friday’s turnover didn’t look capitulatory. That could lead to further losses if emotions and fears flare up next week.

A major theme in my August 30th blog post was the risks associated with holding a sideways market. Every day we own stocks we expose ourselves to the unknown. When we buy right, the market moves in our direction and we get paid for holding that risk. But in a sideways market, we don’t get compensated for holding risk. All risk and no reward is a lousy trade. Long-term investors can sit through these flat stretches and subsequent gyrations, but shorter viewed traders should avoid owning flat markets. Quoting William O’Neil, “all stocks are bad unless they are going up”. While it is helpful to critique the past, what everyone really wants to know is what comes next.

The widely circulated explanation for Friday’s selloff was disappointment over no additional stimulus from Europe and the prospects of a near-term rate-hike by the U.S. Fed. Allegedly this “news” turned traders into sellers on Friday. The question for us is if this was a one-day tantrum, or the start of something far more significant.

The key is figuring out the real reason people were selling on Friday. Anyone who honored their stop-loss levels was flushed out automatically as the market smashed through every technical level established over the last few months. While this technically driven selling added fuel to the fire, there are not many technical levels left to violate. That means most of the autopilot selling is behind us, allowing us to focus on the trading decisions made by humans.

Humans sell for rational reasons and they sell for emotional reasons. Let us start by examining the rational hypothesis. The Fed is going to raise interest rates at some point in the near future, the only real debate is if that 0.25% hike comes in a few days, or a few months. You have to be living under a rock if you don’t know it is coming because the media has been obsessing over it for years. We survived the first rate-hike last December and even traded higher following it. Were traders really selling on Friday because they are afraid of a 0.25% rate hike? Let me ask you, are you afraid of a 0.25% rate hike? Or is something else driving people to sell?

I believe very few stock owners are personally afraid of this rate-hike. This is old news and 0.25% isn’t that meaningful. Certainly not enough to derail our improving economy. And if someone really is terrified of rate hikes, they would have cashed-in months, if not years ago when we first started debating this. People who are afraid of rate-hikes don’t own stocks in this environment plain and simple. If they don’t own stocks, they are not selling stocks. (most investors don’t short stocks)

If traders are not selling because of the rate hike, why are they selling? It comes down to Game Theory. People are not selling because they are afraid of a rate-hike personally, they are selling because they think other people are afraid of a rate-hike. The financial press has conditioned us to believe stocks are going up because of easy money and prices will fall once the spigot is turned off. Say something enough times and people believe it.

We make money in the stock market, not by predicting the future, but predicting what other traders will do. Even though we might not fear something personally, if we think the crowd will get spooked by a headline, we will sell ahead of the anticipated decline. That is what really happened Friday. Traders are not selling the economic damage of a rate-hike (real), they are selling ahead of what they think will cause a selloff (imagined).

What does it mean if most traders are only selling because they think other people will sell? It means there is no meat to this selloff. If no one is changing their personal outlook about the economy, then they will continue to have the same appetite for stocks. While they might cash in some chips ahead of the widely expected “rate-hike crash”, they will jump back in once the waves settle down.

Value investors are not afraid of a trivial bump in interest rates and will start buying the dip once prices get so attractive they cannot resist. This pullback also gives underweight money managers the opportunity to salvage their year by buying stocks at prices they wish they had bought earlier in the year. When there is no real fear in the market, traders jump back in quickly and is why this rate-hike weakness will be short-lived. No doubt emotion and fear could flare up Monday as traders sell “before things get worse”, there is very little substance behind this move and we should be looking to buy it, not sell it. There is no reason to rush in and catch a falling knife, but once prices stabilize, don’t dally and miss these bargains because they won’t last long.

Are you personally afraid of interest rate hikes? Or are you going to take advantage of these discounts? Let me know in the comments below.

Jani

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About the Author

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.

Noah September 10, 2016

Do you think Monday will crash further as bad or worse then the August 2015 crash
Thank you

    Jani Ziedins September 10, 2016

    This will be far less than August 2015 because everyone who sold stocks in that dip looked foolish when the market rebounded weeks later. They won’t make the same mistake again.

      Noah September 10, 2016

      Thank you, greatly appreciate your insights during this turbulent time in the markets

      Jim A September 10, 2016

      I’ve got to agree with this line of thinking. The basic economic news is not bad, this will pass quickly.

Daniel September 10, 2016

Where is a safe place to re enter the market…thx

    Jani Ziedins September 11, 2016

    Risk is a function of height. Even though it doesn’t feel that way, this is the safest place to own stocks in the last few months because we are that much closer to the bottom of this pullback. When the market will finally bottom is anyone’s guess, but I think we are close.

Ron September 10, 2016

Hi,

I agree with your analysis. It’s one of the best explanations that I’ve come across for yesterday.

What concerns me is that the decline accelerated in the last 30 minutes and the Sept. S&P futures continued to drop to around 2120 after the regular market close. The S& P futures were around 2140 at 2 p.m. The indexes fell through numerous technical levels without pausing.

What explains the late-day drop? A lack of liquidity? Stop losses being triggered? Panic selling that could continue into next week?

Like Noah, I’m worried about a repeat of last August. In August, there were huge drops on Thursday and Friday which led to a 1,000+ point drop in the Dow on Sunday night/Monday morning and then massive swings in the market for the next several weeks. The sell-off in August has been explained in part as program selling by price insensitive strategies such as risk parity.

I’m trying to get a sense of how long this could continue. Can you give me your guess on the level that the S&P futures could trade at on Sunday night?

Thanks.

    Jani Ziedins September 11, 2016

    Everything you mentioned is why we went into freefall at the close. People got scared and didn’t want to hold over the weekend. Early Monday futures will also be ugly as Asia and Europe react to Friday’s selloff, but I think the selling will be relatively contained once our markets open. We could open lower as all the over the weekend orders to sell get filled, but I think the fearful selling won’t last because there is not a lot of substance to the fundamental drivers behind this weakness. We did this same thing last August and after the fact most traders realized their impulsive selling was a mistake when the market rebounded weeks later. Having learned those lessons, this time it won’t take nearly as long for the market to right itself.

Martin September 10, 2016

I agree with you that this was an overreaction mainly caused by stop losses. Disagree on the necessity of raising rates. I do not consider this economy as good. It is actually slowing down and Yellen is going to raise rates into slowing economy. They should have been raising rates in 2012 – 2014 period. I think today is too late. It looks rosy because the market is propelled by cheap money and no alternative investment opportunity. Where else can you invest money these days? Even bonds are worth nothing today, so the whole world is investing into the US market as they consider it safe. But that’s only an illusion.

    Jani Ziedins September 11, 2016

    The economy is still growing, but an argument can be made the rate of growth is slowing (second derivative). We will soon see if the recent dip in growth rates was just a statistical blip, or early signs of a bigger deceleration that results in a contraction. Hiring has been robust, meaning managers on the front lines believe the future will be better than it is today, but I suspect we will see a shallow recession at some point over the next 36-months. I don’t think this is the start, but it is coming. The positive is the eventual contraction will be as mediocre as the growth that preceded it. Since the economy hasn’t gotten very hot, it won’t fall very far. But the economy and stock market are far different things and we would see a more severe reaction in stock prices as people freak out and dump their stocks at steep discounts.

Oliver September 11, 2016

Second guessing what others will do is what I have always felt the market was about. I should really have done a degree in psychology, not law. I agree Monday and possibly Tuesday will probably continue down…then you usually get a few days when you can almost hear the market soothing itself. In a week it should be business as usual….and those technicals: yes they are important but only because others THINK they are important and only in normal times. In unusual times like last Friday they get thrown out of the window. Thoroughly enjoy your lateral thinking, Jani.

Oliver.

    Jani Ziedins September 11, 2016

    I’m equally fascinated by practical psychology and is why I have always been drawn to marketing and the stock market. I’ll let the shrinks deal with the crazy people.

    Technicals certainly affect the market because people use them as trading signals like you mentioned (moving averages and trendlines), but there is also substance to them too (support and resistance levels). For example breaking support early Friday triggered a wave of selling because anyone who bought the S&P500 this summer now had a losing position. People don’t need charts to know when their positions turn negative and have that affect their confidence and convictions.

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