Digital Tequila: When Markets Enter the Twilight Zone

By Joe Duarte on December 3, 2017

If this market goes to new highs after the action last week then we are truly in a brave new world. Buckle up.

We’ve all seen an episode of a favorite TV show, perhaps the Twilight Zone when an unsuspecting reveler is given a tainted drink and what follows is very uncomfortable to watch. Well, this past week may well be a prelude as to what can happen when a rigidly programmed trading algorithm is fed the proverbial tainted digital drink.

Investors got a hint as to what a drunken algo can do last week, as the market sold off violently influenced when what ABC news is calling a “serious error” in reporting hit the wires on Friday. The since retracted false report about events related to General Flynn’s legal adventures, courtesy of ABC’s now suspended-without-pay Chief Investigative Correspondent Brian Ross was interpreted by the robots as a factor which could lead to President Trump’s impeachment. And while this might have been an appropriate reaction if it had been true, it turns out it was false. Readers can find the details on their favorite news forum. The bottom line is the report was retracted, but the losses caused by the algo selling spree were not returned to investors. Sorry about your bad luck. For this reason, I believe, the proverbial red line has been crossed and the point of connection between information and market reaction is no longer reliable – lost in space.

Never mind the politics. From a market standpoint there is too much left to the imagination here, which is not a good background for making decisions about money. In other words investors who hear footsteps and look over their shoulders instead of the markets tend to make bad decisions. Ultimately, it seems as if we have entered a new era where the rubber band that connects reality to prices may be irreparably frayed or may have even snapped. And given the current political climate, Friday’s uncanny market action may be a prelude as to what the next market phase will look like – a volatile and uncertain daily grind fed by rumors, inaccurate reports, retractions and a Twilight Zone atmosphere.

Indexes Flinch but NYAD Stays on Course

Investors who solely focus on index charts often miss important factors in the market. And this week’s chart review may be an above average chapter in importance regarding what happens next.

Take the action in the most accurate market indicator of the past twelve months, the NYSE Advance Decline line (NYAD). Regardless of last week’s volatility, NYAD made yet another new high, suggesting the current rally isn’t over yet. It’s also important to note that RSI is close to reaching an overbought level and ROC is reaching levels which have in the past year preceded trend reversals to the down side.

The S & P 500 (SPX) is a bit harder to sort out than NYAD. For example, note the wide price swing on Friday and the negative close. This suggests the intraday reversal came from short covering, not new buyers. Combined with flat On Balance Volume (OBV) and a slightly toppy looking ROC indicator, it seems investors were not fully comfortable with moving money back into stocks. The fly in the ointment for the somewhat bearish case is the slight new high in the Accumulation Distribution line (ADI) which suggests that money is still moving into select stocks, although perhaps in lower volume. Indeed, the divergence between OBV and ADI is definitely worth watching.

The action in the Nasdaq 100 (NDX) is of more concern than that on SPX. Here is why: NDX is starting to make lower highs and lower lows in the presence of flat OBV and falling ROC. That ADI is positive here is more of a sign that the big four stocks at the top, AMZN and the rest are now gobbling up all the new money. This is now becoming a bearish situation.

Oil Sizzles while Bonds Mark Time

Last week I noted I was bearish on bonds and bullish on oil and I haven’t changed my mind. Certainly it’s more difficult to be bearish on bonds than in it is to be bullish on oil. After all, West Texas Intermediate (WTIC) remains within distance of yet another break to new highs while the U.S. Ten Year Note yield (TNX) is still flirting with delivering a sustainable weekly close above the 2.4% yield.

But here is where the bullish argument for crude up: WTIC is in a bullish flag pattern in a bullish seasonal period having closed above $58 with intermediate term support at $53-$56 and with OPEC “promising” to keep supply cuts in place. That last piece of news should keep the algos on the bullish side of the trade – if you can’t beat ‘em, join ‘em.

Strangely enough, I would argue that the bullish action in crude is likely a major factor in keeping the bond bear case from falling apart altogether. Here is what I mean. Oil is inflationary for the economy via higher fuel prices, especially in the winter. There is also a whiff of activity in the grain markets of late, which could turn into a price stampede. If both fuel and grain prices move higher with some conviction, it may be enough to take TNX above 2.45% convincingly. If that happens we could be on our way to 3% over the next few months. Throw in a few Fed rate hikes and voila, bear market in bonds.

The Stock Market Is Wounded but Who Cares?

Never mind what is true. How about what is believable? Markets trade on information, but as each day passes the line between plausible and whatever anyone can concoct is blurring beyond repair. Eventually when traders, human or otherwise, are no longer able to discern truth from fiction, the potential for mayhem is difficult to measure or predict. In this case the internal bleeding gets worse, and it spreads like a virus.

And while uncertainty may have always been a major influence in the markets in the past, the situation now seems worse given the near total domination of trading by headline reading, artificial intelligence driven algorithms with no ability or incentive to discern fact from fiction. In addition, aside from market volatility rising, many investors who don’t trust the information disseminated in the markets may decide to sit on the sidelines, creating a liquidity vacuum. If this is what happens, we can all expect more volatility and uncertainty.

Indeed, last Friday’s total wacko trading suggests that false headlines fed to algos produce the same effect as that one extra tequila shot that anyone who likes to drink may have regretted the morning after. What I’m saying is that Friday’s market is an indication of what happens when robots are fed a poisoned drink.

And while anyone with any trading experience may think that last week was a watershed event, what’s more important in the short term is whether any of this makes any difference to the algos. You fill in the blanks from here and don’t walk away from your trading screen as you ponder the situation.

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