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Analysis, Perspective, Trading Strategy
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Gut Check Time for the Federal Reserve and the Markets.

Editor Joe Duarte in the Money Options

Newly sworn in Federal Reserve Chairman Jerome Powell is in the midst of his Baptism of Fire. With stock prices gyrating wildly, robot traders running amok, the public increasingly fidgety, and the potential for a major contagion of the stock market’s volatility malady threatening to extend to other markets, Mr. Powell’s mettle is being tested right out of the gate. Indeed, the tone of his stewardship of the Fed may depend on what he says and does over the next ten trading days.

Ripe for a Bounce

The market may have given Mr. Powell a gift on Friday afternoon, February 9, as stocks reversed yet another intraday crash ending the day significantly higher as measured by the major indexes. Arguably, but in no way certainly at this point, history may show that Friday’s turnaround was the bottom for the cycle.

As I noted last week, the New York Stock Exchange Advance Decline line – the most accurate indicator of the general trend of the stock market since 2015 – was oversold. Guess what? It is now even more oversold, which of course raises the possibility of some type of bounce in stocks over the short term. We may have seen the start of that bounce on Friday, but it’s still early in the process.

A review of the NYAD all the way back to April 2014 reveals several important facts. First, the long term trend of the bull market remains intact as the NYAD is still above its 200 day moving average. Second, NYAD is historically oversold now based on RSI and the MACD histogram. Third, and perhaps the more important fly in the ointment, momentum to the down side, as measured by the ROC could still go lower. Note the October 2016 low on ROC, right before the election was near (-) 7.0 percent. We are currently at a reading of (-)3.29 percent. Still, it’s important to note that all the major bottoms in 2017 did not reach the very extreme reading seen in October 2016 in the presence of oversold readings in RSI and the MACD histogram. So, it is possible that the current ROC reading may be good enough.

S & P 500 Is Oversold Enough for Significant Reversal

The NYAD may be close to a reversal but the S & P 500 (SPX) is already at a point where a reversal of some sort is more likely than not. Consider the following. SPX bounced just below the 200-day moving average, a classic long term support level, and one which the robot algorithms were not likely to ignore. Next, RSI, ROC, and MACD histogram levels for SPX are all at levels which have launched major reversals to the up side in stock prices since April of 2014.

Furthermore, SPX, despite the intraday reversal of February 9, remained below the lower Bollinger Band. The longer this remains in place, the more likely is a reversal to the mean, in this case, a reversal to the 20-day moving average. Accordingly the market is now set up for three possible scenarios: a V bottom, a W bottom, or a total failure of recent support which would lead to further losses and perhaps a real bear market.

A V bottom would mean that the February 9 bottom was “THE” bottom and the market will be off to the races in the near future. In the case of a W bottom the February 9 bottom will hold and become the momentum bottom - after which there will be a failed rally. In this scenario, sellers will return and prices will head to the recent lows or just below the most recent price lows. This would be the panic bottom.

Panic bottoms are usually very dramatic selling climaxes which usually feature lower volume than the momentum bottoms. After the panic bottom, which is a washout event usually heralded by headlines suggesting that the end is here, there is usually a very meaningful rally followed by a consolidation period.

The Take Home Message

The stock market is now oversold enough to stage a reversal to the up side, although there are no guarantees that such a reversal will occur or last for any extended period of time. The first upside target is the 20-day moving average near 2775. And here is the more important technical factor; if the S & P 500 falls or closes below 2500 without a meaningful reversal, stock prices will likely fall for what could be a painful period of time.

Putting it all together, the market is ripe for an upside reversal based on the current posture of reliable technical indicators. But because the Federal Reserve has been the market’s backstop for the past ten years, much of what happens now depends on what the Federal Reserve may say or do in the next few days and how the robot algorithms react. If the robots and the market interpret the Fed’s actions or lack thereof negatively, we are likely to see significantly lower stock prices in a hurry.

Joe Duarte is author of Trading Options for Dummies, now in its third edition. He writes about options and stocks at www.joeduarteinthemoneyoptions.com.


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