Analysis, Perspective, Trading Strategy
The Stock Market May Be Broken
By Joe Duarte on December 16, 2018
market may already be broken, given the nearly complete collapse of the
market’s breadth on December 14. Consequently, with the Federal Reserve
likely to increase interest rates on December 19, 2018, the stage is set for
an even more explosive move in the markets.
Quantum physicists describe a three tiered system of laws that govern
the universe based on Chaos Theory where the normal state of affairs
is a state of non linear order described as being predictably unpredictable.
When things fall out of this normal state of Chaos, they transition,
often violently, into Disorder, which triggers a mechanism known as
Complexity. It is Complexity that eventually returns situations into
Chaos, although the new state of non linearity that follows a state
of Complexity may or may not resemble past periods of Chaos. More specifically,
at the point when Chaos falls into Disorder, it is said that events
fall off of the “edge” of Chaos.
When we apply this tri-compartmental organizational model to the
current market, the only conclusion that seems plausible currently
is that the stock market and perhaps the global economic order has
now fallen, or is on the cusp of falling off the proverbial “edge”
and we are entering into Disorder.
Market Breadth Collapses
From a charting point of view, I think of Bollinger Bands as the
edges of Chaos and any price action above the upper band or below the
lower band as breaches of the “normal” non linear order of the markets.
When we apply this mode of observation to the action in the New York
Stock Exchange advance decline line (NYAD) it’s clear that something
very important has happened.
Specifically, NYAD, which has been the most accurate indicator of
the trend for the stock market since the 2016 presidential election,
fell precipitously below its lower Bollinger Band on December 14. That
means that Chaos is no longer operational and that the stock market’s
trend has entered the realm of Disorder, even if only temporarily.
So while Chaos is predictably unpredictable, Disorder is a state lacking
any semblance of normalcy. Therefore this breaking outside of the lower
Bollinger Band suggests that we are in a state of unknown risk and
that anything is now possible, no matter how ridiculous it may sound.
Thus no one knows whether stocks could now crash and burn for a nonspecific
period of time or whether they could snap back with a vengeance at
some point in the future, perhaps Monday and destroy the bears who
now are gloating about their apparent victory.
Normally, a severe breach below the lower Bollinger Band eventually
leads to a move back inside the line. But even if that were to happen,
there is no way to know whether that event will last or whether it
will be the final price reversal that will lead to a new leg in a bull
market. For one thing, this is the first time since 2016 that NYAD
has breached the lower Bollinger Band with such violence.
This breach is especially pertinent because the 50-day moving average
for NYAD has now broken below the 200-day moving average after three
failures of the line to break out above its recent trading range. Altogether,
this paints a very negative picture which suggests that the real selling
is more likely to start rather than to end.
The S & P 500 (SPX) is providing a bit more color than the NYAD.
Whereas NYAD just breached its lower Bollinger Band, SPX made a new
low but stayed inside its Bollinger Bands. This suggests that prices
are more likely to head lower than to rebound. This is confirmed by
the negative action in Accumulation Distribution (ADI) and On Balance
Volume (OBV) which points to sellers overwhelming buyers at the moment.
Furthermore, ROC is nowhere near oversold after just breaching its
zero line, another sign that this is now an increasingly weak stock
market which has more room to fall.
Interestingly, the Nasdaq 100 index (NDX) gets
the benefit of the doubt. For one thing it did not make a new low along
with SPX, while sporting a more constructive OBV and ADI picture. This
is not to say that things can’t change here or that the tech sector
is out of the woods, but it is worth noting.
Last week’s oil market action was also notable given the fact that
the price of West Texas Intermediate (WTIC) ran into a resistance wall
at its 20-day moving average but managed to remain above its recent
low near $50. Furthermore, the selling came on much lower volume than
this commodity has seen of late. As a result, as long as WTIC remains
above $48-$49, the odds favor no new lows for the cycle.
The Stock Market May be Broken but Patience will eventually
The combination of the actions of the Federal Reserve, the politics
in Washington, Paris, the UK, and just about everywhere else in the
world may have reached the boiling point. Indeed, at this point there
are too many variables, all spinning out of control, which can generate
news headlines. Headlines trigger robot algorithm trades which lead
to increasing volatility. And volatility makes for messy markets which
could be worsened if there is a sudden evaporation of liquidity as
traders keep their wallets in their pockets.
The bottom line is that the stock market is currently a very dangerous
place. Thus, the most viable strategy is to hold high levels of cash,
considering shorting the indexes via inverse ETFs, using options to
limit exposure risk and slowly building positions in crude oil and
other commodities which are showing signs of having bottomed out. Crude
oil is somewhat attractive as long as it stays above $48-$49 per barrel
on West Texas Intermediate, unless the economic data continues to deteriorate
and the market starts to factor in a major decrease in demand.
Thinking over the longer term, this too shall pass. Thus as we wait
it makes sense to build a trading list for when things get back to
a more predictably unpredictably and nicely Chaotic state of affairs.
Joe Duarte has been an active trader and widely recognized stock
market analyst since 1987. He is author of Trading
Options for Dummies, rated a TOP
Options Book for 2018 by Benzinga.com - now in its third edition, The
Everything Investing in your 20s and 30s and six other trading
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