-- This Week In The Money --

Analysis, Perspective, Trading Strategy

The Stock Market May Be Broken

By Joe Duarte on December 16, 2018

The stock 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 pay off

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 books.

To receive Joe’s exclusive stock, option, and ETF recommendations, in your mailbox every week visit https://joeduarteinthemoneyoptions.com/secure/order_email.asp.



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