-- Trading at the Edge of Chaos --

Analysis, Perspective, Trading Strategy

At the Edge of Chaos: The Panic Bottom is in. But Anything that Disturbs the Stock Market Will Derail the Economy.

By Joe Duarte Editor Joe Duarte in the Money Options

December 26, 2021

Don’t make big bets just yet.

The stock market is treading on thin ice.  Fear is running rampant, but several key support levels held last week. That suggests, that as painful as trading was, we may be making a panic bottom in stocks.

And if that’s the case, then Santa Claus is loading the sled and the traditional year end rally could start at any moment.

On the other hand, if these key support levels fail to hold, the selling will pick up speed and the decline into what could be a major bear market will likely be swift.

Liquidity Holds the Key as Fed Accelerates Taper Pace

Wow!  The Fed is going to reduce its bond purchases – both treasuries and mortgage backed securities (MBS) – by $30 billion per month and is scheduled to stop its tapering in the spring.  Even more interesting, the central banks is penciling in three rate hikes in 2022.

Now, remember that the stock market is fueled by liquidity and that tapering drains liquidity. In addition given the current pay as you go, cash flow, just in time world we live in, when liquidity dries up, markets crash.

But here is where it gets a bit scary. Purchasing manager data from IHS Markit suggests that the economy is already slowing in the face of rising inflation. In addition, small business surveys are pointing to a potential weakening in the economy.

So, the Fed may be tapering into an already slowing economy.

It’s the Market, not the Economy that Leads the System

Be that as it may, based on the central tenet of my MELA model where: M is for markets, E is for the economy, L is for people’s life and financial decisions, and A is for the role of artificial intelligence in the whole thing – the stock market runs the economy, not as traditional economists seem to think.

Here is a quick review:

  • It’s hard to make a living from working, so depending on trading and retirement plans such as 401 (k)’s and IRAs for financial support and spending money is widespread.
  • When trading and retirement plans are doing well, because stocks are rising, people feel wealthy.
  • People that feel wealthy spend money and the economy prospers.
  • Algos speed up information and transactions so people make decisions faster and the economy grows faster.

But, as we saw in March 2020 when the COVID pandemic hit, the markets fell apart and the economy followed.  And it happened in record time because the algos sped up the process.

Welcome to the Edge of Chaos:

The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder.” – Complexity Labs

For more on how to develop a trading plan and how to approach this dip check out my latest Your Daily Five video here.

American Tower: A Five Percenter in an Uncertain Zero PercentDecember 19, 2021

The panic bottom I’ve been expecting seems to have been put in place.  Unfortunately, with all the crosscurrents that are in play, the longer term for stocks, as a whole, remains uncertain. That said, with the market in its current state, playing the long side with care is still the best strategy.

Watch these Big Four Macros

As we head into the last week of 2021, the odds of something extraordinary happening, such as a major market crash, are not impossible, but they remain low. 

Looking ahead to 2022, however, these are the four big market moving issues to watch:

  • Dueling central banks: China is easing while the Fed is hellbent on tapering and maybe actually raising rates
  • The MELA system (Markets, Economy, Life Decisions and Algos) are beating to their own drum, albeit influenced by central banks
  • The virus thing: whatever that will mean next
  • The stock market may still be in technical divergence mode

Specifically, the stock market is the focal point, as it is the centerpiece of the MELA system.

And here is why:

  • Trading and the state of retirement plans such as 401 (k)’s and IRAs for financial support is widespread
  • When trading and retirement plans are doing well, because stocks are rising, people feel wealthy.
  • People that feel wealthy spend money and the economy prospers as long as the stock market is doing well
  • Algos speed up information and transactions so people make decisions faster and the economy grows faster.

What’s the bottom line? If it’s bad for stocks, it’s going to be bad for just about everything.

Welcome to the Edge of Chaos:

Panic Bottom is in Place

The panic bottom that I forecast over the last couple of weeks was put in place last week. 

The New York Stock Exchange Advance Decline line (NYAD) held support near its 200-day moving average and has climbed back into the Complexity zone as it has closed above the 50-day moving average and is also above the 50 area on RSI.

That’s great news, at least in the short term. The problem is that the major indexes are making marginal new highs and NYAD is nowhere a new high. So, we are still in a technical divergence.

This, however, could be corrected in a few days if the market rallies. Thus, all we can do here is watch and wait.



The S & P 500 (SPX) is in good shape, having made a marginal new high on 12/23/21. Accumulation Distribution (ADI) and On Balance Volume (OBV) are in decent shape, but there is overhead resistance at 4750. A move above that could take SPX to 5000 in a few weeks, barring something awful rearing its ugly head. 





And as has been the case for the past few weeks, the S & P Small Cap 600 index (SML) remains the laggard as it’s still trading below its 50-day moving average.



VIX Crumbles Lowering Short Term Risk

The CBOE Volatility Index (VIX) has collapsed, which suggests that the odds of a market decline have been reduced. 



The chart of the S & P 500 Volatility Index (VIX) and the S & P 500 (top panel) shows the following:

Rising VIX usually leads to lower SPX, while falling VIX usually leads to rising SPX. That’s due to rising VIX signaling high put volume.  See above for what high put volume means.

Options Exert Influence on Stocks

The options market is a huge influence on the stock market. That’s because of the effect of hedging strategies of market makers and big hedge funds and asset allocation traders such as commodity trading advisors (CTAs).

In order to stay solvent, market makers and big trading firms are forced to hedge their massive tades and their market making activities.  So, it’s their hedging, via options that increases both trading volume and the general trend of the market.

Here is how it happens:

  • Call buyers force market makers to sell calls
  • Market makers hedge their call sales by buying stocks and stock index futures – this causes the market to rise
  • The cycle self-reinforces as long as call buyers persist and the stock market moves higher

When put buyers are very active as they usually are when VIX rises, the reverse is true. As a result, when put volume rises, it’s because market makers are having to hedge their bets against traders who are betting against the market.

This causes VIX to rise, which in turn signals that the odds of a down market are rising.

So, when there are lots of call option traders, expect rising stocks while high numbers of bearish option traders (put buyers) usually lead to lower stock prices.

To get the latest up to date information on options trading, check out Options Trading for Dummies, now in its 4th Edition – Available Now!

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Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling 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.

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