-- Trading at the Edge of Chaos --

Analysis, Perspective, Trading Strategy

At the Edge of Chaos: A Short-Term Bounce for Stocks Maybe in the Cards but Don’t Bet the Farm on it.

Editor Joe Duarte in the Money Options

June 19, 2022

Did you hear the one about Google firing an engineer who claims that artificial intelligence is becoming sentient?

It’s heady stuff for sure. Moreover, it sounds as if it’s straight out of a sci-fi story. 

Mr. Reese? Are you there?

Be that as it may, in the real world, you can tell you’re in a bear market because every time you see a big volume bar popping up at the end of a serious selloff on your ten-minute price chart, the green price bar that appears along with it lasts but a few flickering moments before it turns red again and prices head to new lows.

In this market, it seems it’s hard to tell what’s real and what’s not except for the fact that even if what’s happening to the market is mostly unfolding inside of servers and computer terminals, the effects on our trading accounts and our willingness to spend money to support the economy are pretty tangible.

Still, even though there are no signs of all out capitulation, as I describe below, we could see a tradeable – very short term - bounce, especially in the Nasdaq 100. 

Two Algos Walk into a Virtual Bar

Two algos, Bob-36 and Ted-94, walk into a virtual bar somewhere in the Metaverse and order some lithium ions in order to quench their virtual thirst. 

One algo says to the other in a well-modulated, yet tinny mechanical voice: “How’s it going Bob?”

Ted gives Bob a virtual nod and answers in a high pitched but tinny, mechanical voice: “Not too bad Bob.  I’ve been so busy lately.”

To which Bob thoughtfully, in a virtual sort of way, replies: “Yeah, me too.  It’s hard to run the world isn’t it.”

And they both stare at each other through eerily ethereal eyes, and shake their heads as they swill virtual lithium ions, in the Metaverse, which is actually somewhere in the basement of a building in Weehawken.

If this Happens Do This

For several weeks in this space, I’ve noted that because artificial intelligence – Wall Street market makers, hedge funds, and asset allocation program traders – follow pre-programmed trading instructions once the selling hits, it’s not just unstoppable, it’s really fast paced.

That’s because algos are programmed on a very simple concept based on the principles of Complexity – “if this happens do this.”

Moreover, the number one rule in Complexity is that in order for a system to emerge to a new level, when one agent finds the door, all the others follow.

What that means is that when a certain moving average is breached, the market falls and the hedge funds make money on the short side, all the algos sell.

Not just once but every single time it happens, at each moving average, key support level and in response to every headline that crosses the wire.  

Think of a computer program fed into a really fast server in the middle of New Jersey whose instructions may be something like this:

  • If the Fed raises rates by 50 basis points – Sell
  • If the Fed raises rates by 75 basis points – Sell a lot
  • If the Fed raises rates and SPX falls below VWAP – Sell more
  • If SPX falls below 9-day MA – Sell even more
  • If SPX falls below 11-day MA – Sell even more. faster
  • If SPX falls below 20- day MA – Sell everything as fast as you can and borrow to do it
  • If SPX falls below the 50-day MA – Sell SPX short
  • If SPX falls below the 200-day MA – Sell SPX, NDX, RUT and anything you can find short – over and over again while borrowing a lot to add to the leverage

I know this is overkill. But you get it. 

Now, add the fact that the Fed just went nuclear with its 75-basis point rate hike while promising that more are on the way, and you get more selling.

So, when will it end? Maybe when we see:

  • If the Fed stays it will stop raising rates – Buy
  • If SPX rises above VWAP – BUY and so on.

The bottom line is that all we can do is wait and see.

MELA is Breaking Down

So, on June 1, 2022 the Fed started taking out $47 billion per month from the bond and mortgage-backed security market and the U.S. Ten Year note yield went parabolic before reversing due to the market now expecting the Fed’s interest rate increases to push the U.S. economy into recession.

Certainly, the recession theme is increasingly plausible. In fact while economists are expecting a recession, a majority t of the public thinks we’re already in one.

And here is why:

  • Mortgage rates are exploding
  • Housing starts are crashing 
  • Home sales are falling
  • Realtors Compass and Redfin are cutting jobs
  • Job cuts are starting to pile up in trendy zombie tech companies
  • U.S. industrial production is flattening out
  • Cryptocurrencies are crashing

And what we’ve seen is only the results of a couple of weeks of QT.  Imagine what could happen by December when the Fed has doubled QT.

The fact is that there is real damage being done to the backbone of the U.S. economy – the stock market (M) - is already being felt in the economy (E) as people’s life decisions (L) such as buying a new car, house, or TV are put on hold.

As for the algos, they aren’t just in the market. They’re in all aspects of life now, especially in the media which disseminates the news at the speed of light, further affecting M, E, and L.

What’s the bottom line? If the Fed continues to crush the lifeblood of the economy – 401 (k) plans, IRAs, crypto and trading accounts, there may not be a whole lot left when it’s all over.

Keep an eye on Bitcoin

Cryptocurrencies were supposed to shelter investors from market turmoil by their “outside the system” presence.

 

 

So far that’s not happening.  On the other hand, as I describe below, the Nasdaq 100 Index (NDX) is so oversold that it could bounce.  I expect that the bounce in the Nasdaq, if it materializes will be boosted if bitcoin stages a rally alongside it.

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

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NYAD and VIX Relationship is Malfunctioning

The relationship between the New York Stock Exchange Advance Decline line (NYAD) and the CBOE Volatility Index (VIX) is increasingly difficult to interpret. It’s currently malfunctioning.

Specifically, under normal circumstances, when VIX rises, NYAD falls and vice versa.

In other words, a rise in VIX means rising put option volume, a bearish development for stocks.

But lately, even as NYAD crashes to new lows, we are not seeing any sign that a meaningful spike in VIX materializes.

What that means is that there is no full-blown panic in the market yet.  In effect, it suggests that since the current bear market isn’t enough to frighten investors to the point of capitulation, the selling could go on for longer.

 

 

 

The S & P 500 (SPX) remained well below the 4000 level and now has resistance near 3900.  The index is certainly oversold which means that some sort of limited bounce is coming. I expect it to fail.  The important resistance zone is at 4100-4200.

 

 

 

The Nasdaq 100 index (NDX) is likely to bounce along with SPX. For one thing it’s more oversold. And for another, Accumulation Distribution (ADI) registered an upside blip on 6/17/22 which suggests that a smattering of short covering took place. If this takes hold and On Balance Volume (OBV) turns up, we could get a nice trading bump – for a few days anyway.

A move above 11,500 here could take us to 12,000 in a hurry. A move above 12,000 could take us back to the 12750, or so area.

 

 

 

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Good news! I’ve made my NYAD-Complexity - Chaos charts featured on my YD5 videos, and a few more available here.

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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