Stock Market Commentary
Pressures continue to build in financial markets. Trading today opened like a typical relief bounce but ended with a thud. A breakdown in the S&P 500 flagged the seriousness of the selling. Fresh highs in a surging volatility index confirmed the magnitude of the pressures from a new fear and loathing for a wide swath of stocks. From Friday’s realization of a new normal for a COVID-19 world to the blindside jolt from a hawkish Federal Reserve Chair, the stock market finds itself unprepared to recapture the equilibrium of complacency that has dominated so much of 2021’s trading. Yet, these pressures have now ushered in oversold trading conditions. The extremes that launch oversold periods also create buying opportunities.
The Stock Market Indices
The S&P 500 (SPY) has tested and wrestled with its uptrending 50-day moving average (DMA) (the red line below) in all but three months this year (April, August, and November). December kicked off with the latest test. The S&P 500 sliced through 50DMA support after first gapping up and gaining as much as 1.9%. The subsequent 1.2% loss and 50DMA breakdown look bearish, especially in the context of an index that has spent so little time this year trading under its 50DMA. However, the pressures from the steep selling three of the last four days are extreme, especially with today’s close well below the lower Bollinger Band (BB). The complete reversal of the October breakout brings oversold trading conditions.
The NASDAQ (COMPQX) is not wilting as much as the S&P 500. The heaviest selling pressure erupted today in the form of a reversal from a 1.4% gap up open to a 1.8% close. The tech-laden index managed to hold 50DMA support. Like the S&P 500, the NASDAQ is extremely extended below its lower BB.
The iShares Russell 2000 ETF (IWM) has experienced intensifying selling pressures for almost a month now. The acceleration over the last 4 trading days plunged IWM well below its lower-BB on heavy trading volume. IWM will likely benefit most from a rally out of the oversold trading period, especially given the proximity to the lower bound of the 2021 trading range.
The Financial Select Sector SPDR Fund (XLF) generated its own sharp reversal on the day. XLF gapped up and traded well into the gap from the previous trading day. However, once the dust settled, XLF ended up with a 1.1% loss and a close encounter with support at its 200DMA (the blue line below). XLF last touched its 200DMA 13 months ago.
Stock Market Volatility
The volatility index (VIX) faded as expected from Tuesday’s 18.4% gain. At its lowest point, the VIX almost reached the low point of Monday’s fade. The bounce from there lasted most of the trading day. Count me surprised that the VIX managed a very rare higher high after two earlier big moves. Now all bets are off. While I always bet on the odds of a bounce out of the pressures of an oversold period, a higher and higher VIX opens up the possibilities for an extended stay in oversold territory. Moreover, the stock market could easily suffer from multiple oversold periods in quick succession.
The Short-Term Trading Call Despite the Pressures of Oversold Conditions
- AT50 (MMFI) = 22.6% of stocks are trading above their respective 50-day moving averages
- AT200 (MMTH) 36.2% of stocks are trading above their respective 200-day moving averages (17-month low)
- Short-term Trading Call: bullish
AT50 (MMFI), the percentage of stocks trading above their respective 50DMAs, dropped to 22.6% and printed a new 2021 low. In fact, AT50 last closed this low on April 20, 2020 in the immediate wake of the pandemic-driven collapse of financial markets. With AT50 trading just above the oversold threshold of 21%, I am officially in oversold trading mode. Accordingly, I upgraded the short-term trading call to bullish.
As a reminder, I recently translated my market breadth indicator from the percentage of stocks trading above their respective 40DMAs. An error band exists with the mapping, so I cannot treat 21% as an absolute line defining oversold trading. Indeed, doing so would have fooled me into missing the July lows and oversold trading period at that time.
As another reminder, I almost always choose the aggressive trading approach to oversold trading. Since most oversold periods typically last just a day or two, I jump right into trades. Today, I focused first on the indices by selling a SPY weekly put spread and buying a weekly SPY call spread. The higher the VIX goes from here, the more aggressive I will get. I will largely avoid rate-sensitive stocks and even treat them as potential hedges against bullishness.
The conservative approach reduces upside potential in exchange for less risk. The first trades in the conservative approach trigger on either 1) the end of the oversold period and/or 2) the first big fade in the volatility index from elevated levels. To review the rules of oversold trading, see “How to Trade Extremes In Market Breadth (Above the 50).”
AT200 fell to a fresh 17-month low. This longer-term measure of market breadth reminds us of the notable damage in the stock market. AT200 may also warn of limited shelf lives for oversold rallies. Stay tuned.
Be careful out there!
Footnotes
“Above the 50” (AT50) uses the percentage of stocks trading above their respective 50-day moving averages (DMAs) to measure breadth in the stock market. Breadth defines the distribution of participation in a rally or sell-off. As a result, AT50 identifies extremes in market sentiment that are likely to reverse. Above the 50 is my alternative name for “MMFI” which is a symbol TradingView.com and other chart vendors use for this breadth indicator. Learn more about AT50 on my Market Breadth Resource Page. AT200, or MMTH, measures the percentage of stocks trading above their respective 200DMAs.
Active AT50 (MMFI) periods: Day #410 over 21% (overperiod), Day #2 under over 31% (underperiod), Day #4 under 40%, Day #8 under 51%, Day #10 under 60%, Day #190 under 72%
Source for charts unless otherwise noted: TradingView.com
Full disclosure: long SVXY
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*Charting notes: Stock prices are not adjusted for dividends. Candlestick charts use hollow bodies: open candles indicate a close higher than the open, filled candles indicate an open higher than the close.