WATCH: The 4 Stage Stock Market Cycle

Articles

Technical Tuesday - Is This Market About to Decline?

By Chris Rowe August 9, 2022 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

.

Hi there…

As I’ve been telling you for weeks now, Demand is returning to the market.

In fact, the bear market rally that began on June 17th is now in its 8th week.

That’s good news, right? Yes, for bullish traders it is. But, rally or no rally, until further notice, we’re still in a bear market. The primary (long-term) price trend is down.

In any bear market, there’ll be times where the bulls come out to fight, and prices advance. The bears will occasionally come out and try to regain control of the price direction.

But there's a red flag waving over this recent rally that we mustn’t ignore.

It’s like when you’re driving along a well-paved parkway, sailing along in light traffic… And suddenly a guy waving a red CAUTION flag slows you down ahead of some road work.

In every bull market and in every rally you’ll run into red flags. This current rally is no exception.

Now, the red flag caution sign does not mean that prices will suddenly reverse and plunge lower. The current market picture is not all black or all white. 

As a smart investor, you must respect and react to any red flags. But at the same time, you don’t want to over react to them. 

Whenever there’s a battle, like the one we see happening, whichever animal prevails will likely make a quick and sudden move in their favored direction.  If the bulls win, you’ll probably see a sharp spike higher. If not, then the opposite.  

And depending on who you are as a trader, you have to decide how you prefer to play it.  This is largely about how much volatility you’re comfortable with.  

If you want to stick to your guns and not make any adjustments, at least you now know what you’re facing. You may want to play out each scenario in your head, today, so you’re prepared and trade emotion-free.  

Whichever direction prices do cut, odds favor a continued move in that direction. (Occasionally institutional investors try to fake you out and there’s very little defense for that, unfortunately.) 

But you do want to hedge and adjust. I’ll show you how to do that in a moment.

First, let’s look at…

One Red Flag I’m Seeing Right Now

Here’s a 1-year chart of SPY, our proxy for the S&P 500. I’ve highlighted the recent rally and I’ve also added a red arrow at the bottom.

(Click any image to enlarge)

The arrow points to the 50-day average volume line on SPY. 

Notice how, almost without exception, the volume bars corresponding to the recent rally all lie below the average line. Volume – which equals “validity” – is on the light side. The implication is that the upward movement is probably not a “valid” move. 

The idea being that price behavior speaks to us. If it’s going up, it’s telling you it wants to go up.  But if there’s lack of volume behind that “statement” being made by price behavior, then the move/statement might be B.S. (an old Wall Street acronym we used to use).  

If you’re bullish, you want to see heavy volume on price advances and the heavier the better. Heavy volume confirms that Demand is strong enough to absorb all of the sellers (bears) once they step in and start selling. 

If volume is too light, that selling pressure by the bears can knock prices down very quickly.

Again, this doesn’t mean prices can’t continue higher but I can almost guarantee you that if they do move higher, they’ll also be revisiting today’s prices within the next couple of months. (When that happens, I am well prepared to profit from bearish positions!)

Here’s a chart of another major average, IWM, which tracks small-cap stocks. Again, notice that volume is at best unimpressive – well below the average line.

(By the way, on those charts I’ve deliberately made the panel showing the volume bars VERY BIG. That’s so we can see them more easily. I won’t do that going forward.)

There’s something else on those charts that should give you pause.

Congestion Ahead

Here’s that chart of SPY once again. The blue lines represent key areas of support/resistance.

You can clearly see that the market is running into resistance near $421.70. In fact, it just bounced off that key level. 

We see the same thing at the blue horizontal line on the IWM chart. The index is running into resistance at a historically key level around $191.

Remember what we said a moment ago? About how heavy volume confirms there’s strong enough Demand to absorb/repel the sellers? 

The sellers begin their selling at areas of resistance. That’s what resistance IS. It’s a price level where, historically, sellers can be counted on to come in and sell, thus knocking down prices or at least preventing them from rising further.

Underwhelming volume on an uptrend combined with imminent resistance is no real recipe for a market primed to charge higher. That said, the market is rallying. We have to respect that. But, again, we won’t view this market through an all-or-nothing lens.

Before I show you what I think you should be doing in the face of this rally and this red flag, I want to drill deeper into the market by looking at eight of the most heavily-weighted stocks in the S&P 500.  

This is an extremely effective technique that I’ve used to call price reversals before they happen. You might remember at the all-time high, back in November, I sent you this article saying the same thing.

These eight tickers – 1.6% of those 500 stocks – make up more than 25% of the entire S&P by weight. The remaining 492 stocks (98.4%) make up the remaining 75%. 

That means… 

Where Those Stocks Lead, the Market Follows

As you look at the following eight charts, notice that… 

  • All are in an intermediate-term uptrend…
  • All are showing less-than-stellar volume on the way up (certainly volume well below what bullish investors would want to see during a price advance)...
  • And all are about to run into heavy historical congestion or resistance (the blue lines and blue arrows).

Here’s Apple (AAPL)...

And here’s Amazon (AMZN)...

Same deal with Facebook/Meta (META)...

Ditto with Google/Alphabet (GOOG)...

Tesla (TSLA) looks similar…

Here’s Nvidia Corp. (NVDA) another tech giant…

Same thing with JPMorgan Chase (JPM)...

And with Exxon Mobil (XOM)...

Again, these stocks make up one-quarter of the S&P by weighting. They can pull the index up or pull it down. If the light volume we’re seeing means demand will be unable to absorb the kind of selling/supply we’re likely to see at those resistance levels…

Then these stocks could decline, dragging the market down with them and stopping the current rally in its tracks. Investors who only have bullish positions, or who own the market, could get hammered.

We actually saw this overweight phenomenon operate in reverse last autumn, as the long-term bull market that resumed in March of 2020 was topping out. 

Then, the giant FAANG stocks were gunning higher and pulling the market up. The news kept reporting how “the market” was strong. We knew better. We could see the light volume that went along with those moves higher. And we could see that most of the other stocks were declining.

So now what?

Some Suggested Next Moves

During markets like this one, where there’s a bullish rally within a bearish primary trend, if you’re like me then you’re going to want to hedge. There are many ways to do this.

You can lighten up on your bullish positions. And you’ll definitely want to consider selling off any underperforming holdings, particularly ones in underperforming sectors.  

Keep in mind that “cash,” just like stocks, bonds, commodities, art, sports cards or real estate, is just another asset class. You can increase your cash position (you don’t have to – and you shouldn’t – sell-out or buy-in entirely). 

Also, consider selling covered Calls on your bullish positions, or buying out of the money Puts (preferably that expire in 5-7 months) on your positions. Use puts that have a delta of -0.25 or the closest possible delta. Again, this would be to buy “protective puts” on your bullish positions as a way to reduce risk, but I also like to hedge my bullish positions by taking bearish positions on completely different stocks or sectors.  

For example, yesterday I bought a Put option position on XLY (Consumer Discretionary SPDR sector ETF). Puts have an inverse relationship to the ETF’s price.  

The sector is having a hard time at the moment and I do have bullish positions in stronger sectors so even if the general stock market advances, hopefully the bearish position on XLY will still be profitable as XLY is underperforming the general stock market.

And I also took a bearish position on XLK as a hedge as well.

That way, if the market sells off, my bearish positions are profitable and (assuming I do sell out of those profitable bearish positions) I will then have a new chunk of cash to plug into cheap, oversold stocks or ETFs, hopefully just before the market reverses higher.

IMPORTANT DIFFERENCE:   

If you buy Puts to protect your bullish position, you want to buy out-of-the-money Puts (the ones with a delta closest to -0.25).  Buy one put for every 100 shares you own. 

If you buy Puts as a straight up bearish position -- if you’re betting on lower prices -- then you’d buy deep in-the-money Puts (the ones with a delta closest to -0.75).  Buy 13 Puts for every 1,000 shares you own, and keep in mind you can’t buy fractional options so use your best judgment. No, 13 is not a typo.  

Again, right now Rule #1 is: keep your eyes open. The market could continue higher for a while. It could reverse lower quickly.  Notice how Semiconductor stocks are getting slammed and those are stocks that tend to do really well when investors become more bullish. Is this the beginning of the next leg down?

I’m watching the market like a hawk and anything I see, I’ll pass along to you. I’ll do my utmost to make sure this market doesn’t take you by surprise.

Thanks for reading,

Chris Rowe

Founder, True Market Insiders

 

 

 

 

“You see it in the price before you see it in the news.”

FREE e-Letter
Sign Up

Archives