The SPDR S&P 500 Trust ETF (SPY) has sold off sharply in the last two months since hitting a new recovery high of 147.24 on Sept. 14. The selling has intensified following the presidential election, with the market steadily trending lower. Negative news and positive news has been sold; it seemed that while for much of 2012 the market was able to levitate on the anticipation of QE3, now that QE3 has arrived the market has shrugged off the latest stimulus efforts.
Furthermore, there are concerns such as the fiscal cliff, in which being bearish on the stock market is in effect a bullish play on acrimony between the two parties. There are also legitimate issues involving poor Q3 earnings and high margins, which are stretched to historical levels contributing to the selling pressure. Another contributing factor is the leading stock in the market, Apple (AAPL), has precipitously declined.
In all, the gains since Draghi's announcement of the EU's own sovereign bond purchases have been wiped out. In this article, I want to explore my reasons for expecting a vicious countertrend move.
With the market's pounding, sentiment has become incredible bearish.
Click to enlarge images.
Its important to note that optimal entry points correlate very well to poor sentiment, because poor sentiment by definition reflects a situation in which many are short or in cash on the sidelines. Therefore, upside moves in price can be exaggerated as shorts are forced to cover and many are forced to chase at higher prices. In terms of the chart above, its important to note that the swings in sentiment are the focus rather than the absolute levels.
Fiscal Cliff Fears
The biggest unknown currently troubling the markets is the impending fiscal cliff. Many corporations have slowed capital expenditures due to uncertainty surrounding future government spending and tax policy. Investors have taken the approach to sell first and ask questions later, while traders are salivating at an opportunity to cash in on a repeat of the 2011 debt ceiling debacle.
I think there is legitimate reason for this fear given the recent Washington dysfunction, where due to the effects of redistricting, lawmakers' chief threats during re-election come from the base rather than the opposing party. The net effect is that compromise becomes more difficult especially on substantive issues.
However, the meeting on Friday was a positive development as both sides seem intent on avoiding a repeat of the disaster last year. From the nadir, the S&P 500 gained on these positive comments continuing into Monday. Of course, no one knows how it will all play out. However, it is clear that the odds of a successful resolution to the fiscal cliff have increased, which is certainly bullish for stock prices.
We can see the U-turn made by the stock market on last Friday's 11 a.m. ET impromptu, conciliatory fiscal cliff press conference on the White House lawn.
In the short term, strength in bonds (TLT) correlates to weakness in stocks. One interesting feature of the final stage of the sell-off in the past week was the relative weakness in bonds. My takeaway is that this lack of interest in the bond market to the weakness in equities foreshadow a move higher in equities, but also signals we haven't seen capitulation yet. So this is not a buy-and-hold opportunity. The bond ETF TLT is shown below.
The message from the VIX (VXX) is the same as bonds. The VIX was strangely indifferent to the broad-based equity weakness, as traders were willing to sell puts with little premium. Ordinarily in these panic situations, such as June 2011 or October 2011, we see the VIX climb almost parabolically.
Trading during the holidays is tricky. Usually nothing significant happens. However, when something does happen, the moves are exaggerated due to thin trading, which can present opportunities in oversold/overbought markets. I'm posting a chart of Thanksgiving trade from last year because I think it can serve as an illustration of the opportunities in thin markets.
Last year, the market went into Thanksgiving with a strong trend down and continued trending down. The following week, we staged an impressive reversal basically wiping out the losses from the past week. It is my hypothesis that we are in the midst of a similar bounce.
One final note of caution would be to reiterate that this low is somewhat different from previous lows in that there was not a spike in terms of bonds or the price of volatility. That is why I consider this more of a trade with a defined stop-loss, rather than a long-term or even intermediate-term buy and hold. In situations like this, the market is very correlated, so all asset classes should appreciate if my hypothesis is validated. Nevertheless, I will be looking at an entry point in the gold miners ETF via the Market Vectors Gold Miners ETF (GDX).
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GDX over the next 72 hours.