If you've read previous articles of mine, you would notice that I have been primarily bullish on equities for some time now. But for the first time, I truly have no desire to "buy the dip" for anything longer than a short-term trade. There are some disturbing early warning signs that the market may be undergoing a fundamental change of character.
I don't presently know how long this will last, but when I see signals like this from the market, I don't risk gambling away my financial future. One of my trading mottos is "when in doubt, get out." I have often likened trading to poker -- and one of the mathematical concepts required to become a winning poker player is an understanding of "pot odds," which is the ratio of the current pot to the cost of calling a bet. Simply put: If the pot is $100, and calling costs $10, then the pot odds are 10:1. Trading is all about odds as well.
While I'm simplifying this analogy by overlooking concepts such as implied odds, etc., the next mathematical requirement in poker is to calculate the odds your hand has of actually winning the pot. Then one compares those odds against the pot odds, and folds or calls (or raises) accordingly.
In order to become a winning poker player over the long-term, one doesn't gamble, but plays each hand with discipline and according to the odds. Oftentimes, inexperienced players will stay in the game despite the odds stacked against them -- usually this is because they either don't understand the math, or because they like "being in the action" and lack discipline. Sometimes, in spite of their poor play, they'll win in the end -- odds are only odds after all, so even bad odds are mathematically required to win occasionally. Unfortunately, the thrill and reward of these occasional wins encourages bad players to continue playing incorrectly, and -- worse -- often leads them to believe that their lack of discipline was actually pure, unadulterated brilliance. The problem is that over the long haul players who have no discipline will, without exception, eventually end up 100% dead broke -- and that is a mathematical certainty. I view trading in much the same light, and traders who lack discipline and overplay their weak hands will certainly end up broke as well.
All that to say, while the market always reserves the right to prove me wrong and go on to new highs immediately, I feel the odds are very good that there are ultimately lower lows still ahead. Note that a near-term reaction rally could begin as early as today's session, but unless the market does something to shift the ball back to the bulls, given what I see today, I would expect the next rally will be sold. Since the best we can do is attempt to play the odds correctly, here are a few statistics and observations to consider:
1. The Volatility Index (VIX) rose more than 30% in the last two sessions. Nearly 90% of the time this has happened previously in the past 20+ years, the market has subsequently gone on to make lower lows before making higher highs. Interestingly, the ferocity of the recent VIX decline also argues for a near-term snap back rally, beginning as early as today's session.
2. Precious metals have been absolutely slaughtered lately, which means the market is at least considering the thought of a deflationary environment. Further, the extreme volatility in PMs can often be a warning signal that things are about to become more volatile for equities as well.
3. The momentum lows we saw Monday are rarely reached in exact tandem with the actual price low, and generally we'd expect to see a bullish divergence before price finds a meaningful bottom. Additionally, the up-volume to down volume ratio was high enough that we would expect to see further downside and new lows in the reasonably near future.
The aforementioned indicators are all signals of a bullish shift undertaking. In conclusion, it's still a bit early to call an intermediate top, but there are numerous warning signals indicating that the "pot odds" seem to be shifting into the bears' favor. Accordingly, I think bulls will want to stay exceptionally cautious and nimble up here, and may want to consider standing aside entirely for the time being. Trade safe my friends.