Last Friday Was A Targeted Sell-Off - What To Expect Next?

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Includes: DIA, IWV, QQQ, SPY, VXX, XLF, XLK
by: Macrotheme Capital Management LLC

Summary

Correlations among stocks are still low.

Thus, we have targeted sell-offs, while broader markets remain stable.

Watch small stocks and the VIX, as the key indicators.

Last Friday (6/9/2017), the technology sector (NASDAQ:QQQ) sold-off significantly (-2.5%) on a very high volume, led by the semiconductors (SOX) down -4.2%. Yet, the broader stock market (NYSEARCA:SPY) finished almost flat, while the blue chips (NYSEARCA:DIA) and small stocks (NYSEARCA:IWV) finished higher for the day.

How to explain the action on Friday?

Clearly, some investors wanted to sell the technology group, including specifically the FANG+Tesla stocks. But, how do you sell these stocks without triggering the stock market crash?

Simple, make sure that the correlation among stocks stays low, which keeps the VIX low, and enables targeted selling. Thus, the partial proceeds from the technology stock sales had to be reinvested in other areas to keep the correlations low.

What to expect going forward?

The most important variable to follow is the extent to which the market moves together. The most bearish scenario is if the Russell 2000, the Dow Jones, the Nasdaq, and the S&P500 all move lower together, as well as the technology (NYSEARCA:XLK) and the financial (NYSEARCA:XLF) sectors.

In this case, the correlation among stocks would rise, which would boost the VIX Index (NYSEARCA:VXX). Given the extraordinary short position in the VIX futures, a rise in VIX could trigger the short covering, which would cause even further rise in VIX - and the vicious cycle starts.

A spike in VIX would cause even more selling in stock market by the risk-parity funds, and any resulting technical damage to the charts would result in an unprecedented selling by the systematic trend-followers.

Clearly, within this scenario, the stock market would crash - deep and fast.

Alternatively, as long as the selling is isolated to one sector or segment of the market, the VIX will remain low, and the broader market could go anywhere from here. Within this scenario, even a sharp short squeeze is possible, sending the markets much higher.

Specifically, I am following the small stocks, given the large short position in Russell 2000, especially in relation to the VIX. Rising Russell 2000 should be treated as a short-squeeze alert. Here is the chart:

Implications:

At this point, we could get a major 1987-type stock market crash - if the VIX rises. Given the action last Friday, we know that it's difficult to sell in this environment without causing a major price downside. So, any type of systematic or forced selling would be catastrophic.

However, note also we could get a 1999-type short covering - if the selling continues to be targeted and VIX remains low.

I will follow the situation and update.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.