More Trapped Bulls

Markets continued lower this week with the SP500 declining -3.4%. The continued calls for the correction being over are rampant and persuasive. Yet despite their opinion this remains a market environment like we haven't seen in years. There was much hope for a V-shaped recovery similar to last October, but there are glaring differences this time around.

First the Hammer reversal that tried to form after last week saw no follow through. This is the opposite of what happened in October 2014.

Another key difference is that trend momentum (as shown by MACD) has broken below the zero line, whereas in 2014 the signal reversed well above zero. Holding above zero is very important for identifying trend health.

We also didn't have the overhead supply in 2014 that is currently in place. Overhead supply is best described as "trapped buyers". These are the bulls who where buying dips within the year-long trading range. But because the decline away from the range was so quick and violent, most have not adjusted yet to the new corrective environment. It appears to me that most are very complacent here and have been expecting a rapid snap-back rally. This is also apparent in the failed reversal from last week. The buyers that were scrambling to put money to work late last week are now also looking at losses. This is so important because buyers that hold losses will typically wait for an opportunity to sell those positions where they originally bought or close to it; they want to "see if it comes back".

The psychology is very important to understand here. There are two possible outcomes here for the trapped bulls:

1. The market rallies and they use the opportunity to sell and "get out even"

OR

2. The market declines further making them more and more nervous and desperate.

The first scenario is where the term "overhead supply" comes from. As the market moves back into the prior buy zones (prior support), buyers holding from those levels sell into the rally creating excess supply of shares. This is the "throwback" scenario. Throwbacks are very common on new breakouts and this is a possibility that we have to be prepared for.

The second option is that the market continues to decline further, squeezing the holders with more losses. This action creates bigger losses and causes these investors to do irrational things. In more extreme cases this is the type of action that causes panics and crashes. We aren't there yet but you need to be aware of that possibility as well.

Possibility of a Snap back

Something I can't help but notice is how extended the Lg-Cap stocks and Indices are from their key moving averages. If you have been following this blog you will know I put a heavy emphasis on the 20 WMA. For one reason or another stocks, especially Lg-Cap stocks, revolve around the 20 WMA and it tends to act as a magnet. When prices get too far from the 20 WMA (and all moving averages for that matter) they have a tendency to come back to that average.

I want to show a few examples of what I mean:

SP500

The SP500 is now trading 160 points below its declining 20 WMA. It will take a 7% rally just to retest the underside of that down-trending average and also the prior support zone at 2060-2040.

PG

Proctor and Gamble will require a $10 rally to retest its declining 20 WMA. $10 from here is 15% from current prices. For those who feel these big blue chip companies are "safe" and basically risk free have gotten a wake up call as PG is down -30% from its high back in December. Its a reminder that a 3.5% dividend yield doesn't offer much protection in a declining market.

CVX

Another widely held name, Chevron, is now down more than -40% from its highs last July. The rapid decline over the last four months has left the chart extended to the downside. CVX is currently trading $20 below its 20 WMA. That could result in a 30% rally and still be in a down-trending market. 

If you are nimble enough to play for a counter-trend rally then I think there will be an opportunity relatively soon. But the important reality to remember is that it will still be a bounce within a larger downtrend. To be attempting to build large positions will likely result in opportunity cost of holding assets while they are still declining or correcting sideways.

Moves like this, crashes I should say, take time to recover. There is little lost in avoiding the bottom calling game. CVX will present an absolutely phenomenal buying opportunity. But until it builds a proper multiple-month support base there is nothing to do here from an investing standpoint.

TWX

Time Warner's decline has been relentless early on. It now finds itself -20% below its declining 20 WMA. A rally back to retest will inspire profit taking and this corrective period likely has much more time to go before it resembles a strong buy again.

AAPL

Everyone's favorite stock is in pretty rough shape despite last week's recovery off the lows. AAPL would still require 15% upside to retest broken support and its key moving average. Again, time will be required to rebuild any support base to trade off of.


What concerns me about this current setup is that many of these stocks could rally 15-20% and simply retest the underside of a now declining moving average. In the Lg-Cap universe of stocks a 20% rally is fairly significant and many would be pleased with taking profits at that time. This is how lower highs are set and downtrends gain momentum. Just something to be aware of as we go forward here. Most new traders and investors have simply never seen a stock market decline or downtrend. You can either be prepared for it or you will fall prey to declining price action.

There are a tremendous number of investors who's mistakes have been covered up by the rising bull market. Many have developed bad trading habits and have been rewarded by a rising tide. But as Warren Buffett has famously said, "only when the tide goes out do you discover who's been swimming naked". Anybody can make money in a bull market, where the true test of a trader and investor lies is in how they survive during corrective markets.

Bottom line: Don't be too quick to buy back into this market. As long as lower lows and lower highs are being set caution is advised. When stability comes back into the market it will be manifested on the weekly charts through a support base and higher lows and higher highs.

Our watchlist stocks came under pressure this week along with the broad market, so there is nothing new to report there. Until we see some better price action under the surface we will continue to sit on the sidelines and await new support levels forming.

In this current market its best to keep positions light. I have taken a few setups recently for shorter-

term swing trades and most have been unsuccessful. In a down-trending environment, if you choose to dip in and out I prefer to keep risk per position to half size compared to strong uptrending markets.

Stay light and keep your focus on swing lows and swing highs. As long as they are maintaining a downward bias this is a market best avoided.

I will leave you with a fantastic quote from Chris Ciovacco on Twitter this week: 

"Capital that is protected can always be redeployed. Capital that is lost cannot."
-@CiovaccoCapital

Thanks for reading
-ZT