Wait For The White’s Of The Market’s Eyes

The stock market swung in a wider than we’re used to range again today. The Dow (DIA) opened the day up a bit, then added on, before breaking down late. The S&P 500 (SPY) (VOO) followed suit. The NASDAQ (QQQ) was down all day on weakness from top holdings Facebook (FB) -5.05%, Microsoft (MSFT) -4.4%, Google (GOOG) -4.24%, NVIDIA (NVDA) -8.18% and Netflix (NFLX) -6.31%. 

The markets are clearly digesting a lot of news from tariffs and trade negotiations, to geopolitical risks, to historic market over valuations, to a tightening Fed and more. As I have said before, I do not believe we are at risk of an imminent financial crisis, but at some point the stock market has to justify valuations in the face of a tightening Fed and the “slow growth forever” reality of the global economy.   

Here’s a playbook for the enterprising investor on how to deal with the rise in volatility. 

How Much Risk Is There?

I originally posted the following chart in: How Low Can The Stock Market Go? 

Market LevelsI think it is fairly easy to digest. There was a significant period of consolidation around 2200 on the S&P 500 in 2015. That appears to be the first level of very large support for stocks should a bear market develop. 

The next level down would imply a more serious economic situation, likely a significant recession or possibly war. I believe the area around 1600 on the S&P 500 is likely eventually, as we can’t avoid a serious recession forever. 

The 1600 level on the S&P 500 used to be resistance before the advent of QE – quantitative easing – by central banks. While a break below that level is possible in theory, it is unlikely to ever happen again in my opinion given the amounts of money now available in the global economy to come in an buy assets. A crash of the S&P 500 would also alleviate the valuation issues we see in the Shiller S&P 500 Cyclically Adjusted P/E Ratio:

CAPEAt this moment we can look to the moving averages to answer short-term risk questions. As of Tuesday, the S&P is once again bumping down to its 200-day moving average. If it breaks below and stays below through the end of the week, that will be a harbinger of a more serious correction, possible the 2200 area on the S&P. 

We need to also keep an eye on the 10-day exponential moving average (in this day of algorithmic trading, I use the shorter 10-day vs more traditional 20-day exponential moving average).

If the 10-day exponential breaks away from the 50-day simple, it often acts like a magnet, pulling up or down. If it crosses the 200-day to the downside, that marks a significant direction change.  It generally needs to break the 50-day back to the upside to signal a new uptrend.

These are rudimentary indicators, but tend to work when we aren’t seeing market extremes. Look at this chart from 2015-16:

SPYLet’s look at the past six months:

SPY 6moHere’s the PowerShares QQQ (QQQ):

QQQGame Plan

First, don’t speculate. We know that the stock market is overvalued across many sectors and on whole – we’ve covered that several times. Eventually we will see a correction.

We could be looking at a more significant correction, but we might be just seeing consolidation that is hoping for fundamentals to improve more and catch up to valuations.

If the 200-day moving averages don’t hold on the week, then we need to be aggressive sellers – quickly. If the 200-day moving averages do hold on the weekly, then we will want to aggressively use our cash to sell puts to the 200-day moving average on our favorite stocks. You have that list. 

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