Everything's OK. Wait, Maybe Not?

Thinly traded markets are always difficult to navigate.  Almost by definition, these markets tend to reflect the collective wisdom of a relatively small number of individuals and/or organizations.  This concentration of potential buyers and sellers invariably leads to price movements that are less dependent upon the particular market’s fundamentals and more in line with the whims of the few participants.  Having started my trading career in the cotton futures market, I witnessed small volume trading from day one.  At that time (and this is still largely the case today as well), the major domestic cotton merchandising companies, Dunavant, Hohenburg Bros., and Allenberg constituted the bulk of a given day’s trading volume and had a great deal of influence on the market’s ultimate direction.  To be sure, fundamental developments such as weather conditions, global supply levels, and crop conditions played a large role in the market’s longer term direction.  However, on days when there was little news to drive the price action, these merchandisers routinely pushed prices around in an effort to skim off short term gains.  They often targeted closely watched technical levels as a way to shake inexperienced traders from their positions.  In extreme cases, rumors of a hedge fund or individual trader with a losing position would be ‘attacked’ in order to force them to cover their positions and, thereby, move the market.  Needless to say, trying to sort out the correct price for the actual cotton commodity was challenging in such an environment.  More than anything, though, this taught me two things:  1) Markets don’t always trade on fundamentals and are likely to see deviations from reality on a regular basis.  However, these day to day fluctuations are, eventually, weeded out in favor of the market’s underlying fundamental condition.  2)  Low volume markets are uniquely exposed to wild price swings.  As such, understanding the internal/technical aspects of the particular market is critical to correctly assessing why a market is behaving in its current manner. 

So what does all this have to do with today’s hard sell off in equities?  Quite simply, beware this market and its light trading volumes (4 billion shares traded hands on the S&P 500 today.  A higher reading compared to recent trading days, but far from convincing in the larger context).  Just as the S&P 500 moved up from its recent lows in a fairly dramatic fashion, so to can it fall.  This is part of the reason why I’ve said that investors need to stay small and nimble in this environment.  That said, today’s decline (down 31.59 or -2.82% on the S&P 500) doesn’t necessarily portend a new leg down.  It is no doubt suggestive of this being the case, but the jury still remains out.  Until we see a move in one direction or another that breaks the 5 billion share level, you’ve got to remain somewhat skeptical of the market’s prevailing direction.  Later on in this post I’m going to highlight a few technical levels that have been breached as a result of today’s sell off as well as a few support levels that remain.  More than anything, this will show that the markets are not likely embarking upon a significant move lower, but, as has been the case for a couple of months now, are continuing the range-bound trade that has characterized the summer of 2010.  As you all are aware, I’ve got real concerns about the market’s ability to rally in the latter part of this year and would certainly like to view today as a manifestation of this thesis.  Despite this desire, the trend doesn’t yet show me this is the case.  Today may ultimately prove to be the day when things turned sour for equities, but it’s simply too early to make that call as yet.

Before delving into the technical picture that is now at hand, I want to just comment on the day’s selloff and the fact that it appeared to run completely contrary to what yesterday’s reaction to the Fed’s interest rate decision implied.  As I mentioned in yesterday’s post, I thought the pop in S&P 500 subsequent to the Fed’s release was clearly indicative of a market that wanted to move higher.  The light volume associated with this move (2.7 billion shares on the S&Ps) was no doubt a concern, but given the fact that the Fed’s statement merely reiterated much of what Chairman Bernanke had stated in the weeks leading up to the rate decision, I thought the market got mostly what it wanted.  Sure, the Fed could have stated that their upcoming policy actions would be more dramatic in scale, but traders always seem to want more from the Fed in this environment.  With the release of this news turning the rumor mill surrounding additional policy actions to fact, it made sense that yesterday’s concerns about too much or too little policy action would be allayed and support a move higher.  Today, however, investors seemed to be looking at the Fed’s decision in one of two different, but negative ways:  1) The Fed is behind the curve again and is proceeding with a set of policies that will allow deflation to take hold, thereby raising the likelihood for the much debated double dip recession.  As such, equities need to be shed now.  2)  The Fed is doing too much.  After maintaining historically loose monetary policy for the last two years, the Fed is continuing down a path that will lead to a devaluation of the U.S. Dollar and rising inflation.  The fact of the matter is that the Fed is marching a thin, but clearly defined line between these two views.  In terms of money supply, yesterday’s decision did little indicate that a significant expansion or contraction is coming.  Therefore, the Fed’s current economic outlook is likely one that sees slowing domestic GDP growth rather than an outright recession in the near future.  To quote CNBC’s Larry Kudlow, yesterday’s Federal Reserve commentary suggested that current policy is akin to ‘Goldilocks’.  Not too aggressive, not too easy.  And, again, this is exactly what they’ve been telling the markets for the last month.  So, assuming that investors understood what was coming in yesterday’s release, today’s selloff has to be attributable more to a shift in sentiment than from a change in the economic outlook.  Perhaps the last month has been one of those times when the market has deviated from its underlying fundamentals and we’re just now repricing reality back into the market.  That’s certainly an argument I’ve been making.  The fact that this change in sentiment may have happened now rather than in September is the element that’s caught me off guard.

As you can see from the daily chart of the S&P 500 below, the index busted through the upward sloping trend line that had been in place since early July.  This is a bearish development to say the least.  Furthermore, the index failed to find support at the 50% and 38.2% retracement levels associated with the high to low move seen from April to early July.  However, the market did find support just above the near term low around 1,085 that was seen on July 30th.  While this keeps the current uptrend alive, it’s hanging by a thread.

The Dow Jones Transportation Average mirrors this move in the S&P 500, though in greater scale.  This increased volatility in the Transports continues to be an interesting development.  What exactly it means at this point remains a mystery to me.

Despite a fairly resilient trade yesterday, crude oil followed the equity markets lower and finished the session down $2.97/barrel (-3.69%) to $77.46.  Needless to say, the support that I had been looking to at the $80 level dried up fairly quickly.  To be sure, oil is an economy-dependent commodity that will see a meaningful reduction in demand if the U.S. economy slows.  However, I still believe that the maintenance of oil in individual portfolios is warranted for geopolitical reasons, which is why I’ll be hanging on to my USO position for now.  Technically speaking, though, crude needs to hold around the $77 level to keep the current uptrend in place.  A break through this level opens the door to a fairly swift move down to $74.50.

Looking at this longer term weekly chart for crude, you can see that the market is nearing a decision point like so many other markets.  How the price action plays out if/when prices approach the down sloping trend line will say a lot about whether or not the bull market in crude can continue.  For my part, I suspect that the slowdown in the U.S. economy will keep a lid on things.  This doesn’t mean that the market can’t test the $90 level, but it does mean that there will be some fundamental challenges to overcome.  Also, any such move will likely be short in nature, so, again, staying nimble will be critical.

After complaining about the markets no giving me much to write about just a week ago, the back and forth of this week is enough for me to long for those stagnant days once again.  Maybe this is in part due to the hit I took in my IYT and USO positions today.  Thank goodness they’re fairly small.  Looking to tomorrow, I think the manner in which the market trades will be critical to discerning where we’re headed for the next couple of weeks.  If the market can hold and/or trade a little higher, the bull case will live on for a little while longer.  If we get another round of selling, though, I’ll be seriously considering squaring my Transports position and moving completely to the sidelines.  With so much uncertainty awash in this market, being on the sidelines could be one of the best places to be.  Until tomorrow…..