Good morning traders. Some excerpts from the morning note I wrote this morning for Waverly Advisors:
Equities: We do have a bit of a mixed bag coming into this week in the global Equities markets. On one hand, our domestic markets seem to be set up quite well for another leg in the rally. Microcap indexes have cleanly taken out the year’s highs last week, and are holding those gains. Leading sectors are performing well, and market structure in the most-watched indexes (Dow Jones, S&P 500, Russell 2000 and Nasdaq Composite) also supports the probability of a continued advance. 1246.50 on the S&P Cash has emerged as a clear inflection point. If this current rally attempt fails, we can easily expect a selloff into the mid 1,220’s (S&P Cash), but we are still viewing any selloff as an opportunity to cautiously increase long exposure.
Looking abroad, the situation is more complex. As of the time of this writing (12:00 AM EST), Chinese indexes are down about 2.5 standard deviations (roughly -3.0%), probably responding to a 1-2 punch of regulatory concerns over pricing in Chinese pharmaceuticals and the precarious situation in Korea. However, this morning’s price action only highlights our concerns in the region. For several weeks, we have reiterated our concerns over the market structure of Chinese equities (and, to a lesser extent, Brazil) where we see momentum on multiple timeframes rolling over, suggesting the possibility of a sharp selloff below support. We are not naïve enough to assume that our domestic markets can absorb a major break in the Chinese indexes without some significant contagion. We maintain our cautiously bullish stance on US Equities, but we do find ourselves focusing more and more on the “cautious” part of that call.
There is a strong seasonal tendency for volatility to crater into the end of the year in many markets, but particularly the stock market. We are currently looking at 20 day realized vols in the major indexes ranging from 11.9% – 13.9%, which is in the lower end of the historical range. Implied vols are generally in-line with realized, with no notable divergences. As a rough rule of thumb, we believe we can expect to see realizeds come in another 2% or so across the board over the next two weeks, with corresponding moves in the implieds of about half that. These seasonally depressed vols may offer attractive spots to initiate long volatility spreads or volatility-dependent hedges, but also beware of potential liquidity risk into the end of the year. An execution mistake in a thin market can undo a lot of careful work on other aspects of the trade.
Currencies: We continue to hold our small short position in the US Dollar Index futures. Though the move in the Dollar has not been clean, we do feel there is good potential in this trade. From a timing perspective, it is also possible that volatility will contract into the end of the year and that the Dollar will remain close to current levels. If so, we will simply give the trade some time to work, as we believe our existing stop is the correct risk level for the position….
Metals: The precious metals continue to consolidate, painting large “triangles” on daily charts that highlight the contracting swings and volatility. Classically, these types of formations do tend to resolve with a breakout that leads to an extended trend. There is also a slight edge to a break in the direction of the pre-existing trend (which is clearly up in this case), but these may also be markets that may languish at current levels through the end of the year. Whether you are long or short, have a clear risk management plan….
For daytraders, the seasonal tendency for volatility contraction is something to think about this week. There is a very good chance that we will see some of the typical “holiday market” action this week — low volume and low volatility as the market chops with no direction. From a practical standpoint, something that will help many daytraders is to simply not initiate a trade if the market you are trading is showing small range bars and is chopping around both sides of a short-term moving average. (More on that in this post.) In-play stocks can trend cleanly in this kind of environment, as there is simply a lack of liquidity on the other side to absorb the volume, but in the absence of a real imbalance, markets this week are likely to be more random than usual. Perhaps cut your risk and/or the number of trades you do during the day, and focus on the best plays.
Today, there are two broad scenarios that occupy my energy this morning. 1) We will probably open at new highs on the year, and could trend cleanly above that level. 1242 on the March futures is the key level to watch for this scenario. As for how strong and how far the market can trend in this pre-holiday environment–that’s another question to which I don’t have a good answer. As long as we’re above that inflection point and the market is showing some upside momentum, you need to be long. 2) There is the possibility of a failure and a 2B top at this precise point. If we fail back below the level on good momentum, this could actually kill the year-end rally. The key to this scenario will be failing strongly (10+ S&P points) on good momentum. Even though foreign markets recovered the drop I referred to overnight, this kind of price action probably does point to a real underlying nervousness at these levels. If you think you see this scenario in play, do not get trapped on a simple pullback below the level. I will be focusing on Financials and Tech this morning, tending to avoid Basic Materials unless I see something very clean. Also watch your sector indexes because it will be possible to tell what is in play in the first 10 minutes based on price action there. More than usual even, I will be relying the SMB Radar to show me what is in play and will focus my attention there.
I will be on semi-vacation this week. I will continue to post this morning note (though probably not tomorrow), but will be trading lightly, if at all, during the day, so I may not have much to say on Twitter. If something is really moving, I will probably be trading it and I’ll try to give a shout out on Twitter so follow me there: AdamG_SMB.
