There has been a notable change in tone in the stock market this past week-and-a-half, which leaves me feeling more uncertain about continuing to “buy the dip”.
Let’s put aside speculation regarding “Nasdaq whales” or “Robinhood traders” for a moment and simply focus in what price action is telling us.
It all began with the Nasdaq’s -5% fall on Thursday 3rd September. This was a sharp descent from the previous day’s lifetime high in the index...which was preceded by a series of near vertical moves in a number of multi-billion dollar mega-cap stocks.
Indeed, in the three trading days following its lifetime high on 2nd September, the QQQ ETF (which tracks the Nasdaq) declined -11.15%. This marked the fastest correction (defined as a 10% fall from high to low) in the Nasdaq’s history.
Since April, “buy the dip” has been a strategy that has worked like a charm - particularly in the Nasdaq. That may be about to change.
Why this sell-off looks more ominous
There are some important technical developments I highlight below, that have me leaning more towards the bearish side for the next little while.
1. S&P 500 and Nasdaq have both closed below their respective 21 EMAs
I find the 21 day exponential moving average (EMA) to be an excellent gauge of a financial instrument’s mean price. It is a price level a stock or index will want to check every so often, whether it’s in an uptrend or a downtrend (for a lesson on reversion to the mean, please review chapter 7 of my book).
Both the S&P 500 (SPY) and the Nasdaq (QQQ) have put in 4 consecutive closes below their 21 EMAs. This is a heads-up that the short-to-medium term trend has changed from down to up.
2. The 8 EMA has crossed under the 21 EMA
Further, the 8 EMA has crossed under the 21 EMA on both the SPY and the QQQ. The last time this happened was 25th February 2020...and we all know what followed.
The 8 EMA crossing under the 21 EMA is a useful short-term sell signal.
What is more ominous is that the intra-day rally the Nasdaq managed to put in on Thursday 10th September failed almost exactly at the 21 EMA. This line - the 21 EMA - will tend to act as support in an uptrend and resistance in a downtrend (I explain how this works in detail in chapters 5 and 6 of my book).
The S&P 500 (chart of the SPY ETF shown below) has all of the same warnings:
i) 4 consecutive closes below the 21 EMA
ii) A rally from beneath the 21 EMA failed right at the 21 EMA
iii) 8 EMA just just crossed under the 21 EMA
Does this mean markets are toast?
I’m not expecting a repeat of February/March. We are in a different liquidity environment from then, and markets are far less paralyzed by the fear and uncertainty of a new and unknown pandemic.
But history has taught me to be far more cautious about buying the dip when the 8 EMA has crossed under the 21 EMA. This is my short-term sell signal.
We will likely get some decent rallies in the days ahead, but I expect they will be mixed with some more big down days as well...something we haven’t seen for months.
In other words, buying every dip - which worked like an absolute charm in August - is unlikely to work nearly so well...at least until the 8 EMA crosses back above the 21 EMA.
The vast majority of my trading has been from the long side since March. I have done a few index hedges along the way but my trading has been almost entirely long.
I expect I’ll be taking a few more short-term short trades in the near future. “Selling the rip” tends to work well in this environment.
Right now it’s time for patience
But for right now, I’m flat. No positions. For the first time in 2020.
Having no positions on doesn’t mean I’m uber-bearish, as some people have misinterpreted. If I was uber-bearish, I’d be short the market!
It simply means I’m navigating a potential change in trend, without any emotional (or positional) baggage.
It is very early days in the potential change in trend that I have highlighted. If we see some solid action to the upside in market leaders like Apple, Microsoft and Amazon early next week, it could be a false signal.
I had a great month in August and a large part of what I’m trying to do here is consolidate my gains and be patient. A fully-loaded long portfolio just strikes me as not the best idea at this moment.
Longer term?
Even if the short-term sell signal is confirmed and stock markets trend lower from here, I do not believe the broader stock market rally is over. Significantly more technical damage would need to be inflicted to call the longer-term trend into question.
I’m anticipating the S&P 500 will find support in the 3150-3250 region. If we get signs of a bottom within in this range, I’ll be loading up long again, with my next upside target at around 3700.
I expect I will have a busy couple of weeks coming up...with trading opportunities on both side of the market.
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