The stock market has been on a roller coaster ride and many people are wondering if it is time to panic. This article will give you some insight into what you can do when the strategy of buying every single dip in the stock market stops working.
The story of the stock market in 2022...
It’s still early days, but it’s been a rough start for the stock market in 2022. Year to date the S&P 500 has lost -7.7%, the Nasdaq has fallen -11.6% and the Russell 2000 has dropped -11.5%.
In the process, all three of these major stock market indices have closed below their respective 200 day moving averages.
Why might this be a big deal? Well, the 200 day moving average (200 DMA) is one of the most widely watched indicators in technical analysis. Market participants use it as a general gauge for the long-term trend. This indicator is the line in the sand between a long-term uptrend and a long-term downtrend. When price is above the 200 DMA, the symbol is in a long-term uptrend, and vice versa.
This is not to say that when a stock or index crosses below the 200 DMA a bear market is imminent. But when a stock or index starts trading under its 200 DMA it tends to undergo a “personality shift”. Speed and volatility pick up.
Where price is in relation to the 200 DMA can give us some insight into who has the stronger hands. Under the 200 DMA, a lot of past buyers are in pain...and they’re quicker to sell (whether voluntarily or forced).
Poor stock market breadth is still an issue
I have previously warned about the very poor breadth in the Nasdaq and things have not improved on that front. In fact, breadth on the S&P 500 is now also looking problematic.
According to Sentimentrader, risk-0ff conditions prevail when the S&P 500 closes at a 40-day low and fewer than 56% of constituents are above their 200 DMA. As of Friday, the S&P 500 meets these criteria for the first time since 25 February 2020. The annualized return for the S&P 500 is during a risk-off regime is approximately half what it is during a risk-on regime (using data since 1927).
Nasdaq 100 breadth looks worse, where only 38% of stocks are trading above their respective 200 DMA.
Signs of Capitulation?
Taking a look at SPY (the ETF that tracks the S&P500) and volume on Friday 21st January spiked to an 18 month high. Could this be a capitulation low? Possibly. The last time volume in the ETF was this high was also at a time SPY was testing its 200 DMA. It survived the previous test...so there is hope!
Put buying also exploded on Friday. The CBOE put/call volume ratio on Friday was the highest since the Covid crash. Significant spikes on the put/call ratio are often roughly coincident with market lows, as they represent a climax in fear.
Some 30m puts were bought in the hole on Friday. These puts have all been hedged by market makers. When a market maker sells you a put, they effectively gain some long exposure to the stock (via being short puts). They need to hedge this risk by shorting some stock. It is in this way that a surge in put buying can exacerbate downside price action.
Now if the market starts to bounce next week, a lot of these new put buyers will likely sell their puts to cut their losses/manage their risk. Even of the puts don’t get sold, the delta on the puts will drop on a market rally.
IF the stock market rallies, market makers will need to reduce the amount of their hedges - because the delta on the puts they hedged is falling and quite possibly because the put-buyers turn seller. Market makers will reduces their hedges by covering (buying back) their short positions. In other words, market makers could add fuel to any incipient rally in the short term. (Of course none of this applies if markets continue to sell-off!)
This week in the stock market
This week beginning 24th January 2022 promises to be a big week for the stock market. Not only does earnings scomeason proper begin, we also have an FOMC meeting on Wednesday.
The Fed is in a tough spot right now. They have embarked on a campaign of tightening liquidity conditions in an environment of decelerating economic growth, decelerating earnings growth and an increasingly fragile stock market.
Will we see a dovish pivot from Powell and Co on Wednesday? If so, I think stocks will rip higher. But this will come at the expense of losing any credibility they may have in the fight against inflation.
What to do in a market like this?
Zoom out. Focus mostly on what indices, sectors, commodities and rates are doing. We’re entering a new regime of higher inflation and higher equity and rates volatility. Macro will tend to supersede everything else in this environment.
I also tighten up my risk management by taking smaller positions, and keeping my positions on a shorter leash (i.e. getting out at the first signs a trade isn’t working). I also moderate my returns expectations. There’s not much to be gained trying to “let profits run” in a choppy market.
When markets plunge, stock correlations tend to converge. In other words, they all tend to move up and down more or less together. I focus 90% of my analysis on what indices, bonds, commodities and sectors are doing. Fundamental stock picking tends not to deliver in this kind of regime...unless you’re only worried about relative performance. But having my portfolio only fall -5% when the S&P is down -7% is NOT my definition of winning.
Be open-minded
If you want to be profitable in this environment it’s important to have more than one strategy. Praying every single day that stocks go up is unlikely to be a winning strategy in 2022, even if it delivered last year. Better to be open-minded and own things that are going up and short things that are going down. If stocks suck, play a different game. Find something that is actually in an uptrend, or learn how to make money from falling stock prices.
In the early part of January I made some money buying dips in names like Qualcomm (QCOM), Ford (F) and the tech sector (XLK). I made more money taking bearish positions in names like Okta (OKTA), Garmin (GRMN) and Treasuries (via TLT). Some losses occurred when I tried to buy the dip in names like PYPL and PTON. Fortunately I got out of these positions quickly and for small losses when it became evident buy-the-dip was no longer working. I quickly more than made made the losses back by taking a bearish position in the Nasdaq (via QQQ). So far, my portfolio is up +13% ytd. Everything hasn’t gone perfectly, but I am happy with my approach in what has been a more challenging market environment.
If you would like to learn how to maximize your opportunities for profit in a choppy and uncertain stock market, check out our flagship online education program Options Academy Elevate today. We’re here to help :)
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