The Arrow Versus The Wash Cycle
If this week’s headline sounds bizarre or discouraging it shouldn’t. Traders love good directional moves and rightfully so because they’re so nice and so profitable – almost on the spot. But the reality is that powerful market trends develop only about 30-40% of the overall trading times. The other 60-70% of the time is spent in transitions and consolidations of various forms and natures that actually set the stage for the 30-40% things.
Since markets are just an extension of human social behavior, I always like to involve analogies when describing market concepts. A directional move, for instance, is like an arrow – or, for my redneck friends and readers, like a bullet J: it travels some distance in a straight line to deliver something, make a point or achieve some combination of both. Its trajectory, while a function of both the release energy and its own weight / gravity properties, is largely predictable – in fact people constantly fired them at opponents throughout history precisely because of that. A transition or a consolidation phase is very different – it is more like a washer cycle: it doesn’t travel much net distance though at all times it can be moving in one direction or the other with different tempos. Whatever it travels, it does so in utterly convoluted forms and its trajectory is largely unpredictable – though the predictable outcome is that any clothing that comes out of a complete washer cycle in one piece can be worn again with a sense of pride and dignity.
Understanding which one of the two things is more probable at any one time can be very empowering. Understanding the imminence of a directional move can prepare you for an upcoming “kill”; grasping the imminence or the unfolding of a washer cycle can help you avoid “getting killed” (i.e. whipsawed) by a choppy market. Combining the two approaches at different degrees of trend may even help you make a little bit of money on small arrows (directional moves) that develop inside larger washer cycles (consolidation / transition phases).
This discussion is very important right now for the reason we have discussed last week: it is a distinct possibility that Trump’s America is evolving into a safe-heaven in an increasingly chaotic and turbulent world. Brexit remains a mess. The economic and social situation in Europe is deteriorating every week. Many if not all major Asian economies are struggling. Things are not perfect in the US but at least somebody is fighting for the country mostly with the right ideas: economic security, low taxes, border and immigration control, an interruption of the imbecilic militarism of the past 3 decades and so on. Increasingly, beneath the non-sense talking and actions of the corrupt career politicians, the markets are recognizing that Trump is right – and he may actually single handedly engineer a 4th wave consolidation and a 5th wave final run of intermediate degree. In all large, mid and small cap indices we are beginning to see hints that while the initial phase of a stock market rebound is nearing completion, the subsequent pullback would find support somewhere above the December lows and ultimately lead to a larger advance. The constant stream of alternating positive and negative domestic and international news is likely to give us an overall sideways market for now, i.e. a washer cycle. This forecast is to be defended at the December lows for now and by extension at some key levels slightly beneath them. With the information we have today, I suspect we have enough reasons to officially return to a cautious buy on dips stance because if our 4th wave idea is correct, the major indices will simply chop higher towards the November and then the September peaks in the first part of 2019.
The counts below explain the key levels and the targets to work with.
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As we head into week two of the new year, implied correlation among stocks remains high even as volatility has fallen. Week two of the new year also brings the kickoff to earnings season further adding to the tricky environment for stock pickers. Due to this, ETFs will remain the play for the week.
While the ETF universe is massive, I have built scans which include only those with a minimum level of volume (500k+ average daily volume) as well as those with a minimum beta so that they move more than the overall indexes. My list includes about 125 names currently.
The theme this week that I noticed when going through the list is “no man’s land.” Meaning, with the sharp bounce we have experienced in the majority of stocks and ETFs so far in 2019, we are at levels that I have found to be overbought, while at the same time almost nothing is shortable either. I had to stretch to find 3 ETFs that I would feel safe taking a position in until we get some sort of resolution. Are we in a market ripe for a sell off? Or are these V bottoms the real deal and we head higher like Q4 2018 didn’t happen? I expect resolution in the next couple of weeks, but until then, plenty of cash is okay.
IYR
| DIRECTION | SELLZONE | TARGET | RISK/REWARD | VEHICLE |
| Short | 77.75-78 | 74 | -.25/4.00 | Options |
The IYR Real Estate ETF has now retraced 50% of the recent downtrend and is bumping up against major resistance with the 5 year VPOC directly above. From this area of confluence we have a ceiling from which we will know quickly if our short thesis is incorrect. That is the best we can do in trading; put ourselves in position to capture up, or in this case downside, while having a very defined level by which we exit if wrong. We don’t predict the future because we can’t.
XLY
| DIRECTION | SELLZONE | TARGET | RISK/REWARD | VEHICLE |
| Short | 104.50-105 | 99 | -.10/5.00 | Options |
A similar look to IYR, consumer discretionary has ripped from the lows up to the daily VPOC taking into account a year of price history. RSI has started to level off and we can see that price has struggled with this area for a couple of sessions now giving us an area for which we can call a near term ceiling. If this falls from current levels watch for XLY to put in a possible inverted head and shoulders from this Adam bottom. Until proven wrong however, I want to be short from 105.
VXX
| DIRECTION | BUYZONE | TARGET | RISK/REWARD | VEHICLE |
| Long | 38-39 | 53-54 | -2/12 | Options |
The VXX ETN seems to be shaping up for some volatility expansion in the coming weeks. This may make sense with earnings season looming that we get an uptick in the VIX. And if you are largely long, it never hurts to buy insurance when insurance is cheap.