The markets continue to remain under pressure, but the narrow based indices continue to hold up fairly well. I continue to mention the weakness and declines in the Russell (broad-based index), which is a better gauge of over-all order flow into the market. We need to continue to monitor the Russell index and watch for support.
Are we crashing?
I did receive some emails from the last couple of days wondering if I believe we are facing a serious correction, especially after my overly critical Market Preview yesterday. I tried to be clear in the previous and recent Market Previews that I didn’t think that we would see a serious correction yet, especially with the mid-term elections and the FOMC meeting in October. That is not to say the improbable is not impossible. One should always hedge against losses, known and unknown. In summary, if you are long stock unhedged, make sure to hedge. If you are looking to entire a bullish position, do so with a hedge or with options.
Watch the Russell
The Russell index is the broadest of the indices and is one of the best order flow monitors of the equity markets. One reason, as pervious pointed out, is the breath of the issues in the index and the lack of over-weights single issues driving the index.
We are in the midst of a pull-back and we are yet to those critical support levels in the broader based Russell index that I tend to watch more closely. The 1110-1120 is the near-term support level in which we saw volume drive back into the broader market. If we got back to the May time period we see consolidation and volume pick up in the 1090 – 1110 area. Currently we are holding right into that first support level are and this could very well be a buying opportunity in the short-term, if we are to get a rebound. However, some volatility could push this index into the lower 1090-1110 area, so expect a ride.
Even CNBC is starting to take note of the narrower based and more highly touted indices seemingly to be stretching their necks a little far when compared to the Russell. We have heard the terms “Death Cross” and stories about the Russell index down on the year and why that should bring broader concerns (just search CNBC for death cross and RUT and you will get a list of recent stories over the last week).
Frankly CNBC is a day late and dollar short covering this concern, they should have been monitoring this from the start as most traders on the floor realize that the Dow Jones is a psychological index at best and is not representative of the entire market. I wrote and extensive Market Preview covering the difference here.
Here is a comparison, take a look at the Russell index compared to the narrower based.
Notice that since the beginning of the year how the Russell has either over or under performed in a relative percentage compared to the other indices. The spreads between relative performances seems to only have widen. The concerns that I have been referring to is since the recent rebound in August, the Russell has sold back off compared to the narrower indices, which are driven by over-weights and have remained elevated. Over-time order flow moves into and out of the market in a tandem fashion and that function creates a mean reversion.
The question is who is driving this bus? Is it the Russell that is the lead indicator of order flow or is it the narrower indices like the Dow Jones or S&P? Traditionally, the best gauge of broad-based order flow has always been the non-over-weight and broader Russell.
If we look when at the start of the year, we see these indices were in tandem and working in parallel. Then by April we see a divergence, were the broader market becomes weak as order flow and volume dry up, yet the narrower indices form a holding pattern and don’t decline. As the Russell sees a drive back up, the narrower based indices pick up again. However, by late June / early July we see weakness return in the Russell as it heads back down, the other indices follow suite shortly after, following Russell’s lead. This coincides with the heighten concern about the Fed raising rates and a move out of equities, however a little late in the narrower indices when compared to the Russell. In early August we see a rebound again, but the Russell never makes it back to its previous high and then sees weakness again and then in delayed fashion we see the Dow Jones and S&P follow the Russell lower.
We should watch to see if the Russell finds support here and starts rallying again. If it breaks down and continues to head lower, it is a sign that money is flowing out of broad based market. That also means it will be significantly harder for the few over-weight headline name stocks to keep the indices from declining. Apple and its big name over-weight brethren’s can only carry the indices for so long.
True, I have seen days in which the NDX index is up and 99 out of the hundred stocks are down, all because Apple is up a huge amount and being the over-weight in the index, it kept the index in the green and positive. However, is the index at this point truly representational of the entire NDX tech sector? Absolutely not, one stock has driven it higher. This is one of the core defects in Dow Jones and NDX and to a significantly lesser extent the S&P 500.
There is also sector rotation. Since the start of the crisis we have seen a rush into yield generating stocks (dividends), that has driven them higher and yields lower. Traditionally we see money staying IN the equity markets moving from one sector to another. Selling tech to buy bio-tech, selling bio-tech to buy defense, selling defense to buy blue-chips. This herd movement widens spreads between indices, driving one higher and another lower. However, this is usually sector specific and is far easier to monitor when looking at narrower based sector driven indices. When we look at the Russell 2000 (2000 stocks) and see a drop in volume and drop in price, that means order flow is also leaving the equity market and not just a sector rotation. I can’t deny we have seen a rush into Apple with the iPhone release, as well as sales of existing stock positions to jump onto new IPOs, like Alibaba – which steals market share from other stock investments.
So we need to expect spreads between indices, that’s normal as we see money chasing the hot sector of the week or month. What we also need to take notice of is broad order flow, volume, and liquidity entering and exiting the market. This is where the Russell (RUT) comes in.
RUT leads the charge?
If we get a bounce in the Russell today, look to see if the percentage increase is larger than the narrower based indices. Look at volume participation as well. If we see the Russell pick up some volume and steam and get above that 1120 level and put in a solid floor here – we could be setting up for another rally. I would feel far more confident in a solid close on volume at 1130.
Courtesy of Silexx
Fed driving the bus!
Again, I am NOT looking for a major correction yet. The Fed is still driving this bus and with the mid-terms they can’t let a larger correction or a crash to take place, it will be detrimental to the administration and the party that put the new Fed Chair and governors in power. Additionally, while not part of their “official” measure of economic data that sets monetary policy, they do watch the equity markets and have even commented on it.
However, to blindly have faith in the Fed is to ignore the probability that risk does and will always exist. Hedging long positions is prudent, now more than ever. Those looking for short-term opportunities, should look to use some option strategies to play for a bounce in this broad support area or even a further drop. Straddle and Strangle type strategies are a great way to play for unknown volatility. In any case, an option position can increase returns and limit risk. What I would avoid is naked long buying stock at these levels.
It may be improbable, but certainly not impossible.
Support & Resistance
The pre-market futures are looking positive, but not super strong. We could be in for some consolidation above 17,000.
This could be a straddle strike area and we could quickly move to 4000 or 4100. I would not be heavily delta directional right now and look at trading from a long Gamma position in here.
This is a critical area for the SPX, if we don’t hold we could drop sharply to the 1960 and then 1940 level. The VIX is elevated, but not reflecting panic just yet.
Even if the Dow Jones, NDX, and S&P 500 are down on the day, but we see a strong day in the Russell closing above the 1120 level, I think it might be a sign of a bounce as we hit support. Watch the Russell on the close. The short-term low range is the 1110 – 1120 range; the broader support is down in the 1090 – 1110 range.
Hedge and take advantage of opportunities!
Now is a time to make sure you have your long-term hedges on and ALSO look for opportunity. When others are panicking, you should be spotting opportunities. I am not talking about just buying a bunch of stock, but taking more calculated positions with tighter risk controls. These short-term events are where option strategies shine and can generate large rewards with limited risk.
Hedge your hard deltas, (long and short stock positions) with options. Meanwhile use options to put on some bullish, bearish, and/or volatile expectation strategies. Do NOT start selling strangles or straddles naked in this environment and this is certainly not the “in the box” vanilla iron-condor time either. If you want to sell premium, which is getting to a good price to sell, LEG INTO those positions with spreads and then lock in gains by converting them into flies.