Everything has gone macro. As the larger equity market sells off, the company-specific news is being ignored by investors. So today, we will discuss what is next for the Dow Jones Industrial Average. Fear about interest rates, political upheaval, caravans, slowing global economy, the stalemate in the trade talks with China, etc. The list goes on and on. These are all short-term concerns. Investors have been ignoring the long-term problems for years (insolvent pension systems, excessive government debt at all levels to name a few). Investors will one day consider these issues, but we will have to wait until we have a protracted bear market and recession before they become a topic of the financial and political news scene.
Socionomically speaking, crowd psychology matters. Happiness and confidence go with bull markets. On the flip side of the coin, anger and fear go with bear markets. Fear and anger seem to be where we are right now. The riots in Portland Oregon are getting out of control. In case you are not aware of what is going on there, here is a video of what took place about a week ago. Warning, there is offensive language. Here is another. With certain parts of society becoming unhinged, it is not surprising that negative emotions from the extreme ends of society are beginning to bleed into the average member of the crowd. While we might like to believe that investors, even professional investors are rational, they are all people and there are times when emotions overrun rationality. As a result, this angst and fear comes out and shows up in the equity markets as investors would rather sell first and ask questions later.
The chart above shows the short term price action of the Dow Jones Industrial Average. When the world gets emotional, the wave structure of the market often becomes more clear. After peaking at the beginning of October, the index fell in 5 waves. It appears that the 5 wave move is over. If this is the case, then we should see a bounce in equity prices that will take a week or two to play out. At the end of that bounce, the selloff should return with a vengeance.
At this point, we have some price targets for the bounce. The first target area we look at the range of wave 4, which is the 25,000 to 25,800 range. To target specific points, we look at 38.2% and 61.8% retracements of the sell-off. These points are 25,380 and 25,930 respectively. If this forecast is correct, then we should expect a rally of about 1,000 D0w points give or take a few hundred points.
One should be aware that there are other interpretations of the wave count that are extremely bearish. It is entirely possible that the equity markets are in the process of a crash. But, we put the odds of such an event at just 10% or so. But 10% is significant in this context. We are in the bounce camp at the moment because the RSI is oversold on a daily basis and downside momentum is at near-term extreme levels. These technical readings suggest to us that we are at a short term extreme.
In addition, the Volatility Index shows that investors are starting to pay up big time for short-term options. The VIX is now trading at 24.5% which is just around the area where it traded during the selloff off in February of this year. It indicates that investors are fearful and willing to pay up buy puts to protect their portfolios. Put these factors together and we think a bounce is on the way that will serve as a Prozac to investors. Just when that fear is gone and people think the worst is past, this is when we will be on guard for the next leg down.
There are 2 courses of action one can take. You can play the bounce and use that bounce to sell positions you might feel trapped in or wait until the bounce is over and set yourself up for the next leg down. If you want to play the bounce, we suggest you consider a call or at the money call spread. We are not really too excited about these trades as implied volatility is so high at just over 22% which makes options very expensive on a historical basis. That said, with SPY trading at $267.28, the following analysis shows a bullish call spread.
In this trade, the investor pays $259 up front with the hopes of making $241. Given that there is just a 40% chance of making a buck on the trade, the risk-reward is not as attractive as the typical trade we discuss on these pages. Hence our reluctance to suggest such a trade. If you do decide to trade the bounce, we suggest options on SPY. They are more liquid than options in DIA and IWM.
On a final note, ideally, we would have liked to suggest a single leg call. But as you can see, a 22-day call on SPY that is $0.75 out of the money costs $5.61. Such an option is going to decay by about $0.20 to $0.25 a day. To fight this decay, the bounce must be strong and persistent for the investor to make out of the trade. Net-Net, we have low conviction at this time.
We are following the situation closely as we want all our readers to be prepared for the next leg down.
Mark is long some far out of the money call spreads on IWM and SPY that were sold long ago expecting them to expire worthless shortly.
