Psychology of a Turn

On Tuesday I used the George Soros quote “volatility peaks at turning points and diminishes as the trend becomes established” to suggest we might see larger volatility which could lead to a tradable rally in this severe downtrend. Yesterday we saw the release of “bad news” with a larger than expected reading on the CPI, I suggested that it might be a case of “bad news comes at the bottom”. These catchy phrases have real consequences in the market and understanding the psychological meaning of them can help to be better prepared to capitalize when they become relevant.

Let’s look at the Soros quote first. The most recent leg lower (from last Friday) has not been very volatile in terms of price movement. I consider a highly volatile market one where prices have huge swings in very short periods of time, which is different than what the VIX measures. From the highs of June 9, the market sold off in a neat and orderly fashion, there was very little back and forth movement. On Tuesday, we saw some wild intraday price swings, this action is caused by a fierce battle between buyers and sellers trying to take/ keep control of the trend.

While most people have been looking for a “V” bottom, where buyers suddenly gain control from sellers, this market has taken a couple of days to build a more solid level of support to rally from. The sellers have had control of the market for the last six weeks and there is no reason to think a rally will be anything more than a short term condition in an oversold market. Do not get me wrong, I am looking forward to trading from the long side if this bounce can develop further from here, but the market is in a primary downtrend and therefore all rallies should be viewed suspiciously. That means that long side trades should be kept small relative to your portfolio size and you need to be extra disciplined with your stops.

What about the phrase “bad news comes out at the bottom”? This mainstay in the financial press is very insightful if we consider who takes action when bad news comes out. If you have been short this market from higher prices because of a fear of inflation, you sold short anticipating we would see evidence of higher prices to the consumer. Yesterday’s CPI release confirmed the evidence that inflation may be creeping back into our economy. With large paper profits, the forward looking short sellers realized that what they expected was now known to the average person who picks up a daily newspaper. When everyone knows, who is left to sell? Only the least sophisticated investor. From the May 8 intraday high to yesterday’s open, the Nasdaq 100 shed 11.25%. For short sellers, this rout has been a windfall and locking in some of those gains by purchasing some of those shares sold short from some of the least sophisticated participants in the market is a no brainer.

The market looks poised for further gains this morning, but the primary trend remains lower, so be careful and do not chase stocks higher. Last night, I outlined a short term bullish play based on a MACD divergence on the hourly timeframe of the QQQQ and then timing a decision based on the 10 minute timeframe. If you are not familiar with this strategy, I suggest you view that video below. One last word of caution, the market trend remains lower, any rally from here should be treated as a counter trend rally and that means small share size and strict adherence to stops. Trading against the primary trend can be rewarding, but the rallies have a higher chance of failure.