Blow-Off or Ending Diagonal?
When we recently wrote about the stock market's technical condition following the FOMC decision, we took another look at the wedge that has formed in many indexes and noted:
“Sometimes markets accelerate into a blow-off move from such formations – it has e.g. happened in 1999-2000. However, this is not always the case.”
We then spoke about the so-called 'ending diagonal', a formation the market could also be in the process of building. Obviously, we cannot see the future, but both the fundamental backdrop and the market's technical state give us important clues of an 'if-then' variety.
So what do the technical conditions tell us? Essentially they are saying: a big, temporally compressed move very likely lies directly ahead. From a trading perspective one would ideally wait for the market to make the direction of the move obvious via a break of either important support or resistance levels, and then take positions accordingly.
Option traders may even consider straddles, since volatility premiums are very low and the move is likely to be big and fast enough to compensate for the leg of the straddle that will be forfeit.
John Hussman recently also discussed the growing blow-off potential following the Fed's 'non-taper' decision, presenting a Sornette log periodic bubble formation in this context:
A bubble according to the Sornette log-periodic model: dips become ever more shallow, and the market's advance becomes 'parabolic'. The Sornette model shows that the market's fractal structures have a tendency to be repeated at several degrees of trend, something that will be familiar to Elliott Wave practitioners – click to enlarge.
It is important to keep in mind though what Mr. Hussmann points out with regard to the ultimate outcome of the formation of such a bubble:
“Whether or not this sort of outcome unfolds, the completion of the present market cycle appears likely to wipe out more than half of the market’s gains from the 2009 lows, as even run-of-the-mill bear market declines have regularly done in market cycles throughout history.”
Keep also in mind though that such a 'blow-off' move is by no means foreordained. Here is what the SPX currently looks like on a daily chart: as can be seen, the market still remains within the confines of the wedge we have previously discussed (as an aside, this also applies to the larger wedge in the weekly and monthly time frames):
SPX daily: still inside the wedge – we have drawn in the Fibonacci retracement levels of the rally from the November 2012 low – click to enlarge.
In other words, the 'ending diagonal' type outcome, which would be a very swift decline that erases all the gains made during the formation of the diagonal (and then some) in one third to one half of the time it took for the diagonal to form is by no means off the table. As to the fundamental backdrop: the just concluded German election and its aftermath as well as the upcoming debt ceiling wrangle in the US have the potential to serve either as a 'wall of worry' for the Sornette-bubble type blow-off, or as the 'excuse' or 'trigger' for breaking the wedge in a downward direction. It is impossible to tell which one it will be unless one is the mighty Zoltar.
When in doubt, we can always consult him…the mighty Zoltar!
(Image via )
Clues from the Yen
Now we come to what actually caused us to write this update. The one currency that to our mind remains the major 'risk on/risk off' indicator is the Japanese yen. And the yen has just built a formation that corroborates the above expressed view that a major move in a number of financial markets is imminent. Once again, it says nothing yet about the direction: it only says that a big directional move is soon going to begin.
A large contracting triangle in the yen – this will produce a major directional move and stocks can be expected to move in the exact opposite direction – click to enlarge.
This triangle in the yen is a 'classic' chart formation. It almost always results in a big directional move – usually it is more likely that the previous trend will be resumed (which would argue in favor of a blow-off move in stocks), but we cannot be certain of that until the yen actually breaks out. As can be seen, the triangle's apex is quite close, so the time is very soon. Here is the current speculative positioning in yen futures:
Speculators in toto continue to hold a large net short position in yen futures, but it has been reduced somewhat from its recent high – click to enlarge.
As can be seen, speculators continue to hold a large net short position, so the general expectation is that the yen will fall further. Often the market likes to confound such widely held expectations, but speculators have been quite correct about the yen during its initial leg down, so we must reserve judgment for now.
As can be seen below, the Nikkei index has also built a triangle in recent months, and here too one must consider that usually such a formation is held to be a continuation formation. However, we must once again wait for the actual breakout to occur before coming to a firm conclusion with regard to that. What once again holds is that the next move is likely to be a big and fast one:
The Nikkei, daily – another triangle – click to enlarge.
JGBs have been curiously strong in recent weeks, and currently rest almost right at their 200 day moving average. This market is likely to give us a clue as well by either being rejected at that moving average (bullish for stocks, bearish for the yen), or surpassing it (with the opposite implications):
JGB weekly, with 40 week (roughly equivalent to 200 day) moving average.
The Machines Are Lying in Wait
Back when we restarted this blog in May of 2010, our first post was entitled 'Dress Rehearsal for the Fully Automated Crash' – a reference to the HFT enhanced 'flash crash' that had occurred a dew days earlier. It may be worth recalling a passage from that article:
“Naturally, the computers doing the trading do not have emotions – that is precisely the reason why quant strategies have become so popular in the first place. It is held that they remove the human error factor from securities trading, by maintaining cold, pre-programmed objectivity in all situations.
This conviction is a close cousin to the conviction back in the late 1980's that 'portfolio insurance' using S&P futures to protect a basket of stocks dynamically with a likewise fully computerized procedure, could in fact insure stock portfolios against losses. Instead the combination of portfolio insurance and program trading (a form of arbitrage between stock index futures and the underlying baskets of stocks) combined to produce the biggest one day market crash in history in 1987. Any market in which a specific trader has 'become' an overwhelming percentage of the positions in this market is bound for problems. HFT and other quant strategies are a form of trading that effectively transforms the many different firms engaging in it into a single entity, due to the strong similarities in the strategies employed.
After all, the algorithms used by the black box community have been programmed by humans, all of whom work with the very same set of historical data to come up with effective trading rules that can be back-tested and thus legitimized. Instead of eliminating human error, the computerized strategies are in fact multiplying it, by dint of all of them reacting in virtually the same manner to a given set of inputs. And so the machines are perfectly capable of reciprocating the mindless greed and equally mindless panic that characterize the emotion-laden trading of mere humans, and in fact, it appears that they are capable of exacerbating both.”
This is just a reminder that once significant technical levels are violated, an onslaught of orders originated by computerized technical trading strategies can be expected. Regardless of the move's direction, these strategies are going to magnify it and speed it up. A true 'market test' of HFT and similar strategies probably still lies ahead.
Conclusion:
For nimble traders, a major opportunity is beginning to shape up in the markets. Longer term investors will have to consider their exposure as well, depending on the direction of the coming break. A failure of the wedge in SPX/COMP/NYA, etc. (downside break) would indicate that the danger of a major decline in stocks has risen considerably, as this wedge-like structure is repeated at several degrees of trend.
On the other hand, a blow-off like breakout to the upside would make life very easy for investors, as there would be a congregation of greater fools begging to buy their stocks at wildly inflated prices for several weeks just before they crash back down to earth.
For traders, the blow-off variety would require extra nimbleness: not all blow-offs are the same in extent and duration. The biggest one we have ever seen in stocks (aside from freak oddities like the late 80's bubble in the Kuwaiti OTC market) was the blow-off in the Nasdaq in 1999/2000, which started from a wedge-type formation as well. By contrast, the Nikkei's last gasp in 1989 was far smaller. One way of determining potential targets for such a blow-off is to calculate Fibonacci extensions,if only because a number of people as well as systematic black box trading systems (i.e., the above mentioned computer algos) will be doing that as well and thereby to some degree create a 'self-fulfilling prophecy' effect.
One thing is certain: the coming weeks and months are going to be 'interesting'.
Charts by: BigCharts, StockCharts, BarCharts, John Hussman