The Goldilocks Economy Meets the Big Bad Bear
Last week was quite a week to say the least. All the negatives that had been ignored for so long have finally come home to roost. The market suffered its steepest decline in over three years. The sell-off was so severe that it managed to undo five months worth of gains in only six trading days!
The main reason ascribed for the last week's carnage was what many market observers and I have been writing about for the last several weeks. Credit worries have finally come to the fore, and in a big way.
Why did the market shrug off these problems in the past? To answer this question we need to understand that markets act as a discounting mechanism. In the last six months when the subprime issue hit the markets, they quickly recovered. And in the case of the Dow and S&P, they went on to make new all-time highs. What was known to the markets then, was that the Subprime problem was contained and thus did not pose any threats to the overall economy, and by extension the equities market. Strong corporate earnings, a robust global economy, and tame inflation trumped mortgage concerns - up to that point. The Goldilocks economy was humming right along.
Recent developments have changed these views. The market's no longer complacent in regards to the repercussions of a credit crunch. The aftermath is being felt throughout not only the mortgage lenders and homebuilders, but several hedge funds have closed as a direct result of being over-leveraged in these dubious loans.
What's disconcerting to the markets now is the fact that this predicament may no longer just be exclusive to the lower echelon of the mortgage market. The latest casualty: American Home Mortgage (An Alt A Lender) on Tuesday of this week announced that they were unable to borrow money to fulfill their Loan obligations - in effect putting them out of business. The stocked dropped 90% after the announcement and was the main contributor in that days' late day price reversal.
Readers may recall in my piece {Subprime: the gift that keeps on giving} I wrote that the markets response to the news is much more important than the actual headline itself. Well, the market has spoken loud and clear. At some point, the market will discount the worse case scenario; this will be the point where the market will reverse. When this will happen is anybody's guess. As traders, all we can do is let the market speak to us - "loud and clear".
Now that we've delved into the whys and wherefores of the last dozen or so trading sessions, let's look at this week's charts. We'll start with the weekly chart of the ER2 (Below). I seldom have to look at this long a time-frame when I trade, but last week was one of those weeks that happen once about every three years or so.
We have not been witness to this wide of a weekly range, since the teeth of the bear market in 2002. This type of volatility is just what the doctor ordered, as far as we traders are concerned. Volatility equals opportunity, if you are prepared for it. Unfortunately for traders that have been trading less than three years, the current daily range expansions may prove to be too much if the proper adjustments are not made.
Now let's move to the daily chart of the ER2 below. What stands out is how oversold we are at current levels. Readers may also note that we closed at a major support area, going back to March of this year. This will be breached as of today's opening bell. As I write this newsletter early Wednesday morning August 1, the ER2 futures are trading down 5 points in the Globex overnight market.
Just because the ER2 is grossly oversold, does not mean it has to stop going down. When momentum takes hold of the market, very few catalysts can slow it down.
The last chart we'll look at is the hourly chart of the ER2. On this chart we see Monday's rally, which carried over to Tuesday morning, was repelled by the 30 EMA just as the slow stochastic was becoming overbought. This is classic corrective phase behavior.
In summary: Last week was the worst week for the bulls in almost 5 years and Tuesday's wicked reversal just served to heighten the overall anxiety among market participants. The character of the market is definitely changing; it's starting to feel like what a bear market feels like. I believe that even the long-term trend is becoming vulnerable here. In my previous report, I made note of the glaring divergences that were occurring as the market was making new highs. These proved to be very good early warning signs. In addition, when price action confirmed that a downtrend had emerged, shorting then became my preferred strategy. Going forward, the market is in a very precarious position. I have yet to see any signs of a bottoming process. I believe the market has not fully discounted the worse possible scenario from this Subprime fiasco. Therefore, as long as the short and intermediate term trend is down, I will favor selling rallies.
So until next time, I hope everyone has a profitable week.
|
Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the