​Stocks Need an Energy Drink, So Trade Small Lots, Stash Your Cash

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Trade small lots (if you trade at all), to increase hedges, to reduce longs during rallies and to put any new money into the confines of cash accounts. Use rallies to lighten up on stocks and ETFs, writes Dr. Joe Duarte.

Steven Tyler of Aerosmith once crooned in the classic hit Sweet Emotion: “my get up and go musta got up and went.”

Cash is king and the stock market seems in need of an energy drink.

Rising interest rates and the prospect of further rate increases by the Federal Reserve are starting to drain the bull market’s energy. In my prior note June 18, I described a scenario where the lure of higher yielding Treasury bills, money market deposits and other income producing low risk investments would eventually attract enough investors and thus cause a sluggish stock market as money flowed into cash.

Unfortunately, after last week’s crushing decline in the major indexes, it seems reasonable to consider that the process may be well under way. And while these trends take a while to be fully evident, this week I want to expand on the mechanics of this unfolding process as well as to provide a historical parallel which seems to be repeating at the current moment and can serve as a guide as to what may happen next.

Is History Calling?

As usual I will start with the New York Stock Exchange Advance Decline line (NYAD), the invaluable indicator whose accuracy regarding the stock market’s trend has made its analysis indispensable since the 2016 election. But before looking at the present, let’s have a look at what happened to NYAD in 1994, a period where the actions of the Federal Reserve were similar to the present.

chart 1

In 1994 the Federal Reserve, after a three-year period of lower interest rates to aid in the recovery after the now forgotten savings and loan crisis and banking meltdown, raised interest rates from 3% to 5.5% starting in February - leading to a bond market rout where the U.S. 10 Year note yield (TNX -middle panel bottom row of indicators) rose from 5.5 to 7.9%.

The result was a meltdown in the NYAD and a very choppy trading pattern for the S&P 500 (SPX). Most significant, from a charting standpoint, is the February to April period as the effect of suddenly rising interest rates led to a highly volatile stock market in which SPX dropped a full 10% before bouncing in April and July before finally falling apart by September.

chart 2

Flashing forward to 2018 we can see that so far, the stock market (SPX) has slowed its advance and has entered a trading range between 2580 and 2820 after the January swoon in stocks.

It is troubling to see the index behaving this way even as the NYAD has made several new highs. Interestingly the plot of the U.S. 10 Year note yield (TNX, middle panel of current NYAD chart) is eerily similar to the 1994 plot, both in scope and trajectory. Indeed, it’s a bit unnerving that SPX took a dip in February, similar to its 1994 decline and that it is also struggling in the present as it did in 1994.

A closer look at the money flow in SPX suggests traders are struggling with the market direction as the Accumulation Distribution (ADI) indicator has rolled over along with ROC while On Balance Volume is trying to improve as the index gropes for support at the 20-day moving average.

The result was a meltdown in the NYAD and a very choppy trading pattern for the S&P 500 (SPX). Most significant, from a charting standpoint, is the February to April period as the effect of suddenly rising interest rates led to a highly volatile stock market in which SPX dropped a full 10% before bouncing in April and July before finally falling apart by September.

FAANG Stocks Seem Tired as Market Turns Sluggish

Although the Nasdaq 100 (NDX) recently made a new high, this was likely influenced by the likes of Netflix (NFLX)) and the rest of the FAANG pack of stocks, whose market valuation heavily influences the index.

chart 4

Facebook (FB)), Apple(AAPL)), Amazon(AMZN)), Netflix(NFLX)), and Alphabet (GOOGL)) have been money magnets carrying NDX higher for most of the year. A look under the hood of AMZN, a stock which is representative of the entire group, shows negative money flow is increasing, as investors start bailing out.

chart 5

Especially alarming is the nearly broken down On Balance Volume on NDX coupled with a rapidly falling ROC; the latter indicating a loss of momentum.

You can see similar indications on the AMZN chart as well. Even more concerning is the lower low registered by ROC during each subsequent new high in NDX and SPX over the past 12 months, a sign that each new high in the indexes has been reached on lower momentum than the preceding rally.

Is It Time to Fade the Next Rally?

We may be near the point where even a good shot of caffeine, amino acids, and vitamins may not fully energize the stock market, at least for a while.

That’s because higher interest rates are usually the death knoll of bull markets and there are now persistent indicators that we may be closing in on that inflection point where investors realize it’s less risky to earn interest in cash than to throw money into the markets just to have the robots take it away.

In 1994, because interest rates were at 3% when the Fed started raising interest rates – compared to near zero in 2015 when the current cycle started – the stock market swooned soon after the central bank started its moves.

This time around it’s taken longer for the stock market’s struggles to begin as rates remained historically low even after three or four hikes. But, based on what I’m seeing at the moment with rates above 1.5%, the inflection point is either close at hand (weeks away) or has already passed.

It’s not certain, although not completely out of the question, that the stock market will crash. Instead, as best as I can tell at the moment, it seems as if there will be attempts to take stocks to higher highs from current levels at least for a while albeit with each rally being pushed by ever failing momentum. Accordingly, until proven otherwise, I’d say the odds of the rallies failing are well above even.

Thus, as I’ve said before it’s a good time to trade small lots (if you trade at all), to increase hedges, to reduce longs during rallies and to put any new money into the confines of cash accounts.

It also makes sense to use rallies to lighten up on stocks and ETFs unless they are inverse ETFs used in hedging.

Finally, if you’re looking for a reference point as to where the Fed may stop raising rates, history shows that the so called “sweet spot” – the range where the Fed thinks GDP can grow at 3% with inflation under control is a Fed Funds rate between 2.5 and 5%.

We are nowhere near that destination, which likely means that stocks will need energy drinks for the foreseeable future.

Joe Duarte is author of Trading Options for Dummies, now in its third edition. He writes about options and stocks at www.joeduarteinthemoneyoptions.com.

This article was originally published by MoneyShow.com: Founded in 1981, MoneyShow is a privately held financial media company headquartered in Sarasota, Florida. As a global network of investing and trading education, MoneyShow presents an extensive agenda of live and online events that attract over 75,000 investors, traders and financial advisors around the world.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 145.01 0.51 0.35 18,095,450 Trade
GOOGL Alphabet Inc. 1,073.54 -0.19 -0.02 1,249,238 Trade
NFLX Netflix Inc. 276.02 1.14 0.41 8,374,161 Trade
AAPL Apple Inc. 170.95 1.85 1.09 31,761,136 Trade
AMZN Amazon.com Inc. 1,658.38 -5.16 -0.31 5,253,067 Trade

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