Renowned economist John Maynard Keynes was famously quoted as saying: “Markets can remain irrational longer than you can remain solvent”. So far, 2023 has been very irrational. In the past 15 months, the Fed has been on one of the most aggressive rate hiking cycles in history. Raising the benchmark Fed Funds Target Rate from 0.25% to 5.25%. These rate increases take at least 12 months to impact the widespread economy, which means that the impacts of the last 3.5% worth of rate hikes have yet to hit the bottom line. In layman’s terms, there is still some economic pain coming.
Growth has already stalled in the US with present GDP readings of 2.6%, a bit below the historical average of around 3.13% (1948-2023). Real Estate, which makes up about 15% of GDP is also facing strong headwinds. 30-year fixed rate mortgages have skyrocketed from 2.5% to over 7% in less than 2 years. This increase may price many out of the market. The chart of the Case-Shiller 20-City home price index illustrates how severe the rate increases have been on home prices.
While investors enjoyed 20%+ year over year gains back in June of 2022, they are now experiencing -1.1% YoY losses! The last time we saw prices drop this quickly was back in 2007.
Earnings will also play a significant role in stock prices going forward. FactSet Researches latest report on earnings, estimated earnings for the S&P 500 to decline by -6.4% in Q2. The largest since the -31.6% decline in Q2 of 2020.
Despite all of this gloomy data, money is pouring into the equity markets. From the January 6th 2023 lows to the closing of the stock market last Friday, the Nasdaq 100 is up over 42%, and the S&P500 up over 16% in the same period. It’s getting to the point where I expect to see Alan Greenspan dust off his famous Irrational Exuberance speech from 1996!
Technically, markets are over bought and right in overhead supply zones which makes the prospects for a market pullback very appealing.
There is a slew of momentum indicators which are screaming that the markets are overbought right now. For example, on the chart below of the Nasdaq 100 ETF (QQQ), you can see 2 studies below the price chart.
The bottom one is RSI which measures the relative strength of this security to itself over the last 14 days. Readings over 70 indicate an overbought situation. At present we’re at 76. Above that is Stochastics which offer a similar view. It tells you where the price is in relation to its trading range over the last 20 days. A reading over 80 implies an overbought situation. Current reading on Stochastics: 94.
Directly over the price of QQQ’s, I’ve added Bollinger Bands, a classic overbought/oversold indicator. Based off statistics, there is a 95% chance that prices will remain in the blueish shaded area. Presently we are extended above the upper Bollinger band, further reinforcing the overbought theory.
While all the above arguments point to a market correction, the fact is that prices are continuing to ascend. The higher the market rallies the stronger the argument for a price pullback. Which brings me to my favorite market mantra: “The trend is your friend until the bend at the end”. As a trader, you have 3 choices here.
1 – Short the market immediately. This is the riskiest of all 3 options. The markets are indeed overbought, but that does not mean that they need to go down NOW!
2 – Just keep buying. While that will work for now, when the pullback comes, it could cause you more financial harm. Make sure you have a stop loss in place.
3 – Wait for the price to hit supply and move down, then either open short positions or sell current holdings.
Personally, I’m working on number 3. As you can see on the above chart, the Nasdaq is right in a weekly supply zone that goes back to March of this year (illustrated by the yellow box on the chart). I’m anticipating prices having difficulty making it through that level this week. I’m looking to short inside the yellow box, with a tight stop loss just above the supply zone. If that trade does not work out, there is another supply zone around $400 that I’ll try the same trade on.
My old mentor used to tell me that prices simply move from one point to another. When they start a move, nobody is in the trade. As prices move in one direction for a period, more people jump on the trade until there are no more people to push it. Then it simply starts in the opposite direction, with few people trading that direction.
If we’re not there now, we will be soon. Investors have been throwing caution to the wind despite some obvious market headwinds. This week also brings 2 days of testimony by Jerome Powell on Wednesday and Thursday which will add unpredictable volatility! Trade safely my friends!
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