Chart Of The Day: Here's Why Stocks Are Likely To Rebound

On January 29, all four major US indices fell the most since the start of 2018, when yields reached their highest since April 2014.

The causal relationship between equities and Treasuries is threefold:

1. Investors rotate out of bonds and into equities when they seek growth, and rotate back to bonds when they seek security.
2. A rising yield suggests an outlook for a faster pace of rising rates, leading bond investors to cash out of current bonds and reinvest into higher yielding bonds after rates rise. Higher rates increase the cost of borrowing for companies which impedes growth and props up equity prices for investors.
3. A high yield makes it palatable for investors to give up on growth assets in favor of bond security.

In the first day of the selloff, on January 29, the S&P 500 index dropped a relatively modest 0.67 percent, the most since September. The overall decline erased nearly 12 percent of value within nine trading days, rendering it the worst two weeks within two years. This included the February 5, 4.1 percent plunge, the worst one-day decline since August 2011, when markets feared contagion from the European sovereign debt crisis.

Yesterday, the S&P 500 dropped the most in almost three weeks.

Intermarket structure dictated that the fundamental drive for the selloff was higher yields, especially due to the last two points mentioned above. The only problem then is that the S&P 500 capped its best five days since 2011, as investors demonstrated that they no longer fear higher yields and are embracing a stronger economy, which includes higher rates. At first, the prospects of faster economic growth and the higher interest rates that follow increased fear of higher borrowing costs hurting company growth, making it more costly for investors to prop up equity prices. But now investors have shifted the focus to the positive aspects of economic growth, which would provide a nurturing environment for companies to grow and for investors to afford buying stocks.

So far, so good, right?

Okay, so then what was yesterday’s selloff about? Fed Chair Powell signaled a faster pace to rising rates. But, wait a second. Didn’t we already cover that? Investors readjusted their expectations and all that. Confusing? Welcome to market psychology.

Any freely traded asset, much like fashion, is subject to trends. People are social beings, which means that they are affected by others. In ancient times, this drive to follow the herd was crucial for survival. Today, this same underlying psychology affects traders. When the S&P 500 dipped to the 2,532.69 low, a few brave traders went against the herd and bought into the dip. These are the equivalent of the tribal leaders, who stand up to the crowd; the cool kids who wear something new, to be copied by everyone else. The term we use for market leaders is smart money.

The more the price advanced, the more traders took notice and started seeing dollar signs, joining the new trend up, pushing it further along. Finally, by February 16, after a mind-numbing 8.75 percent rebound in six business days, the fastest advance in 18 months, traders took a step back. They questioned whether they had gone too far too fast. The last push, on February 14-16, was especially sharp, forming a “flag pole.”

The next three trading days were a consolidation – a flag, a continuation pattern – time for investors to take profits, handing over the mantle for taking prices higher to new blood, as well as for soul searching on the market environment.

Finally, the Friday-Monday rally provided a decisive upside breakout of the flag, signaling a resumption of the prevailing trend, starting at February 9, from the low of 2,532.69.

In a post breakout market dynamic, a decline, or “return move,” is typical. It is said to “retest” the integrity of the completed pattern. In other words, it tests whether its support or resistance will hold. In trading mechanics, a return move may be the last remnant of supply (demand, in a downside breakout), before the whole market is on the same side.

A second reason for a return move is that after the initial breakout (Friday), prices kept going (Monday), as bears rushed to cover fast-losing short positions, inserting their own demand into the equation. Once the shorts were covered, demand falls, overwhelmed by the same supply. However, after the near 4 percent flag pole and 8.75 percent rebound, investors would presumably consider this a buying opportunity, resuming the prevailing trend.

The Market Narrative

A new market narrative often accompanies such reversals as traders try to make sense of a seemingly senseless market. For example, stocks sell off on signs of faster economic growth, because it is bad for company profits and stock prices due to higher rates; then, stocks rally, because a faster pace of growth will be good for company profits and stock prices, and finally, stocks sell off again, because of the original reason.

The same thing happened around President Donald Trump’s election. Stocks rose ahead of elections because Clinton was the favorite to win, suggesting Trump was bad for the market. However, after Trump won, unabashed investors were justifying higher prices, reasoning that the same Trump agenda would be great for the economy and the market.

Trading Strategies – Long Position

Conservative traders would wait for the long-term trend to be reaffirmed by prices posting a peak higher than the former, January 26, 2,872.87 high.

Moderate traders might wait for a full return move, to bounce off the flag, at around 2,720. Then, they may wait for a green candle whose real body engulfs the preceding red body, or for a close above 2,780, the first upside breakout.

Aggressive traders may risk entering now, providing they accept the potential of a full return move.

Equity Management

Targets:

1. 2,780 – presumed resistance where initial breakout got stumped, overtaken by supply.
2. 2,820 – the height of the flag pole, as the same excitement is expected to repeat itself, as the tribe follows its leaders.

Stop-Losses:

1. 2,720 – presumed pattern support.
2. 2,700 – presumed support of end of late-February selloff.

There are many trading strategies available for the same instrument in the same time. A trader must establish a plan, which would include his resources and temperament. This is crucial and determines success or failure.

Pair entries and exits should provide a minimum 1:3 risk-reward ratio. They should suit your time frame, with the understanding that the further the prices are, the longer it will take to achieve them. Finally, understand that these guidelines are probability-based, which means by definition they include losses on individual trades, with the aim of profits on overall trades.