What happens when the market begins to fixate on something … say, progress (or setbacks) toward a cure for a global pandemic?
Might that singular focus result in dangerous volatility as good (or bad) news toys with investors?
Today, let’s answer this and several related questions with the help of our resident quant experts, John Jagerson and Wade Hansen.
In their newsletter, Strategic Trader, John and Wade combine fundamental and technical analysis, along with historical market data, to profitably trade options even during times of massive volatility.
In their update to subscribers last week, John and Wade touched on a range of topics — from how investors should respond to markets being overextended right now, to Wall Street’s myopic focus on a coronavirus vaccine, to what risk indicators are telling us (think junk bonds and transportation stocks), and more.
As always, John and Wade provide timely, actionable takeaways that can make a difference in your portfolio.
So, in this Sunday Digest, let’s see how they’re viewing the markets today.
Have a wonderful Memorial Day weekend,
A Market with a Single Focus Can Lead to Surprises
By John Jagerson and Wade Hansen
This week’s update will emphasize some of the reasons the market may be overextended right now, but it is not a suggestion that you become bearish or avoid any bullish positions.
Rather, our objective is to be clear-eyed about the risks we face right now and why our strategy should remain focused on generating income as a way to profit and protect our gains even if the market declines again.
From a fundamental perspective, forward valuations haven’t been this high since 2002, which indicates that stock prices are a little “rich” and the trend is fragile.
All the job losses over the last few weeks have put the labor force participation rate at multidecade lows, which is likely to add weight to resistance levels and should motivate us to avoid stocks in the home builder and basic materials sectors, among others.
And as we mentioned in last week’s update, the market is showing some signs of shifting sentiment. Nothing appears to be too problematic yet, but the potential for the S&P 500 to hit resistance at or around 2,930 is something we want to keep in mind.
On the bright side, Monday’s 3% rally was the biggest bullish day in six weeks. April 6 and April 8 were better, with gains of 7% and 3.41% respectively, but, interestingly, the same kind of news drove all three days’ gains.
In April, the buying was triggered by quickly falling death rates in some virus hotspots in Europe, and on Monday, it was news that a new vaccine therapy may be ready more quickly than expected.
When traders have a mono-focus like this, the potential for surprises at resistance levels increases. For example, yesterday The STAT reported that vaccine experts do not see the preliminary results provided by this vaccine’s developer, Moderna (MRNA), as strong enough to back up its claims of effectiveness. The major indexes reversed lower after that news hit the market.
When traders become hyper-focused on a single issue, volatility tends to rise. Consider the bear market of 2018, which was triggered by a long back and forth over a resolution to the U.S.-China trade war.
The best way to deal with this kind of risk is not to bet against the market but to be assertive about how we are managing our own bullish risks. This is one of the reasons we were eager to cover Nike (NKE) with a short call on Tuesday, even though the stock was on its way higher.
If more unexpected bad news about the virus or a vaccine hits the market over the next several days, selling calls and collecting premium gives us a hedge against potential losses and an opportunity to compound our income on the declines.
Because a hyper-focused market can lead to a volatility feedback-loop, we should discuss what we are watching that would trigger a more conservative outlook.
As you can see in the following chart, the S&P 500 hasn’t made much progress from where prices were at the end of April. This is true of several other asset classes as well. Gold and oil are higher, but the dollar and Treasury bonds are flat compared to last week.
Daily Chart of the S&P 500 (SPX) — Chart Source: TradingView
Risk indicators are mostly unchanged as well. The CBOE SKEW Index (SKEW) and CBOE S&P 500 Volatility Index (VIX) are back to where they were last week.
Another index that we like to monitor closely for signs of market stress is the high-yield or “junk” bond market. However, here too, sentiment seems relatively flat.
The exchange-traded funds (ETFs) that hold high-yield bonds act as a good proxy for judging the health of the junk bond market, and we’re looking at the iShares High Yield Bond ETF (HYG) in particular.
It is not uncommon for junk bonds to give us warning of a weak market. For example, junk bonds sold off two months before the 2018 bear market, and in the chart below, you can see they failed to make corresponding new highs with the S&P 500 before the selloff this spring.
Daily Chart of the iShares High Yield Bond ETF (HYG) — Chart Source: TradingView
Because government-subsidized borrowing is an important part of the current stimulus negotiations between the U.S. House of Representatives and Senate, this is a good indicator to monitor for weakness.
From a technical perspective, a break below $78 per share on HYG would serve as a good warning that we should wait before adding any new bullish positions in the portfolio. It would also be a sign that we should be more aggressive with any new covered calls.
Transportation stocks could also give us an early warning about a decline, or they could alert us about an upcoming bullish breakout. Most analysts haven’t been watching the transportation sector as closely as usual because of the distortions created by the COVID-19 pandemic, but with the initial impact priced in, this is an important group to monitor again.
As you can see in the following chart, despite rising oil prices, which are usually a boost to transportation stocks, the Dow Jones Transportation Index has lagged the major indexes and remained below its April highs. From a technical perspective, a break below 7,800 would be an alarming signal for stocks.
Daily Chart of the Dow Jones Transportation Average Index (DJT) — Chart Source: TradingView
The Bottom Line
We are currently in the doldrums of scheduled market news. Earnings season for the first quarter is essentially wrapped up, and most of the big monthly economic reports have already been released. This is when unexpected news can have a bigger impact on the market, and we need to be extra vigilant.
John Jagerson and Wade Hansen