Market Support Was Breached – Still More Downside This Week. SPY $176 Should Hold

January 27, 2014
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last Friday, the market broke critical support at SPY $181.50 and I took my lumps. On a short term basis, technical damage has been done and we have more work to do on the downside. From a longer-term perspective, this is a normal pullback within a longer-term uptrend.

SPY $181.50 was our stop and you should have exited bullish positions once that was breached.

Credit concerns are the number one rally killer. Central banks have been printing money like mad and emerging markets have been able to mask deficit spending. Now that the Fed is tapering, currencies are fluctuating. Turkey and Argentina are struggling. A tiny ($500 million) credit trust in China is on the brink of default and that added to the panic last week.

Debt levels around the globe are extremely high and a full-blown credit crisis can unfold very quickly. It is critically important to keep this mindset at all times. China is likely to bailout the failing trust and it will not be an issue. That will set a precedent. Turkey and Argentina are isolated countries and contagion should not be an issue. PIIGs yields are still at multi-year lows.

The FOMC will meet this week and they will taper ($10B). Many analysts hope they will wait a month. If the Fed holds off, the market will stage a knee-jerk rally and then it will stage a nasty decline a few days later. This would signal that the Fed is worried about foreign markets and they would be painted into a corner. They need to continue on their path and let foreign markets adjust naturally.

This is a damned if you do, damned if you don’t scenario. When the Fed does taper on Wednesday, the market won’t like the news and we will probe for support. The first major level is SPY $178 and the second level is the 100-day moving average ($176.40). Either way, the reaction will be negative and shorts can get a little aggressive ahead of the news.

Stocks bounced on the open, but that move failed. Shorts will probe for support. Asset Managers can feel the selling pressure and they will not bid.

Earnings have been good and the majority of companies have been able to exceed estimates. Profits are up more than 7% year-over-year and cash flows are at record levels. At a forward P/E of 15, stocks are attractively valued. This is the busiest week of releases and the news will generally be good.

Many companies that posted strong results have pulled back with the market. These will present nice buying opportunities when the dust settles.

This price adjustment could take a few weeks and that timetable lines up with the debt ceiling extension. The market is likely to trade in a range between $176 and $181. Politicians will find middle ground and the market will rally.

Global economic conditions are still strong. China’s GDP came in at 7.7% and that is good by any measure. Activity in the EU is improving and that news has been swept under the carpet.

I am trading from the short side today, but I am keeping my size small. The market still has some probing to do and the FOMC will keep investors on edge. Asset Managers won’t start bidding until they see a hard bottom. That is likely to come off of a capitulation low.

The better trade will come when the market finds support. We want to stick with the long-term uptrend. The baby has been thrown out with the bathwater and I am seeing some great bargains.

Swing traders – start lining up strong stocks. When the market and the stock finds support, sell out of the money put credit spreads. Option implied volatilities are elevated and you will be able to distance yourself from the action. Make sure that your short strike is below a major support level. If that support level is breached, buy back the spread and take your lumps. This strategy will allow you to take advantage of time decay and inflated option premiums. You can generate income while you wait for support to be established.

The market is very nervous and there is more downside this week. Look for the 100-Day MA to be challenged.
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