Stock market reversals


Every investor and trader is concerned about another stock market reversal. A lot of assets are tied up in the markets and no one wants to get caught holding the bag and not have a chair when the music stops.  But how do you know that another major stock market reversal is coming?  I wish I had a crystal ball and could pinpoint the exact time and day when it will happen. Of course no one can, but there are some general features of markets that occur over and over again.  First we will cover our favorite big picture idea and then introduce you to the work of our good friends at Technical Traders. Their research supports our conclusions that this time is no different than market reversals in the past.  In fact what we see in the landscape is somthing far worse. Finally we will review a few option strategies that can be used today to help mitigate the risks of current market uncertainty.

The Big Picture

Anyone trading in the markets today needs to grasp the significance of time prefeence. It is fundametal to the workings of all markets all the time.  I believe it is key to unlocking the door to stock market reversals.

I have covered time preference before and I suggest you read the prior post on the subject.

Basically,Time preference is the willingness of consumers to postpone current consumption in favor of saving for a rainy day. This postponement of consumption leads to low rates. Producers can borrow those resources and put them to use for longer term future goods.  These longer term goods are called discretionary. We will see how the discretionary goods sector has been performing a little later in this post.

Consumers and Producers work hand in hand

Low time preference (low interest rates) signals producers to engage in longer term production.  Low time preference is synonymus with low rates of interest. Produces can borrow at low rates of interest and look to profit in the future when they bring their goods to market. The consumer is saying, “We are willing to wait for you to bring what we want to market”.

Market Interference

But  a minute you say.  Consumers are not postponing current consumption.  They are consuming as if here is no tomorrow.  So what the heck is going on???  It’s very simple.

The FED is playing games with the markets again. And this is where the trouble always begins.


False signals

When the FED artifically lowers rates, it sends a false signal to producers.Producers are led to believe that consumers are willing to postpone present consumption and begin to put longer term capital goods into production.

Producers are fooled into thinking that consumers want longer term products.  But no shift of this sort has taken place.  Connsumers are NOT saving and do not want long term production goods.

Over production of long term goods has been soaring.  This is evident in the price of producer goods stock..  We are seeing this in the technical indicators for those sectors.

Technical Analysis

We want to thank our good friends at Technical Traders for pointing out the sector rotation they are seeing in the durable goods space. Recently, the strongest major US sectors appear to be Discretionary, Industrials, Materials, Energy, and Financials. We have seen the stock valuatios in these rise significanytly since the erly spring when the FED strted pumping money into the economy. Sadly, tht was only the beginning. If we see Bonds, Utilities, and Precious Metals start to rally while some of these strongest sectors begin to weaken, we would start to become very cautious of any continued rally attempts in the near future. For example, if Energy, Financials, and Transportation start to decline, then we may be starting a shift in how the markets expect this bullish trend to continue.

—-Click here to read the full article about the indicators—–

Meeting at the cliff

It doesn’t take a rocket scientist to see the implications of these converging realities. Alot of money chasing after producer goods that nobody wants.We are sailng into a perfect storm with no life boat other than more borrowing and monetary pumping. And a very uncertain future..The article I referenced  speaks to their view on current and future uncertainty i.e volatility.

OptionTrading opportunities

For Options traders we have the opportunity the be on both sides of the market at the same time. This fact is ever present. And now it is more important than ever to be able to hedge your bias and put yourself in a position to take advantage of these developements.   We can use defined risk strategies that take advantage of high volatlity and uncertainty.  As traders and investors become more uncertain of future outcomes, they bid up the prices of options. These higher prices drive volatility, which, is what we want as options sellers. as options sellers. As we have learned before high volatility is mean reverting and being prepared to take advantage  of this is where we want to be. The defined risk Iron Condor and the undefined risk Strangle strategies are excellent plays in high volatility environments.

No one knows for certain what the future will bring.  But we can look at the economic history and piece together a plausible scenario. And with the help of technical analysis we can put ourselves in a better position just being the deer in the headlights.

It has been said many times that history repeats itself. That may be true or not, but it sure does rhymn.

Please leave a comment below and share your ideas. I would appreciate your feedback and suggestions.

Powered by FeedBurner