The Oversold Chronicles End As A Fed-Inspired Stock Market Explodes Higher

AT40 = 20.4% of stocks are trading above their respective 40-day moving averages (DMAs) (ended 13 days in oversold territory)
AT200 = 14.9% of stocks are trading above their respective 200DMAs
VIX = 21.4
Short-term Trading Call: bullish (with caveats all over again)

Commentary

All oversold periods must end – it is just a matter of how and when. In the latest case, the oversold period took 13 days to run its course and ended in an explosive display of upside. The last three chairs of the U.S. Federal Reserve sat right at the ignition point as they met on an economic panel to play cheerleader for financial markets and the job the Fed does to steer good outcomes.

What happened on Friday was essentially a continuation of the bullish signs I pointed out on Wednesday. These signs were rudely and abruptly interrupted on Thursday thanks to poor economic data, a “shocker” earnings warning from Apple, and wild gyrations in the currency market (I covered it all in the last Above the 40 post). While stocks sold-off on Thursday, currency markets steadily healed and set-up financial markets for their own bout of healing on Friday. The Australian dollar (FXA) versus the Japanese yen (FXY) is still my favorite indicator of risk attitudes, and I followed it in awe as AUD/JPY led the recovery from Wednesday evening’s low liquidity, flash crash low. AUD/JPY managed to end the week essentially flat with its pre-flash crash price. I will now be a lot slower to close out my long AUD/JPY position.

AUD/JPY took two days to completely reverse the loss from its flash crash. Can the upward momentum continue?

AUD/JPY took two days to completely reverse the loss from its flash crash. Can the upward momentum continue?
Source:
TradingView.com

The chart above shows that the extreme of the flash crash was met by an extreme rebound. Stocks responded on Friday. The S&P 500 (SPY) gapped up and soared 3.4% to a 2-week high.

The S&P 500 (SPY) gained 3.4% and closed just under its downtrending 20DMA resistance.

The S&P 500 (SPY) gained 3.4% and closed just under its downtrending 20DMA resistance.

Like the the S&P 500, the NASDAQ and the Invesco QQQ Trust (QQQ) jumped to their respective downtrending 20DMAs.

The NASDAQ gained 4.3% and closed on top of its downtrending 20DMA.

The NASDAQ gained 4.3% and closed on top of its downtrending 20DMA.

The Invesco QQQ Trust (QQQ) gained 4.3% to close just under its downtrending 20DMA.

The Invesco QQQ Trust (QQQ) gained 4.3% to close just under its downtrending 20DMA.

The buying was so strong it propelled AT40 (T2108), the percentage of stocks trading above their respective 40-day moving averages (DMAs), out of oversold conditions. AT200 (T2107), the percentage of stocks trading above their respective 200-day moving averages (DMAs), reflected the deep technical damage remaining in the market by only managing a gain to 14.9%

AT40 (T2108) surged to a 3-week high and created a V-shaped recovery from the depths of an extreme oversold period.

AT40 (T2108) surged to a 3-week high and created a V-shaped recovery from the depths of an extreme oversold period.

AT200 (T2107) jumped to a two week high but still reminds me of all the technical damage remaining in the stock market.

AT200 (T2107) jumped to a two week high but still reminds me of all the technical damage remaining in the stock market.

The S&P 500 finished the oversold period with a 2.6% loss. It opened the 13-day oversold period on December 14th (note I had to make corrections in past posts on duration of the AT40 periods). The performance was in-line with historical performance and just below the overall projection. Friday’s surge brought an end to the risk of “scenario 3” playing out in full for an extended downward trajectory in oversold conditions. The 13-day oversold period was one of the longest in history (dating back to 1987).

The performance of the S&P 500 for a given oversold duration (T2108 below 20%).

The performance of the S&P 500 for a given oversold duration (T2108 below 20%).

Given the marginal break out of oversold conditions, I am looking for an immediate follow-through of buying before calling a definitive end to the oversold period. Recall the October sell-off where two oversold periods were separated by just one day of trading. The second oversold period took the S&P 500 even lower than the first oversold period and rendered the end of the first oversold period nearly meaningless.

The volatility index continues to suggest that this latest period of elevated volatility is coming to an end. On Wednesday, I noted how I would have concluded the VIX hit a top absent knowing the after hours turmoil. The VIX did not jump nearly as much I expected on Thursday, and on Friday the fear gauge plunged again – this time by 16.0%. The VIX still looks topped out. I took profits on my single put on ProShares Ultra VIX Short-Term Futures (UVXY). I will resume fading volatility after a large spike and/or after the VIX drops below the 20 threshold. However, I will switch to long volatility around the 15.35 pivot line as hedging should get very cheap at that point.

The volatility index resumed its plunge from the Christmas Eve peak. The VIX even closed below its own uptrending 50DMA.

The volatility index resumed its plunge from the Christmas Eve peak. The VIX even closed below its own uptrending 50DMA.

In the last Above the 40 post, I lamented: “I absolutely hate feeling short-term bearish while the stock market is still in deep oversold territory. Yet, the trading action, and now the economic and financial data, point to an extended stay in bear market territory.” I granted one key upside scenario: “Perhaps to the upside, government action from China and/or the U.S. will trigger a buying opportunity (most likely from monetary policy and NOT trade policies).” Friday’s rally was a double reminder of the dangers of getting too bearish during an oversold period and of forgetting how central banks are ultimately beholden to respond to the misery of financial markets. While China made yet more moves to ease monetary policy on Wednesday and more on Friday, it was Friday morning’s Fed-speak that truly turned the tide.

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Disclosure: Long SSO, long AUD/JPY, net short U.S. dollar, long AMZN call spread, long BBY puts, long CAT puts, long GS put, long NFLX put, long INTC calls, net long AAPL shares, long ITB calls, long ...

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