It is hard to believe, but major US indices are roughly unchanged for the week as I write this on Friday morning. Here’s the proof:
5 Day Chart, S&P 500 Index (SPX, 3-minute red/green bars), NASDAQ 100 Index (blue line)
Source: Interactive Brokers
Although we are in about the same place as where we began the week (and month, by the way), it has been quite a wild ride. Come to think of it, roller coasters also end up exactly where they start.
The gut-wrenching part of this week has been the intraday and day-to-day volatility. Thus far this week we have seen intraday ranges in SPX of 2.6%, 1.3%, 3,8%, 4.0%, and 2.2% (as of 11:30 EDT). The swings in NDX have been even bigger. We have been quite consistent in reminding readers to expect volatility in 2022 since making it the key theme in our outlook for this year. Our rationale remains the same. Massive fiscal and monetary stimuli in 2020 and 2021 dampened volatility. Every dip became a buying opportunity as the constant flow of money provided a bulwark against sustained declines and created ever-hungrier risk appetites. The fiscal stimulus is over, and the Fed has been telling us for months that they would be taking away the punch bowl.
Traders need to change their thinking, and quickly. What worked in the 2020-21 period is not likely to work as well in 2022. We’ve been adamant that tactics that worked during aggressive fiscal and monetary stimulus – like seeing every dip as a buying opportunity and consistently selling options premium – are simply not appropriate when the tide of money is ebbing, not rising. And we have only just now begun to see the tide peak and ebb only slightly. It makes little sense to continue to apply the same trading and investing strategies that worked in a remarkably loose-money environment to one with tighter conditions.
Yet when I try to explain this week’s staggering volatility, I look to dip buyers as the culprit. The problem arose because traders have been too quick to seize upon every bounce as a potential rally point.
When markets were rising throughout the stellar post-Covid period, dips became shorter and shallower. Dip buying had become an essentially foolproof strategy, so it made sense for traders to act ever-more aggressively to catch dips that had become more fleeting. This week shows the folly in trying to replicate that strategy in today’s environment. We originally sold off on Monday after a woeful end to the prior week but rallied sharply when the tide turned in the last hour. It appeared that institutions had been buying throughout the day, as can be customary at the start of a new month and saved a disproportionate piece of their orders for the end of the session. When they were no longer able to buy into weakness and needed to get more aggressive to get their orders filled by the end of the day, other traders noticed the turnaround and jumped into the fray to turn a 2% decline into a higher close.
Yesterday we explained Wednesday’s rally, which turned out to be a head fake, thusly:
As is often the case, traders fixated on one line in the commentary – Mr. Powell’s comment that a 75-basis point hike was not “actively considered”. We noted yesterday that Fed Funds futures were implying just under a 50% chance of a 75-basis point rise at the next FOMC meeting. After an evening to consider that comment, many investors realized that a 12.5 basis point reduction in the implied Fed Funds rate for the coming six weeks[i] was hardly worth the enthusiastic response. For starters, Mr. Powell kept the possibility of bigger hikes on the table, they’re simply not under active consideration. Alternatively, many investors took the relatively dovish tone of the press conference as a sign that the Fed’s inflation-fighting resolve may not be sufficient.
When investors had time to realize that they had overreacted to one small piece of an otherwise sober commentary, they gave back all their hard-won gains.
The moral of the story is this: Building a bottom is a process, not a one-day thing, like we saw on Monday and Wednesday. Some of the sharpest rallies occur during bear markets – and like it or not, NDX is in a bear market – and those rallies should be sold. Only one of those rallies is the true bottom, the rest are false breakouts. I’d rather miss the bottom than go all in on a head fake. And many traders went all in this week before yesterday.
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