Big market drawdowns need a big catalyst…
For example, global shocks like the pandemic or the 2008 financial crisis can cause the market to be cut in half… or more.
Smaller drawdowns are usually the result of extended prices, where everyone is fully invested, and the market needs to reposition to attract new investors.
A few weeks ago, the market was concerned about the spread of the delta variant, which sent the S&P 500 down a “blistering” 3%, only to touch the 50-day moving average (MA) for the seventh time this year and make new all-time highs once again…
Yet, it seemed like whatever concern the market had for the delta variant was quickly pounded into submission by Jay Powell… since the overall message at the Jackson Hole meeting was “carry on, nothing to see here.”
The market has simply been on a tear, led by the financial sector. That’s a good sign… market leadership in cyclical sectors like financials is a good indication that the underlying economy is healthy.
For example, the Financial Select Sector SPDR Fund (XLF), the ETF that tracks all the financial stocks in the S&P 500, led all other sectors over the last 6 weeks with an 11% gain.
But fundamentals don’t always drive markets, and underneath it all, enthusiasm is waning…
That’s because the options market is showing clear signs of divergence.
This Indicator Works Best at Extremes… and We Are Probably There
Tracking the size of the options market gives great insight into the level of enthusiasm for a trend and whether it’s at risk.
But first a note of caution… there is no single indicator that predicts all market moves.
But at extreme levels, options indicators are predictive.
So, let’s take a look at American International Group (AIG), the top performer in the top performing sector during this recent “melt-up” phase as Jeff Clark called it earlier this week…
First, I’m going to go over a couple of terms…
The first one is open interest, which represents the total number of option contracts that are open. For every call or put option bought, an option contract is sold until those contracts are closed. Net open interest, which I’m using, is the difference between all the calls and all the puts.
Now, in the chart below, AIG’s net open interest (black line) is overlaid on the price action of AIG (green line) leading into the pandemic and up to the end of this August…
When this indicator is positive, it tells you how many more calls are out there vs. puts – a signal that the options market is bullish. And when it’s negative, it means there are more put contracts out there.
I marked four areas on the chart – A,B,C, and D – to show where this indicator diverges from the trend and when it supports it…
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The A indicator marked the exact peak of AIG right before the reality of the pandemic sunk into financial markets. You can see how the indicator started to drop sharply, yet AIG continued to rise. The rest is history… as AIG, along with everything else – collapsed.
But then the indicator found a bottom and diverged the other way in the section marked B.
Although there are nuances with this indicator, it did signal major weakness for this stock all the way into October – a stretch where pretty much everything else was rising in the market.
But the entire trend that started in October 2020 – marked C – all the way to August 2021 was supported by a corresponding trend in rising net open interest.
But right now, we’re at D, which marks a big divergence for the top performing stock in the top performing sector. This kind of divergence is called the “alligator jaws” pattern, where two opposing forces are creating a lot of pent-up energy.
And like previous instances at extreme points in the market, it signals that the trend may not be your friend at this point.
So, with the S&P 500 above 4500, I recommend treading lightly and being very nimble.
Investors need to be picky here and play the risk management game more than just buying what looks good.
Also, keep an eye on financials. A breakdown in market leadership as we enter a seasonally weak period would likely mean we’re not bouncing from the 50-day MA for an eighth time.
Regards,
Eric Shamilov
Contributing Editor, Market Minute
P.S. On Wednesday, my colleague and legendary hedge fund manager Larry Benedict will be hosting his special presentation on a rare, yet explosive event happening in the markets very soon…
He calls it the “7-day blitz,” and it only happens four times a year… yet very few traders know about it or even know how to trade it. But during the presentation, Larry will reveal how to profit from this short window using just ONE ticker that could help generate triple-digit gains.
But this opportunity won’t be available for long, so click here to reserve your free spot for this upcoming event next Wednesday, September 8 at 8 p.m. ET.
Eoin’s Insights
Happy Friday Market Minute readers. Today, I have another video presentation where I’ll be talking about Fidelity’s hiring spree, the all-time highs in the S&P 500, and gold
Just click below to start watching…
Reader Mailbag
Before we look at today’s mailbag, if you have any questions for Eric – and would like to be featured in next Friday’s mailbag issue – please write in your questions to [email protected].
And now, let’s take a look at today’s mailbag, where Jeff Clark Trader member Daniel shares his thoughts on Eric’s essay on the future of agricultural technology…
Agriculture Technology is essential for the future of farming, and maximizing yield with limited space. However, Big Money buying up farming seems to be the real story… the traditional farmer is going by the wayside as the technology is so expensive small farmers can’t compete.
I’m curious as to how this will affect our ability to profit from this sector in the future. I would like to learn more on the average investor’s opportunity to invest as Bill Gates and others start to control the industry. This usually seems to take out the small investor’s opportunities as well as the small farmers.
– Daniel
And, Jeff Clark Trader and Delta Report member Barney thanks Jeff for his timely updates…
Hello, thank you very much for the latest update. This is very encouraging and helps me feel that I did right by subscribing. I’m in the process of setting up my trading account so that I can trade options.
Once I make some money, I can think about all of the other subscriptions around. For now, my resources are limited and must be preserved so I have something to use to trade with. Thanks again for the very timely and helpful email. It has helped to make this a very encouraging day.
I’m very new to trading anything so the promise of step-by-step help caused me to subscribe, even though the cost seemed very high to me. Today’s email helped me to feel that I did the right thing by subscribing to your service. Thank you again.
– Barney
Let us know your thoughts – and any questions you have – at [email protected].