Analysis, Perspective, Trading Strategy

At the Edge of Chaos: Break Below SPY 415 Could Mean “Coitains” for the Stock Market

Editor Joe Duarte in the Money Options

June 20, 2021

“It’s coitains for you Rocky, coitains” – Bugs Bunny in “Racketeer Rabbit” - 1940

A decisive break below 415 on the S & P 500 SPDR ETF could trigger a selling avalanche and create a large mess for the stock market in a hurry.

I don’t want to be negative, but it’s starting to feel as if not all is well in Marketland, especially after a very messy Quadruple Witching options expiration on 6/18/21 and reports that COVID is starting to once again flare up in China and elsewhere.  Certainly, it’s been pretty obvious to anyone who watches or trades that the bull market in stocks has been struggling of late.

And even though Friday’s selling was impressive, it does not mean that an extended crash similar to what we saw in March 2020, is pending or has started. But it also doesn’t discount either possibility. In fact, although it is plausible that we are in the midst of an intermediate term correction, we could still see some more selling in the days and perhaps weeks ahead, which could well turn into something worse.

That’s because, as I’ve said too many times to count in this space, this bull market has been built nearly exclusively on QE. And everyone is now focused on not whether, but when the Fed will raise interest rates and end or slow that QE. Moreover, since history clearly shows that the central bank always does the wrong thing at the wrong time in the cycle, especially when it comes to raising rates, it makes sense to be on pins and needles since the “taper” talk from the central bank seems to be getting louder.  In addition, as I describe directly below, the Fed may be up to more than talk and could be on the verge of yet another “policy error.”

Plainly stated: in a global economy powered by debt and easy money, it’s not going to be pretty when the easy money goes away. And as anyone who lives in the real world will testify, that’s because when the easy money disappears, there is less real money in the coffers due to debt servicing. Therefore a it becomes harder to pay off debt and to continue to operate businesses and households at the same time.  And when people have to choose, they will almost always choose to put life first and debt second.

The Fed must have missed that day’s lesson in Real Life 101.

MEL Alert: It's Always About Liquidity for Stocks

Unbelievers in the relationship between liquidity and the stock market have likely slept through the last sixteen months as the Fed’s unprecedented QE in response to the Spring of 2020 COVID Crash gave us a whopper of a bull market. Well, given what we’ve seen over the last few days, that bull market is clearly struggling. And while there is some merit in the mainstream points regarding inflation and fears of higher interest rates as causes for the problem, there may be more to it than that. Specifically, the problem for the stock market is in the banking system; the rules that govern how much money a bank can have on its balance sheet, and what the Fed is doing to try to “fix” the problem.

I certainly don’t want to get into the arcane weeds of banking, so let’s just get to a simple explanation of what the central bank is doing and how it could upset the market’s apple cart in a big way:

• The Fed has pumped too much money into that banking system via QE since March 2020, but it knows it can’t stop QE at once, so it’s trying to finesse the situation – it won’t work
• The banking system is - due to the rules that limit the amount of reserves banks can hold, and the lack of loan demand/unwillingness to lend by banks – too full of money
• The Fed is having to take the “excess” money they’ve put into the banking system back via what is called a Reverse Repo maneuver while still putting $120 billion into the system monthly via QE (which is confusing to everyone)
• This simultaneous injection and draining of liquidity can be destabilizing, not to mention begging the question as to why wouldn’t they just change the rules or just stop QE since it’s no longer needed?
• Reverse Repo maneuvers drain liquidity from the banking system for some banks but not others as those who tender reserves to the Fed do so by their own choice
• This lack of uniformity in who tenders reserves to the Fed could create problems in the repo market for those banks/financial entities such as mortgage lenders who are low on funds at any time since they may not be able to pay their bills on time
• Lower liquidity in the banking system can lead to less money being available to buy stocks and for banks to lend to one another to square their books which creates uncertainty
• If this continues, stocks will likely continue to struggle or embark on a meaningful decline
• If things get bad enough, we could have major problems in the repo market as a liquidity crunch could hit the banking system
• Because the stock market is the key to the economy, what happens in stocks is once again likely to extend to the real economy

What’s the bottom line? If liquidity is the blood supply of the stock market, and the stock market is the fuel for the economy, then it makes sense to worry about what could happen to MEL if the Fed, on purpose or otherwise puts a tourniquet on the markets’ liquidity spigot. Even worse, if the liquidity inequality were to blossom and hit enough banks, the banking system could freeze and we could see a 2008 type scenario unfold in the Markets, the Economy, and People’s Life Decisions.

SPY 420 Support Broken. Is 415 Next?

The algo games in the S & P 500 SPDR ETF (SPY) options market continued last week with the clearly defined trading range between 420 and 425 having been broken decisively to the down side on Friday. The break started as the Fed’s statement came out on Wednesday afternoon (6/16) and the S & P 500 (SPX) index dropped but found support at 420. However, by 6/18, as the Quadruple Witch options expiration hit, the put volume drowned the call volume at 420 and the support level gave way.

So now we have to see how the hedges develop in the new cycle starting on 6/21. Certainly, there is heavy put volume at 415 and heavy call volume at 420, which suggests this may be the new trading range until something else happens. However, a decisive break below 415 on SPY could well trigger a selling avalanche.

Incidentally, to learn more about how options may make sense for you check out my recent presentations: “How to let Your Stockcharts Lead you to Great Covered Calls,” and “Five things to know about Covered Calls” on Stockcharts TV.  Catch them here and here.

And if you want more in depth options analysis that you can put to use in your daily trading you can catch me live and in Person at The Money Show in Orlando in June. Register here.

Datadog Has its Day in the Sun

Shares of IT company Datadog (DDOG) went against the choppy grain last week and delivered a nice chart breakout.

As the name implies, Datadog’s business is that of keeping up with its customer’s data and analyzing how all the pieces are working together. And in uncertain times the better you are at knowing how your systems are working and use that data to not just assess the current status but to make plans is in high demand. As a result, the company has been gaining market share and the stock finally reached critical mass breaking out above $100 on June 17.  Aside from the fact that a breakout is always nice, what stands out here is that DDOG delivered a significant move higher in the midst of a very uncertain market, a sign of relative strength, especially when no major news came on the day of the breakout.

Of course, in this type of market breakouts without staying power are common. As a result, it’s important to pay close attention to whether the stock has the potential to move higher.

The technicals are solid with Accumulation Distribution (ADI) and On Balance Volume (OBV) pointing to strong money flows. RSI is nearing the overbought area of $70, but it’s early in the rally so the stock could still move higher while being overbought.

Perhaps the most interesting side of the story is the fact that DDOG recently gave very upbeat guidance about its entire fiscal year while beating its earnings and revenue estimates.

I own DDOG as of this writing.  For more stocks and options with huge upside potential check out a FREE trial here.

NYAD Tests Key Support

In a market where liquidity is questionable, the New York Stock Exchange Advance Decline line (NYAD) becomes a hugely important indicator as it gauges the general health of the market and how it’s responding to current external conditions. And what we’re seeing is that the market’s breadth is undergoing a short-term decline and testing key support at the 20-day moving average with a test of the 50-day possibly lurking.  In fact, this is not a complete surprise as the NYAD recently gave us an overbought reading which is usually a prelude to a consolidation or potential decline and which may prove to be correct.

Now, the line in the sand becomes the 50-day moving average as the RSI has already begun to test the 50 area. When the RSI breaks below 50 and NYAD breaks below the 50-day moving average decisively without a rapid upside reversal, the odds of a major market decline increase (a Duarte 50-50 Sell Signal). 

The Nasdaq 100 index (NDX) took a moderate beating on 6/18/21 but did not break any major support levels.

The S & P 500 (SPX) broke below its 50-day moving average while its RSI fell below 50. If this situation is not reversed, it’s likely the index will move lower from the 6/18/2 close.

Good news! I’ve made my NYAD-Complexity - Chaos chart featured on my YD5 videos, and a few more available here.

Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best sellingTrading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com - now in its third edition, The Everything Investing in your 20s and 30s and six other trading books.

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