The Needle and the Damage Done

Yep, I’m doing my homework out loud again this week. Not sure it’s going to become a habit. I usually don’t have to time it takes to write all this up. But it’s been useful to me given the intricacies and the strange times of late. And I’ve had lots of positive feedback on it too. So I’ll do it again this week.

And yep, the title’s a Neil Young song about heroin addiction. When you think about the relationship we have to oil and kind of damage oil price convulsions can do to the other US markets it fits, no? So let’s start there.

As I tweeted on Friday (and every day last week after the close) in terms of the big-picture numbers Reindeer Air Flight 12-25 from the North Pole is still on theoretical schedule. The S & P 500 finished the seasonal weak week discussed last week down 3.8% at about 2002. This is well within the norm of a 2-5% drop prior to a so-called Santa Claus rally.

In fact, from one point of view there’s a kind of of poetry to the finish of this week. Right at the end of the day Friday the ES closed a weeks-old gap around 1998. Just like the Corleone family from The Godfather, the ES hates leaving family business unfinished. The WTI crude oil contract broke through the $60 dollar mark and bumped its way down to  the high $57s. Lots of loose ends in these two important markets were tied up. Which leads me to ask whether we’re all done and ready to hear Jingle Bell Rock over and over and over in every mall store, xmas tree lot and gas station in the US for the next week and a half?

Well, after another peek under the sleigh tarp I saw a few interesting things happening. Let’s start with the correlation of price action in the ES and CL:

 

ESvCL-Week50

First this is a TPO Evolution chart which assigns a color to each trading day and then builds a profile for the week as the days progress. It tells a story which can’t readily be seen in a regular profile. With the exception of a surprise show of bull strength which caught many traders off guard on Thursday morning (upside erased later in the day), the rest of the time the ES followed the CL contract around as if it were the tanker trailer and CL was the semi tractor. Note the similarity of day by day progress as well as the overall shape. This kind of real-time, short term sympatico is unusual and caught my attention.

Friday I saw many traders looking for an afternoon rally and trading that direction. Normally this is the right thing to do given the circumstances. But not Friday. Friday was a day to react to the chart and not act on your bias. I could see all size-trading ES eyes were clearly focused on CL. Now before you call hindsight bullshit on me, I tweeted this twice when the ES reached critical junctures in the day and said to watch the CL for direction (see my tweet history if you care). The last one was theeee big trade of the day and the move started just moments after that tweet at 11:20 PST. Once the ES returned to the range mid, open, ETH and RTH VWAP near 2014 the table was set for the CL close and I tweeted as much. If CL did puke into the close there would be painful margin calls, just as there had been the prior 2 days. The fact that is was Friday also increased the odds of forced liquidation, amplified by the Russel 2000 as it neared zeroing for the year. And sure enough….

I was kind of flip about it in the tweet, I admit. I was tired and there was little time to get all that in a tweet. Sorry.

Anyway I bring this up to illustrate how I use Twitter. Some people like to tweet entries and exits, etc. Why, I don’t really know. Without having risk/reward, sizing and rationale underlying those entries and exits announcing them is just so much noise in my view. No one’s going to learn a thing from those kind of tweets. I mean, the occasional victory dance tweet can be fun. I do it sometimes. But mainly I tweet at inflection points and when I see unusual real-time correlations and contradictions which may swing the action one way or another. It’s mostly a way for me to crystallize thoughts quickly (see definition: congnative dissonance) about the action as it unfolds. If it’s useful to you too, all the better. There is an element of esprit de corps and a real time sentiment gauge in my stream that I find valuable and to which I try to contribute. I also say funny things from time to time.

By my reckoning, I usually have between 5 and 30 seconds (tops) to make a decision about entry/exit and size of a trade I have anticipated at the best prices. There’s no time to tweet anything like that kind of information anywhere near the point of an actual trade decision, either before or right after. To do so is much the same as texting while driving in my view, a dangerous activity which steals focus from where it should be.

‘Nuff said. Back to the charts.

So given that we’ve taken care of some overdue ES family business, what’s next? For some clues let’s compare the 2014 #weakweek to 2013:

[one_half first]

ESw13

Weak Week 2013

 

[/one_half]

[one_half]

ESw14

Weak Week 2014

[/one_half]

Regardless of the why, the fact is that we have the same pattern of starting off higher and ending far lower. Except this year the magnitude of weakness was far greater – about 2x. If you put your finger over that big selling tail the stories are even more similar. So is that a difference with a distinction? In this case I think it will be, at least early in the week.

The SPX closed just above 2000, an important psychological level. The ES finished much lower, but remember the ES is not the instrument it’s the derivative. That big blue tail above was created by liquidation from positions which had gains in order to offset margin losses (as far as I can tell) and not because of sudden bearish force majeure. That’s how margin investing works. You have to sell things which have gains to offset losses, sometimes when you don’t want to. Friday at the close was a settling of this kind of business. This liquidation created some extra downside momentum and it will no doubt cause a level of short term nervousness for many who suffered this liquidation. And also for the retail crowd who only sees a big red candle and doesn’t really understand the (pretty rational) mechanics of what happened.

So again, what’s next? Believe it or not, my favored scenario is that the Santa Rally Playbook will still be in use, though the execution could be kinda warped. I’ve done tons of macro homework over the last few weeks and I see no reason why there won’t be short term equity bargains to be snapped up as a result of this downside. Longer term, I have some thoughts I’ll save for later. But let’s look at how the post-#weakweek week played out last year (say it 10 times fast):

ESw13+1

In a nutshell, we tested lower but quickly caught a bid for the bargains which lifted the whole ES boat and created range expansion on both sides. Similar dynamics appear to be in play this time around too, albeit with a fair amount more force.  So I am expecting Monday to see some continued early selling, especially with a good chance of market on open (MOO) sell orders from large players squaring and frightened retail investors. There is support in the form of a composite HVA starting around 1987, though it’s not a big area of prior balance (see chart below). I am looking for the potential for the open gap and naked VPOC in the 1981-82 area to be taken out. If the rout in oil continues with ferocity,  I even expect that we could be taking a hard look at – and second-guessing – ourselves all the way down to the notch at 1965. The scorched Earth target would be the cluster of gaps and VPOCs and prominent balance area at about 1950. If oil and the liquidation forces were not asserting themselves so aggressively, I’d say this level of downside is likely beyond the pale. If it does go that far though, I am expecting the big selling tail from about 1990 to 2010 to be a prime target for any upside in the week and also to spend some time balancing there and (re)assessing the circumstances. There is tension building between low(er) equity prices and the (positive economic) effects of lower oil prices, and at some point that tension will be released. As long as the the world remains sanguine on geopolitical situations (again force majeure) this should be a trade-able tension release.

What exactly is this tension I mention? Well at some point the large US equity players have to starting sucking up the bargains. That’s how they make money and the year-end clock is ticking. They can’t make their numbers on the downside or in cash. Plus liquidation may weaken some player’s numbers enough to give other players an opportunity to outperform and enjoy the requisite spoils of war. And that’s a fundamental difference between the equity and oil markets. Oil (or other commodities) can go keep going up or down until liquidity goes away because both sides have the potential to make money by naked exposure or hedging. Then one side just quits. Totally different supply/demand motivation and dynamic in equities. But I digress. Should the equity players stop caring about the oil slick or should there be a cease fire in CL for the time being I’m expecting that we could very plausibly end the week somewhere in the lower volume area between 2031-2057 with the gap at 50.25 being the prime first target.

ES

 

In my view, given what I see right now, this is not a week to take big risk unless you are feeling lucky, punk (a Dirty Harry reference). That may change as the week progresses. It may make sense to press some bets. But don’t forget too there are a couple additional jokers in the deck this week in the form of FOMC and Japanese election news flow which, really, could start at any time now.

As for oil, I’m not going to try to call a bottom. In fact, as I tweeted on Friday I’m starting to think that sellers are going to have to plain run out of willing buyers (liquidity) in order for this to bottom. There’s no structure down here. You’re kidding yourself IMO if you think years-old  low prices and trend lines are a trade-able feature. The situation is so radically different now than it was then. I do expect a character change, however. This week I imagine continued downside to be pool-and-drop, level by choppy level, rather than a mass of water spilling over a broken dam like its been for so many months. My read is that there are more other time frame (OTF) players involved in the market now than even a few days ago. This alone would palpably change the action of such a low-volume contract.

So to sum up, the Russel 2000 state, Japanese politics, crude oil, the Treasury Bond yield curve and options expiration/contract rollover could all have a hand in the large cap equities action this week.Possibly lingering effects too. Save God and the central banks, no one knows for certain what the future holds. But this week we know one of them is talking.

I leave you now with this CL chart. It’s the first interesting cumulative delta divergence I’ve seen in weeks. It’s not huge, but worth mentioning:

CL

 

Trade ’em well this week, amigos.

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