In the middle of last week, as fear and anxiety gripped the market at its near-term lows, it seemed like traders everywhere were predicting a crash of 1929, 1987, or 2008 proportions.
Now, just one week later, everything has changed. The bullish euphoria is overwhelming. Market sentiment has turned on a dime — flipping from ultimate fear to noticeable greed in only four trading days.
When I see trader sentiment shift this quickly … I don’t trust it. Then again, I don’t wanna be the guy buying puts while the market rips to new highs.
Let’s talk about why I’m skeptical of this rally (and what I’ll need to see to pick a direction for trading).
Examining the Damage
The market rout that’s occurred over the past two months has been considerably harder on certain sectors than the index charts reflect.
Here are the YTD peak-to-trough losses for each of the three major indexes:
- S&P 500: -12%
- Nasdaq: -17%
- Dow Jones: -10%
These are big discounts, but they don’t reflect the destruction of certain high-flying momentum stocks in the same period.
Take a look at a few examples of these peak-to-trough losses in the past year:
- Cloudflare Inc. (NASDAQ: NET) dropped from $221 to $76 — down 65%
- Asana Inc. (NASDAQ: ASAN) dropped from $145 to $44 — down 70%
- Snap Inc. (NASDAQ: SNAP) dropped from $83 to $28 — down 66%
- Square Inc. (NASDAQ: SQ) dropped from $289 to $101 — down 65%
- Pinterest Inc. (NASDAQ: PINS) dropped from $89 to $27 — down 70%
Do you see the pattern?
All five of these Nasdaq favorites (and many more I didn’t mention) have had two-thirds of their market cap erased in the past three months!
This is a huge haircut for any stock in such a short period. It’s important to note that non-penny stocks don’t usually see drops this big this quickly.
Of course, these stocks were wildly overvalued three months ago. But now, we have to ask ourselves something…
Is it time to draw a line in the sand and get bullish off the bottom — or re-load puts in anticipation of further downside?
What I Need to See
After two days of unstoppable buying on Friday and Monday, today’s price action is especially important. The market is at a crossroads — just like we are as traders.
If the index charts can hold their moving averages and avoid a major sell-off later in the week, the technicals will show all of the signs of setting up for more upside.
On the other hand, if the bullish momentum stalls out at any point, that could provide a slam-dunk entry for shorts on a variety of stocks. Be cautious of a potential rug pull at any time.
So what’s my plan? What specific levels am I watching? And what do I need to see to make a definitive call on the market’s direction?
First, I’ll avoid the temptation to make a bet one way or another until I see a clear trend forming.
A small uptrend is forming on the SPDR S&P 500 ETF Trust (NYSE: SPY), but it’s too early to say if it will form into a multi-week rally.
Coming off of this rally, the first red day will be crucial. If it erases a large part of the gains from the past four days, that will be an extremely bearish indicator.
But if the first red day brings healthy consolidation (without a brutal sell-off), and the indexes hold their 200-day moving averages, I’ll be much more inclined to get bullish.
The most important chart for me is SPY. I’m watching the $450 level as resistance and $420 as support. Take a look…
Notice that the $450 level acted as resistance all the way back in September. When a chart backs off at the same level months apart, that’s a sign that the level is incredibly important.
To summarize: We’re at a crossroads in market sentiment and sitting near a critical price level on the most important chart in the world.
It’s a good time to be patient and wait for a clear trend to emerge. For me, this is all about the key levels on SPY…
If SPY can break out above $450 on high volume, I’ll be much more confident in the legitimacy of this rally.
But this level is a double-edged sword. If SPY fails to crack $450 (and sells off on high volume), the past four days will look like a dead cat bounce. And I’ll probably buy more puts.