The price action tells us to favor the short side.

PRE-OPEN MARKET COMMENTS FRIDAY – A month ago the market was clicking on all cylinders. The S&P 500 made a new 52-week high and we were preparing for mega cap tech earnings. The Fed was closer to the end of the tightening cycle and economic activity remained strong. Now everything has soured. Welcome to August. As you know from my market comments, this is a seasonally weak period for the market and it lasts through September.

Bond yields are jumping. The market had been pricing in a rate cut in Q4 and those traders are taking losses on that bet as the Fed stays steadfast in their fight against inflation.

An old concern is starting to gain momentum. Evergrande (large Chinese commercial property developer) filed for bankruptcy and other large commercial developers are missing bond payments. China said that it will “support” those developers, but no one knows what that means. The PBOC cut interest rates by .15% this week and that was interpreted as a sign of weakness, not strength. Their economic data points have also been soft. This is the second largest economy in the world and problems there will impact global markets. To put this into perspective, China and the US account for almost 45% of the world’s GDP. China has been the global growth engine for the last three decades and if they are in decline, where is the growth going to come from? Even worse, what if they have a financial crisis?

I have been pointing to China as a legitimate market threat for over a year. The way their credit situation is deteriorating reminds me of 2008 in the US. Over a quarter of China’s GDP is tied to commercial property development.

“Gosh Pete, you are scaring me.” Know that there are plenty of headwinds and that the money printing “House of Cards” that central banks have built over decades is on shaky grounds. The wind is blowing and someday it will implode (I hope I am not around for that, but I suspect I will be). If that fear kept me sidelined, I would have missed one of the biggest rallies of all time during the last decade. If that fear kept me sidelined, I would have missed the entire rally this year. If I had shorted based on that fear, I would have been wiped out and I would not be writing this. My realization that I don’t know SHIT has kept me in the game for 30+ years.

We are traders and we actively manage our money. In these turbulent times, that is prudent. We don’t try to predict the outcome of events, we read price action. When the smart money is buying, that’s what we do. When the smart money is selling, that’s what we do. Technical analysis helps us follow that trail of bread crumbs.

The market closed below the 50-day MA and it closed on its low yesterday. The SPY has been below AVWAPQ and that is also bearish. The trendline that started on March 13^th was also breached. Without question, there is a negative bias and the selling pressure is increasing. That’s enough for us to favor the short side.  

Bull markets die hard and buyers need to be discouraged. They have been conditioned to buy dips and that mentality was pervasive near the 52-week high. That is why we are seeing mixed overlapping candles and choppy intraday price action. As major support levels fail, those buyers have to exit long positions at a loss and the selling pressure increases. Profit takers who were reducing risk become more aggressive because they want to exit while the market bid is still strong. Short sellers who were scaling in notice that the bounces are brief and shallow and they also get more aggressive when support fails. The price action since the high has been orderly and that is a sign of resistance. I believe the downward momentum is going to accelerate.

We have the technical breakdown that we needed to favor the short side for day trading and we can even consider overnight bearish swing trades. I would NOT be selling WATMs. That strategy has a neutral to slightly bullish bias and your short put could quickly be in trouble if the selling pressure accelerates. Instead, consider selling OTM bearish call spreads on weak stocks or buying ATM put debit spreads.

I would NOT suggest getting aggressive with shorts today. If you have bearish swings on, ride them. This is normal seasonal weakness and the volume is fairly light. The market found support and the uptrend this year has been strong. That means we are likely to see a bounce.

When the market bounces, look for signs of resistance. Then enter short positions. When we get a nice drop or a gap down that finds support, take gains on shorts. This approach should be used for day trading and swing trading. Yesterday I told you that we would have a nice entry point for shorts. A gap up in a bearish market is our best set-up. We nailed that move!! A gap down after heavy selling like we are seeing today is not a great set-up.

So on gaps down there are a few scenarios to watch for and I highlight this in my articles in The System.

1. We set a deep early low and we see stacked green candles on heavy volume. That is a sign that the selling has reached a short-term climax and that we are due for a bounce. This needs to happen in the first two hours of trading or we will not fill the gap today. Overseas markets were fairly weak and the news was “heavy” so that is not likely.

2. We see stacked green candles instantly on heavy volume and we easily recover half of the gap down in the first 45 minutes. This would signal a selling climax and it would be bullish. It is unlikely because this move is just getting started and traders are trapped in longs (they need to be flushed out). The news is “heavy” and overseas markets were soft. The market still has plenty of room down to the 100-day MA and I sense it will be tested soon.

3. We have a wimpy bounce with mixed overlapping candles and light volume that does not retrace more than half of the gap. This is possible and fairly likely (25%). This is our best scenario. When that bounce stalls it will set up a great shorting opportunity.

4. We see a drift lower with mixed overlapping candles on decent volume with lower highs and lower lows. This is the most likely scenario (35%). This is a difficult set up since the opening move is already substantial. Most of the move has already been realized and the chance for a snap back rally looms. The market will continue to drift lower and support will form after 90 minutes of trading. Then the market will compress in a tight trading range. In this scenario it is best to find stocks that are just breaking support on heavy volume D1. They are not too far out of the gate and they have room to drop. You will need to weather a few bounces, know that you are on the right side of the market. As long as there are no deep air pockets, the threat of a major reversal is slim. If we do hit an air-pocket, that is likely to be a selling climax and you should take gains.  

Support is at the 100-day MA and resistance is at the close from Thursday.