Home Deep Analysis Beware of countertrend rebounds (NASDAQ: QQQ)

Beware of countertrend rebounds (NASDAQ: QQQ)

by WOOWinvest
0 comment
business collapse


pictafolio/iStock via Getty Images

The rally that took place last week was epic. Global stock markets were collectively relieved, and investors responded by buying all stocks. This is especially true among groups that have been hit by small-cap growth, consumer discretionary and, to a lesser extent, large-cap growth. These are areas of the market that I pay close attention to, as they indicate whether Wall Street is in a bullish mood. After all, if big money thinks we’re going higher, they’re allocating into growth areas to take advantage of outsized moves. This is the same reason why utilities and other defensive names do so well when duressed.

The big question, however, is whether this move is the start of a new bullish phase, or whether it’s just a relief from the big fears during the options expiration week. The week of option expiry is usually a very volatile week, and you’ll remember that option expiry tends to be skewed downward during roaring bullish periods. This time, however, the bias is significantly higher as we have been in a long-term bearish phase. In other words, if the trend for option expiry dominates, it’s a fairly safe bet that we’ll see the option expiry move in the opposite direction. That’s exactly what happened last week. Whether it has staying power is a big question, right now, I’m not so sure.

Part of the reason I’m not so sure is that we’ll discuss that later, but allow me to elaborate on option expiration and the role of market makers in that. When an index or individual stock moves sharply to one side or the other — in which case we have pretty much everything lower in an opex week — in-the-money options are heavily skewed to one side.

In this case, we actually have billions of dollars in in-the-money put premiums expiring on Friday. This gives market makers a huge incentive to inflate the prices of various securities to “balance the size” between call and put premiums. This is not a new phenomenon by any means, and it is well known. But I think it’s worth keeping in mind in the context of the massive rebound we saw last week, because I’m not overly convinced that things are as optimistic as they seem.

Let’s take a look at the chart.

chart

stock chart

The key point for this chart begins with the Nasdaq’s triple bottom (NASDAQ: QQQ) has been at $317 over the past few weeks. Having a triple bottom provides an excellent launch pad for any kind of bullish action, what a launch pad it is; just last week, we saw QQQ jump 10%. It’s an incredible uptrend in such a short period of time, and I’ll admit it’s somewhat undermined my bearish view.

The reason is because the QQQ jumped higher and kept moving above the 20-day exponential moving average or EMA, which is the first sign I look for to determine if the stock/index has bottomed. The second sign is a successful retest of this EMA, which of course has not happened yet. What QQQ does when it happens will be very instructive for the next phase of this move. Is it bouncing off the 20-day EMA in a bullish fashion and heading higher, or are we seeing a further breakdown. We may get this answer in the next few days.

Now, the QQQ has fully bounced back to its blue 50-day simple moving average, and I have placed an arrow at resistance. Monday will be very interesting as QQQ spends a total of 2022 above the 50-day SMA for the first trading day of the year. If this is really a new bullish phase, then the 50-day SMA must peak and continue. While this is certainly possible, if we look at the momentum indicator, I think it’s a tough task for the bulls.

PPO is still in bearish territory, in fact, not even close to bullish. One bullish thing about PPO is that the histogram is close to +1, but that also means the ETF is overbought on this basis. We can see other examples of histograms hitting +1 (or around), suggesting that the ETF needs at least a breather, or maybe a pullback to fix this. After rising 10% in a few days, it’s no surprise that QQQ is overbought.

Second, the 5-day RSI is in overbought territory, and while it could become more overbought, it presents another resistance for the bulls. The 14-day RSI is also looking more bullish now, finally reaching the centerline after failing to do so for several weeks. That’s why I said earlier that the bearish case for this chart has done some damage, because these are actually bullish developments and I’m not turning a blind eye to them. I still think it’s an oversold bounce related to opex, but we’ll know soon if I’m right.

Inflation and stock valuations

Let’s now turn our attention to another potential problem for the bulls, inflation and interest rates. We all know everything about inflation, but let’s review it with a long-term chart. Below I’ve plotted 20 years of CPI data by month, and the one-year rate of change in the bottom panel.

chart

stock chart

We can see that, in most cases, inflation will gradually increase over time. However, we do have periods of deflation, like the onset of the COVID crisis, and they usually resolve within a few months. This time it happened again, but instead of gradually going higher, we ran higher. The one-year rate of change is now 8%, and given the situation in early 2021, it is likely to rise for at least another month. In addition to all the impact this has on consumers, it also has an impact on interest rates. Since interest rates affect stock valuations, inflation is key, as we’ll illustrate now.

Interest rates are a huge potential headwind

Below we have the 10-year Treasury rate and the QQQ below the correlation to that rate, on a 100-day basis, so it’s a medium-term indicator in this case.

chart

stock chart

To be clear, in general, we have seen an inverse relationship between QQQ and TNX, which makes sense as the equity risk premium that we would see in equity valuations would have to be higher if risk-free rates were higher lower. This results in a lower P/E (or P/E or whatever) because investors could theoretically get higher risk-free returns from U.S. Treasuries, all else being equal.

In fact, the 100-day correlation between QQQ and TNX is now -0.82, which is a very strong inverse relationship. You might be saying now, so what, why do I care? Well, if inflation continues at 8% or higher, then interest rates will be higher. It’s a fact of life, and you can look at any inflationary period we’ve had in the past to see this. Indeed, the period following the Great Depression saw extremely low inflation and historically low interest rates of all kinds; it is no coincidence that the same thing happened the other way around.

So if this pattern is followed and we see inflation rising, we should raise interest rates, and therefore, we should see a negative reaction especially in growth areas, such as QQQ. This will continue for weeks or months, not days, so expect a bullish period like last week.

Volatility remains an issue

Finally, let’s look at VXN, the Nasdaq’s volatility index. This is the same as the S&P 500’s VIX; it’s just a measure of volatility.

chart

stock chart

Over the past few weeks, VXN has formed a very clear top in the 39/40 area, which coincides with the recent bottom of the QQQ. This is normal behavior as volatility readings this high are highly unusual, so it’s not surprising to see some relief bounces from these extremes. However, I think this chart suggests that investors should be cautious right now, and like the QQQ chart itself, we’ll have some sort of resolution on this chart soon to see if I’m right.

There is a trend line that is rapidly approaching the price of VXN and this is something the bulls need to negotiate. It’s about $2 below the current price, and in today’s market, a $2 move in VXN could happen within a few hours, so it’s close.

I also think that the momentum indicator shows that VXN is falling too, too fast, and a rebound is more likely. PPO shows a centerline test, consistent with the histogram showing oversold levels at -3. While VXN is definitely heading lower, this suggests that volatility may have dropped too quickly.

We saw similar behavior in the RSI, and the 5-day RSI has actually entered oversold territory. When you look at the 10-day change rate of -20%, you can see why the 5-day RSI is in oversold territory.

give me a summary

All of this meant that the market was extremely bearish and oversold last week heading into options expiration week. Market makers actually have a multi-billion dollar incentive to inflate stock prices to offset the extreme in-the-money put premiums that have accumulated, and this is exactly what happened.

My view is that unless we continue bullish behavior next week, I’ll be cautious, as a quick bounce from oversold conditions to opex is not a solid foundation for a new rally. Will it happen? Absolutely. can you? I do not believe.

Given all of this, I think the bulls have a tough road ahead, and I still think we have a good chance of not only retaking the lows but breaking them in the next few weeks. This view is probably very unpopular at this stage and I might see some dummy tar and feathers in the comments. But I think the macro headwinds are too big right now for this rally to be sustainable, and I think there’s a bigger downside before we actually hit a bottom. we’ll see.

You may also like

Leave a Comment

Our Mission is to help you make better trading decisions by providing actionable investing content, comprehensive tools, educational resources and assist you in making more money in the stock market.

Latest News

Newsletter

Subscribe my Newsletter for new blog posts, tips & new photos. Let's stay updated!

@2022 – All Right Reserved. Designed and Developed by WOOW Invest

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More

Privacy & Cookies Policy