Between the Fed and Algo Trading, Buckle Up for Vertigo this Week

02/26/2018 3:33 pm EST

Focus: STOCKS

Joe Duarte

Editor, Joe Duarte In the Money Options

A confused market may lower volume trading, decrease liquidity, and increase volatility. In such a scenario, extremes of behavior, such as Flash Crashes and wild price swings are likely to be more common, asserts Joe Duarte, MD of Joe Duarte In The Money Options.

Investors should have some Dramamine handy in the short term, as the stock market is stuck in a dangerous tug of war between the Federal Reserve and robot algo traders. Moreover, this week’s congressional testimony – Tuesday and Thursday - by new Fed Chairman Jerome Powell, plus a full calendar of economic data releases capped by Friday’s employment numbers, could well take the volatility gauges to levels which may lead to a bad case of trading vertigo.

Expect extreme price volatility in stocks

As I noted last week robotic algorithms tend to follow textbook trading tactics generally based on knee jerk reactions to headlines coupled with standard support, resistance, and trend following technical analysis.

The February bottom was a perfect example of such extreme price activity based on program trading. The problem is that computer traders became used to former Fed Chair Janet Yellen’s style and general tendency to be cautious with interest rates pronouncements and the way the Fed conducted monetary policy.

But last week’s action, specifically the trading on Wednesday and Thursday suggests the bots are a bit on their back foot and the Fed may be taking back the playing field.

As a consequence, the market took a wallop on Wednesday as the Fed released its most recent FOMC meeting minutes which some headlines heralded as a signal that the central bank would raise interest rates more aggressively than expected. Then, Thursday morning, Fed governor Bullard made more conciliatory comments about interest rates which generated benign headlines and the market rallied. Both Bullard and Powell are on the speaking trail.

NYAD points to significant and volatile move ahead

The current position of the NYSE Advance Decline Line (NYAD), the most accurate indicator in the stock market for the past eighteen months, is similar to what we saw after the post election, November 2016 bottom with one important variation.

Now, as then, NYAD has fought back to the 20-day moving average (dotted line) as the Bollinger Bands (black lines enveloping line above and below NYAD) are closing in. Furthermore, the RSI indicator is neutral, confirming that it’s getting close decision time in this rally.

Note also that ROC, which measures the market’s momentum is at a nearly identical point now as it was in November 2016.

chart 1

But this time may be different as the magnitude of the price swing in the S&P 500 (SPX) – [lower panel line chart] is much wider and painful. Consider this: In 2016, SPX lost 4.6% from the September top to the November bottom. Now, compare that decline to the nearly 12% decline in less than two weeks in February 2018.

Mixed money flow indicators raise liquidity questions

If you look at price alone, the S&P 500 seems to be tracing a bullish consolidation pattern which is very suggestive of an upside breakout. And that may be the way things work out. Yet, under the hood there is a subtle change in the flow of money into stocks which suggests the rising possibility of poor liquidity and increased volatility.

chart 2

Last week I noted the Accumulation – Distribution (ADI) and the On Balance Volume indicators (OBV) were both positive, which seemed bullish for stocks at the time. Will the real robot please stand up?

Yet, the picture may be changing. Consider this week’s chart of SPX which shows ADI rolling over while OBV is still mostly positive.

This suggests sellers are creeping into the market. Furthermore, lower volume over the last couple of weeks is a sign of poor liquidity. If there is some stealth selling combined with lazy buying, and this combination is not reversed, we may not make it back to the old highs or worse.

Indeed, it’s too early to make a call right now, which is why the reaction to the Fed Chair’s congressional testimony will be crucial as the algos interpret the headlines and act.

It’s all about the Fed, the numbers, and the potential for extreme volatility

There is a new sheriff in town and his name is Federal Reserve Chairman Jerome Powell and no one has figured him out yet. Therefore, robots, like the rest of us, are now both spectators and participants in this market. Furthermore, the combination of stealthy selling and low conviction buying in this market is a sign of poor liquidity.

Above all, an illiquid and confused stock market is a recipe for increased volatility. Moreover, a significantly higher level of volatility will likely make it very difficult to assess the dominant trend for stock prices and may, in and of itself, lead to a vicious cycle: further lowering volume trading, decreasing liquidity, and increasing volatility further. In such a scenario, extremes of behavior, such as Flash Crashes and wild price swings are likely to be more commonplace.

Of course, if Powell and the numbers don’t disappoint, new highs could be just around the corner.

Joe Duarte is author of Trading Options for Dummies, now in its third edition. He writes about options and stocks at www.joeduarteinthemoneyoptions.com.

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