February 2021 | Archimedes Methodologies

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Updated Discussion with a few Corrections and Stops

General Discussion – You May Want to Skip to the Buys Below

This morning, traders have taken the S&P 500 below last night’s Globex low, ran the stops, and now brought it back the Weekly Expected Move (“WEM”) low. As you will recall, the WEM is where exchanges set the options expiration last Friday for today. No surprise in that, but I note that both last night and so far this morning, the bears don’t seem to be able to find sellers below recent lows – at least so far. I will allow for the possibility that the market makers are holding the market to the WEM low – but it was handily breached on the NASDAQ 100. So I will still carry the lack of sellers forward into next week.

Also, this is the last trading day of the month, so fund flows at the beginning of March next week have the potential to push prices higher, at least for the first few trading days.

Treasuries are rallying this morning – beating back interest rates. The bottom I had been expecting in the steep decline for bonds is forming. With bonds bottoming, 1.5% now establishes the upper resistance line for the 10-year treasury interest rate (bonds and rates move inversely to each other). Arguably, the 10-year rate is the most important in the system. Most loans key off this rate. We can stay bullish as long as the line holds.

In my view, 10-year yields tell you all you need to know as far as inflation, the economy, and interest rate pressures go. It is the simplest barometer you will find. For now, 10-year rates, and the pace at which they just rose, are thumbing their nose at the Biden economic policies. Both Treasury Secretary Janet Yellen and Fed Chairman Jerome Powell will pay close attention to this rate. We get the next Fed meeting two weeks from now and more insight on the Fed’s plan for yield curve controls. Perhaps a rally into that meeting, even if we don’t experience new highs, is in order.

Given the potential stagflation scenario ahead, and even if it were not, I am still targeting the XLF and the XLE. The steepening yield curve (long-rates higher than short rates) will be a windfall to bank earnings. The XLE will continue to benefit from rising oil prices – even the rise we have experienced thus far. Oil is reacting to the weaker dollar and inflation pressures. Obviously, the two are related.

I always need to be comfortable with the stock market’s macro trend direction and our algorithms from a strategy perspective. While I was not expecting this retest, so far, we are putting in a solid low here – as far as the S&P 500 index goes. Some reverse rotation back into the NASDAQ 100 (QQQ) is presenting as well today following the very steep correction in technology we just experienced. Nothing has changed in the tech world – save some higher borrowing costs. It is nice to pick up some tech exposure when the stocks are on sale. That puts the XLK and QQQ also on my radar.

I have no difficulty executing on all of this with futures. We must make certain that we have enough runway ahead to swing trade options – without you having to live by your computer screens, micromanaging the positions. Options don’t permit you to set stops, or it would be easy. I feel like we are in more of a short-term trading market. As we saw this week, we did not have much runway for implementing a strategy with options. I am wondering how many of you are managing – without checking your emails every 15 minutes.

Buys

We bought a 10% futures position in the Founder’s Group in each S&P 500 index and the NASDAQ 100 index this morning. Our entry prices are 3801.50 and 12,762.50, respectively.

We are using micro-futures to get the lessened exposure rather than an entire mini-contract. We get more flexibility in scaling in and out with the micros.

We also took a 5% position in each of the XLF and XLE 16 April 21 calls. We did the 33 calls on the XLF and 49 calls on the XLE. If you are using SPY rather than S&P 500 futures, you can use the 384 calls, and if you are substituting QQQ calls for the Nasdaq 100 futures, you can buy the 318 calls. The same time series – 16 April 21 monthly calls – should be used on the SPY and QQQ similar to the XLE and XLF. Essentially, you are targeting the at-the-money calls on all of the instruments. I usually put in my orders between the bid and ask if the market is not moving too fast.

The new investments bring us to a 30% invested position, but these are all highly leveraged instruments. You expose a lot more than 30% of your capital when the leverage is taken into account. Be sure you understand this. Alternatively, you may want to buy the non-leveraged cash indexes using the QQQ, SPY, XLE, and XLF. Just buy the number of shares you find appropriate to your risk tolerance, defined as permitting you to sleep at night.

I hope that with this additional sell-off, we can hold these positions long enough to swing trade the options, but I cannot be sure. For the positives, I am focusing on Algo buy signals, a successful retest of Tuesday’s lows, a short-term peak in 10-year treasury rates, relative strength in the identified sectors, and the typical fund flows we get at the beginning of each month. As well, there may be a positive reaction to more stimulus passed by Congress over the weekend – at least for stocks.

Negatives remain lofty valuation, giddy sentiment, and rate velocity if and when the 1.5% resistance ceiling is penetrated.

As always, just because I am doing this does not mean you should. I am sharing my thoughts, but I am wrong from time to time. So do your own homework and draw your own conclusions.

I am following this write-up over the weekend with some housekeeping items that will discuss the opportunity to join the Founders Group and/or have us direct your trades when you cannot be by your computer. We have been programming the technology over the past four weeks and will be beta testing next week.

Stops on all of these instruments should be a few ticks under this morning’s lows for now.

Stay tuned.

A.F. Thornton

Founder's Trading Journal

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Normally, I would expect a retest of any significant, cyclical low. But when the low is associated with a spike “V” reversal, the penultimate head and shoulders reversal pattern, the market typically skips the retest. We have had many of these quick reversals in this liquidity-driven bull market. Tuesday’s low fit the pattern.

Nevertheless, I always keep an open mind. Moreover, when the first rally from a cyclical low is sharp and fast, I have to consider that it might be short-covering – rather than confident buyers. So, after deploying our cash close to the bottom Tuesday, the Founders Group sold half the position near the peak on Wednesday. We were stopped out of the remaining position Tuesday night in Globex. We had a substantial profit on the move.

I kept you up to date on the Founder’s Group’s moves on these pages. The option investor, limited to regular session trading, could sell the first half of their position at the peak on Wednesday but did not have the overnight flexibility we have with futures. Still, I set an intraday stop for the remaining half of their position yesterday and advised them not to let the options drop below break-even.

A swing trader must give the market room to breathe – even after a sharp rally. We did so in the Founder’s Group, and then we put our toe back in the water with a half position in the S&P 500 futures at the point where the market should have turned yesterday, assuming a “V” reversal was in place. We used a 10-point stop on the new position. Soon after, our stop hit on the new position, and we hit the stop set for options. The market then sold off viciously, landing back on the Weekly Expected Move low (where the options expire today), which was about the same level as Tuesday’s low.

So we are back to 100% cash, and the issue today is whether this retest will hold. Perhaps more importantly, we have to analyze yesterday’s behavior. Was the market tuned to our original scenario, and something intervened? Or is the market still on the path to the 20-week nominal low we had been anticipating?

In my view, yesterday’s behavior telegraphed a sea change – if the behavior continues beyond a one-off bad day. Not only was the volume heavy on the sell-off, indicating that institutions were raising cash, but the selling was also indiscriminate. Both long-term investors and short-term traders sold everything. They sold copper, precious metals, commodities – everything. This does not bode well for the low holding today. And even if it holds today, we must consider what the market will do once the weekly options’ safety net expected move/expiration low today is not in place on Monday.

Why is this weakness presenting so soon after a low seemed in place on Tuesday? As indicated in my 2021 outlook, inflation pressures have been mounting. The pressures manifested yesterday in the 10-year treasury interest rate breaching our previously identified inflection point at 1.5%. Intraday, the level hit 1.6%. To be sure, rates are still low. Yet the rate has doubled in less than two months.

Looking at the chart, the sell-off in bonds leading to the rising rates is now vertical, indicating emotional excess and perhaps a waterfall decline bottom soon, at least for now. So I would not be surprised to see rates back off a bit, which would allow the stock market low to solidify. I cannot be sure, but that is my best judgment.

One might postulate that rising rates reflect a recovering economy. That should be good for stocks and earnings. A steepening yield curve normally precedes rising growth. All should be well.

Truly, growth is improving. But here, I believe that the market is concerned about stagflation. Stagflation is what we had in the 1970s—stagnant growth with high inflation.

While stagflation requires an entirely separate discussion, let me distill it down to a couple of important points. First, the Biden administration’s initial moves have been anti-growth. So, rather than celebrating potential growth, market participants are concerned about the administration’s moves and that the Federal Reserve is losing control of inflation and rates. All of the Fed’s activities and authority centers around short-term rates. It is by manipulating short-term rates that the Fed attempts to influence longer-term rates.

The rate that really counts is the 10-year treasury interest rate. Most loans are tied to that rate, including home mortgages. In fact, in four of the last five months, home purchases have been down. Higher rates will make that worse. Higher rates will negatively impact growth and recovery.

While the ultimate interest rate is important, also of concern is the velocity or delta of rates. Rates are not just rising. They are rising at an alarming pace. That makes yield curve control even more challenging. Here, I believe that the market is focused on the untargeted stimulus set to pass Congress today.

Money is going to people who are likely to spend it. This has more potential to induce demand-driven inflation as opposed to past actions of the Fed, where they liquify the banks – allowing the banks to loan funds in a more discriminating way. That is less inflationary and one reason why increasing the money supply in the past 40 years has not been inflationary.

Supply chain disruptions from the Pandemic have already led to shortages and rising costs. Lumber, steel, copper, and other raw materials are at 12-year highs. There are shortages in microchips. The Texas utility crisis will further drive demand. Most importantly, substantial debt is rolling over in 2021 in the government, corporate and commercial real estate sectors. In fact, the debt at issue is the most leverage in the recorded history of the country. Rolling over this debt, or the inability to roll it over due to rising costs or tighter lending standards, pose significant structural risks to the economy. These are major issues for the government and corporate bond markets.

The Fed’s mandate is to fight inflation but maintain as close to full employment as possible. If costs are rising – whether they be financing costs or costs for raw materials and labor – this could impede growth and lead to more layoffs. If the Fed loses control of rates or investors experience a confidence crisis in the Fed’s available tools or the currency, economic circumstances could deteriorate quickly. To control long-term rates, the Fed will need to buy longer-term bonds than it typically does as part of its quantitative easing. Other than that. the tools are limited and unpleasant for stock market participants.

I know this is boring stuff first thing in the morning, but it is important to understand the issues at hand. The bottom line is that the rising rates, together with the pace at which they are accelerating, is causing market participants – especially the smart money – to reconsider their strategies. The fact that inflation fears are driving rates higher (rather than growth expectations) is why the rising rates affect the stock market even though the rates are still low. The stock market will tolerate higher rates that are associated with growth expectations.

For our part, no algorithm or indicator will guide us here – we have to use our brains. We have to be very, very careful.

Today's Plan

Use the overnight high at 3849 as the sand line for bull/bear bias and determine whether more short-covering is possible. Note that the settlement (3831.50) and the volume point of control are close to each other in yesterday’s regular session distribution. Short plays can target this area as settlements and points of control are often revisited.

Given where we are opening, the better futures trades will present once things shake out a bit. The overnight range is compressed compared to the regular session, and we will open close to yesterday’s volume at the price peak (the point of control).

I ask myself three questions every day. What is the market doing as far as general tone and bias? What is the market trying to do? Finally, how good of a job is the market doing getting there? I learned this from one of my mentors – James Dalton. As one of the grandfathers of Market Profile, the bedrock of his theory is excess and balance. Where is the market demonstrating emotional excess? When are buyers and sellers evenly matched or in balance?

As previously communicated in these pages, I don’t typically trade on Mondays and Fridays. The options expiration (especially around the Weekly Expected Move at 3833) will impact and distort trading as it typically does on Friday. The same level also matches up with Tuesday and yesterday’s low.

I will use the weekend to dig deeper, and you will be the first to know (after the Founders Group) of my findings.

A.F. Thornton

Founder's Trading Journal

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I hit my 10-point stop on the re-entry this morning – and the market is violating key levels that would have confirmed a turnaround. Whether in options, futures, or any other instrument, it is time to go back to cash.

The wild card this morning has been interest rates. The 10-year has breached resistance – rapidly approaching 1.5%. To read the chart above, you add a decimal point after the first number.

Let’s let the market find its footing. For now, the market met all prior pattern projections, and the reversal pattern we had identified as a possibility today simply did not materialize. While it may have started as valid; rising interest rates interrupted the process.

This is a market that requires near perfection to justify its levels. While likely reflecting a recovering economy, the ascent of interest rates requires an adjustment to equity prices – especially tech and growth stocks. Also, we need to analyze why rates are ascending so fast. It is not normal.

A.F. Thornton

Founder's Trading Journal

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I just issued a buy signal to the Founders Group for a 50% invested on the S&P 500 index at 3886 with a 10-point stop. If the market progresses, I will go to a fully invested position – but I need more confirmation.

If you still have a half-position in options, you hold and do not add to it until we return to a fully invested position.

Again, remember that this is a risky market. Futures are a risky, leveraged investment. The unexpected move would be down – as most expect the market to pivot up. Keep that in mind.

A.F. Thornton

Founder's Trading Journal

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So far, so good on our latest buy signal. However, in the S&P 500 futures contract, we stopped out of our remaining half last night at 3915. If you are in SPY options, that was not a possibility—more on that in a moment.

For now, I got my coloring books out this morning and drew what I think the market is trying to do here. As I mentioned yesterday, a small Head and Shoulders pattern often forms part of a larger Head and Shoulders pattern. Here, after completing our topping pattern over the last week, we now see a potential reversal pattern forming. We saw a smaller Head and Shoulders reversal pattern forming yesterday, which now may have formed the head of an even larger pattern. If so, I have laid out the probable path, and I am looking to redeploy back into the market around the 3888 level, give or take five points.

The other possibility is that the market peaked again last night, and the correction will continue to new lows. I don’t think that is probable for all the reasons I have laid out the past few days. But I have to keep an open mind.

In allowing for the latter possibility, if you are holding options, at no point should you let your options go into a loss if you can manage it? Your mental stop, at minimum, should be break-even. Of course, you cannot control what happens in the overnight markets – hence why I prefer futures. Other than break even, your mental SPY options stop should be 375.50 for now.

For today, the overnight correction is mild, and Russell futures are still rallying. I will assume that buyers are still in control unless we were to take out the overnight low and start to gain some acceptance in the single prints of yesterday’s regular session distribution. Where the value area (70% of volume) develops today will be of paramount influence on my outlook.

Even if we take out the overnight low in early trading, 3775 is the line in the sand that keeps this rally intact – at least from the Head and Shoulders reversal pattern perspective. In addition to the usual quartet, key levels to watch today include yesterday’s halfback at 3891.50, the Value area low at 3876, and an untouched volume point of control from Tuesday at 3844.

The left shoulder took a few days to form. Forming the right shoulder could eat up a few days as well, perhaps most of today and tomorrow.

Also, remember that the S&P 500 is a march in 50-point increments. Most of the struggle is about maintaining (or surrendering) these levels. So the market conquered the 3900 level yesterday and should not easily surrender it, at least on a closing basis. It follows then that the battle today is holding the 3900 level. If the market fails, it will then congregate around the 3850 level. If 3900 holds, the next battle is to conquer 3950.

If you take all your indicators off your chart, then give yourself a couple of years of data to review, you can step back and see that the market congregates around each of these 50 point levels as it progresses forward or corrects.

A.F. Thornton

Founder's Trading Journal

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I could do an entire video series on cycles and their role in market analysis. In fact, eventually, I will. For now, understand that there are ebbs and flows of buying and profit-taking in the markets that have discernable rhythms. You just witnessed one of the short-term cycles in operation. In the illustration above, the grey area established the target bottoming zone.

As we saw yesterday, the stars were aligned to pull us into the low, and the Head and Shoulders chart pattern further confirmed the cyclical top, with a new one marking the bottom.

Two more cyclical principles are handy. First, in the stock market, cycle lows tend to align rhythmically, while cycle peaks are all over the place. Moreover, when multiple cycles are bottoming simultaneously, the market’s pull into the low is more powerful, usually leading to a deeper correction. In the chart above, when the semi-circles at the bottom line up, representing multiple cycles, you can (and typically will) experience that more precipitous correction.

As to the why of cycles, some attribute it to the alignment of the planets. As an example, there is a 30-day cycle some attribute to the moon cycle.

My theory is a bit different. Cycles are the natural result of multiple investors operating in different time frames. Longer-term investors take profits on a different time frame than swing traders or even day traders. The business and debt cycle exert an influence. Even multi-generational attitudes, like the Fourth Turning I previously discussed in these pages, have their impact. That is all you need to know for now.

So we have a nice follow-through from yesterday’s buy signal. The sharp, reversing Head and Shoulders pattern I showed you this morning is taking nicely, projecting a move at least up to the old highs:

O.K, so this makes it all look easy, right? Well, sometimes it can be, but most of the time, it is not. There was a lot of other confirmation of the low, but I can only focus on a few at a time in these pages.

There is still pressure on commodity prices and interest rates going on in the background. While Chairman Powell gave the markets some balanced and reassuring tones yesterday, we cannot ignore the risks:

This market is moving so far so fast; I am having trouble setting a stop. The next resistance is around 3825 – barely 2.5 points above us at this writing. I will take profits on half of our position now (at 3822.75) in the Founders Group. I will hold half with a stop at 3915 (below on the New York close) – we will also carry a hard stop into Globex tonight. This is a weird one, to be sure – but I would rather sell early and keep our stop tight than ride a wave back down.

A.F. Thornton

Founder's Trading Journal

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Some corrections are easier than others, especially when a chart pattern appears to confirm it. One of the most commonly discussed chart patterns is the Head and Shoulders pattern. Growing up in what I am now terming the “Golden Era” of the 1950s – 1970s, we all remember the shampoo commercials. Hence the title for this ditty. Do you remember the commercial with Farrah Fawcett and Penny Marshall? The time has passed so quickly.

Now, most chart patterns don’t seem to work these days. Or, possibly, most technicians never dug deep enough to understand them. The Head and Shoulders pattern tends to mark a peak in prices, and there is an upside-down one that marks a low. The magnitude of the peak or low requires context. The context on a Head and Shoulders pattern is a cycle peak or trough. Very few market mavens seem to understand this.

So when such a pattern appears when I am expecting a cycle peak or trough, I am a lot more confident that it is a pattern that will take, versus some random grouping of prices.

As you know, I have been expecting a market cycle peak for a few weeks. As I have also indicated, I did not think this peak would be the big Kahuna. Remember our diamond pattern of a few weeks back? I was confident it would mark a short-term peak as well. When the diamond pattern went up and not down, which is the least likely case, it hinted at the pattern that would ultimately form. The diamond pattern turned out to be a left shoulder in the larger pattern.

The Head and Shoulders pattern not only appears at and marks a potential peak, but it allows a projection as to where the market might bottom, at least short-term. You measure the distance from the top of the head to the neckline and then project the same distance from the ultimate neckline break. Yesterday, that projection and the Weekly Expected Move low were almost the same target – 3830 or so on the S&P 500 futures contract. And so, like a force of nature, the market did exactly what was expected, spiking low into the target, allowing us to enter right near the projected low. By the close, the market had traveled right back to the neckline. That was a $2,000 plus profit on a single S&P 500 futures contract.

This morning, we see a similar pattern potentially forming in reverse. If it completes, we know the next projection point. It would also confirm that the cycle low is in. I am not as confident in this diagnosis as yet. There is a wide time swath for this cycle bottom – all the way into Mid-March. The cycles have been tending to bottom early of late – but I will keep an open mind until we have further confirmation.

Also, these patterns can form the tops of a much larger Head and Shoulders pattern forming on a larger cycle. So, for all we know, this entire pattern is forming the left shoulder of a much larger Head and Shoulders pattern of the nominal 18-month cycle top, with the next run-up forming the final peak. Let’s hope it is that easy, as it will help us project that cycle low with some accuracy. I doubt it will be that easy, but one can hope.

Today's Day Trading Plan

I don’t see any early imbalance from Globex that would set up an early trade. Let the market shake out a bit before trading. Responsive longs have good odds of working against some of the usual key levels. There is likely still inventory that is short in this market – so more short-covering can boost us higher.

I will use the back-to-back settlements at 3875.25 as a line in the sand to gauge bias, with above being more bullish and below more bearish. The developing value area (where 70% of volume occurs) will be important as well.

Nasdaq futures continue to show relative weakness to the S&P 500. Keep this firmly in mind as further or intensifying Nasdaq 100 selling can curtail S&P 500 rallies. Remember, the FANGMAN stocks still dominate the cap weighting of the S&P 500 as they do the NASDAQ 100.

My overall focus today in the bigger picture is whether or not value can establish higher or not. This will confirm the reliability of yesterday’s reversal. While we closed relatively high in the session, the volume and time points of control did not migrate higher with price, and the value was clearly lower.

Founder's Trading Journal

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Founder's Trading Journal

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Founder's Trading Journal

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In our last episode (last night), I left you thinking that I would see what the Europeans wanted to do with these markets. They voted with their feet – exiting stage right and thanking the Asians for driving their exit prices a bit higher from the New York close. It is nice to score a couple of points against China.

If the futures are to be the harbinger for the day, the NASDAQ 100 broke its 50-day line and its recent trendline last night. The NASDAQ 100 has also easily breached its Weekly Expected Move low, not a great sign for the market makers – who are largely responsible for selling futures this morning to neutralize their portfolio deltas.

The S&P 500 futures are slicing through the mean at the 21-day line – following the NASDAQ 100 down this rocky road. The S&P 500 futures are now taking out last week’s low and moving into the January price range, more potential negatives. I am starting to think that this is the intermediate correction I had discussed last week and slated to bottom in mid-March.

Overall, I don’t think the S&P 500 really wants to be in this correction. The energy and financial sectors still want to rally. But technology is 30% of the index. While the financial sector will benefit from the steepening yield curve up to a point, it is not so good for technology and growth stocks. In any event, this correction is still a mild one – with a 5% top to bottom line correction still well below us at 3750. That would not be much to complain about – given the gains leading up to it.

The technology sector was all well and good when the seven FANGMAN stocks carried the entire market on its back (constituting 40% of the entire 500 stock index at its peak). But now, we are rolling the tape backward. The S&P 500 really doesn’t want to sell off and has much stronger underpinnings. But we cannot have it both ways now, can we?

And then there is the concept of throwing a match on gasoline. It won’t take a lot to get the crowd to panic here. So the S&P 500 index will only tolerate so much bifurcation. The financials are the key to everything right now, and I will be watching the XLF closely.

So the market is serving dueling banjos with your coffee this morning. Financials are still trying to carry us north, with the energy sector as its caboose. Technology wants to take us south. Who will win this battle? Only time will tell. Know this. I would rather watch than participate, at least for the moment.

The Navigator algorithms remain 100% cash. If you want to day trade the market today, gap rules are in play this morning, once again. Be careful with any early attempt at a fill.

With the large point divergence between the futures and cash this morning, moves are harder to predict. Let the gap rules be your guide with the emphasis on two and four.

If there is counter-trend rally action, monitor closely for the continuation and target the full gap fill at yesterday’s low. Take it step-by-step from there on any further strength.

Any gap and go continuation scenario will be coupled with extremely bearish internals and a partial to no gap fill in early trade. I can’t stress enough (like yesterday) that this is a hard play to pull off early as the market’s natural tendency is to take care of old business first, which is to deal with the overnight shorts in the gap.

Stay tuned…

A.F. Thornton

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