How Bull Volatile Turns To Bear Volatile - How To Proceed

Let’s talk about Bear Markets

Since this market chaos has taken hold, each week I’ve been covering each aspect of the different market regimes. Last week we talked about going from Quiet to Volatile and I touched a bit on the differences in bull and bear markets.

If we are to take the agreed upon (by whom) definition of a bear market, 20% below it’s high, then we are no longer in a bear market on a number of tickers, as we are no longer down -20%

Using that weird and entirely useless metric of -20% being a bear market, we should all go out and breathe a global sigh of relief because we are above the -20% mark on the Dow SPX and Nasdaq indices… for now, it could change in five minutes. 

I think we can all agree that this magic 20% number is entirely useless because what happens if we are -19.9% like we were in December 2018 on SPX, yet NASDAQ was down -26%...so yes and no on the bear market??? Kinda???

It’s great for headlines, and I’m sure CNBC, Fox, CNN, MSNBC and Facebook are all at all time highs in ad revenue as measured by freaking out viewers waiting for someone in a suit to tell them what to think and how to react. 

Considering that in December - January we were in that beautiful sweet spot in the markets, the bull quiet regime. A time when every dip is bought, every breakout is bought and things seem perfect in the world. And today we are thoroughly nested in the bear volatile market regime, a whole different mess. 

Today I’m going to spend some time talking about the market characteristics found in a bear volatile regime. This is important because if you know what to expect, you can then figure out how to participate, or not. 

Bear Volatile Regime

The first signs that we have indeed moved into a bull volatile regime are when we see the market dip, and it’s first rally is sold off. 

The SQN indicator, shown below has already moved into a bull volatile regime, but the characteristic price action of the bull volatile regime had not yet shown up until a couple of weeks later. 

This is why I reiterate that the SQN is a trailing indicator, not a leading indicator. It will give you a good idea of what’s happening, generally, but price will give you a better indication. 

Next the market does eventually buy the dip, and we drift higher to new all time highs, again. 

Notice the SQN indicator is actually rather timely there, warmly wrapping us into it’s soft bull quiet embrace where everything is amazing, and it’s easiest to just be long. 

This is what creates the perfect storm that is the bull volatile regime. Dip after dip is bought, new high after new high is in, and everyone gets conditioned to believe that the market will never go down again. The more aggressive will have bought the dip and are celebrating, even gloating that they bought the dip, leaving others to think that they missed their opportunity and need to buy now, at whatever cost!

This ends up being the last buyers (with bullish intentions) to enter so there’s very little buying pressure left. 

However since we’ve just put in the first really bearish looking reversals (shown on the chart) only the most aggressive bears will have gotten emboldened when those beautiful short setups printed. I say the most aggressive because nearly every other bear in the world at this point will have thrown up their arms and ran off to Twitter to yell about the Fed printing money or any other narrative they can come up with. 

This is why the drift higher is so quiet and calm, it’s almost entirely bears covering their shorts. The momentum is dying out and it’s really just traders handing their positions back and forth with each other.

The last bull has bought, the last bear has shorted and stopped out (bought to cover) and not much happens, there’s no one left. 

This is why a Bull Volatile regime is needed to have an actual market top in place.

Having already established the bull volatile regime all the top buyers (and weakest hands) are wholly unaware they are smack dab in the middle of the volatile regime (we talked about volatile and quiet without respect to direction last week). 

But with that “free money” low volatility price action, shorters of Vol will have no choice but to participate, and very highly leveraged, because everyone is doing it. 

The thing about a bull volatile regime is that they can last weeks, months and even years. Simply having a bull volatile regime DOES NOT confirm a top, but it is a requirement to have a market top. 

This top was particularly nasty, for the reasons I mentioned above. There is no one left to buy at the top, and the last people to buy are the weakest hands. This is important because they KNOW that they are risking more than they should, this is often people who have been dollar cost averaging and contributing to their 401k or IRA regularly. 

They’ve been seeing the market go higher and higher to new all time highs day after day, with nothing but good news on the horizon. They decide to lever up, maybe take from their savings account, borrow on their credit cards, maybe even take advantage of the all time low interest rates and refinance their home and put some of that money to work in the stock market so they don’t miss the move. 

I’d also like to note that going in to 2019, Wall Street strategists were the LEAST bullish they had been in 15 years.

Meaning that while the S&P500 was up over 30% in 2019 a lot of big money wasn’t positioned for that move and they had to chase this market higher...let’s call these people the large money managers and hedge funds.

We have all this money piling in at the end of 2019 to show their investors that they were positioned for a rising interest rate environment not a high momentum environment and had to play catch up to reposition in Q42019

The final cohort to add to our basket of chaos, I’m going to borrow from Barrow. @MacroOps co-founder and fellow former Marine Alex Barrow wrote about in an article titled “A record breaking market” (by the way, nailed the timing) 

• Options market gone wild
• According to SentimenTrader “leveraged traders of expiring contracts have never held so much exposure to a rally in stocks… With the surge in call buying, their total outlay has exceeded more than $7 billion in premiums paid each of the last two weeks.” Which is “far beyond anything we’ve ever seen before.”
• 20-day Put/Call ratio at lows hit only 3 other times over the last 6-years.
• According to Charlie McElligott “Investors have gotten extraordinarily (and mechanically) long the market via options and the overall index trade to ATH, with Delta across the S&P 500 currently in the 99.5th percentile”
• And Goldman Sachs points out that single stock option notional volumes as a percentage of shares are at 91%. The highest level ever.
• Short interest in the SPY is at its lowest point since early 2007.

This final group, the speculative options players were pouring kindling and lighter fluid into thousands and thousands of dumpsters already full of baby diapers and fire wood. These dumpsters were uniformly placed in a complete barrier around huge tankers of a massively overcrowded jet-fuel storage facility.

Let’s summarize:

• Sellers of Volatility have crowded in to the best game in town because it just keeps printing money
• We have the late to the game conservative long term investor who once a year logs in to their Schwab account, is now deviating from their tried and true plan of putting a little bit in every month and borrowing money they can’t afford to risk at the new all time highs on things like TSLA and SPCE or...Eurodollars (seriously). 
• Hedge funds and financial managers chase the top to show their clients that they defensive moves in 2018 were the right moves and now it’s time to buy equities, because they are going so much higher(?). A lot of that was done through options to grab that big leverage needed to catch up the numbers. 

The weakest hands are the top buyers and volatility traders, they are all getting stopped out of their positions, margin called and quickly.

Then we print a sexy hammer reversal, aggressive traders are getting long but more importantly eeeeeeeveryone has been conditioned to buy the dip for the past 10+ years, and have been rewarded nicely. The Pavlovian response is strong and a 5-7% up move rewards them and reconfirms their brilliance.

I’m not going to lie, that second hammer’ish reversal candle looks BOWL-ISH

But what we learned from the Profitable Trading Blueprint course and is proven over and over again in the Systems Building Mastery course is that sure that looks bullish, and should probably be bought, BUUUUUT we have technique that is better than witchcraft to ensure that we DON’T get sucked in to that trade.

If you follow the plan, you are safely on the sidelines with your capital resting comfortably just waiting for the market to pull you in to your well backtested and well executed trade. If it doesn't pull you in, then you carry on with your life. There's no FOMO'ing in to the market that never would've filled your order.

Which leads us to this past week, when crude oil gapped down -30% and sent a flying elbow off the top rope into the jaw of every single market across the globe.

There was no saving it, despite press conferences, Presidential addresses, plunge protection team or emergency injections of capital. Everything was liquidated, futures markets were lock limit down off and on throughout the week.

Then Friday afternoon arrives, and in a thoroughly inspiring event, we actually got to see the rarest of all animals, Lock Limit UP!

I feel like I recall back in the early 2000’s that I had experienced a lock limit up market, but I honestly am unsure. 

This was a “fun” little look back at how the markets have played out over the last month or so.

“This time is different”, but that’s because every one of these meltdowns/crashes are different. 

As systematic traders we have tools to adjust risk in a risky environment like this. We have position sizing tools, we have backtested all of these environments, we know the proper strategies to trade in a Bear Volatile market regime.

If you’ve never traded this sort of market and don’t understand how to categorize market regimes matched with the appropriate strategies, then you really should get the Systems Building Mastery course.

In it you’ll learn how to categorize markets, which strategies work in the different market types, but most importantly you will be ARMED with the tools to do this yourself. You won’t need to guess or rely on anyone else to help you navigate these crazy markets.

It Was The Corona Virus

The market regimes inform us as to how news is going to be absorbed by the markets. Different market regimes are unusually sensitive to certain types of news and completely dismissive to others. 

In a bull quiet regime, bad news is a reason to buy

In a bull volatile regime, bad news has dramatic negative (and positive) effects.

The fragility of a bull volatile regime is simply because the weakest of all bulls bought the top, there is extreme levels of over leverage and overly long exposure, so what would normally be a small reaction is amplified and becomes this recursive loop of this is bad, so that makes that bad, and now I feel bad, so this is bad, which makes that bad and now I feel more bad.

If it wasn’t the Corona Virus that came it would’ve been something else, perhaps even worse, to shake the markets. Perhaps it might’ve been the Sauidi/Russian crude war, perhaps it might’ve been something that we haven’t heard yet. Either way, being in a bull volatile regime was the perfect place for such chaos to be nurtured.

What do I Think Going Forward?

The S&P 500 possibly saw the bottom neighborhood of its new trading range. I say neighborhood because we can easily go lower but for now the markets have found a spot that they liked, at least as of Sunday afternoon after the Fed surprise cut rates.

Remember that there are a lot of trapped longs, and they will sell every bounce that comes. 

Also as there are a lot of people who are not long anymore and they still remember that buying the dip is what has been working for over a decade. These people will need to be taught and reinforced new lessons, but until they learn them these face ripping rallies will suck them in. 

The largest up moves come in bear markets, the single largest up moves have all happened in bear markets, simply because it moves so quickly that shorts have to cover faster and most participants are in cash waiting to go long.

The buy the dip crowd will be punished and we will likely be in a sideways trading range with a downward drift for the foreseeable future.

Bear Volatile is one of the hardest markets to trade as the moves are so fast and travel so far it’s quite difficult to size positions quickly, and mistakes are more easily made. 

Much like market tops, a bear volatile regime is required to put in a long term bottom, it can take days, weeks, months or years for those bottoms to be formed, but it is a requirement. 

What Held Up Well

In my Quantitative Earnings Strategy we do have 2/11 sectors that did not get completely demolished. 

Using quantitative techniques to score the different sectors, despite the carnage Tech $XLK remained fairly neutral while Healthcare $XLV remained more bullish. 

We might have a lucrative and very interesting earnings season this quarter despite the carnage elsewhere, if you know where to look.

Earnings always brings the gamblers out who think they know what a company is going to report. Rather than trying to guess how a stock will react to news, with the QE System we don’t care what every big stock is going to report and then try to guess the reaction. We filter out all the stocks that we don’t have a quantifiable edge with and focus on the sectors and tickers that we do. 

As always if you have any questions, hit me up on Twitter or simply reply to this email. I might be slow to respond, building out a couple of new products that will soon be released! 

Stay Tuned