"The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder." – Complexity Labs
The stock market continues its slow upward grind – without a convincing confirmation of new highs on indexes from the market's breadth – even as traders quietly fret about what may come out of the Fed's Jackson Hole, Wyoming summit scheduled for August 26-28. Meanwhile, as investors continue to walk a potentially unstable tightrope, sound trading principles are the most likely way to survive and perhaps thrive, no matter what comes out of the summit.
Specifically, the elephant in the room at the summit is whether the Fed will signal that it's about to taper its QE, which would mean that it would buy less than $120 billion in treasury bonds per month from the banking system in the future. If that happens, that would mean two things:
- Less liquidity in the banking system
- Less money for banks and shadow banks to speculate on stocks as a source of income
In other words, the stock market would likely stumble in a big way, probably with lightning speed as the algos hit the sell button all at once. On the other hand, given the rising geopolitical and COVID uncertainties, the Fed may not taper anytime soon, although talk of tapering may be just as harmful in the short term.
Nevertheless, since no one really knows what the Fed may do, and since they have a record of making big policy mistakes in the past, the next two to four weeks will favor the following sound trading tactics:
- Being prepared for the Fed to make a bad decision and the market to fall rapidly – and to be 100% cash at some point if things get ugly
- Considering the effects on the markets of a return of China to a major lockdown and subsequent supply chain squeezes
- Using option-related strategies to hedge any stock market bets and produce income
- When buying stocks, purchase small lots
- Keeping somewhat tighter-than-usual sell stops in the range of 5% rather than 5-8%
- Never let a winner turn into a loser
- Considering contrarian strategies such as I describe in my latest Your Daily Five video:
Housing: It's A Supply Squeeze, Not a Bubble
The mainstream view that we are in a housing bubble may be misguided and perhaps completely wrong. That's because, even though prices are rising and some buyers are being shut out of the market due to cost, the supply and demand equation still favors a continuation of the bull market for homebuilders.
The fact is that the housing sector is a significant portion of MELA, the complex adaptive system composed of the markets (M), the economy (E), people's financial decisions (L) and the algos (A). That's because choosing where and how to live is usually the most important life and financial decision for a person.
Now consider the fact that, as big cities become difficult to live in due to rolling COVID surges and other issues inherent to their operational status, there are likely to be renewed and recurrent waves of people looking to relocate. There is your stable and occasionally rising demand. Meanwhile, as most homebuilders note in each and every earnings call, there is limited supply of land and labor. And, as realtors continually note, there isn't a sufficient supply of existing homes to meet demand even at historically high prices.
So, unless I'm mistaken, those are the basic tenets of a bull market – tight supplies in the face of hearty demand which is showing no signs of falling. Moreover, there is nothing in the horizon that says this dynamic is likely to change in the near (or perhaps even in the distant) future. In addition, a key part of the definition of a bubble is that the rapid rise in assets is not commensurate with the underlying fundamentals, which is arguably not the case at the moment.
In fact, the point clears up nicely when you compare the fundamentals of a true bubble, the subprime mortgage bubble to the present. Specifically, the subprime bubble was based on the existence of empty subdivisions being hawked to phantom or completely unqualified buyers, along with fraudulent mortgages and equally questionable derivatives, while presently there are lots of potential buyers and not enough homes.
Certainly, the current supply-and-demand situation is not a guarantee that home prices can rise forever, nor that homebuilders and flippers will be in eternal profit bliss. And there is no way to know how many derivatives are out there waiting to explode.
But, given the current situation in which millions wish to move to different locations and the supply of homes is limited, it seems as if the historical definition of fundamentals in the housing market has evolved, while those who monitor, describe and measure them seem to be using what at this point may be outdated metrics.
Flip or Flop: Homebuilder and Lumber Stocks Rumble while Zillow Sleeps
Those who have followed this column for the past few weeks have likely noted my focus on the housing sector. Specifically, I've suggested that the Homebuilders ETF (XHB) seems poised to breakout and that the $76 area was a crucial resistance area, above which the ETF could move to the $80 area fairly quickly.
Indeed, that's what's happened as the $76 area was finally breached and XHB has moved steadily higher. Meanwhile, I've also noted that the lumber stocks, specifically Louisiana Pacific (LPX) also seemed ready to move higher, which again has been the case.
This week, I want to highlight an interesting divergence between the stocks of leading homebuilder DR Horton (DHI) and online listing service and aggressive flipper of existing homes Zillow (Z).
DHI, the proxy for new homes, has been forming a base in a comfortable area of Complexity above its 200-day moving average of late and recently took out short term resistance at $97.
Meanwhile, Z, the proxy for existing homes waiting to be flipped, is in the Chaos zone well below its 200-day line, looking as if it may begin to form a base in the next few weeks. What this difference in stock price suggests is that, in a difficult market, buyers are more willing to pay high prices for new homes with a lower potential for needing repairs. It may also be suggestive that, since new home subdivisions are more likely to be in less populated areas than existing homes, this may be an attractive option for buyers.
Finally, the U.S. Ten Year note yield (TNX), the benchmark rate for many mortgages, is now at the Edge of Chaos, trading between its 50- and 200-day moving average. This means that we can expect some sort of decisive move in the not-too-distant future. If, as I expect, TNX fails to rise above 1.4-1.5% decisively, it should be a very bullish development for homebuilders and perhaps even existing homes.
I recently recommended DHI, and other homebuilder related stocks, which is why a FREE trial subscription to Joe Duarte in the Money Options.com may be worth considering. Click here for more information.
I own shares in DHI, LPX and XHB at the moment.
SPY Options Suggest Traders Are Cautiously Bullish
Options players continue to play a cautiously bullish game. The call volumes remain high at the current and near strike prices for SPY above the current price. At the same time, the put volume remains high just below the current active strike price. That suggests that traders are willing to bet on the market moving higher while keeping a short leash on any potential break to the down side.
What that means is that, if the market turns lower, it would likely do so in a hurry.
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Market Breadth Retains Bullish Bent with New All-Time SPX Highs
The New York Stock Exchange Advance Decline line (NYAD) has not given an all-out all clear signal for the current grinding rally in stocks. However, it continues to move higher, delivering higher highs and higher lows while erasing a recent potential sell signal. Thus, the market's breadth remains reasonably good but not quite excellent.
That means the overall stock market gets the benefit of the doubt. Still, it would be best if we get a new high on NYAD sooner rather than later, as the longer the indexes make new highs without confirmation from NYAD, the more likely will be the odds of a decline at some point in the future. And with the Fed hinting at a QE taper, things could get dicey in a hurry.
The S&P 500 (SPX) and the Nasdaq 100 (NDX) held up fairly well, with SPX delivering a new high and NDX again remaining not too far behind.
So, for now, the bullish bent in the market, albeit somewhat softened, remains in place.
Good news! I've made my NYAD-Complexity, Chaos chart (featured on my YD5 videos) and a few other favorites public. You can find them here.
Joe Duarte
In The Money Options
Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com and now in its third edition, plus The Everything Investing in Your 20s and 30s Book and six other trading books.
The Everything Investing in Your 20s and 30s Book is available at Amazon and Barnes and Noble. It has also been recommended as a Washington Post Color of Money Book of the Month.
To receive Joe's exclusive stock, option and ETF recommendations, in your mailbox every week visit https://joeduarteinthemoneyoptions.com/secure/order_email.asp.
