A S&P 500 futures trader once told me: “After a sharp sell-off, the bounce leading to a first kiss of a 20-day moving average from below is a short sale.”
But, I had to ask, “Why?”
“That’s how it is,” he said with a typical New York City assertiveness and did not elaborate.
That very well may be “how it is” for the unwritten trading rule to look to sell the S&P 500 Index near the 20-day moving average after a sharp sell-off, but I still personally need to know the “why.”
Technical trading has value, but simply looking at charts is not enough for me. So, I decided to come up with some reasons behind why you should sell this particular rally:
1. Oil Prices are Surging
Oil is above $100 per barrel as the bombardment of Libya has started. A missile already hit the Gaddafi residential compound — “even though he is not a specific target” — which, if successful, would have likely shortened the operation and brought a quicker resolution to the situation.
While Gaddafi has halted his attack on Benghazi after jet fighters attacked his troops directly, there is still plenty of fighting elsewhere. It looks to me that the rebels will use the situation to regroup and mount an offensive. In this situation, no foreign oil workers will return to the country anytime soon, causing Libya to further cut oil production. In addition, the situation in Yemen and Bahrain, both of which border Saudi Arabia, is rapidly deteriorating.
In this scenario, I recommend taking a look at the U.S. Oil Fund (NYSE: USO). This exchange-traded fund (ETF) has pulled back along with the front-month futures it tracks. Oil is likely headed higher in the short term, as all the factors that caused it to go to $107 have deteriorated notably while the price is below that level as of the time of this writing. There are liquid April, May and June options on the USO that offer numerous strategies to play the upside. Naked calls are the most risky, while any relevant option spreads will limit your risk and your rewards. (Smart traders try to minimize risk; greedy ones try to maximize the reward.)
2. Shadow Banking Liabilities Plummeting
There has been a very peculiar drop in shadow banking liabilities in the past quarter, which basically says that what the Fed is doing is not working — the broad money stock in the U.S. financial system is shrinking.
As reported by Zero Hedge several days ago: “So far this theory has been a massive disaster with 11 consecutive quarters of shadow banking liability declines. And where it gets far worse, is that after five consecutive increases in traditional bank liabilities, which hit a record $13.1 trillion in Q3 2010, this number declined by $231 billion in Q4 to $12.8 trillion. Thus the combined move in Shadow and Traditional Banking liabilities was a whopping $438 billion in Q4!”
Against this backdrop, Treasurys deserve a closer glance. I know everyone simply hates Treasury bonds, but they have been working since the Libyan situation arose, and they may keep on working with such a peculiar drop in the broad money stock.
I have grave concerns about the long-term viability of the strategy to borrow ourselves out of the current economic mess — this rampant government borrowing implies higher interest rates in the future — but I think that in the next three months or so we may see a further rally in Treasury bonds. If oil keeps rallying and the broad money supply keeps shrinking, bonds should rally. The Fed may be printing money, but you certainly can’t print collateralized debt obligations (CDOs) and the now-bankrupt banks that used to buy them.
Traders should consider call options on the iShares Barclays 20+ Year Treasury BondFund (NYSE: TLT). As with USO, we have liquid April, May and June options on TLT. Again, naked calls are the most risky, while any relevant spreads will limit your reward, but also your risk.
3. Heavy Selling Volume
Finally, the sell-off in the popular SPDR S&P 500 ETF (NYSE: SPY) has come on notably heavier volume since late February. This is very similar to what happened in late April through early May, when we had an initial rebound to that 20-day moving average that my futures trader was referring to.
It looks to me that we are in a similar sell set-up right now. Last year, the second sell-off marginally undercut the initial “flash crash” low. There are no guarantees in trading, but if I had to guess, there is another retest coming of the S&P 500 1,250 level that stopped the sell-off last week.
There are liquid SPY puts, inverse (and leveraged) S&P 500 ETFs, futures, and all kinds of interesting instruments that would appreciate in value if the index is indeed at a prime selling point — and I think it is.