By Amber Hestla
As the end of the year approaches, many of us look back. Changing the calendar presents an opportunity to think about the past, and that often includes a review of the most important events of the year.
For traders, one of the most important events of 2018 was the selloff that occurred in February. The chart of the S&P 500 below details how that all unfolded over several months.
At the time, it seemed like the bull market had ended. Initial selling was followed by increased volatility and then a period of time when prices moved sideways.
Now, at the end of the year (as I write this), we are seeing a 15% selloff and a period of increased volatility. As always, the biggest question in the market is what comes next.
According to technical analysis, what comes next is most likely further downside.
Chart Predicts Future Downside In Stocks
Let’s look at the 200-day MA first.
The 200-day MA is important to many large traders. It’s an indicator of the direction of the long-term trend. Some large investors will avoid making new buys when prices are below the 200-day MA because it is always easier to make money following the trend instead of fighting the trend.
Looking at the chart, you can see that prices generally remained above the 200-day MA during the February selloff. However, during this most recent selloff, prices have broken well below that MA, which means it’s less likely that we’ll see an influx of buyers swoop in to take away some of the downtrend’s pressure.
Buying when prices are in a downtrend is an example of fighting against the trend. And most stocks are in downtrends. The chart below shows just 31.3% of the stocks in the S&P 500 are trading above their 200-day MA. Obviously, this means 68.7% of the members of the index are below that MA.
The percentage of stocks trading above their 200-day MA offers insight into how a portfolio is performing. It’s often said that a rising tide lifts all boats; and when most stocks are rising, even a mediocre investment manager is usually enjoying gains. But when most stocks are in downtrends, even the best investment managers are likely to be showing losses.
Since the beginning of October, more than half of the stocks in the S&P 500 index have been trading below their 200-day MA. This was not the case earlier in the year when the majority of stocks remained above that MA in the previous selloff. That means many large investors viewed the February selloff as a buying opportunity. This time is different in that they are seeing few attractive buying opportunities.
Next, let’s talk about the lower panel of the chart, which shows Profit Amplifier Momentum (PAM) for the S&P 500. Earlier in the year, the chart shows that PAM was rising after the initial selloff in the S&P 500. This time, PAM is making new lows. That indicates the downtrend is likely to continue.
Small-Cap Stocks Also Tell a Bearish Story
Another bearish omen is the fact that small-cap stocks are about 19% below their highs. As the next chart shows, PAM for the iShares Russell 2000 Index Fund (IWM) continues to make new lows. IWM is an ETF that tracks small-cap stocks.
Small-cap stocks tend to be popular tax-selling candidates. As investors review their portfolios at the end of the year, they may see losses in their small-cap stocks. Selling these stocks would allow them to realize a loss for tax purposes, possibly lowering their tax bill. This could add to selling pressure into the year.
A Trade You Can Make Right Now
This creates a potential trading opportunity. Put options on IWM could deliver significant gains. I find the IWM Dec-31 $142 Put at about $4 to be among the most attractive options available. (That’s a put option on IWM with a strike price of $142 that expires on December 31, 2018.)
This call closed at about $4.50 on Monday and was trading slightly below that level Tuesday. Since a contract covers 100 shares, buying the put around $4 would cost $400 to open. That is also the maximum possible loss.
Looking beyond the end of the year, I expect the stock market decline to continue in 2019. Economic data is showing signs of a slowdown, and that means a surprise could trigger a recession. The surprise is likely to be a news event that analysts are underestimating the importance of.
News from Europe is concerning, with the United Kingdom, France, and Italy all sources of potential problems. China’s slowing economy and a potential trade war are a concern. Closer to home, unrest in Latin America is an underestimated concern. A refugee crisis is possible as Venezuela implodes, and violence has increased in Brazil and other countries.
It’s almost certain one of these hotspots will boil over soon, and I am watching foreign markets for potential trading opportunities.