Rev's Forum: 3 Underlying Themes to Find the Best Trading Action

 | Nov 17, 2016 | 7:16 AM EST
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Stock quotes in this article:

QQQ

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IWM

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twlo

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nvda

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drys

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glbs

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dcix

"Follow the trend lines, not the headlines."

-- Bill Clinton

Understanding the character of the market is the key to superior trading results. Market action isn't as simple as up or down. Good markets that go up are good in their own way. If you can embrace the themes that are prevalent, you have a far greater chance of success.

Most of the time, the indices aren't very helpful in this quest. They will give us a general idea of the overall trend and the intensity of the buying or selling, but they won't tell us about leadership or the key areas of trading action.

Since the election, this market has been all about themes. There are three key ones that have been in play lately:

  1. First, the market simply had to adjust to the reality of the election of Donald Trump and the fact that it is being treated as a major short term positive. This election stunned the market. Expectations of market players were completely wrong and there has been a mad scramble to adjust to the realization that, rather than selloff on increased uncertainty, we are celebrating change and the potential for some new fiscal policies. Market players were, and may still be, poorly positioned and they are still feeling the reverberations of it a week later.
  2. The second theme has been rotation. Market players are determining the sectors that will be winners and losers under Donald Trump. We have seen a massive move into financials, infrastructure, drugs and biotechnology. Money has flowed out of big-cap technology, precious metals and interest rate sensitive stocks. The disparity between the Nasdaq 100 ETF (QQQ) and the Russell 2000 ETF (IWM) is profound. As the rotational action slows, there is a greater focus on individual stock picking. We had good examples of that the last couple days, as names like Twilio (TWLO) and Nvidia (NVDA) have suddenly attracted interest although they don't reflect any obvious Trump driven theme.
  3. The third theme is heightened speculative action. For a number of reasons, many of them psychological, there has been a burst of aggressive trading action in small-cap "junk names". The foremost illustration is the action in shipping. There isn't any logical fundamental explanation for these stocks to explode, but traders have been confident enough to chase them to crazy heights. Dryships (DRYS) is up 2433% in the past week and is halted. Globus Maritime (GLBS) is up 739%, Diana Containership (DCIX) is up 661% and so on.

This sort of speculation is something we haven't see in quite a while. There have been a few brief flurries of crazy action in sectors, such as solar energy, biotechnology and energy, the last few years, but nothing of this magnitude.

Some folks claim that this sort of speculative action is a contrary indicator that tells us that emotions are extreme and a reversal is coming. On the other hand, it excites traders and they start digging to find the next group of stocks that are going to move like this. Already, there is some similar chasing in small-cap China names.

These are the three main themes that have been at work over the past week, but we need to watch for them to shift. Many market players believe the moves are an overreaction and that they will reverse. For example, I'm looking for some pullback in biotechnology and am playing that with ETFs.

We have Janet Yellen in front of Congress today at 10 am ET, which is going to help shift the focus from the recent themes. Presently, the market is anticipating a near 100% certainty of a Fed rate hike in December. The bond market is confused, and Janet Yellen is likely to move it with her comments today. The shift in interest rates is driving these themes and is going to have substantial impact as the Fed discusses its plans.

The big picture is much more complex than usual, but the speculative action is making trading very interesting. I expect the pockets of aggressive momentum to continue under the surface and that will be my main focus.

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