Folks, the final days of big bear market rallies are dangerous…
You can’t overreact and chase stocks that simply “look” to be breaking out.
Instead, in bear markets, something else must be in your corner as well…
The fundamentals need to back up the technicals.
The key idea to remember in market environments like the current one is “FOMO” – the “fear of missing out.” In tough times, FOMO can really mess with investors’ emotions.
Don’t think you’re above this danger.
I’ve seen many professional investors break down and lose their discipline due to FOMO. And it can be costly.
Plus, the setup is more challenging than ever today. That’s because institutional sellers are currently playing a game of “cat and mouse” in the options market.
Let me explain…
The latest batch of nonfarm payrolls data came out on January 6. And the report showed that wage growth didn’t meet analysts’ expectations.
That led to a flurry of “put” selling. And in turn, that created a bout of “unhedging” by the broker-dealers who make the markets in options.
Now, that’s a lot of industry jargon. But it just means that the broker-dealers were partially responsible for the buying in recent days and weeks. And as odd as it sounds, the buying wasn’t investing. It was just the process of closing a trade, not opening one.
And importantly, this setup has already happened in recent months…
Back in November, the market found one positive thing in the Consumer Price Index report and the Federal Reserve’s comments. And then, stocks rallied higher.
Once again, institutional investors used the opportunity to make big moves.
Their strategy involved “short covering” in November. That goes back to what I mentioned above…
It’s about closing a transaction, not opening one. When you’re dealing with a short position, you need to buy back shares of the stock you originally “sold short” to close the position.
The thing is… soon after that November rally, the selling started again.
Please understand that the buying you think you see on the chart isn’t always real. At best, it’s an illusion. And at worst, it could be a portfolio-wrecker.
Here’s what I mean, in a nutshell…
Broker-dealers make the markets in options. They act as the buyers when no other buyers exist. And they’re the sellers when no other sellers exist.
When the broker-dealers do that, they make a markup on the transactions. But they have to hedge their exposure, too.
So for example, let’s say a retail trader wants to buy a put on the SPDR S&P 500 Trust (SPY)…
The retail trader would need to find a seller. The broker-dealers will mark up the trade and sell it to them.
When that happens, the broker-dealer is on the hook to deliver SPY shares at a lower price. So in turn, it sells short SPY shares to prevent a huge loss.
In other words, it hedges its exposure.
But when the retail trader sees the markets spike higher, he loses value in his put and frantically sells. The broker-dealer buys back the put and then buys SPY shares to cover the short position.
That closes the trade for everyone.
But now, I ask you…
Does this sound like a “real” buyer? Or does it sound like a hedger unhedging?
It’s the latter option, for sure.
This unhedging creates volatility. And stocks all over the board will spike higher as momentum traders follow the crowd. Even if these folks simply buy into the indexes and related exchange-traded funds, that fuels the stocks in those indexes. And they jump, too.
Our brain then takes over and our “fight or flight” instinct kicks in. We react when we should re-evaluate.
Folks, whatever you do, don’t chase stocks that are breaking out in bear markets. That’s especially true if the stock you want to chase has bad fundamentals.
So in the end, you want to avoid three things…
- Don’t react to the market’s moves that make you “feel” like you missed the big move. Nothing good ever comes from FOMO.
- Don’t buy only technical breakouts. Always consider the fundamental aspects and the market’s trend. If the current trend is down, you’ll want to keep your guard up. That’s why using both fundamental and technical indicators is the best approach.
- Be aware that even in bear market rallies, some stocks can still go down when they change trend. Focus on relative strength – even in bear market rallies.
Illusions have haunted humans since the beginning of time. And for investors, the worst ones can be catastrophic.
But if you can remember these three things, you’ll be able to keep your emotions in check.