What is Bubbling Away Under The Surface? The Big Opportunities That Are In Plain Sight
This week I was inundated with text messages from friends and Elite members asking why the stock market was rallying so hard in the face of such bleak economic numbers.
After all, we're looking at anywhere from 15% to 25% unemployment in the United States. These are numbers so bad they go all the way back to the Great Depression.
We also have the greatest business contraction since the Great Depression. So why would the stock market be rallying? First off, I’ve learned never to ask why in trading. To me, the “why” is superfluous and almost irrelevant. Price is the news and the only thing that counts is whether the market is going up or down.
To me, the questions you should be asking as a trader are:
- Where is this market going?
- How much do I want to risk to participate?
Asking why is pointless. The why never fully known because the market applies a discounting effect.
But if you insist on a “why” for this stock market rally, it’s because the Fed is dumping literally trillions of dollars into the system. While many bright minds claim those trillions in stimulus money aren’t enough to restart the post coronavirus economy (and they may be right) there’s a difference between the stock market and the economy. As we saw with the quantitative easing experiment in 2008, the Fed is content to inflate the stock market and wait for the economy to catch up to that inflated price many years later.
The Fed has learned from the 2008 playbook and accelerated things very dramatically. They’re dumping trillions of dollars into the system almost every week.
So courtesy of the Federal Reserve, rising stocks and a shrinking or stale economy are not mutually exclusive. Remember the saying “the market can be irrational a lot longer than you can stay solvent”?
As we've learned time and time again, you can't react to the markets based on what you're seeing in the news. That’s because the news is already in the price.
Let’s look at the price action in the NASDAQ.
As you can see, prices have been explosive within a large trading band known as an ascending broadening formation. You can see it gets wider the longer it continues.
This is typically a reversal pattern but we won't know for sure until it's confirmed. Confirmation here means prices dropping back to the key support level at the bottom of the pattern and then piercing it.
In the meantime, prices have roughly jumped 50% from the recent lows. A lot of people who swear by a Fibonacci retracement and things of that nature are suggesting that a 50% retracement or 61% retracement are often potential turning points. That might prove to be true, but I’m content to simply observe prices within this vast trading range for now.
That’s because it’s so difficult to determine risk here. When we get into an area where the movement is so great, the risk is also great. To be a successful trader, you need to understand the risk/reward potential of any given trade.
With the NASDAQ moving so violently within a vast trading range, I can make a case for it going higher and I can make a case for it going lower too. But the undefined risk on both sides means I'm not going to play. I'm going to wait until this thing sorts itself out.
I’m looking for a consolidation or reversal pattern that will form the basis of a worthwhile trade.
That doesn’t mean there are no trades available.
In fact, I took some excellent risk/reward trades last week and which I will discuss today.
They’re based on less sexy markets than the stock market. (With all the pandemic talk, the focus has been on the stock market, gold and other big asset classes and so I've been focusing on certain trades hiding away from the spotlight.)
Here’s an email I sent out last Tuesday to my Elite program about AUDUSD (the Australian dollar versus the US dollar) and a setup that was just coming out of the gate.
For the last three, four even five years I’ve been primarily shorting AUDUSD and I’ve been writing that this is the weakest currency on the board.
AUDUSD has indeed plunged, including its most recent drop that triggered a bunch of stops. But last week it looked like AUDUSD could be turning around, making the recent lows a bear trap for anybody who sold recently.
I saw a double bottom and the price was right at the neckline of that pattern. To me, this was a good risk-reward play. I told members to put a buy stop at 0.6209.
Here’s how AUDUSD has traded since:
AUDUSD is now about 150 pips higher on this daily chart.
That may be surprising because, for the past couple of years, AUDUSD has been in a well-defined downtrend. I was advising members that the neckline of the descending triangle would get taken out.
I was bearish because of the triangle and also because there were so many support points at the 0.66 – 0.67 area. When a support level gets hit so many times it eventually gets taken out. That happened with a vengeance as all the stops were triggered underneath that neckline. The market collapsed.
But now that price action could become a bear trap. I think AUDUSD could snap right back in their face.
I observed a very unconventional double bottom where the bottoms were not symmetrical, bought at the neckline (see the email above), and so far the price action has proven my prediction to be correct.
This is a good example of how you really have to be fluid as a trader. You can't have a fixed opinion forever. Of course, for the last several years I've been very bearish on AUDUSD (and for good reason) but it now looks like that price action has played out.
AUDUSD could now shift in the opposite direction after both the currency and the Australian stock market were whacked particularly hard. It seems AUD is going to be the first to recover against the dollar and against a host of other currencies. So what was the weakest currency is now emerging as one of the strongest going forward.
We'll see how that plays out but for now, we have about 150 pips of profit.
I’m looking at this turn in AUDUSD to be consistent with my thoughts that the US dollar is going to turn.
But first, some comments on GBPAUD (the British pound versus the Australian dollar).
Here’s another email I sent out last Monday about GBPAUD after noticing a coil at the top of this pair’s resistance area. (I’ll explain what that is in just a moment.)
Just like the NASDAQ, there’s a large ascending broadening formation here.
But unlike the NASDAQ, there was a good risk/reward trade to be made here. I felt GBPAUD was forming a double top within the context of its ascending broadening price pattern.
Here’s how GBPAUD has traded since that call:
The trade is currently up 450 pips and so far it’s reinforcing my notion that the Australian dollar may be transforming from what was one of the weakest currencies on the board to what could be one of the strongest.
With GBPAUD, it’s true that the British pound is strong. But on a relative basis, the Australian dollar seems even stronger than that.
That because not only was I seeing an ascending broadening formation, I was also seeing a double top.
The NASDAQ isn’t yet forming any tradable price structures, but GBPAUD has. By this point, the ascending broadening formation certainly appears to be a top.
GBPAUD still needs to hit and pierce the lower line of that formation to confirm a reversal, though. But if that happens, then there are about 2,000 pips on the downside to be had here. (The 2,000 pip target is because reversals from ascending broadening formations tend to drop all the way to the beginning of the pattern.)
That means there’s still lots and lots of room to run on what could be a very profitable trade.
However, what I want to stress right now is why I perceived this was a good risk/reward opportunity.
The double top was bearish, but I waited for further price action to indicate GBPAUD had topped. That confirmation was a series of inside bars immediately after the second top.
An inside bar is when the range is contained entirely within the range of a larger earlier bar. GBPAUD had two inside bars in a row, which represents what I consider a “coiling” of energy.
That energy was due to be unleashed, and since GBPAUD couldn’t sustain any more upside momentum, it was surely headed down.
That’s why I recommended that members sell on a break underneath those inside bars.
I don't always know if it's going to work, of course. But this represented a good risk/reward trade. My stop was above the inside bars. If I was wrong and the market somehow broke out of the energy coil to the upside, then I would be stopped out.
If and when such a movement happens, I take the loss, dust myself off and move on to the next one.
But as you can see, I'm now sitting with a gain of 450 pips in this trade already. I'm not looking to get out anytime soon (or add more yet) because I’m waiting to see if the price really can penetrate the neckline of the double top and subsequently the trendline of the ascending broadening top.
This won’t happen in a straight line. GBPAUD could break through both of those lines and bounce, for example. If so, I’d look for another insurance bar like a key reversal or another inside bar or two. Then I’d put in an additional sell stop order to add to my short position, then wait.
So many people say you can't predict the tops or bottoms in the markets. I disagree because I think that's my key strategic advantage. I follow price action to help me understand when and how markets turn. Then I get in early based on price action.
This trade is a perfect example. I’m sitting on a 450 pip cushion while I wait to see just how low GBPAUD is going to go.
This is what trading is about. Trading is not about why a market is going in a certain direction.
Trading is about assessing where the market is going and how much risk I want to take on when making a bet on the direction I see.
That’s why when I look at the NASDAQ, and it looks like could go up or go down, I don’t see a good risk-reward opportunity. With GBPAUD I did.
Now I want to talk about the US dollar because I think we're at a pivotal trading area in the US Dollar Index (USDI). Here’s a 45-year chart of USDI:
USDI has had a huge bull market over the last 10 years while the Euro has dropped from 160 to almost parity during this time. But if you put it in context with what's been going on over the last 45 years you can see USDI has been making a series of lower higher.
This is a bearish pattern and I don't think the dollar rally will be sustained much longer, particularly when you look at the double top that’s formed now.
Obviously this chart has been smoothed out, but you can see that when the dollar picks a direction it goes in that direction for many years at a time. From 1975 to 1985 (10 years) … 1985 to 1995 (10 years) … 1995 to 2000 (five years) … 2000 to 2010 (10 years) and then the latest 10 years run to today.
This suggests we could have a five to 10-year USDI run to the downside.
Now I don't like to think in fundamental terms, but it's not a coincidence that we're seeing a turn in the US dollar just as the Federal Reserve is flooding the system with trillions of new dollars. I think that will add to the pressure on the US dollar.
Here’s USDI on a weekly time frame now:
You can see that consistent with the long-term view, USDI is at a resistance area. What’s more, you can see that in the last two weeks USDI has had two inside bars. As with GBPAUD and anywhere else they appear, inside bars represent a containment of energy. That energy will always be unleashed eventually.
USDI’s energy could be unleashed up or down. But since it’s at a major resistance area I believe it’s on the precipice of turning lower.
In fact, I’m starting to see a turn in a number of dollar pairs, including AUDUSD which I reviewed earlier in this report.
That’s all I want to say about the forex markets for today.
Now let’s take a look at the relationship between gold and silver with a long-term 50-year chart of the gold-silver ratio beginning in 1970.
If you’re not familiar with the gold-silver ration, it’s easy to determine. Just divide the price of gold by the price of the silver. Right now gold is trading at almost 113 times the price of silver.
You can see that the ratio has been trading within a wide trading band over the last 50 years. It hit a couple of highs and lows along the way. And at the moment, it’s at an inflection point at the high point of the range. This chart is also at the upper end of the relative strength indicator at the top. Note that when this happened before, the ratio dropped from 105 all the way back to 35.
This means that the price of silver rose tremendously against the price of gold, or that the price of gold crashed much harder than the price of silver (it was actually the second of those two).
So this does have vast implications for how we look at these precious metals and their likely price action.
Because the ratio is at a historical apex, we can anticipate there may be some contraction. It may not be as big or as forceful as the earlier apex. It’s much too early to tell yet.
But this ratio chart does look likely to contract to a more normal trading range soon.
That suggests the price of gold could crash while the price of silver stays the same. It also suggests that both metals could rise but silver rises relatively faster. Silver prices could also accelerate rapidly while gold consolidates at or near current prices.
Let’s examine both spot gold and spot silver and see which potential opportunity looks the most likely.
Here’s XAGUSD (spot silver) on a weekly basis:
For the last several months, I’ve believed that silver has been in a bearish market and that it ultimately would take out the $14 level. That’s because it was hitting the $14 level too many times. If a market has bottomed, it shouldn’t give participants so many opportunities to buy it.
That mimics the discussion on AUDUSD, of course: a long decline followed by a steep crash. Just like AUDUSD, XAGUSD did indeed trigger all the sell stops that were waiting under the $14 area. Just like AUDUSD, XAGUSD pivoted right back into its trading range to set up what might be a bear trap for those who sold under $14.
It’s a bit early to say where this is headed now. I’m inclined to wait until silver breaches at least the $19.50 area. But this is why I'm focusing on that gold-silver relationship chart. Because if that relationship starts contracting, it could mean silver accelerates very quickly.
There could be a short squeeze on those traders who got short under $14. They got rewarded for that trade for about a half a minute. And if they weren't fast on the trigger, they're now looking at losses, even substantial losses if silver starts getting some momentum.
Of course, I don't know if this is going to occur. But I'm getting the feeling we could get a short squeeze in silver. The way prices react from current levels will tell us a lot.
If you’re very aggressive, you could take a shot at this level and put on a fairly disciplined low-risk trade as I’ve outlined on the chart. Buy with a buy stop above last week’s high with a stop loss under last week’s low.
This is not a recommended trade, however.
I’m only suggesting the possibility because this could be one of those sneaky plays like AUDUSD where there were low expectations for a bullish run until it actually happened.
Remember that not all trades work out. But I suspect we could get a big turnaround in the price of silver sooner or later.
Here’s XAUUSD (spot gold) for comparison:
The governing pattern here is the double bottom all the way back in 2015. (A governing pattern is the one that continues to govern the future price direction.)
Once gold broke through the neckline of an extended bottoming pattern at $1,380, it was off to the races. It’s had some strong runs with lots of volatility along the way.
And at the moment, gold is trading within a reverse triangle. One with a huge trading range. While I did make a good profit on a short during this time, the price shot right back up and the volatility makes it difficult to assess risk and reward (just like the NASDAQ, in other words).
Gold is also at resistance now. It could blow through here, but I’m not interested in a trade just yet. I find the risk/reward is too hard to assess.
In the meantime, I’m watching the gold-silver ratio and waiting for a trade setup where the risk/reward is more in my favor.
And that’s it for this week! To recap, I’m bullish on the Australian dollar and therefore long AUDUSD and short GBPAUD. I’m bearish on the US dollar overall and I think we might see a short squeeze in silver.
I’m not trading the stock market or gold until better opportunities arise.
And so with that said, I hope you’re keeping safe and self-contained wherever you are. We're all united by this strange time that we find ourselves in. Thank you for your loyalty and support and I wish you a healthy and prosperous trading week going forward.
Mark "ShortSqueeze" Shawzin