The first nine weeks of 2003 have proved to be a frustrating time for the majority of speculators actively trading the endless undulations of the US stock indices.
The bulls are losing patience after their long-awaited major rally remains conspicuously missing in action. The bears are losing faith as well as the recent sideways trading action in the major US equity indices is not helping their outstanding short positions one bit.
Speculators crave risk and action, and dull sideways-drifting markets cause much consternation on both the long and short side of the trading community. This ongoing titanic struggle between bull and bear forces that has certainly appeared stalemated at times recently is nowhere more apparent than in the mighty QQQs.
As the NASDAQ still commands the dubious honor of being ground zero for today's active index speculators, the QQQ NASDAQ 100 tracking stock remains one of the most actively-traded issues on Earth each day. With more speculators around the globe interested in trading these Cubes than in any other speculation vehicle, the QQQs are certainly the place to look to analyze recent market action.
While often hyper-volatile, the Cubes have been acting relatively sedate recently. With neither the majority of bulls nor bears feeling comfortable with the QQQ situation at the moment, perhaps some technical and fundamental analysis of the current state of affairs in Cubeland can shed some light on the whole confusing scene.
Have the QQQ bulls finally regained the upper hand after several years of misery? Are the QQQ bears about to be proven right again in spades? Or is the recent sideways action merely neutral with neither side of the trade gaining a decisive advantage?
As usual, many insights into the most probable answers for these crucial questions lie in the charts. We'll begin with a longer-term strategic perspective on the QQQs and their closely-related NASDAQ 100 Implied Volatility Index, the VXN.
While painstakingly watching QQQ action day after day can lead to a perception of nothing much happening in the Cubes for either bulls or bears to enjoy, the long-term strategic view remains overwhelmingly bearish. From this perspective, there is absolutely no doubt that the QQQ bears have the upper hand in the current market struggle.
Powerful long-term technical trendlines, unambiguous moving-average behavior, and unnaturally complacent implied volatility readings are all conspiring to suggest that the next big move in the QQQs will be massively down. The QQQ chart above is screaming that the Great Bear is not finished but is still stalking, preparing a cunningly awesome ambush and slaughter for the increasingly bold index bulls.
The long-term technical downtrend in the QQQs remains extraordinarily powerful and oppressive. The Cubes' top resistance line is drawn in above as a dotted-blue line. In order to be even remotely bullish, the QQQs would have to trade decisively over this heavy overhead resistance level for a few weeks. Thus far the Cubes haven't even been able to tentatively pierce it, let alone trade above it!
Provocatively all seven attempts to explode through this de facto cap on the QQQs since mid-2001 have utterly failed. The most recent trio of attempts, starting above where Rally 3 is circled in yellow, have also been easily repelled before seriously challenging the QQQ downtrend.
The latest major QQQ bear-market rally, Rally 3, couldn't even manage to make it quite up to this overhead resistance line in early December. A secondary smaller bear rally after this interim top in mid-January failed to punch through as well. A third valiant attempt was launched by the bulls in mid-February, but this assault was also easily shattered.
The bulls have had three golden chances in three months to bust the QQQs through their heavy overhead resistance but have failed three times in a row. Three strikes is enough to dampen anyone's confidence, and as long as the overhead downtrend line remains intact the ongoing QQQ Great Bear is just messing with the bulls' minds.
It is also somewhat ominous to compare these latest post-Rally 3 attempts at breaking out with the post-Rally 2 breakout attempts around early 2002. Just as there were three failed attempts to rally above the QQQs' resistance line in recent months there were also exactly three failed attempts over a year ago. Last time around, after failure numero tres, the QQQ downleg accelerated dramatically. Déjà vu?
I suspect that three strikes this time around will also be extraordinarily depressing for the bulls and lead to more selling accelerating our current QQQ downleg. It is very difficult psychologically to be faced with three failures to break out to the upside in a row and stay upbeat about the QQQs' near future prospects. The slow inverted-U-shaped initial decay of any major bear-market rally occurs as bulls gradually realize that their initial exciting V-bounce rally is over and new lows are rapidly approaching.
Interestingly, on a fractal-geometry side note, we are also already well underway in the third major downleg in the QQQs since mid-2001. The first was after Rally 1 above, the second after bear Rally 2, and the third is now unfolding after our recent bear Rally 3. Some bears out there believe this current QQQ downleg will be particularly vicious and violent because it is the third time around for a major QQQ downleg. Indeed it quite possibly could get ugly if enough bulls totally give up and capitulate after being so badly burned three times in a row.
As is often seen witnessed with long-term trendlines, the QQQs' downtrend is parallel with their 200-day moving average, shown in black above. The QQQ 200dma hasn't even hinted at turning higher yet, one of the initial early warning signs heralding any new bull market. Without a turn and moderate upslope in the 200dma, the QQQ bulls are skating on dangerously thin ice believing a new bull market is imminent.
The much shorter 50-day moving average of the QQQs, shown in white above, strongly confirms the immensely bearish outlook projected by the 200dma's sharp downslope. It is interesting how shortly after each major bear-rally interim top the 50dma nosed over and began heading south. These episodes have been fantastic short signals in the near past and are marked above accordingly.
Just as in early 2002, only recently the QQQ 50dma kissed its 200dma but failed to break out as it stalled and began falling again in earnest. With the 50dma heading down again and a short-term 50dma top already carved into the chart, the probability of the current QQQ downleg accelerating dramatically is quite large. QQQ bears rejoice and QQQ bulls beware!
Another very bearish technical omen for the QQQs' near future is the unnaturally-calm declining volatility situation. The colossal falling wedge in the VXN is shaded above in red. After my friend Dan Basch told me about this a few weeks ago I wrote an essay on it called "Trading the VXN Wedge". While the early signs of the mid-February breakout proved to be a mere teaser for the bears, the VXN wedge remains unsustainable and very bearish.
Volatility is one of a speculator's best friends because it telegraphs so much about current greed and fear in traders. When traders are scared, they tend to sell first and ask questions later, causing the enormous spikes in volatility evident above at previous interim bottoms in the Cubes. Conversely when traders grow complacent and greedy, volatility dries up as the pace of trading slows.
Unnaturally low volatility, like we are witnessing in the VXN wedge today, is one of the greatest warning signs of a coming sharp downleg. Short-term market movements are dominated by endless waves of greed and fear. With the QQQs failing to break out and downward-sideways-grinding trading action gathering steam, this current crest of greed is fading fast and fear is growing.
The colossal VXN falling wedge will reach its apex near the end of April. Technical breakouts from these formations tend to be very powerful as well as explode to the upside. When the VXN wedge fails and volatility breaks out, it will signal rapidly mushrooming fear as QQQ traders dump their remaining long positions in earnest to avoid getting slaughtered in the accelerating downleg.
While the long-term strategic perspective on the QQQs today remains very bearish, so does the short-term tactical perspective. The following graph uses a unique methodology we introduced in "Bear-Market Rally Autopsy 2" of indexing recent bear-market rallies through time to make them perfectly comparable.
Each of the three major QQQ rallies circled in yellow in the long-term graph above are distilled down into a common indexed range between 0 and 100, with 0 being their respective preceding V-bounce interim lows and 100 representing their bear-rally apex interim tops. The X-axis represents time in trading days, from 60 days before the perfectly-matched bear-rally tops at day 0 to 80 days after these tops.
This unconventional perspective enables speculators to easily compare today's tactical QQQ behavior with that witnessed after recent major-bear-rally interim tops. The similarities are uncanny and disturbing, especially if you remain stubbornly bullish on the QQQs despite the overwhelming bearish current market conditions.
Every single time the QQQs rally more than a couple percent I receive a phalanx of frantic e-mails from frightened speculators who are upset that their QQQ puts fell in value on the mini-rally. These excitable folks who strangely choose to continually dwell upon single-day action rather than the big picture can benefit tremendously by the unique tactical perspective offered by this graph.
When viewed in their proper context, the expected mini-rallies after a major interim top as the bulls refuse to surrender easily are not at all frightening. The blue line above showcasing our recent late-2002 QQQ major bear rally and the currently evolving downleg is remarkably routine when compared with the slow early decay curves of the last two major QQQ downlegs.
After any major bear-market rally general greed and euphoria is extreme and has to be slowly bled off as prices arc through a graceful inverted-U shape before plunging down into the violent V-bounces. As the bulls valiantly try to salvage their failing major rally, a few sharp and powerful mini-bear rallies inevitably erupt to punctuate the moderately-downsloping early decay trend.
The first major QQQ rally shown above, which topped in May 2001, had at least three distinctive and powerful mini-bear rallies, which are numbered in yellow. The second major QQQ rally, our December 2001 specimen, had two sharp mini-bear rallies before it finally turned south and gave up its ghost, numbered in red above. Our current major QQQ rally, the blue one, has also witnessed two sharp mini-bear rallies numbered above, one in mid-January and one in mid-February.
In context these mini-bear rallies punctuating the usual slow decay after a major interim top is carved are to be expected and are nothing to fear for the bears and nothing to get excited about for the bulls. Markets don't rise or fall in straight lines and the dominant trend at any given time is always interrupted periodically by forceful countertrend moves. These are a direct consequence of vacillating ultra-short-term sentiment, greed and fear, taking turns dominating the markets for a few days at a time.
The current short-term QQQ downtrend channel, bounded by the dotted-blue support and resistance lines above, is extremely interesting to me. I had known that the post-interim-top mini-bear rallies are normal but I wasn't aware before we created this graph this week just how closely the current Cube downleg is following the script from the last two QQQ downlegs in their early phases.
Provocatively any of the three major early downlegs shown above could be substituted for any other and only the most painstaking examination would be able to discern the difference. The slope of the downtrends as well as the oscillation within these downtrend channels for each different QQQ episode are almost technically interchangeable!
The indexed QQQ short-term tactical perspective agrees with the long-term strategic perspective in being overwhelmingly bearish. Once again the recent QQQ behavior has conformed exactly with what speculators would expect to see happen if a major accelerating downleg is imminent. Not even the most diehard NASDAQ zealot could mistake anything on the chart above as being even remotely bullish!
This is great news for the QQQ bears today but the bulls are about to get their heads handed to them when the Great Bear ambushes them again for the umpteenth time in this brutal bust. One would think that they would learn to wait for the bear to end one of these days, but they keep ignoring history and valuations and coming back for more punishment for some cryptic reason.
In light of the bearish strategic and tactical QQQ charts shown above, it is surprising that the QQQ bulls remain so steadfast in their rampant optimism for near future NASDAQ 100 behavior. Amazingly enough, the bullish crowd is not just complacent, but they have suddenly waxed hyper-bullish!
The following chart assembled from raw data directly from the Commodity Futures Trading Commission's official
The official US-government-produced CoT reports for the NASDAQ 100 (NDX) futures and all other futures contracts are separated into three groups of futures traders, the commercial hedgers, the large speculators, and the small speculators.
Of these three groups, the futures world considers the small speculators to be "dumb money", small traders who haven't yet made it big and usually get caught and slaughtered on the wrong side of their trades most of the time. As I mentioned in the new March issue of
As futures trading (and most speculation) is a zero-sum game, for every winner of capital in every trade there is also a loser. Typically on balance the small speculators, new players without serious capital or extensive market knowledge, are the losers who feed the growing capital war chests of the large speculators. The big eat the small, just like in nature.
Since the little guys are usually wrong, it is useful to see if they are bullish or bearish at any given time, and as a contrarian speculator take the opposite position of course. The CoT reports give a rough proxy on the general sentiment of small speculators, either greed or fear.
The graph below shows the NASDAQ 100 net long and short levels for the three classes of futures players. Remember, as a zero-sum game the overall number of long and short positions in any futures contract is always equal, but different classes of traders are usually net long or net short. Longs expect the NASDAQ 100 and QQQs to go higher and shorts expect them to head lower. The left axis shows the number of NASDAQ 100 futures contracts net long and net short for each major futures-trading class.
I think you'll agree that the following NDX CoT data defies rational belief!
This graph is busy, but for this week all we really need to focus on is the blue QQQ line and the red net long/short NASDAQ 100 futures exposure of small speculators.
Since early December, when the latest major QQQ bear rally topped, small speculators have become fanatically hyper-bullish! As the huge red spike into net-long virgin territory of extreme bullishness shows, small speculators truly believe the bear market is over! This gargantuan level of net-long commitment among the small specs in NDX futures is staggering and unprecedented within the context of this Great Bear bust!
These small traders are vastly more bullish now than they were in even early 2000 before the NASDAQ topped!
Not surprisingly these folks the futures professionals call "dumb money" have been net long most of the bust to date, consistently losing money as the NASDAQ 100 and hence the QQQs plunged. But for most of 2001 and 2002 the small specs averaged a net-long level of only a few thousand contracts, moderately bullish. Suddenly in December their net-long exposure in NDX futures exploded though, rocketing up to almost 21k contracts net long before settling down to the current stellar 18k contracts net-long levels.
What on Earth are they thinking?
As the first two graphs above illuminated, the technical picture for the NASDAQ 100 is simply abominable. And fundamentally the index is currently trading at the staggering level of 33x earnings, still above the general historic bubble-top level for extreme overvaluation! No major bust in history has ever ended at overvalued levels, they all relentlessly grind back down to historically undervalued levels before the Great Bear goes back into hibernation.
Since the technical and fundamental case for the NASDAQ 100 is so depressing, I suspect the small speculators must be fanatically hyper-bullish because of the war. The fog of war is obscuring many investing and speculating decisions and has created much uncertainty, the bane of investors and speculators.
Even though all war is immensely destructive and negative for capital deployment and wealth creation, financial television has been hammering home a distorted fantasy that war is bullish. The TV crowd takes random examples from history near wars, shows rising stock-market performance after a war erupts, and erroneously concludes that all war is bullish.
Tragically these talking heads completely ignore valuation in their analysis. If a stock market is dismally undervalued trading at 8x earnings as it was going into World War 2, sure it will rally in the future. Stocks always rally from historically undervalued levels! But today, trading at valuations higher than the traditional bubble top of 28x earnings, the coming Iraq war is not holding back a new bull market but rather delaying a long-overdue bearish execution.
I suspect the majority of traders today have let the prospects of war cloud their speculation decisions. Wars mean murdered youth, higher taxes, wasted capital, destroyed infrastructure, and much higher inflation. War doesn't help economies, it retards and hinders them. War is the mortal enemy and polar opposite of prosperity. Even if Baghdad is flying an American flag in a couple weeks, the US stock markets will still be overvalued and the Great Bear will still be very active.
When the explosive combination of unprecedented general greed and euphoria is combined with horrible technical and fundamental prospects for the NASDAQ arena, it looks like many small speculators are tragically walking into a brutal ambush.
As is evident in the graph above, the large speculators, who grew large because they are smart and understand how markets work, are now almost as heavily short as they have ever been in this bust to date. The big guys have seen the technical and fundamental writing on the wall and they are about to eat the little guys alive. The current ambush the bears have deployed to slaughter the bulls is exceedingly cunning and will spill a frightening quantity of blood.
Dear friends, if you are still long the NASDAQ, NASDAQ 100, or QQQs today you really ought to ask yourself why. The bearish case for the NASDAQ complex in the near future is overwhelming and the coming carnage and barbecue of bull flesh will be great. Who would you rather side with, the "dumb money" small guys or the experienced big guys who have traded and survived long enough to amass considerable capital?
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With the fog of war about to be lifted as Washington invades Iraq, all excuses for fighting the Great Bear will suddenly vaporize. The legions of fanatically-bullish NASDAQ faithful are almost certainly going to be slaughtered in a brutal Great Bear ambush as this QQQ downleg accelerates.
Make sure you are on the right side of this trade!