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At the Edge of Chaos: The Stock Market is Betting that the Fed will Fold

The stock market is already pricing in a Federal Reserve reversal of its quest toward higher rates. And while a Fed pause would be bullish for stocks, it’s way too early to make big bets. On the other hand, events unfold rapidly these days, so investors should be prepared for just about anything.

As I describe below, even though the Fed is indeed the most important outside influence on stock prices, the fate of this rally depends on how many investors actually believe that the central bank is close to ending its rate increases. This week, I’m taking a broad view of where things stand from multiple points of view, including:

A general overview of MELA with focus on bonds and homebuildersA close look at a bellwether stock (KR) which has an upcoming earnings release, andAn extended review of the relationship between the CBOE Volatility Index (VIX) and the market’s breadth as measured by the New York Stock Exchange Advance Decline line (NYAD).

How Many Believers are Out There?

Stocks rallied yet again behind a massive wave of short covering last week. All of which brings us back to the billion-dollar question: “Is the bear market finally over?”

The answer, of course, is complex and complicated. It’s complex because the stock market is the ultimate complex system where component agents – traders, market makers, investors – interact with the environment, which is essentially composed of the Fed and the global governments. Of course, it’s the interaction between all agents that creates the conditions which eventually lead to trading outcomes. And, as with all complex systems, when enough agents find success, the others follow and the system emerges to a new level.

On the other hand, the complicated part of the equation comes from the fact that, even though complexity is a natural phenomenon, the work of human hands makes everything complicated – much harder than it needs to be. And that, of course, is what creates volatility and engenders Chaos, which is pure disorder.

My point is that while last week’s rally was welcome, there is no way to really know what’s going to happen next week, which is why being prepared for yet another round of weird trading is the only solution to the problem. In essence, the key as to whether that was really the bottom or just another fake out lies in the number of believers (agents) who believe that it was the bottom. If we’ve indeed achieved critical mass in believers, then it’s plausible to consider the possibility that the bear market is over. Moreover, if the market signals that the Fed should stop raising rates and the central bank ignores their opinion, then the MELA system has indeed emerged to a new level where the market is doing the unthinkable – it’s fighting the Fed.

And wouldn’t that be something?

Welcome to the Edge of Chaos:

The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder.” – Complexity Labs

From a trading standpoint, however, little has changed. So; the bottom line is as follows:

If you own something and it’s working, keep it.  If you see something that looks interesting, nibble and see what happens.  Otherwise, keeping a short-term mindset makes sense.

For more on a risk-averse approach to trading stocks, consider a FREE trial to my service. Click here.

Federal Reserve Turns Somewhat Cautious as MELA Shudders and Bond Yields Roll Over

Of course, the rally in stocks was fueled by the perception that the Federal Reserve may cut its rate hike cycle short, with perhaps the last increase in the Fed Funds rate coming as early as September. That would be nice, except for what happens to the stock market from now until then, when the short-covering rally runs its course. My concern is based on the fact that the economy is already showing signs of rolling over without the Fed Funds even hitting 1%. You can see it in the softening of recent employment data, such as jobless claims starting to climb and tech companies planning to lay off workers or cut back hiring, along with awful earnings and guidance in the retail sector.

Remember, as my MELA system (M=Markets, E=the Economy, L=life decisions and A=artificial intelligence) clearly illustrates, the stock market is the major driver of the economy. So if there is no recovery in stocks, the odds of a protracted economic slowdown will rise. And the bond market, as highlighted by the continued fall in the U.S. Ten Year Note yield (TNX), is taking note. TNX closed below 2.75% last week and is now on the verge of breaking below its 50-day moving average.

What’s more important is that, if TNX breaks below this key support area decisively, its next support level is near the 2.4-2.5% yield area. That would signal that bond traders are less concerned about inflation, which in turn would send a message to the Fed that its tightening maneuvers are already working. Moreover, it would be bullish for stocks, especially the homebuilders (XHB), which are already showing signs of perking up.

Note that XHB’s price chart is a mirror image of the TNX chart. In addition, XHB is also at its 50-day moving average. In other words, if bond yields fall, expect another jump in XHB.

Kroger Earnings Loom

Walmart (WMT), Cisco Systems (CSCO) and Target (TGT) recently delivered negative earnings surprises and their respective shares took a drubbing. Now, we’ll see what Kroger (KR) says when it announces its earnings on June 15. I think of Kroger as a bit of a bellwether because it attracts a wider variety of customers than WMT. And that means that a miss in sales would be a sign that MELA’s problems are expanding beyond the discount crowd.

I don’t expect Kroger to miss on sales given that, every time I go to my neighborhood store, I pay more and often get less than the last time I went. So, the key will be what Kroger says about how expenses are eating into its margins and what it says about the future.

The stock took a drubbing after making an outrageous new high of $62 per share in April and found support at its 200-day moving average, as Buffett may have added a few shares. But the stock is still below its 50-day moving average and Accumulation-Distribution (ADI) and On Balance Volume (OBV) are bouncing, but not showing that much vigor.

I would not bet on the stock moving too much higher either, as Volume by Price (VBP) shows little support until the $46 level. Moreover, implied volatility (IV) is well ahead of historical volatility (HV) ahead of earnings, which suggests that the earnings news will likely lead to a big move, which could reverse fairly quickly.

The bottom line is that, if Kroger beats expectations and says the future is bright, it would be a good thing. But, more likely, I expect that, no matter what the past quarter shows, even Buffett darling KR may not have much good to say about the future.

For more on how to develop a trading plan and how to approach this market, have a look at my latest Your Daily Five video here.

VIX Gets Crushed as NYAD Soars

Last week, I noted that “there may be a temporary pause in the selling in the next few days. But there doesn’t seem to be enough panic in the market to suggest that stocks will turn up for any extended period of time. However, it is plausible that we may see shares bounce around recent levels for some time as the market digests its recent decline.”

So, we got the bounce I expected. And here’s what stands out:

NYAD shot up to its 50-day moving average with lots of momentum behind itVIX looks as if it could be headed for its recent lows below 20

In other words, this rally could go on for a bit longer. But the key is what happens when VIX hits its recent lows and NYAD hits its 200-day moving average.  

Stay tuned:

The S&P 500 (SPX) broke above the 4000 level and is in the midst of a significant resistance zone at 4100-4200. There is still major resistance in SPX all the way back to 4300-4450. 

Accumulation Distribution (ADI) shot up in a big way during the rally, which means the short sellers are bailing out. On the other hand, On Balance Volume (OBV) bottomed out, but did not move up in a similar fashion. If OBV starts to move aggressively higher, the rally could well move higher as well.

The Nasdaq 100 index (NDX) rallied as well, but remains well below what was key support at 13,000, which now becomes a key overhead resistance level.

To get the latest up-to-date information on options trading, check out Options Trading for Dummies, now in its 4th Edition – Get Your Copy Now! Now also available in Audible audiobook format!

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Good news! I’ve made my NYAD-Complexity – Chaos chart (featured on my YD5 videos) and a few other favorites public. You can find them here.

Joe Duarte

In The Money Options

Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by and now in its third edition, plus The Everything Investing in Your 20s and 30s Book and six other trading books.

The Everything Investing in Your 20s and 30s Book is available at Amazon and Barnes and Noble. It has also been recommended as a Washington Post Color of Money Book of the Month.

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