Meltdown or “Melt-up”? Markets Await Fed Chairman Speech at Jackson Hole

August 28^th, 2012

Nick Hays

Dhaka, Bangladesh

Today – on The Long and the Short

* S&P 500 meets short-term resistance (as forecast)

* Mild correction on weak volume as markets await key Fed speech at Jackson Hole (Aug 31)

* VIX spikes 20% after hitting 5-year low

As forecast in my last post, the S&P 500 encountered resistance at the 1420 level and is correcting (mildly so far) from a short-term overbought position. As well as being a technical sell-off this is also being driven by profit-taking ahead of Ben Bernanke’s speech at Jackson Hole on August 31^st.

Bernanke’s speech is expected to provide the markets with more clues as to the direction of Fed policy (QE3 – will they or won’t they?) and with the performance of risk assets increasingly tied to expectations of monetary stimulus, Friday is setting itself up to be a critical day for the markets.

Messages coming out of the Fed ahead of the 31^st have been distinctly mixed and the potential outcomes are looking increasingly binary in nature – meltdown or “melt-up”? Amidst this uncertainty, we are seeing some profit taking place and the drop in volume suggests many traders have moved to the sidelines.

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This increased uncertainty can also be seen in the so-called 'fear index'. Since my last post, where I pointed out that the VIX’s 5-year low was signalling an overly-complacent market, the index has jumped more than 20%:

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As hoped for, soon after I last wrote, a shorting opportunity presented itself: a brief ‘head-and-shoulders’ rally above 1420 failed and consequently threw up a decent opening for a bet on falling prices at the 1419 level. See chart below:

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Since the short at 1419 the market fell as much as 1.5% intraday on the 24^th, then recovering some of that ground. As shown above, secondary resistance may now be forming at 1415.

Now that I am short the market, do I need to review my original stops to manage the risk/reward? Considering the unpredictable and potentially high impact newsflow coming up on the 31^st, this is a critical question.

A stop-loss too close to 1420 and I may be taken out too soon by another ‘head-fake’ like the one we saw on Tuesday; too far out and I leave myself open to the risk of greater losses.

Given the environment, my current stop-loss of 1440 is too far out I feel so I am going to reduce risk by moving the stop-loss a little closer, to 1430. This should be enough to catch a 'genuine' breakout above 1420 at which point I can cut my losses.

On the downside, I see a decent chance for short-term gains in the coming week. Should Bernanke disappoint, either by hinting at no further stimulus or simply by offering very little in terms of new information, we may see a stronger sell-off.

For the timebeing I am maintaining the original target of 1370 - this is at the lower end of the upwards trading channel where the market may find some support.

We'll keep watching to see what the next few days bring. No doubt Friday's speech by Bernanke will be closely watched and should provide some direction to the markets, one way or the other.