At the Edge of Chaos: Forget Everything Else, The Future of Stock Prices Depends on Liquidity

Forget the market’s external troubles. Instead, focus on liquidity.

The fact is that, while the pundits argue about whether we are in a recession or not, when it comes to the stock market, the only thing that matters is liquidity – that is, the amount of money available to trade stocks. And despite the generally difficult external environment and the Fed’s best efforts, there have recently been some subtle signs that liquidity in the markets may be improving. Of course, improved liquidity is the lifeblood of advances in stock prices.

In my recent Your Daily Five video, I highlighted a little-known but highly useful indicator of the MELA (M – markets, E – economy, L – life decisions, A – artificial intelligence) system’s liquidity – the Eurodollar Index (XED). In the video, I noted that the indicator seems to have bottomed out.

You can catch the video here and above, but here is a summary and an update.

The relationship between stock prices and liquidity is built around interest rates. Generally speaking:

Rising interest rates decrease liquidityDecreased liquidity increases bearish sentimentRising bearish sentiment leads to falling stock prices

This relationship is well supported by the XED chart above, which shows that a fall in XED, caused by rising interest rates, leads to a rise in the CBOE Volatility Index (a rise in bearish sentiment which is illustrated by a rise in put option volume). The rise in put option volume then causes an increase in stock selling, which pushes the price of the S&P 500 (SPX) lower.

Currently, the action in the chart suggests that liquidity is no longer contracting, although there is no sign that it is expanding aggressively. Still, this bottoming out is predictably having a positive effect on the S&P 500. So the real question is whether this is the proverbial “dead cat bounce” or, perhaps, the start of what could be a significant bottoming process for stocks. A failure of XED to remain above the 97 area would likely signal that liquidity is contracting and that the rally is likely over.

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

Money Flows Suggest Wall Street is Betting on a Recession

If, indeed, the stock market is in the process of bottoming out due to improved – or at least not worsening – liquidity, it’s a good idea to see where the money is going and where it’s not. Here are three interesting areas.

First, there is the biotech sector, as in the iShares Nasdaq Biotech Index (IBB), which is up nearly 20% from its recent double bottom.

It’s pretty obvious that money has been moving into IBB aggressively, as both Accumulation Distribution (ADI) and On Balance Volume (OBV) are moving higher. Meanwhile, the Volume by Price (VBP) indicator shows a big price bar near $135, which also corresponds to the 200-day moving average. Thus, it’s that price area which will likely make or break the rally in biotech.

The second area is pharmaceuticals, which is increasingly difficult to differentiate from biotech given that there have been several mergers and acquisitions by big pharma companies which have led to more hybrid corporate entities.

Be that as it may, however, the Health Care Sector SPDR ETF (XLV), which includes hospitals, health insurers, wholesalers, drug store chains and big pharma and biotech companies, has been doing quite well on its own. XLV has indeed bounced back to its 200-day moving average with resistance at the $132-$133 price area, which also corresponds to two big VBP bars. ADI and OBV for XLV are also very constructive.

On the other hand, the energy sector, despite all the media attention, has been getting clobbered, with the Energy Sector SPDR ETF (XLE) down nearly 30% from its June 2022 high.

Here, we see that XLE crashed through key support between $75-$80, where two very large VBP bars failed to bring in buyers. Now, the ETF is trying to find support at its 200-day moving average, which also corresponds to a fairly good-sized VBP bar.

The takeaway is that health care stocks are attracting money, while energy stocks are not. If there is an economic message here, it’s that the stock market is betting on a recession. On the other hand, it’s also worth watching for possible reversals in these sectors and conditions evolve.

VIX Rolls Over Further. NYAD Holds Steady

The NYAD Advance-Decline line (NYAD) has been improving of late. So even if it’s nowhere near a new high, at least it’s no longer making new lows on a regular basis. Moreover, it’s trying to move above its 20- and 50-day moving averages. If it can accomplish these two tasks, I expect the rally will gather steam.

Meanwhile, the CBOE Volatility Index (VIX) continues to make new lows, which should be more bullish for stocks than it has been so far.

The S&P 500 (SPX) is continuing its bottoming process. The index has now managed a marginal close above 3900 and has room to run toward 4000. Accumulation Distribution (ADI) is rising, which means short-covering is ongoing. A turn up in On Balance Volume (OBV) would be very encouraging.

The Nasdaq 100 index (NDX) has moved above its 20-day moving average and may have a fighting chance to move above the 50-day and the 12500 area if liquidity conditions improve. Accumulation Distribution (ADI) and On Balance Volume (OBV) are showing some steady improvement.

What comes next is clearly going to hinge on what happens if and when the major indexes reach and test the approaching resistance levels. And, of course, that will depend on the liquidity available in the market.

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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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