Options Update: Rare Divergence, The Market Becomes a Bit Disjointed.

Rare Divergence has occurred in the S&P 500 and the Nasdaq 100.  Markets have become a bit disjointed, making stock and sector selection EXTREMELY IMPORTANT! 

So, the Fed continues to be hawkish, markets gyrated and ended mostly higher on the week.  The SPX Dow Jones, and the Nasdaq 100 were all up 1.48%, 1.20%, and 1.81% respectively.   

Friday’s close seemed to be encouraging, and with little meat on the economic calendar this week with the exception of Friday’s PCE Core numbers, there is a good chance we drift higher as the regional bank contagion drama from the last two weeks begin to subside.  

As a follow-up to last week’s newsletter, the higher-quality financials GS and STT have leveled off and in some cases are beginning to move higher (see below).  Traders who implemented my poor man’s covered calls were well-rewarded so far for sticking their necks out!

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The VIX, although somewhat elevated, has also subsided (see below), and the “backwardation” of futures contracts has also diminished, showing a slightly more bullish tone than a week ago. With all those long upper shadows on the chart, it seems as though fear tried to enter, and the bulls simply weren’t having it.

This leads us into the most important observation I have this week.  The S&P 500 chart still looks terrible, where moving averages are sloping down or sideways, and the Nasdaq chart looks pretty darn healthy, where price action is sloping upwards (see two charts below). 

Usually more than 80-90% of the time, the major indices are correlated to one another.  This is one of those rare periods of market history where it is not the case.  As a professional trader, I’ve learned over the years not to wonder “why” something is occurring, but to act and profit on it as quickly as possible. 

But if you are scratching your head at this divergence in the S&P and the Nasdaq, and just need to know “why”, here are a couple thoughts:   

First, the financial sector is currently the worst performer due to the regional banking issues we’ve faced, and this disproportionately affects the S&P and Russell 2000.  Another terrible sector is energy, which remains vulnerable since its massive two-year rally in 2021 and 2022. This sector has zero representation in the Nasdaq.   

Finally, with higher rates come higher yields on US Treasuries as well as corporate bonds.  With more attractive yields in these groups higher on the credit and capital structure than dividend-paying common stocks, they become the preferred choice of the income-seeking crowd.  

Those now out of favor boring defensive and utility names are largely in the Dow Jones and S&P, again with no representation in the Nasdaq. 

So, with XLU, XLI, XLRE, XLV, XLF, XLY, XLB, XLRE, and XLE all underperforming, and XLK and XLC the only two sectors looking decent, where does the market go from here?  This divergence will not last forever, and eventually highly correlated markets will eventually find themselves back in sync, for better or for worse! 

This is why my method of basket trading options is so effective.  In disjointed markets like this it is more important than ever to analyze each group within the market separately and make bullish and bearish calls simultaneously.  If you rely on your same old watch list every week, and do not make adjustments, you are finished in a market like this.  

I don’t know which direction the market will break, if the Nasdaq takes the S&P higher, or the other way around, but here is what I do know:  It doesn’t matter.  

I will know when it happens and change my positions accordingly, because that is what traders do.  Opinions mean nothing, trading what is in front of you is everything.

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