The Fight Continues

9.27.2011

Since our last post here two weeks ago, the S&P500 has had a large trading range of 9.5% top to bottom, yet has moved a net sum of .3% higher in that time. The market remains in the same ‘fight zone’ referenced two weeks ago. However, we now have more information on which to base our outlook.

Two key events have occurred just in the past week in the US equities market: a significant lower high and a significant test of the August low. The lower high made on September 20th was significant because it did what was expected of an intermediate-term downtrend within a long-term downtrend: buyers stalled, then aggressive sellers returned before the market could pivot above its prior swing high which was made on August 31st.

The second event, the test of the August low, was significant for several reasons. The first is the fact that the test occurred so rapidly after the swing high – there was true seller aggression all the way down to the closing low of August 8th, and it got to the low in only two days. The second important aspect of this test of support was the fact that the selling dried up very quickly – within one day – upon testing the low. Clearly there is some level of value there, as buyers are able to gain control from the sellers when the market is at the level of the August low. The third important point is the fact that the market rallied vertically the next two and a half days with very little in the way of selling. This presence of buyers remaining in the market at the low end of the now eight-week trading range means that the trading range will remain intact indefinitely.

However, as last week’s test of the August low was the third such test, any subsequent arrival there in the short term is likely to frustrate the buyers, who will likely dump stocks in an emotional, capitulative move below the August low. The likelihood of the market remaining below the August low for more than a few days remains quite low, as bullish divergences continue to proliferate. Therefore, a significant intermediate-term, and possibly long-term, bottom would be likely after any multi-day cascade down below the August low.

The action in the VIX has provided little useful information the past few weeks, as it has simply traded inversely to the equities market. However, the VIX remains anomalously high, currently in the mid-upper 30s, and has not confirmed a new intermediate-term downtrend. One bullish element of the VIX is the decline in the average movement of the measure itself since late-August – this indicates relative comfort with the current level of volatility.

In summary, the market continues to coil sideways, likely in advance of a large move out of its eight-week trading range. With such elevated volatility and emotion continuing to build, a decisive directional move becomes more likely with each passing day. Though the intermediate- and long-term trends favor the downside, signs of underlying strength are increasing. The short-term lines in the sand are now drawn at 1120 on the downside and 1220 on the upside. A breach of this range will likely lead to a significant move in price in whichever direction it should break.

Hurry Up and Wait

The US equities market has continued to experience elevated volatility the past few weeks. It is quite rare for volatility to remain as high as it has since early-August for as long as it has. Other similar periods occurred in late-2008 and early-2009, as well as in 1998 during the Russian debt default /Long Term Capital Management debacle. We are therefore not anywhere close to uncharted territory in terms of volatility, though, certainly, such periods are uncommon and therefore poorly understood.

The VIX volatility index topped out this year at 48 on August 8th, a day before the S&P500 made its intraday low of the year. Since then, the VIX has seen successively lower highs, yet remains above its 30-day simple moving average. During the same time, the S&P500 has seen successively higher lows (with the exception of 9.12’s slight breach below 9.6’s low), and remains below its 30-day simple moving average.

The analysis of such moves in the broad equity market and the VIX shows that the market has been coiling for the past few weeks with roller-coaster moves that have left prices net flat since mid-August. Such indecision on the part of the markets often precedes a large directional move one way or the other. Since the long-term and intermediate-term trends are down, according to our work, the likelihood of lower prices must be weighted as the higher probability.

However, as bullish divergences have already occurred in many stocks and foreign stock indices, the likelihood that US equity indices will breach their August 9 lows for any great duration is quite small at this point in time. Should such a breach occur, it may last only minutes or perhaps as long as a few days. On the other hand, should the market close above its August 31 highs in the next few days or weeks, there is a high likelihood of higher prices thereafter.

As for now, the market remains in the thick of a ‘fight zone’, where buyers and sellers duke it out, and nobody wins for more than a few days. Time to hurry up and wait.