The Test

10.28.2011

Our call for a likely multi-week rally three weeks ago has turned out to be accurate. Equity markets worldwide have experienced anomalously large gains since the October 4th lows, with many indices up more than 15%. As strong as this intermediate term rally has been, long-term downtrends in the major US equity indices have not been broken. The NASDAQ and S&P500 both tested long-term downtrends this week – sustained moves higher in the weeks ahead are necessary to confirm new long-term uptrends.

If the market does not revert back below the lows of October 27th in the next week or so, then the probability is high that a new long-term uptrend has emerged. However, signs have appeared that indicate the uptrend off the October lows is aging – former leaders have fallen hard, former lagging stocks and sectors are attracting money at the expense of former leading sectors, and aggressive sellers have made their presence known.

The rate of advance since the October lows is unsustainable and has characteristics of a bear market rally. Structural shorts, or, those who believe the market has entered into a long-term downtrend, have likely begun to reinitiate positions this week, as rallies have been spiky and have drawn in aggressive sellers at levels of resistance. This group of sellers will remain active henceforth. The deciding factor in the long term trend of the market will be the aggressiveness of the buyers: will they continue to overpower the sellers as they have since the October lows? Or have they put all the money they wish back into the market already?
We see the following scenarios as most likely in the weeks ahead:

1. Continued consolidation around current levels with false upside breakouts, then resumption of the long term downtrend; possible test and breach of October lows several weeks thereafter

2. Consolidation then breakout above this week’s highs to confirm new long term uptrend; possible new highs for the year within weeks to a month or two thereafter

While these two scenarios are polar opposites, it is clear that price stability has not yet been established, which lends a greater weighting to Scenario 1. Additionally, the long-term downtrends of the major European equity indices, the Dow Jones World Stock Index and the Emerging Markets Index have not even been tested. While the gains in the month of October have been impressive, the long-term downtrends set in motion in early May of this year have yet to be fully extinguished. There will be a battle in the weeks ahead between buyers and sellers, and plenty of articulate arguments for both the bearish and bullish side. What is important is whether the markets are able to sustain around the highs of this week. This is a binary outcome situation, which is why the moves of the past few days have been emotionally driven and quite large. If the VIX volatility index, which has come off significantly in recent weeks, continues to decline and realized volatility does the same, then the market will likely continue to rally for months. Otherwise, a resumption of long-term downtrends has a high probability of coming soon.