Look Out Below

11.22.2011

As expected in our October 28th outlook, the US equity market has continued its long term downtrend and confirmed a new intermediate term downtrend as well. After its exhaustive buyers’ capitulation on October 27th, the market traded sideways in volatile fashion into mid-November. The major indices then broke decisively below multi-week ranges and key moving averages, confirming the continuation of the long term downtrend that began in early May, as well as a new intermediate term downtrend that began on October 27th.

As the rate of advance from the October low to October high was unsustainable (see prior post), the necessary outcome was a consolidation of some sort thereafter. The consolidation in the first half of November, followed by the subsequent move lower the past two days was the most likely and most bearish outcome. There is now a high probability of downtrends continuing in the weeks ahead. Developed European as well as global emerging market equity indices have all fallen into intermediate downtrends and remain in long term downtrends as well, thus increasing confidence in lower prices to come.

However, neither implied nor realized volatility has confirmed the new intermediate term downtrend in equities. While the overall level of volatility remains quite high, it remains significantly below highs seen in August, September and early October. In addition, volatility has failed to breach highs seen as recently as mid- and early-November, despite the major equity indices slicing below their respective multi-week lows. Taken alone, this is a bullish development, as it indicates that the recent declines in equities have occurred in a more orderly manner than in August-October. All the same, implied volatility has climbed significantly as the market has declined since October 27th, so the likelihood is that volatility will increase as the market continues to move lower.

In summary, equity markets are poised to go lower in the weeks ahead. Here are several scenarios:

1. Multi-day bounce, then test of August-October lows within weeks

2. False break above this week’s high, then test of August-October lows within weeks

3. No consolidation or bounce – vertical drop to August-October lows

4. Multi-week consolidation, then test of August-October lows a few weeks thereafter

Large US financial stocks have already started nearing their October and multi-year lows. The major equity indices are likely to follow before long.