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Looking for Odd Clues

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Plunge, Bounce, Zoom, Crash! That pretty much defines the action in the broad markets so far this week and it's only Wednesday. Traders who are trying to put on a directional trade in this volatile market have been frustrated by the lack of directionality. This week's strong moves in both directions are simply a microcosm of what has been happening over the past few months. Most days start out with a gap, sometimes with the trend and sometimes against it, but always difficult to trade. Lest you think you are missing something important, let me propose that there are a lot of traders that just can't seem to make sense out of the recent market action.

There are plenty of traders that are playing the expectation that we are near an important market bottom, but there are just as many that are acting like they expect the bottom to fall out, just like we saw in late July. One clue to this bifurcated expectation is the CBOE Volatility index, which has been whipping around between 36-47 for the past month. The VIX remains high like this when there is a lot of uncertainty in the market, and that is definitely the case right now. Looking at a daily chart of the VIX this afternoon, I noticed that the VIX hasn't been below 30 since the first week in July. That's nearly 3 whole months where the VIX has refused to dip into its historically normal range between 20-30. My VIX chart only goes back to 1994, but in that timespan, late-1998 is the only period that presents a picture of such sustained volatility. Then we saw the VIX holding above 30 from late-August until the end of October, or roughly 8 weeks.

We've been at these elevated levels for about 50% longer than in 1998, and judging by the action in the markets this week, the volatility doesn't appear likely to let up any time soon. What I find particularly interesting about this behavior is that while the VIX has remained high, the Bullish Percent PnF charts on all the major indices have cycled from Bear Confirmed in oversold to Bull Confirmed back to Bear Confirmed in Oversold. There are some slight variations between the different indices, but let's focus on the Dow Industrials for this discussion.

In early July, the Bullish percent for the DOW was Bear Confirmed near the 30% level, and then proceeded to fall as low as 4% as the index fell as low as 7532 on July 24th, with the VIX printing an intraday high of 56.74. That was followed by an impressive rally (albeit a volatile one) that took the DOW briefly above 9000 before the late August through September plunge that dropped the DOW as low as 7460. What was interesting about the rally off the lows is that the VIX only dropped to just above 30, even while the Bullish Percent Chart went from Bear Confirmed to Bull Alert, all the way to Bull Confirmed with a high of 60%.

The most recent decline has dragged the Bullish Percent chart all the way back down to 10%, although it is still in Bull Correction mode. The Bullish Percent would have to drop all the way to 2% (due to the extremely low reading in July) in order to go back into Bear Confirmed status. Throughout these wild swings in the market, the VIX has remained stubbornly high.

So what does all this mean? I honestly don't know, but I'm trying to piece it all together into an actionable plan. According to my analysis, all of the major indices have bearish price objectives below their recent lows, but trying to game the downside right here carries with it a higher level of risk (as seen in yesterday's 346 point DOW rally) due to the depressed levels of the Bullish Percent charts. Here's where the Bullish Percent readings currently reside:

DOW - Bull Correction at 13%
S&P 500 - Bear Confirmed at 28%
S&P 100 - Bear Confirmed at 23%
NASDAQ 100 - Bear Confirmed at 21%
NASDAQ Comp - Bear Confirmed at 29%

Based on these metrics, it is clear that the bulk of the risk in the broad markets is to the upside, due to the fact that the Bullish Percent charts have a lot more upside potential than downside. But the bears still appear to be in control as all but the DOW are in Bear Confirmed.

From a purely technical standpoint, I note that the Weekly oscillators (RSI, MACD and Stochastics) on the major indices are all trying to round higher, but haven't been able to pull it off just yet. My gut feel says that we are near an important bottom, but there is still some significant work to do before that expectation becomes reality. That thesis would play nicely in conjunction with the historical pattern of the markets to put in important bottoms in October, but that still leaves us with 4 weeks of continued volatile trade.

Coming back to the topic of volatility, I took a look at the PnF chart of the VIX this afternoon and noticed an interesting pattern. Remember that the PnF chart format helps to remove a lot of the noise that we normally see on the bar and candle charts. So let's take a look at that chart and see what it tells us.

Volatility Index (VIX) - Point and Figure Chart

I normally don't look to the VIX for trading signals, but recognizing that we are clearly not in 'normal' market conditions, I'm looking for all the help I can get. The sideways consolidation of the VIX on the PnF chart tells me that the broad market is getting ready to make a big move and when it occurs, I think the VIX will confirm that it is THE MOVE by breaking out of its recent range. It is interesting that the low on the VIX on yesterday's huge rally was 39.77. It will take a print at 39 or below to put the VIX on a Sell signal, and nullify the current bullish target of 61.

My gut feel is that we'll get one more push lower in the broad markets (possibly setting new lows for the year), which will be accompanied by one more blowoff in the VIX above 50. That would make sense given the still-gloomy fundamental picture as we head into what is likely to be a dismal earnings season. But then we ought to see a confluence of factors lining up to give us a very nice rally into the end of the year.

Here are the factors that I'm looking for to confirm my bullish view between now and the end of October:

1. VIX pushing above 50 again with the broad markets slightly breaking their lows for the year.

2. Bullish Percent charts for the major indices reversing from oversold condition below current levels.

3. Successful upturn in multiple oscillators (MACD, RSI and Stochastics) on weekly charts of all the major indices.

While I know my musings today don't necessarily provide an actionable trading plan over the near term, it does provide some benchmarks that we can use to evaluate the progress of the markets over the next few weeks. As an added bonus for my bullish thesis for the last 2 months of the year, I'd like to see the S&P 500 testing the bottom of that long-term descending channel (between $700-725) that I spoke about in the LEAPS column last weekend. That would give me added confidence that the bulls have enough fuel (due to a deeply oversold market), so that they can stage a solid rally off the lows like we saw at the end of July. One thing I think we can rely on, is that October is likely to be an exciting month!

Have a great week!


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