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Blind Squirrel Finds Acorn

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As the pivotal month of October reaches its mid-point, the one factor that has remained constant is volatility. Triple-digit moves on the DOW continue to be a nearly daily occurrence, as investors struggle to make sense of the early earnings reports coming out of Corporate America. Since the August highs, the markets have been sold hard, with all of the major indices (with the notable exception of the OEX) moving to fresh multi-year lows. At the same time, all of the PnF Bullish Percent readings moved very close to the extreme readings found in late July, the last time the market attempted to put in a bottom.

Two weeks ago, with the broad markets looking like they were trying to form a bottom, I went looking for some metrics that could be used to gauge the likelihood of a bottom formation. In case you missed it, here are the three signs I was looking for, to prompt me to consider fishing for a bottom.

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.

Hmmmm...that's kind of interesting. Since that time, all of those factors have shaped up in the bulls' favor. Is it any surprise that the DOW experienced a powerful 1000+ point rally off its recent lows? Let's look at the individual factors, as they have shaped up over the past few weeks.

Volatility (VIX):

When we looked at the VIX two weeks ago, I pointed out that the index had been rangebound between 40-48, and needed to either break out over the 48 level or print a value of 39 or below to break out of this range. I was looking for the VIX to push through the 50 level, in conjunction with the broad market violating the July lows. With the broad market already deep in oversold territory, my expectations were for any breakdown to be short-lived, leading to a strong short-covering rally. Sure enough, last week's market weakness led the VIX to push briefly above 50, while the DOW, SPX and NDX all pushed to new multi-year lows. Since last Thursday morning, the VIX has fallen from a high of 50.48 to a low yesterday afternoon of 39.58. Isn't it interesting how the print at 50 confirmed the PnF Buy signal just in time for the market (and VIX) to reverse with vigor? The PnF picture for the VIX has changed dramatically in the past couple weeks, and it is in the bulls favor. Take a look at the updated PnF chart below and you can see that the drop in the VIX in recent days has put the VIX on its first PnF Sell signal since early September.

Point & Figure Chart of the VIX

As the VIX is a pretty reliable measure of investor fear, this reversal of fortunes in the supply/demand of the 'Fear Index' tells me that this fledgling rally in the broad market still has some room to run.

Bullish Percent:

Index July Low October Low Current S&P 500 12% 19% 32% -- Bull Alert DOW 3% 7% 36% -- Bull Confirmed NASDAQ-100 8% 13% 38% -- Bull Alert

That's one heck of a recovery in such a short period of time. Typical of a bear-market rally, the rebound has been fast and furious, as shorts have stumbled over one another trying to close profitable positions before those profits melt away. While the initial upthrust has been violent and abrupt, dominated by huge gap moves, the internal strengthening demonstrated by the improvement in the Bullish Percent numbers hints that the market has already factored in most of the negative earnings news and is willing to let prices continue higher over the near term.

Price Charts:

That leaves us with one more piece of the puzzle that needs to be evaluated -- the progression of the weekly price charts, along with their oscillators, such as Stochastics and RSI. Just 2 weeks ago, the S&P 500 (SPX.X) was struggling to hold above the 800 level, while the NASDAQ-100 (NDX.X) had just posted fresh multi-year lows near 825. Clearly, that situation has improved significantly since then, but let's see what those weekly charts have to say.

Weekly Chart of the SPX and NDX

The recovery off the price lows of last week has put the charts in a much more bullish position. The weekly Stochastics have reversed nicely out of oversold territory, as the price charts have marched sharply higher. And then we have some bullish divergence between the price charts and the RSI oscillator. While price in both the SPX and NDX moved to lower lows than what was seen in July, the RSI for both indices put in higher lows. This gives us another hint that the bulls are gaining strength.

Well, how do you like that? All three of the indications that I was looking for to signal the next sustained bullish move have been satisfied -- and in short order, to boot! Every once in a while, a blind squirrel manages to find an acorn!

Of course, we need to temper any bullish long-term enthusiasm with the realization that both of these indices are still well under their multi-month descending trendlines and we still haven't seen the pattern of lower highs challenged. Before we'll even have a hint that the bearish nature of the market has changed, we need to see a higher high to break the persistent downtrend of the past 2+ years. That means the NDX needs to push through the 1055 level, while the SPX will need to convince us by scaling the August highs near 965.

Between here and there, significant upside exists for traders that are willing to side with the bulls for awhile. To recap, all the weekly charts are in the early stage of a bullish advance, the VIX has turned bearish (bullish for equities) and all of the Bullish Percent charts are telling us of a bullish advance that is just getting started. Does this mean that we can go long with impunity? Not by a long shot! But it does tell us that the trading environment has changed. No longer is "Sell the Rallies" the battle cry of the successful trader. Since late July, we went from deeply oversold to overbought and back to oversold. Now we are in the process of working off that oversold condition, and now "Buy the Dips" appears to be the 'en vogue' approach.

Changing our bias as quickly as the current market environment demands is difficult, even for experienced traders. Hopefully this discussion, where we have combined option volatility analysis and supply/demand metrics (Bullish Percent charts) with the more widely understood price charts gives you a fresh view and more tools to apply in the battle we face every day.

Best Trading Wishes!

Mark



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