Batten down the hatches because a storm is coming. While that may be navy parlance for lock the doors and windows the correlation for traders is to reduce your positions and make sure your stop losses are in place.

The coming Brexit vote on Thursday could produce some extreme volatility in either direction. A "stay" vote should produce a strong rally because the huge uncertainty that has been weighing on the market would be erased. A "leave" vote would intensify that uncertainty since no country has ever left the EU before. If citizens vote to leave there is a two-year waiting period once the Article 50 notice is filed. That means nothing is going to happen immediately but the market may react as though the EU died. Most investors do not understand there is a two-year waiting period while all the details of the actual exit are worked out and finalized. Therefore, a leave vote could provoke a knee-jerk response to the downside. I would view that as a buying opportunity and I am sure the smarter institutional investors also understand the rules.

The 2000 stock NYSE Composite index touched resistance at 10,625 the prior week and then declined to support at 10,200 on Thursday. The NYSE has everything from the smallest to the largest stocks and covers all sectors. This is a broad representation of market sentiment. Today, the dip to support and minor rebound was bullish. The NYSE closed positive on Friday in a weak market.

The broader Russell 3000, which is the 3,000 largest stocks in the market, is showing the same bullish pattern. It touched support at 1,250 and did not fully retest support at 1,195. The Thursday low was 1,209.

The broad indexes are showing the same relative strength as the S&P and Dow even though the S&P did come closer to the prior highs with a miss of only 23 points. If we were to see a dramatic sell off this week the 2,040 level is the key level to watch. That was strong support back in May. That is where I would expect institutions to trigger their buy programs.

The Dow Transports ($TRAN) were also positive on Friday after bouncing off strong support at 7,460. However, with FedEx reporting earnings on Wednesday it could be volatile after that report. The decline in oil prices was a positive but I think they will remain locked in the $45-$50 range for some time.

If the Dow Transports can remain positive or at least remain above 7,460 it will be supportive for the Dow.

The Volatility Index has returned to what would be a normal buying threshold at 20 but it has the potential to hit 30 next week and that is definitely a "fear in the streets" buy indicator. It rarely stays at that level for more than a couple days. A leave vote could propel it higher and a stay vote could knock it back down to 14 in a very rapid move.

If it hits 25 or even 30 I would sell a VIX bear call spread because the risk of a continued move higher is very low.

Despite the market weakness over the last couple of weeks the percentage of S&P-500 stocks over their 200-day average remains strong at 69.4%. That is significantly higher than the Jan/Feb levels. This suggests the majority of stocks are bullish but that is not the case. I have a symbol screen of roughly 800 stocks and I would estimate at least 650 of them are in a downtrend. The mismatch is because the 200-day average is slow and the rebound from May was sharp. The declining stocks have not yet dipped back below their long-term average.

The percentage of stocks over the shorter duration 50-day average has already declined to 53.0%. It would not take much in the way of a market decline to push that back down to the 40% range.

The percentage of S&P stocks with a buy signal on a point and figure chart is currently 57% and declining. That is still a relatively strong number but a couple more days of market declines could alter it dramatically.

The correlation between the High Yield ETF (HYG) and the S&P-500 remains intact at 72%. There has been some bleed as a result of the Fed meeting and the outlook for interest rates. In this environment I would not expect the HYG to decline significantly but anything is possible. More than $78 billion in outflows from equities have moved to bond funds year to date. If that money begins to rotate back into equities it could upset the correlation.

The correlation between oil prices and the dollar is also intact. However, should the vote be for an exit, the dollar is going to spike and oil prices are going to crash. That could also drag down energy equities.

The Semiconductor Index rolled over last week and is now dragging the S&P lower. The large number of chip stocks influence the tech sector and the combination of the two is a large drag on the S&P. If the semis return to test that May low, no amount of fund buying will overcome that drag on the S&P. In May you can see the bigger dip on the $SOX and the drag on the S&P.

Gold surged to $1,318 intraday on Thursday as a safe haven trade despite a sharp rise in the dollar on the same day. Cooler minds took over on Friday and gold settles right at $1,300. In case of an exit vote several analysts are predicting higher gold prices but the dollar is going to spike significantly and that will be a major headwind for gold. Analysts are saying the British Pound could decline 10-20% and the euro could decline 5-10%. That would mean a 10% or greater spike in the dollar and that would be dramatic and impact all commodities negatively.

There is no way to accurately predict the market direction after the Brexit vote. A stay vote should be market positive and a leave vote should be market negative. I would expect any dip to be bought but maybe not on the first day, which is Friday. Possibly, by Monday cooler heads would prevail. However, the dollar will be the key. If the dollar is headed to the moon we would probably need to see that move slow before equity buyers will return to the market.

If you can take a vacation from trading next week and come back the following Monday, the market will still be here and the volatility will be a lot lower.

Enter passively and exit aggressively!

Jim Brown

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