Don’t Get Bearish Quite Yet

December 23, 2012 (5:45 pm)

With all of the negative political theater going on in the country right now, there are a number of reasons to feel bearish on the broader markets. Friday’s early morning thrashing was the direct result of the politicians inability to come to an agreement on how to move forward as a country. Both sides are ineffective in their arguments to the American people. So let’s keep our eyes on the markets and the likely direction of the next move.

Where The Broader Market Stands

The SPY (S&P 500 index) dropped $2.00 to start the morning on Friday, following the fiasco that was the Republicans attempt to gain some leverage on the fiscal cliff. It made a late day comeback, rising almost $1.00 off its lows. The SPY has been forming a clear rising channel since the middle of November. Friday’s gap down found firm support at the lower trend line. That lower trend line coincided with additional support that the SPY has found at the $142 level over the past few months.

Volitility and the VIX

Along with the firm support found on Friday morning, there’s an additional piece of strong evidence that the SPY should recover shortly. The VIX chart is below. The VIX is the measure of volatility in the markets. Next to the orange arrow, you can see a long black candlestick, which represents Friday’s move on the VIX. To start the morning, with the enormous gap down in the markets, the VIX exploded to the upside and jumped from 17 to 20 (well above the upper Bollinger Band – the green moving average lines). It dropped during the day as the markets made a slight comeback, but didn’t manage to regain the upper Bollinger Band. When the VIX opens and closes above the BBands, it historically signals a top in the market volatility for a brief period. A drop in the VIX typically coincides with a rise in the markets.

This may seem like a confusing concept, but think of it like this. As fear permeates the markets as it drops, you see volatility in the markets increase rapidly. Conversely, as the market stabilizes and slowly rises, you see fear (and volatility) slowly leave the markets. For this reason, volatility and the markets are thought of as inversely correlated. That’s why our expectation of a drop in the VIX should mean a steady increase in the broader markets.

Push-Up Pattern

Another signal that the markets should have at least one more attempt at hitting its highs for the year is something called the “push-up pattern”. Typically this pattern has a trend line forming with two points, as a higher high is created. When the market fails to reach that trend line during the third push higher (push-up), it creates a “failed” three push-up pattern and you tend to see a more meaningful sell-off. You’ll notice on the chart below that there are already four tests of the green trend line. Clearly this isn’t a three push-up pattern (more like a five). However the concept remains the same. Before a sharp reversal, you should see the SPY attempt to test that trend line. Only on a failure of that re-test should there be a sharp reversal of any kind. The blue lines indicate the quickest likely pull-back scenario. That’s not to say the SPY will definitely pull back. Just that before a meaningful pull back, it should test the trend line at least one more time.

Hollow Red Bar

The last piece of evidence for a near-term increase in SPY shares is the type of candlestick formed on Friday. You can see the last bar on the right from Friday formed a hollow red bar. This is an intra-day reversal candle, with an open below the previous close, and a reversal that closes the day at a higher price than the open. When you see this happen on very high volume – which we did – it tends to be an exhaustion bar in the direction of the movement (in this case, down). It tends to precede a reversal.

On the Other Hand…

There’s one thing holding me back from declaring Friday’s price action as a clear loss for the bears. The chart below shows a potential double top on Friday’s share price action. The double top, in this case, has a $141 price target. With RSI and Chi-Osc neither overbought nor oversold, it’s not impossible – nor extremely unlikely – that the bears are able to quickly take the SPY down to the $140-$141 level before the bulls are able to take over.

We went long 3,500 shares of SPY on Friday at $142.30. About half of the portfolio is invested, and the other half in cash. If the market does take a dip on Monday morning, we’ll try to capitalize on the evidence above to fully invest the portfolio for a quick test of the upper trend line. Otherwise, we’re happy to ride our current investment and keep some powder dry for unknown events – which will very likely come from our trustworthy politicians. Happy holidays.