December 30, 2012 (9:30 am)

During the middle of Friday’s trading session, we posted the chart below (which we’ve since updated) and explained that there should at least be a re-test of that upward sloping trend line before a true trend reversal takes place.

SPY Push Up

While we do still expect a rebound, it will likely be a good opportunity to get out of long positions and into some shorts. The SPY pulled back $5.00 non-stop, meaning the downward momentum is strong. It looks like we’re still on the first leg down. After a moderate rebound, it would be surprising if a second leg down did not develop.

Bearish Indicators

Two important things stand out when looking at the chart. The first is that the highs formed before this most recent pullback were very likely a re-test of the highs from early October. You see this pattern develop often over the intermediate-term charts. It tends to be a bearish signal that is similar in concept to a double top reversal. Not only did the market fail to break above the previous high, but it failed to even reach the same level. That’s when you see the bears attempt to take over and drive the shares down.

The second is that we never re-tested the lows put in during mid-November. The chart below illustrates the rising channel (blue trend lines) formed after the November 16 low. The market formed a V-recovery, which is a path it doesn’t often take. You tend to see a re-test of the highs or lows before a successful reversal.

Since we’ve now broken down from that rising channel, we may be on the brink of re-testing the November lows over the coming weeks due to (a) the failed re-test of the October highs, (b) the strong down momentum, and (c) the fact that we haven’t yet attempted to test the lows.

SPY Rising Channel

Double Top Target Fulfilled and Nearing Oversold Conditions

The chart below depicts the double top we illustrated a week ago Friday, when we mentioned the development of this potential pattern could throw our near-term bullish expectations out the window. This pattern has now been completed, having met the price target on Thursday. Now the SPY is nearing oversold conditions. It will need to clear those oversold conditions during a rebound before establishing a more sustainable downtrend.

SPY Double Top

Volatility Indicator (VIX) Signals Potential Near-Term Rebound

So, while we now expect a bearish downtrend to continue in the intermediate term, the near-term is a bit more bullish-biased. The VIX has closed above its upper Bollinger Band for multiple days in a row. This could be the sign of a near-term top on the VIX, which tends to correlate with a rebound in the markets. The VIX is also at an RSI level that has typically preceded near-term rebounds. The bottom of the chart below uses colored arrows to illustrate the significant of this buy signal, which has successfully called a near-term bottom in 9 out of last 11 cases.

VIX

What This Means for Apple

Apple is still trading within an enormous falling wedge. You can see in the chart below that this pattern is contracting very quickly. While Apple can fall to $499 and remain within this pattern, we’ve recently become very accustomed to seeing false breakdowns and breakouts with shares of Apple. A false break happens when a clear-cut chart pattern breaks one way, before reversing sharply in the other direction. It’s an accumulation strategy for market makers and fund managers by allowing them to take out the “stops” of other traders and investors.

AAPL Falling Wedge

It wouldn’t come as a big surprise if, during a steep sell-off in the markets, shares of Apple fell into the high $400’s. This would come a few weeks before they’re scheduled to announce earnings. A breakdown of this pattern would allow fund managers and the “smart” money to accumulate massive positions heading into Apple’s best seasonal quarter while the shares are down 25%+ from its recent highs. Whether the shares hold $500 or not in the very near-term doesn’t really impact the long-term fundamentals for the stock. While the short-term is determined by sentiment and technical factors, the strong fundamental story will drive share growth over the intermediate- and longer-term.

Previous Apple Corrections

In early November, Horace Dediu, the author of asymco.com (highly recommended), posted an article entitled “On Not Being Boring: A Dramatic Reading of Apple’s Share Price.”

The article included two important concepts. The first was that of the duration of Apple corrections. In the chart posted below from his site, duration (in days) is represented on the right, and the rate of decline on the left. The longest Apple correction lasted 150 days, and the second longest lasted 120 days. The current correction is now in third place at 100 days. It will soon end.

The second concept, which was most interesting to me, was attempting to find consistency in Apple’s sell-offs.

“Is the pattern of share price collapse actually rooted in some fundamentals, transient or otherwise? There is a clear failure in understanding the long term but were these downdrafts justified as the market “foresaw” or “discounted” the near future? Were these more than just crises of confidence? Was there wisdom in the drops because they were followed by earnings drops or slowing growth? In other words, if there was smoke, was there fire? Was the market being efficient?

No.

The graph below shows the share price change in the more recent episodes above and the earnings growth during the current and following quarters.

At least since the iPhone launched, every dramatic drop in share price was followed by a surge in earnings growth. One could even say the worse the bear, the better the growth.

Sounds completely counter-intuitive, but there is some perverse logic in this as well. The market reflects crises (as well as over-abundance) of confidence. Unforeseen growth is what creates wealth and the crisis in confidence is a reflection of the improbability of continuing out-performance. When Apple’s performance is foreseeable the stock moves slowly upward. When its performance is unforeseeable the stock moves dramatically downward.

A pithy way of putting it is: No news is good news. Good news is bad news.

When a product is understood the stock is mildly desirable. When a new product appears the future is hazy and the stock is undesirable. But that haziness hides potential but up and down. New products is what innovators produce. Bizarre new products is what disruptors produce.

In other words, the paradoxical observation in the chart above of “the more drama in the market, the more success in the marketplace” makes sense when inverted.

For disruptive companies, it should be “the more success in the marketplace, the more drama in the market.” In that sense the current downdraft may be quite auspicious.”