Conflicting Market Signals


February 25, 2013 (6:45 pm)

We explained in our post last Wednesday that the market would likely continue down on Thursday before re-testing the high’s early this week. As we expected, the market fell to an intra-day low on Thursday (down to $150) before rallying up to $152.85 this morning, just shy of its 52-week high formed last week. After that re-test, the markets completely rolled over and dropped nearly $4.00 into the close. That’s a 2.5% single day drop, from high to low. We’ve seen reversal after reversal over the past few days. That’s a sign of a transitory market. Since we’re sitting near a 5-year high, a transition from here can only be bearish. However, there are some conflicting signals that indicate a near-term rebound may already be due. There are a lot of charts here, so we’ll go through them relatively quickly.

SPY Failed Re-Test. After seeing a quick and significant sell-off last Wednesday and Thursday, the SPY rallied back to re-test its previous highs this morning. It got to within $0.50 of its previous highs before rolling over even more quickly than it had rallied. A failed re-test is an important piece of the topping process. After failing once, investors like to try a certain direction at least one more time before moving the opposite direction. They want to be confident that the shares are rejected at a certain price level and that demand has truly dried up. This is as true for the bulls as it is bears. With this failed re-test, the bears are now free to take over. However, that doesn’t necessarily mean that they will.

SPY Failed ReTest

SPY Trend Lines. Here’s another view of the sell-off. The bottom trend line (that the shares are now approaching) was formed by the November 16th bottom and the fiscal cliff bottom. On one hand, we now have a failed re-test that gives the bears the necessary runway to drive a correction. On the other hand, the SPY is reaching a significant trend line that may mark strong support and an inflection point. The shares, if they reach the bottom trend line, will also be oversold. We have an interesting near-term situation in the works.

SPY Channel

SPY Support Levels. Here’s yet another view of where the SPY sits. This morning, the shares rallied and tested the bottom trend line of the well-defined rising channel. They were clearly rejected at that trend line and dropped nearly $4.00 immediately. Oversold conditions will likely slow the selling in the near future. We doubt that investors will witness another day like today in the near-term, since the RSI is already so low. We will likely see consolidation around the current levels before dropping to $146, which is the first level of significant support. Below that is the gap that was formed after the fiscal cliff resolution.

SPY Support

SPY Rising Wedge. We’ve shown this chart multiple times over the past few weeks. The SPY shares were rejected at the upper trend line of this very long-term and significant rising wedge. We’ve seen negative divergence form over the past two and a half years, as well as decreasing volume. Both of these help to confirm that this pattern is to be taken seriously. Just for your knowledge, the implied price move is roughly $45, meaning the target of a breakdown is roughly $100 on the SPY (or about 1,000 on the S&P500). Interestingly, the bottom trend line currently sits at the $146 level, which we explained earlier as significant near-term support. We’ll likely see a bounce off this trend line before a more significant and sustained correction can begin.

SPY Rising Wedge

SPY Intermediate-Term Correction Targets. This next chart is not to be viewed as a near-term target, but instead on the intermediate-term. We expect to see the $140 level in the early May time frame. Our targets were derived by two independent methodologies that both happen to suggest the same price level. The first is a 100% measured move of the previous correction (Sept-Nov 2012). The second is a 61.8% Fibonacci retracement of the current rally. Both suggest the $140-$141 price level (again, likely around the early May time frame, not imminently).

SPY Targets

QQQ Failed Re-Test. Now let’s take a look at the NASDAQ. Just like the SPY, the QQQ’s saw a failed re-test of the highs and subsequent breakdown today. However, the QQQ’s are already within the oversold zone on the RSI. Since the first down leg was so strong, we’ll likely see a second leg down after a brief rebound or consolidation period.

QQQ Failed ReTest

QQQ Consolidation Zones. As we’ve recently discussed, the QQQ’s have formed a series of consolidation zones throughout the past four months. Each is has a tighter price range and shorter duration than the last. After last week’s sell-off, the shares today re-tested the highest consolidation zone and was firmly rejected. It’s now sitting at the bottom of the zone created after the successful resolution of the fiscal cliff. A 61.8% Fibonacci retracement of the recent rally gets us to fill the gap (almost exactly) that was created after the cliff resolution.

QQQ Consolidation

QQQ Long-Term Resistance Level. The chart below is self-explanatory. The $67.75 level represents significant, long-term resistance for the QQQ’s. Only a successful and decisive breakout would confirm a true bullish environment. Below it, the bears are in control.

QQQ Resistance

QQQ Head & Shoulders. This pattern is still squarely in play after the firm rejection of the long-term resistance level at $67.75. You can see the gap from the fiscal cliff sits directly below the current levels. If the shares continue to decline tomorrow, that gap represents a vacuum – meaning the shares will likely retrace the entire gap area. There’s no real support anywhere within the gap.

QQQ H&S

Volatility. This next chart is extremely important. It’s a bit complex, so we’ll decipher it one step at a time. The VIX measures the amount of volatility in the market. Low volatility implies a melt-up market, where complacency reigns and investors are confident that the market will continue to slowly rise. High volatility implies a turbulent market, marked by either (a) wild swings or (b) sharply falling prices.

VIX

On the chart above, we have two sets of horizontal lines. The first set are thick purples lines (of which there are 5), which mark each time the VIX hit a 70 RSI. At the bottom of the chart is the SPY index (which is representative of the broader market). You can see that each time the VIX hit a 70 RSI in the past year, there was a near-term rally in the markets. The second set are thin red lines. Typically, when the VIX runs above its upper Bollinger Band, the first close back within the bands marks a top in the VIX, and inversely, a bottom in the markets (the market tends to be inversely correlated with the VIX). We placed the thin red lines where the VIX drops back below its upper Bollinger Band. The green and red arrows indicate where this works (10 instances) and where it doesn’t (one instance). This may be confusing at first blush, but re-read it until you understand what we’re doing because it’s an important concept.

CONCLUSION. So you can see that there are a number of conflicting signals here. What we think it means is this. There will likely be downward pressure in the market because this first leg down after the failed re-test of the highs was so strong. However, since both the SPY and QQQ are nearing oversold levels and support levels in the near-term, we’ll likely see at least consolidation before a second leg down. This is also confirmed by the VIX indicator that signals a likely rebound from here. So the near-term crystal ball is obscured between the bulls and bears.

The intermediate-term course is a bit clearer. All signs point to re-testing the $146 level first, and eventually, the $140 level. Be cautious here, however, since we may not test it over the next few weeks. This is a two- to three-month process in our view.

  • Ewan

    Great analysis and charts! Thx