Mid-week market update: Is this the pullback and correction that I’ve been anticipating? If so, how far can it go?
Take a look at this weekly point and figure SPX chart. Is there any doubt that the intermediate term outlook is bullish?
While my inner investor remains bullish based on the intermediate term trend, my inner trader is cautiously bullish and not all-in as there may be some near-term choppiness ahead.
The message from the VIX Index
First of all, I want to address the recent article by Mark Hulbert showing that the level of the level of the VIX has nothing to do with future market returns.
I agree 100% with that analysis. As the market has been trading in a very narrow range, realized volatility is shrinking and therefore it is no surprise that implied volatility (VIX) would fall as well. However, there is information when the VIX Index moves too quickly by either spiking or cratering, as defined by its relationship to its Bollinger Bands (BB).
The chart below shows the three-year history of the VIX Index. In the past, the market has either stalled or staged minor pullbacks whenever it has fallen below its lower BB (blue vertical lines). The index breached its lower BB last Friday.
What if the BB band narrows because of reduced volatility? The bottom panel of the above chart shows the BB width and it has fallen to very low levels. As this analysis from SDJ10304 shows, past instances of VIX lower BB breaches combined with BB width under 20 have produced flat to negative returns.
To fully appreciate the statistics from the above analysis, you have to be a bit of a math geek. Please note that the forward 1, 5, and 10 day median returns are flat, while the average returns over the same periods are negative. In addition, the % higher statistic over 1, 5 and 10 days are all 50%. That indicates that the typical returns after such trigger events (VIX below BB and lower BB width) tend to be flat, but there were instances where the market tanked so much that they pulled down the average return figures.
In other words, expect market returns to be flat but risk is skewed to the downside for this week and next.
This conclusion is also supported by the Bloomberg report that large speculators (read: hedge funds) are in a crowded short on VIX Index futures.
These conditions set up the possibility of a short-term volatility spike in the near future. As volatility tends to be inversely correlated to stock prices, it also suggests that the stock market may suffer a near-term setback soon.
Given the positive fundamental tailwinds behind stock prices (see my weekend post Breakout, or fake out?), I expect that downside risk is likely to be limited. If the SPX were to weaken further, it will have to test three levels of support. The first support will be mid-BB, or the 20 day moving average (dma) at 2170; the second support will be the lower BB, which is currently 2156; and the third and major support level is the 50 dma and breakout level of 2120.
My inner trader took some partial profits from his long positions last week but he remains cautiously bullish. He is awaiting either signs of further weakness or an upside breakout to new highs before adding to his long positions.
Disclosure: Long SPXL