What should traders make of the pre-Christmas panic today? S&P 500 futures were down as much as -2.5% overnight. The market opened up down about -1.5%, but recovered most of its losses to a -0.4% retreat today. More importantly, the bulls were able to hold support at 3650.
The VIX Index surged above its upper Bollinger Band, which is a sign of an oversold market. In the past year, most of the similar instances saw the market either rise or stabilize after VIX upper BB readings (blue vertical lines). The only exception occurred in February, when the market cratered as the news of the pandemic spooked risk appetite (red line). On the other hand, the 5-day RSI (top panel) is nowhere near an oversold condition.
The start of a major correction?
There is no doubt that sentiment indicators are greatly extended. It would be no surprise to see the stock market correct from these levels. Here is what I am watching.
We already had an early warning from my quality factor tripwire. The past two melt-ups have ended with low-quality stock leadership. Low-quality small caps have already flashed a bearish signal. Large cap quality remains in a relative uptrend. Will it signal a correction too? The low-quality factor has been early to warn of market tops in the past.
I am also watching the NYSE McClellan Summation Index (NYSI). In the last 20 years, NYSI readings of over 1000 have signaled either sideways consolidations or corrections about two-thirds of the time (red vertical lines). But market weakness does not occur until NYSI definitively rolls over. We are not there yet.
Finally, the % of S&P 500 stocks above their 200 dma surged over 90% recently. In the past, such conditions have been indications of a sustained advance. In most of all instances when this indicator rose about 80%, the market has not topped out until the weekly RSI reached an overbought condition of 70. This argues for further gains into year-end and possibly into 2021.
I am monitoring these indicators and keeping an open mind. In light of the seasonal tailwinds, my inner trader is giving the bull case the benefit of the doubt.
Disclosure: Long SPXL