Mid-week market update: Market internals are showing signs of a wash-out. Readings are normalizing after an extreme oversold condition against a backdrop of extreme fear. Stock prices should advance from here.
However, the S&P 500 just experienced a “death cross”, where the 50 dma falls below the 200 dma. Notwithstanding today’s negative surprises from NVIDIA and Fed Chair Powell, the inability of the index to overcome resistance at the 5500 level, which is the site of the 50% retracement and just below a price gap, is disconcerting for the bulls.
What happens next? Let’s review some historical studies, otherwise known as “torturing the data until it talks”.
A Wash-out Market
Numerous indicators point to a wash-out market. The VIX Index is normalizing after a spike. The term structure of the VIX is similarly normalizing after a steeply inverted condition, which indicates extreme fear.
Historical studies of VIX spikes have tended to resolve in higher stock prices.
Different indicators of price momentum (fast money) against quality (patient money) are showing a renewed dominance of price momentum. I interpret this as the recent episode of risk manager mandated forced liquidation is over.
The Death Cross
The S&P 500 just experienced a “death cross”, which is a trend following signal whose implications are less clear. One historical study of the last 20 episodes points to positive short and longer term returns.
On the other hand, a longer term and more detailed study going back to 1957 indicates turbulence up to a one-month time horizon.
This is what I mean by “torturing the data until it talks”. Small variations in data sets, sample sizes, and triggering signals can lead to very different conditions.
Here is my interpretation. The market is washed-out and ripe for a rally, but the trade war uncertainty that led to the sell-off hasn’t been totally removed. This will lead to short-term choppiness with a minor upward bias in stock prices. Under such circumstances, a useful strategy might be to take advantage of the elevated uncertainty to sell volatility. A buy-write strategy of buying the underlying stock or index while selling call options against that position has the potential for superior returns.
As per the note published Sunday, my inner trader exited his long position in the S&P 500 on Monday. He is standing aside for now.
We had a TWIST last week that often marks an intermediate low or even a bear market low.
I track the four Factors, Value, Quality (Growth), Small Cap and Low volatility and have watched how they are doing after the TWIST.
Low Vol is leading. That happens n the past when the TWISTs fail and we are seeing the failure now. That makes sense. You would want economically sensitive beaten up indexes like Value and Small Cap to lift off best to mark a true TWIST low.