At A Crossroad

The key question is, where do we go from here?

The VVIX Index, which is the volatility of the VIX, fell below the key 100 level. Such instances have been short-term bullish in the past year (marked by vertical lines), though there are no guarantees that the rally will continue. On the other hand, the advance left the index extended and it may be forming the right shoulder of a head and shoulder formation. With the caveat that H&S patterns are incomplete until the neckline breaks, this is potentially a bearish development that could see stock prices weaken further.
 

 

The market is at a crossroad. Here are the bull and bear cases.
 

 

The Bull Case

Let’s start with the bull case.

Price momentum is still dominant. Nautilus Research studied past instances when the S&P 500 had five consecutive closes above a 50 dma and within 10% of an all-time high. Pullbacks during such instances have been “orderly”, and the market subsequently tended to rise further.
 

 

Sentiment was getting washed out, which has intermediate-term bullish implications. The triple-leveraged inverse S&P 500, SPXU, experienced a volume spike at the most recent panic bottom. Such events have usually marked durable bottoms in the S&P 500.
 

 

I am also seeing signs of improving breadth, which had been plaguing this market advance. The NYSE Advance-Decline Line is very close to an all-time high, which would be an intermediate bullish sign. Other breadth indicators such as the percentage bullish on P&F and the percentage of S&P 500 above their 50 dma broke out to new recovery highs. As well, net highs-lows recovered from negative to positive, which is another indication that the bulls have taken control of the tape.
 

 

Last week, I pointed out that Zweig Breadth Thrust Indicator became oversold at the panic bottom, which had short-term bullish implications. The bounce off the bottom displayed an incredible level of price momentum and the ZBT Indicator is close to an actual ZBT buy signal. This indicator has another week to generate a buy signal, which would have strong intermediate- and long-term bullish implications.
 

 

As a reminder, ZBT buy signals are rare. The out-of-sample track record of such signals have always resolved bullishly over a one-year time horizon. Short-term momentum failures occurred against a backdrop of the Fed raising interest rates, which is not the case today.
 

 

In addition, liquidity conditions bottomed when the government shut down and they continue to improve. The Treasury is spending its large TGA balance and injecting the funds into the economy, which improves system liquidity and provides a tailwind for asset prices.
 

 

Lastly, sentiment readings still indicate a fair degree of skepticism, which is contrarian bullish. The CBOE put/call ratio remains elevated, though not at a fearful extreme, indicating more room for sentiment to improve and stock prices to rally.
 

 

 

Reasons for Caution

The S&P 500 experienced a 5% pullback from its highs. Historically, such drops are a dime a dozen. The question is whether this is a breather within an uptrend or the start of something worse.

During such times of indecision, it’s worthwhile to analyze the charts from a different perspective. The accompanying charts show the S&P 500 and equal-weighted S&P 500 on an inverted scale. Would you buy these charts?

They both show constructive bottoming patterns. The equal-weighted S&P 500 is more developed because of the poor breadth exhibited by the stock market during the latest advance. Taken as a whole, this looks like topping patterns for stock prices if you re-invert these charts and this isn’t the kind of market structure that the bulls welcome.
 

 

Jeffrey Hirsch’s seasonality analysis shows a choppy first half of December, followed by a rally into year-end starting in mid-December.
 

 

Tactically, investors could see some price weakness early in the coming week. As Thanksgiving week saw extremely bullish price action, expect some short-term weakness on Monday, as shown by Rob Hanna’s analysis at Quantifiable Edges.
 

 

In addition, the stock market could be prone to downside volatility on the day of the Fed meeting. The current consensus calls for a quarter-point cut, followed by a multi-month pause in Fed policy. In other words, a hawkish cut. While the bond yields may not react much as such a development is already priced in, the stock market may be disappointed by the prospect of having to wait several months for the next rate cut.
 

Investors may also see further volatility on Tuesday. The market is pricing in a virtual certainty of a quarter-point rate cut at the upcoming December FOMC meeting, which is contrary to Powell’s characterization at the last post-FOMC press conference that a December cut “is not a foregone conclusion”. Powell is schedule to make a speech Monday night after the market close. The Fed hates surprising the market, watch for Powell to either affirm market expectations of a December cut, or to correct market expectations.

These historical price patterns set up a scenario for a market pullback early next week and open up the possibility of a formation of the right shoulder of the head and shoulders pattern I previously highlighted.
 

 

Eyes of the Beholder

Putting it all together, the stock market is at a crossroad when it comes to a bull or bear judgment.
From a long-term perspective, my market timing model remains bullish, and I am inclined to give the bull case the benefit of the doubt. As a reminder, this model turns bullish whenever the monthly MACD (bottom panel) turns positive from a negative reading and flashes a sell signal whenever the 14-month RSI exhibits a negative divergence.
 

 

In addition, my Trend Asset Allocation Model is bullish based on a combination of the recovery of the S&P 500 above its 50 dma and the uptrends shown by global equity averages.
 

However, it could be said that the bull and bear judgment is in the eyes of the beholder. The accompanying chart shows the Euphoriameter from Callum Thomas at Topdown Charts. The bulls will argue that sentiment readings are coming off the boil, which opens up the possibility of further stock price advances. The bears will point out that declines in the Eurphoriameter can mark either bear markets or periods of consolidation.
 

In conclusion, the stock market is at a short-term crossroad. It recently experienced a panic bottom on oversold readings and wash-out sentiment. I am watching for signs of a bullish follow-through after the expected relief rally. The bull or bear judgment will depend on the market’s action over the coming days.

Subscribers received an alert Friday morning that my inner trader was exiting his long S&P 500 position and taken profits. From the degree of excitement that I am seeing on social media about possible breadth thrust signals, short-term sentiment may be getting a little giddy, and I wouldn’t be surprised to see the market take a breather in the coming week and the breadth thrust models fall short of their buy signals.