Tuesday, October 4, 2011

Volatility Likely to Remain High

Click on Chart to Enlarge

Today was an interesting day and not unexpected based off of past similar instances. When Monday and Friday are down, there is a noted "turnaround" Tuesday effect historically. Also, the August low was exceeded significantly today in the S&P 500 and Dow 30. When a significant low breaks it often invokes some fear and also a reaction rally. The rallies are almost invariably extremely sharp really hurting the short term holder, running the stops on traders who shorted on the break to new lows. However, it is possible that the rally fails. Noted failures happened in Sept and Nov 2008 as the July and Oct 2008 lows were penetrated, respectively.

On a major bottom reversal day that closes up, the best reversals have extremely strong breadth. So looking at the advance-decline line is helpful in gauging the strength of the reversal. What is notable on today's reversal is that the NYSE adv-dec was relatively weak. See chart below.

Click on Chart to Enlarge

Note that today the reading came in at 633. That is lower than either of the up days last week and is not high on a relative basis to past similar instances either. Strong new upward patterns have started over the last few years with reading around 2500 coming off a significant new low. Also, for an intermediate bottom to be in place, the breadth on the reversal will often be higher than the highest readings of the recent move down.

So this reversal today does not look that strong on this basis. The technical analysis picture is definitely showing a bullish divergence on these new lows, so a reversal must be respected here. I just am leaning toward this not holding. The time relation is not ideal from my perspective for this move down to bottom. I think next week or even a couple weeks out would be better. In addition there is a tendency for market turns to happen around options expiration. So that would also suggest a little more "work" before a bottom.

If this low fails to hold, what will the following decline look like? From how this chart is developing the Sept 2008 and Nov 2008 precedents look most similar. One thing of significant importance is that the "a" and "b" wave labels I have on the top chart of this post, show that "b" is larger than "a" at -10.2% vs -8.7%. So the pattern is starting with EXPANSION. So if today's low is broken I expect the next move down to be larger than -10.2%. So a 14% or greater decline is reasonable or expected from my analysis if that happens. Again, the 1050 S&P 500 level is the next major chart support area (long term support and resistance).

There are a few other points I could make here that I have touched on in the past, but my take is that I think today's low is failure prone and certainly likely to be retested. However, we could see a dramatic move up (a large gap up, etc) for a day or so before it fails.

It is very tempting for me to post a bullish/long trade here, but I think that in this scenario waiting for a higher swing low would be very wise. So if we get some upside then a higher swing low, I would likely take that trade with a stop below the low.

One point that I don't know what to make of is that at basically all of the past similar occurrences from 2007-2009, when a low like this was broken, the put call ratio spiked. We just didn't see that here yet. The equity put/call ratio has consistently exceeded 1.00 at times like this. But today it was just 0.78 down from 0.85 yesterday. What I interpret that as is that there has not been enough fear generated for a lasting rally to happen. That fits with the analysis above. The other interpretation is like at the end of the last bear market in March 2009 where the put/call ratios didn't spike and in retrospect was an obvious sign of bullish sentiment divergence.

Bottom line, the long term is pretty objectively down right now, and I would use stops very close below any reversal if trading long. The market could get whacked hard if any reversal fails.

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