VIX plunges under 14. Mr. Market banishes all thoughts of bear.

This has been an extremely dramatic decline, from 22 to 13.9 in one trading week.

Previous drops under 14 in recent years have been followed by limited upside in stocks and an increased incidence of significant declines.

This week’s action seems to be based on relief that Congress has come to terms on the budget. Never mind that taxes are going up for everyone (payroll tax “holiday” ends), and that no progress was made on spending, not even so-called “cuts” to the rate of growth.

Side note on the budget:

High inflation remains baked into the cake for the coming years, just as it appeared in the later years of the secular bear markets of the 1910s, 1930s-40s, and 1966-1982. This is not just because the government is running trillion+ deficits without end, because the Fed has tripled its balance sheet and the monetary base in just four years.

When enough bad debt has been written off for lending to start back up in earnest, the upswing of the multi-generational interest rate cycle will have severe repurcussions for the budget. The effects will be greater because the US Treasury is not taking advantage of low long-term rates, but issuing mostly shorter-term notes.

Note that I was a rare bull on Treasuries going into the last debt crisis. That is no longer the case, but I’m not necessarily bearish on them just yet.

VIX & Put:Call starting to make puts attractive again

A fair degree of complacency has snuck back into markets over the last month.  We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:


Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:


The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:

Week in review and intermediate-term thoughts

Today I’m going to lay out what I’m watching for clues about the intermediate-term prospects. The action of the last 4 weeks has been more suggestive of a reversal than any we’ve had since the March 2009 lows. However, even if a top is in hand and we are finally at our spring 1930 moment, I’m not willing to throw caution to the wind and discount the possibility of another few weeks of rally.

Let’s start with the 5-day average equity:put call ratio, which has nailed so many intermediate-term tops, not least of which this last, which it suggested would be followed by a serious decline:

The put:call ratio could use a bit more of a reset, which could be achieved by just a few more days of calmer or rising markets. Nothing major required here, just a pause.

This break has shaken up a few traders, but judging from interviews this week, the majority remain fairly sanguine about a continued bull phase and consider this a healthy correction, much as they did the first declines off SPX 1550 in late 2007 and early 2008. Also, the past year has established a very clear pattern of modest declines followed by new highs on extreme bullishness. Traders and their machines may be programmed to buy this dip, but with the recent technical damage (we busted the last low for the first time in the whole rally and experienced a mini-crash) I’d expect any rally to be relatively shallow.

There is a pattern of reduced oomph on each subsequent rally phase, which you can see in the diminishing slopes of each rally. You can also see the weakening of the larger trend in the angles between subsequent lows.  (Click to enlarge the image.)

TD Ameritrade

I’ve drawn those ovals on RSI to show a technique I have for picking bottoms. It gets most intermediate term bottoms, and perhaps more importantly, it has a low false-positive rate. A rally becomes likely when you get a double bottom in RSI. This works on any scale you chose, from 1-minute to daily or higher. The likelihood of a rally increases if the second bottom on RSI is higher than the first. This is common because the middle wave of a decline is usually more intense than the final wave.

Now, this current juncture has such a double bottom signal, though the second RSI bottom is not higher than the first. It is also trickier because the first was formed by the latest black Thursday, May 6. I’m not sure how such an event should factor in, but it throws off our analysis somewhat. Perhaps the May 6 event should be discounted (it was really just 1 hour of trading that produced the reading) so that we can’t actually count this RSI bottom as a 2nd.

In terms of time, we’re just over 4 weeks into the decline, which is approaching the average for an intermediate-term decline over the last 3 years (the last one was very short at 3 weeks, and others have lasted up to 8 weeks).

Also of consideration is the extreme complacency that we are correcting. Look again at CPCE in the first chart above. From what I can tell, it set a record for complacency going back to at least the year 1999. This suggests we may have more decline ahead before an extended relief rally. Sentiment has turned negative, but not overwhealmingly so, and it has only been negative for a couple of weeks, so this is not a contraint to a further decline.

One more consideration is the 1930 parallel. Once stocks broke that April after their rally from the crash of ’29, they failed to rally hard for years. The decline was steady all the way down to the bottom in July ’32. In this analalogue, we would have another week or so of choppy and weak rally, followed by the bottom falling out, an outcome that would elegantly resolve our situation. The dip-buyers pile in, but the oomph is gone, momentum weakens and RSI turns down, then BAM, we’re back to SPX 750 this summer.

Prophet charts

I am approaching this situation by being neutral on stocks at the moment. I am holding a core position in December 2011 and 2012 SPY puts and some calls I’m short on IYR and GDX, though I sold a portion of the puts on Tuesday morning and and the rest are hedged with a short in VIX futures (I do this because spreads on options make them costly to trade in and out of). Essentially, I’m flat on equities.

I closed a ton of shorts from last Thursday to Tuesday morning, and went long SPX, ASX and Nikkei futures (and long CHF, EUR, GBP and short JPY and VIX) early this week when I saw divergences in the VIX, currencies and commodities (ie, stock indexes made a new low that was not confirmed with new extremes elsewhere, a buy signal) as well as a glaring RSI divergence on the hourly scale. Those “long risk” positions I closed for profits on Thursday and Friday, since we’ve already corrected the extreme short-term oversold condition and are in neutral territory. Equity-wise, I ended the week where I was on Tuesday morning, since the drop in volitility hurt my puts as much as my various longs made me money. Vol is a bitch that way — sometimes you time prices right, but it’s not enough.

Speaking of the VIX, I think it could settle down for a few weeks, though to a higher level than in April, before the next decline pushes it up again. I think it will remain elevated (as from Oct 2007 onwards) for many more months or a couple of years:

Prophet charts

In the commodity space I’m even more convinced that a major top is at hand, since some trendline breaks have been decisive (platinum, palladium, oil) and the declines have been so violent all around. Commodities tend not to rally as hard as stocks once the trend changes to down, so I entered shorts on oil, silver, gold, palladium and copper near their highs late in the week. The precious metals are looking particularly suspect to me here, and I still think my July 2008 double top analogue is in play.

The euro, Swiss franc and British pound are still looking very weak. Sentiment has been in the dumps for four months now, which is a set-up for a spectacular rally, but judging from their heaviness this week as stocks and commodities and CAD and AUD rallied, I think they may slide to one more low before that rally.

Rosenberg concurs: 400 point rallies are bearish

From Tea with Dave (free sign-up here):

The obvious question is: how can the bull market possibly be over considering that we enjoyed that amazing 405-point rally on the Dow just three days ago (Monday, May 10)? Wasn’t that an exclamation mark that the bull is alive and well?

Far from it. There have been no fewer than 16 such rallies of 400 points or more in the past, and 12 of them occurred during the brutal burst of the credit bubble and the other four took place around the tech wreck a decade ago. See Chart 2 below.

2007 all over again

This is a big, rounded top. It’s taking its time, though it is still compressed relative to the ’03 – ’07 cycle wave top.

This week’s strength was very impressive and could mean new highs on the Dow and SPX in the next couple of weeks if that previous wave is any guide. Our January-February ’10 drop was akin to May-June ’06, Feb-March ’07,  and July-Aug ’07. Tops are processes, bottoms are events.


Maybe the VIX will even scoop out a big rounded bottom and fall several more points:


Note the advance:decline ratio I threw on there as well. This was a big up day relative to everything since last summer, with 5 stocks up for every decliner. These spikes during a bull trend tend to foretell that prices will drift up some more, though not always, and they do occur in bear trends as well, when they simply serve to clear the way for a resumed decline, as in late Sept ’08. There is still a larger declining trend in the A:D spikes, indicating declining oomph during the strongest rallies, as in the year leading up to the Fall of ’08.

The A:D ratio is also a measure of jumpiness. You can see how it spiked up as fear crept into the game in summer ’07.

Of course, this market is now extremely short-term overbought and treading on very thin ice, so it could just plunge at any time. This could have been our clearing rally.

You can see that the daily A:D was nothing like earlier last year, but you still have to respect this signal.

VIX cycles

No strong conclusions here, just some food for thought:


You can also see a possible 30-day pattern: 30 days down, then a ramp. Let’s put this in perspective. Here’s a 5-year weekly chart. All I can note here is a divergence on the RSI over the last few months:


I’ve also noticed how Treasury bonds have resembled the VIX for some time (I put in those RSI buy/sell signals just for fun — not as effective here as in the 60-min chart of Dow futures, but not bad either):


Just goes to show, when you think you’re trading US stocks, Chinese stocks, commodities, bonds and options, you’re really just trading global patterns of fear and greed. It doesn’t matter what market you choose these days. They’re all the same.

Cleared to fall

A lot of markets have had more than sufficient clearing rallies, and their charts would exhibit a nice proportionality if they were to top right around these levels. I think it’s likely that they meander or float a little higher for the next 2-5 days, but they could just as easily reverse hard at any moment.

The Australian dollar looks like a lot of these charts right now:

The same wobbly pattern of rolling over can be seen here, in this Russian market ETF:


The charts of the Canadian and New Zealand dollars, oil, copper and platinum are also remarkably similar to these above.

In the major US indexes like the Dow, seen below, the initial crack from the highs was much more violent, so the same impulses have not brought prices near to the old levels. This is similar to when the post-crash rally was broken in 1930 (2nd chart below).


The Euro had a decent rally early in the week, but like the British pound after its June highs, its spirit is looking broken and it has fallen out of pace with the pack:


Of course, if the current urge to speculate persists, I think a short-squeeze in the euro is still very possible.

One last chart here, the VIX (90-day view), which really shows the ebb and flow of fear and greed. Wouldn’t it be pretty if it bottomed right here?

The distinct possibility of a crash

Technical trading is a game of probabilities involving indicators, patterns and history. There are times, like near the peak last month, when the odds of a certain outcome are very high, since you have so many indicators in positions that have been followed by the same outcome. There are other times, like right now, when you don’t have strong odds of any particular outcome, but you do have a higher than usual chance of a rare outcome: in this case, a violent resumption of the deflation trade from relatively oversold conditions. A hard decline from oversold conditions can lead to panic, since it feels like the market “just isn’t going to stop falling.”

I still very much like the summer 2007 analogue, since this winter, as then, the market fell hard off of a very long and calm stretch of gains on low volatility and extreme complacency (the “Goldilocks era”). What I see now is a market that, with yesterday’s rally to 1080 and this week’s little ramp in DSI bullishness, has corrected its oversold condition just enough to resume the decline. Stock bullishness now has 20% or so of downside to go before reaching the level seen at the bottom of declines of this nature (hard first plunges from long periods of complacency: May-June 2006, Feb-March 2007, July-August 2007, Oct-Nov 2007).

The VIX has the room to spare, as does the put:call ratio. I see in early trading this morning that several markets are showing weakness as they approach support. It is still possible that they bounce and we charge ahead towards 1100 and beyond, but I would not count on it. Like I said a few days ago, and Daneric actually mentioned last night, perhaps this decline resembles the start of wave 3 of primary 1 (May-July 2008), a stair-step process of small rallies just big enough to keep people guessing, followed by new lows.


I’ll be away from the markets for the next few hours, unfortunately, but I have sell-limit orders in place for the above possibility. This of course would negate the Euro rally I’ve been considering.