Current Q1 Rebound is taking a Breather
DOW JONES INDEX: To recap our January 21 Blog Titled “Markets Need More Than Just a Bounce” we referenced the top graph. The markets failed to take out the trend line (labeled TR1 resistance) and then tested the lower trend line (labeled TR2 support) around 17,000. When the market violated the 17,000 support line it accelerated downward and started looking for the next support areas (labeled TR3 support and TR4 support). This was where we were a few weeks ago. We believed that the markets could finally find support between TR3 and TR4 and reverse the trend with a rally that could take us back to 17,000 at a minimum. We were beginning to put a small amount of cash to work and formulate new positions. However, we remained cautious until our upside momentum indicator confirmed the reversal.
As can be seen in the updated chart (above), the markets continue to move higher into an area of overhead resistance that could prove to be a problem after a strong rally for the past three weeks and are approaching some resistance areas of previous difficulty at around 17,500–18,000 on the Dow Industrials. We suspect that it could take some time to work through these resistance zones but the momentum behind the current rally is also such that it could continue to build and break out sooner than many would expect. We would not be surprised if there is a short-term pullback that may be somewhat dramatic when it occurs. Despite any sharp snap-back on the near horizon, we view such a pullback as a normal dip that will likely be a good buying opportunity for an eventual breakout to new highs on the indexes.
The number of advancing stocks has increased to some of the best readings we have seen in some time, which we believe means that the broader market has been outperforming the major indexes and is a good bullish indicator for a possible continuation of the underlying positive trend. The sentiment has also been slow to improve, as the rally has only been three weeks long so far, but some continued strength could cause some of the bears to switch, which could then add even more momentum to the move. A breakout through the high end of the resistance bands would be a strong signal that a longer-term uptrend was underway and we suspect that this trend in stocks will resume after a token dip and rally into May before a typical summer neutral period begins.
VIX INDEX: Again, to recap our January 21 Blog Titled “Markets Need More Than Just a Bounce” we referenced the first chart below. The chart was the most compelling of the charts shown in the blog. It represents an overlay of the S&P 500 Index and the spread of the VIX spot (current) price minus the VIX 3 month futures price (as represented by the green and red shaded areas on the chart). It showed how rare it is for the current volatility to exceed the future expectation of volatility. This is called “Backwardation” and, when at extremes, can represent a near-term reversal in the equity markets. What’s compelling is that every time this VIX indicator showed a premium (shown in green) a short-term reflex rally ensued. We believed that, given the data shown below, the probability of a V-shaped rally was high and a rally could ensue. It did, bringing us to our next chart.
To reference the updated VIX graph (below) we are at an inflection point and await to see if the market will hold and continue its recent rally or begin its sell off again. It the market heads lower we will focus on this indicator to look for a bottom and/or a new V-shaped rally. We believe the markets could have a very quick (relatively small) pullback which would allow us to continue putting money back to work which could get us fully invested if the market moves to take out the all-time highs. The probability is medium-high in our opinion.
TRADING UPDATE: We have continued to buy into this market since the last update and have cut our cash weighting. We will be looking to add into this market at key levels with the goal of being fully invested early Q2. The remaining cash can be put to work quickly should we see opportunities present themselves. As always, the potential for using hedge positions as a trading tool to improve risk exposure in the portfolios will remain an option if market direction calls for it.