Current State of the Markets Early 2016
Correction | Volatility | Fed | Global Risk | Commodity Rout
This Blog is the third revision from the blogs titled Short Term Reflex Rally Approaching Heavy Resistance UPDATE 2 released in the fourth quarter. The current Market Themes for the opening of the year are the Corrective Action of the Markets, Volatility, the Fed, Global Risks and the Commodity sell off. We have been predicting these Themes since June of last year and are right in the center of the activity as we release this Blog. The following is a snapshot of our research as we see it half way through January.
The stock market in the fourth quarter was in a range of 17,000 – 18,000 on the Dow Industrials, where it was continually stalling for most of the year. The pattern for individual stocks and groups were also similar with a smaller number of large stocks holding up the indexes, while the broader list of groups and stocks are very mixed in their trends. It’s was the same type of market that we had seen for the past year, which we believe made it difficult to build a case for a sustained bullish trend.
We believed that consolidation was likely, which could have left the bulls and bears frustrated for the coming months. Eventually, we expect the longer-term bull trend to return, but it may not happen soon enough for those who were expecting a year-end rally and a good start in 2016. The following two charts show the Dow Jones from the early December update and the updated chart January 20.
DOW JONES INDEX: 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 TR 3 support and TR4 support). This is where we are currently. We believe that the markets could finally find support between TR3 and TR4 and reverse trend with a rally that could take us back to 17,000 at a minimum. We are beginning to put a small amount of cash to work and formulate new positions. However, we remain cautious until our upside momentum indicator confirms the reversal.
S&P INDEX: The long-term secular bull market trend continues to be bullish from the 2009 lows, however the recent 15% pullback by the S&P could signal the beginning of a short-term cyclical bear reversal. The two charts above illustrate the current market change discussed earlier. The overall intermediate trend went from neutral to slightly negative with the possibility of a short-term rally that could bring us back into the intermediate range. The short-term trend reversal would be a recovery after the recent correction with stocks engaging in mostly mixed but overall improving trends. As we stated earlier we remain cautious as we evaluate whether technical behavior outweighs the mixed economic data.
VOLATILITY: With the recent strong corrective action in the equity markets and the fact that the market was approaching heavy technical support, the VIX (volatility Index) spiked to levels that correspond to our writing above. These levels are now showing signs that the market decline could be slowing down and that a possible short-term strong rally could ensue. We are contemplating selling volatility here as we slightly add the long side of the equity markets.
This chart is the most compelling of the charts shown in the blog. It represents an overlay of the S&P 500 Index and he 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 shows 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 believe that, given the data shown above, the probability of a V-shaped rally is high and could come within the next two weeks.
TRADING UPDATE: We have been putting a limited amount of cash to work into stocks as conditions warrant. We have been rebalancing portions of the portfolios over the past week by selling existing positions and adding new and existing positions while not changing the overall cash weighting of about 35% in the accounts. As mentioned in the past, we are not seeing clear indications of what areas of the market may lead in a recovery, so a more bottom-up approach is best at this time. The cash can be put to work quickly should we see opportunities present themselves and the potential for hedge positions will remain a trading tool to improve risk exposure in the portfolios.
We are finishing a lengthy blog regarding our 2016 forecast and it should be released next week.