Weekly Market Brief

Battle Lines

There are a lot of people expressing certainty about the rest of the year. For most the next move is higher as they are expecting a massive seasonality based rally especially if the Fed holds off on raising rates in December. Some are coming out and predicting a sell off and a bear market to evolve.

While I’m in the latter camp in the longer term I’m currently in the perhaps lonely flexible camp. The reason: These markets have been acting very technically and have very much respected levels and pivots and as such they currently offer possibilities for both sides of the year end argument, but neither technical case offers a clear direction yet. There are times when technicals offer you conviction sell set-ups (Lying Highs & KISS SetUp: $SPX) and there are times when technicals offer you conviction buy set ups (Positives & KISS SetUp: $QQQ).

What we are witnessing now is a battle for control and hence we are in a tactical phase while technical patterns are evolving. In New Highs or Bust a few weeks ago I suggested that the next nature of the next rally would be decisive to determine whether this market can sustain its bull trend or fall into a bear market consistent with previous topping patterns.

So let’s first review the context of what just happened and how technicals and signals are aligning to then get a clear understanding of the battle lines for control.

Let’s firstly review this counter rally:

What this counter rally did accomplish this week is largely meet the technical target zone I outlined in Positives:

See also Technical SetUp: $ES for the evolution of the long SetUp.

The trigger for this push higher was of course the US mid term election result. As I stated last week in “Back With a Vengeance, But“:

“I think it’s fair to say that many participants are looking forward to a bullish interpretation especially if the historic script plays out, which is that the ruling party will lose the House”.

And that’s indeed what happened with Democrats taking over the House as the expected gridlock brought in buyers.

And this trigger served to achieve what the counter rally needed to get accomplished, reconnect with key MA’s, trend lines and fib levels which suggested highly probable major resistance and a fade opportunity.

As I outlined on twitter specifically the 2016 trend line would offer resistance:

And that’s precisely where we rejected on Friday:

And from a technician’s point of view this was a beauty and it highlights 2 very important points: This market is acting very technically and this broken trend line is now confirmed as resistance and it is rising steeply.

And you can see it on the $SPX cash chart as well:

Which brings me to the bearish case: If bulls can’t recapture this trend line they risk falling hard off of this trend line and face a possible retest of lows (which could spark a “W” bottom) or new lows.

The new low scenario could very consequential for several reasons. Firstly, as you see in the chart above the recent correction has not even retraced to the larger fib levels since the 2016 bottom. The nearest major fib level is at 2508 on $SPX which would bring us to new lows for the year. If this market resolves bearishly that level may or may not get hit in 2018, but it’s possible.

But a bearish resolution could certainly open markets up to this lower risk zone:

Several things to note on this chart: Very clean rejection of the 2016 trend line with a sizable weekly reversal candle. Note we also broke the previous wedge. These are all showing bearish market behavior as patterns are resolving bearishly. Note also on this chart I’m using different fibs dating back to the US election on a cash basis. Why? Because the .382 fib here has proven to be very market relevant and it was a technical target/bounce zone I had outlined in Positives. Also note the .50 fib on this alignment is at 2510 closely matching the .382 fib on the 2016 low fib constellation. Coincidence? I can’t say, but it suggests major support confluence were markets to retrace to there.

Further supporting the bearish case:

$WLSH monthly chart:

The structure continues to show astonishing similarity to the 2007 top in that we had a new high on a monthly negative divergence which produced a 10% correction which fell below the monthly 5EMA. The same thing has happened here. In 2007 that drop off the new highs produced a counter rally that reconnected with the monthly 5EMA, but then failed.

This counter rally here just now also reconnected with the 5 EMA. As it’s early in the month it is too early to tell whether it will fail, but I note the structure for a possible major topping pattern remains currently in play, but bears have to prove their case.

Also keep in mind the critical juncture markets are at:

While the 2009 trend line was saved into the end of October, this trend line keeps rising steeply leaving very little room for error here. Even a retest of the lows would put this trend line at grave risk of breaking in which case the macro fib retrace opportunity becomes a monstrous one. 2072 is currently the longer term fib and would be a longer term target on a confirmed break.

And don’t forget the context of yields. Yields have not been relenting:

And hence markets are at risk of seeing something we haven’t seen in 3 decades: See the 10 year break out above its 3 decade long trend.

Even a shorter term time frame on $TLT highlights the critical nature of the current time:

$TLT is also at critical trend line support. Not much room for error and if it falls below the trend line that 10 year yield is likely to break above its trend at the same time. This last week’s Fed meeting produced little clarity and the Fed’s statement was sufficiently opaque to not offer any particular relief in regards to its December intentions.

So yields remain a critical piece of the puzzle to watch and a yield scare may favor bears.

Yet there’s a solid bullish argument to be had:

There are only 7 trading weeks left in the year and there is much positive seasonality at play including 2 major holidays, Thanksgiving and Christmas and a couple of OPEX weeks to throw around. In addition we’ve seen how different markets act with and without buybacks:

So one may argue bears are running out of time to prove their case and the next 2 weeks may prove critical.

Which brings me to a potentially very bullish scenario.

Firstly recognize that Friday’s reversal made perfect technical sense. I had already outlined the 2016 trend line as a natural point of resistance. But it was more than that.

Note the counter rally was so steep (over 8% on $SPX) by Thursday night $NYMO had reached its most overbought reading in almost 3 years:

And it did so right as $SPX tested its 2016 trend line hence it offered a nice point of confluence for a fade.

Furthermore $ES hit its .618 fib at the same time and because the rally was so steep the context of the previous decline offers the possibility of an inverse to be formed as I outlined on twitter:

Note I had mislabeled the .618 fib as .the .382 fib in my tweet. Maybe there’s a hidden case of dyslexia rumbling inside me, it happens :-).

That aside the reversal on Friday certainly respected the .618 fib and leaves room for this inverse scenario:

Was this retrace it? Too early to tell, but note the inverse pattern has room for a larger retrace and while it can drop as low was 2712 it is the 2735 area I suspect would be a major battle line. Ironically note the deeper the retrace now into these levels, the potentially stronger this pattern would be.

Only if this inverse fails and we break below the outlined levels would then bears have a shot at a retest of lows or new lows altogether.

So let’s be clear if this potential inverse pattern were to confirm (and that’s a major “If” at the moment) its pattern target would be 3035 which would curiously match up with a major macro fib we’ve been watching all year:

This scenario leaves room for a grand finale to this bull market. Not saying it would happen this year, it could extend into early 2019 and a Fed caving in December may certainly be an impetus to achieve this.

Bottomline: We’re in a period of uncertainty while this battle for controlled is being fought.

What I do have reasonable certainty about it is that the time of permanent bullish asset allocations is going to come to an end at some point:

The last time we’ve seen any real shift in Rydex allocations was during the 2016 lows. Both the February 2018 and October 2018 corrections have been met with a collective shoulder shrug. No fear. None.

Whether we see a shift in allocations this year or next is a tactical consideration from my perch. Strategically speaking we are likely to see a major shift into next year and with it vast volatility expansion.

And I submit this process of volatility expansion is already upon us:

Note that we have broken outside of 2 descending wedges on $VIX. The first was the 2 year pattern amidst record central bank intervention that culminated in the lowest volatility year on record, 2017, then the February 2018 correction broke out of that pattern, and 2018 then build a second descending wedge pattern which we also just broke above in October.

That’s the market sending you a message. Now in the bullish scenario I outlined it is entirely feasible that $VIX will retreat back to it lower wedge trend line for the end of the year and retest it. That gives you $VIX 11/12 by year end. With holidays and seasonality and perhaps a Fed caving that would actually not surprise., but if a retest or new lows are coming on $SPX $VIX looks to go much higher.

I’ll leave you with one other scenario also rooted in history and it’s the scenario I frankly dread the most:

This was the 2000 top. It too produced a strong counter rally from October into early November, but instead of offering a clear resolution it resulted in months and months of chop. Big rallies and big drops mostly within range.

While in hindsight we know that markets then didn’t bottom until late 2002, this initial phase was messy and it required utmost flexibility to navigate very choppy waters. So it’s perhaps fitting that I find myself very flexible here as well. Topping patterns are processes and while this market phase may resolve quickly in either direction, it may also not and that is the least considered case at the moment.

For the rest of the month the battle lines are clear: Bulls will want to defend any potential retrace to 2735 and recapture the 50MA to then tackle the January highs at 2873 and bears will want to see a drop below the 200MA again to then break the 2735 support zone to try to invalidate the potential inverse.

Whatever happens the larger $VIX chart above suggests is that the times of extreme low volatility are behind us. They may still calm down on occasion, but the larger message is: Volatility has come back and it will make 2019 its playground.

The battle lines are already drawn. Be ready.


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Authored by: Sven Henrich

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Categories: Weekly Market Brief

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39 replies »

  1. Northman
    I know your current analysis is focused on stocks, and rightly so. However, I would like to ask you about short-term interest rates. You have clearly stated that you foresee extreme volatility and a likely collapse in stocks in 2019. If this plays out, do you foresee similar “fireworks” and VOL explosion in the front-end of the yield curve as the Fed most likely “caves” and cuts rates? Could short-term rates plummet towards ZIRP again in 2019? Would that be consistent with the historic market moves you anticipate next year? If not ZIRP, could the Fed, instead, cut rates by ONLY 100ish bps or so and get Fed Funds back to 1ish% from its current mid-2%s? Do any of your charts/technicals forecast such a potential drop in short-term interest rates? Thanks

    Mike

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