VIX IS TOO LOW FOR FOUR-YEAR CYCLE BOTTOM -- MORE ON POINT & FIGURE CHARTING -- WHY I TRACK GOLD AND THE DOLLAR
PREVIOUS CYCLE BOTTOMS SAW A HIGHER VIX ... There was a lot of discussion about the four-year cycle at the conference of the International Federation of Technical Analysts (IFTA) in Switzerland. Most of the discussion centered around the unusual nature of this year's rally. In most instances, the market hits a four-year cycle low during the fourth quarter (usually in October) of the mid-term election year (Chart 1). I've suggested that this year's cycle low might have occurred earlier than usual due to the summer peak in crude oil prices (oil usually peaks in October). One of the reasons Bruno Estier, a Swiss technical analyst, is suspicious of this year's cycle low is the unusually low level of the CBOE Volatility (VIX) Index. He pointed out that most of the recent four-year cycle lows took place with the VIX at a high level and peaking. That's not the case this time.
Chart 1
RECENT HISTORY OF THE VIX ... Chart 2 plots the VIX over the last ten years. That includes the last two four-year cycle lows that took place in October of 1998 and 2002. Bear in mind that the VIX usually trends in the opposite direction of the stock market. In other words, a rising VIX is bearish and a falling VIX is bullish. But there's more to it than that. The VIX has upside and downside parameters to help us determine when a trend has gone too far. Historically, VIX values over 40 have coincided with important market bottoms (green line). That's what happened during the last two four-year cycle lows (green arrows). Prior to 2003, VIX readings below 20 often coincided with market tops. At present, VIX is near a record low at 10. The point of the chart, however, is to show why this four-year cycle low is so different. A low VIX is more consistent with market tops than market bottoms. The fact that it's so low this year calls into question the validity (and staying power) of this year's four-year cycle low.
Chart 2
TWO WAYS TO LOOK AT THE VIX ... The daily bars in Chart 3 show a series of declining peaks and troughs in the VIX since the middle of the year. A falling VIX is bullish for stocks. To the bottom right, however, notice that the VIX is levelling off near 10 (lower green line). If it holds at that level (and starts to rise), that would be the first sign of a possible bottom in the making. To signal an important upturn, however, the VIX needs to clear its late September peak at 13.41 (upper green line). Chart 4 is a point & figure version of the VIX. To reverse the p&f downtrend, the VIX would have to exceed the top of the last x column at 13. Since each box is worth .50, the VIX would have to hit 13.5 to give a buy signal in the VIX and a sell signal in the market.
Chart 3
Chart 4
MORE ON POINT & FIGURE CHARTS ... Another thing my trip to Europe reminded me of was how popular point & figure charting is overseas. That's especially true of European chartists. I shared a cab to the Milan airport with Jeremy du Plessis, a British chartist who has written the best book on point & figure trading that I've seen. In fact, it's called "The Definitive Guide to Point & Figure" (it's available in the Stockcharts.com online bookstore). I highly recommend the book to anyone wanting to delve more deeply into the subject. [Tom Dorsey's book "Point & Figure Trading" (also available in the Stockcharts bookstore) is another good source, but not nearly as thorough]. That being the case, I thought I'd take the occasion to do a little point & figure charting myself. [A chapter in my book "Technical Analysis of the Financial Markets" also covers the subject)].
Chart 5
A POLE IN THE DOW ... Chart 5 shows a current point & figure chart of the Dow Industrial Average. Each box is worth 50 Dow points (the default value used by Stockcharts) and it's a three-box reversal chart. That means that prices must move at least 150 points (3 boxes) in the opposite direction to move the price into a down column. The last buy signal was at 11350 during August. It's normal to put protective sell stops below the last o column. In this case, however, that's too far away. On page 288 of Technical Analysis of the Financial Markets, I discuss a situation where there are ten uninterrupted x's with no intervening correction. It's called a "pole". That's the case here. One way to stay with the existing uptrend while also protecting against a downturn is to use a three-box reversal to the downside to do some profit-taking. Since the highest Dow box reached 12150, it would have to fall 150 points (to 12000) to register a three-box reversal. That's not a bona fide sell signal (which requires it to fall below a previous o column). It's just a technique to do some profit-taking in an over-extended market. Or, you can use a more sensitive p&f chart.
Chart 6
MORE SENSITIVE P&F CHART GIVES CLOSER STOPS ... Chart 6 is also a three-box reversal point & figure chart of the Dow. But it cuts the box size in half (from 50 to 25). That makes for a more sensitive chart (it takes only 75 points to create a three-box reversal). As a result, there are lot more reversals shown on the chart. The main value of the more sensitive chart is to give a closer stopout point below the last o column. On this chart, that would take place at 11925 (about 100 points below today's price). Notice also that the Dow has already moved into the down column (the red letter B marks the start of November). That's not enough to give a p&f sell signal. But it's interesting to note that the Dow has fallen five boxes over the last week. That's the biggest drop in two months. There a numerous ways to employ point & figure charts on price charts and technical indicators. I'm just scratching the surface here. It's an area of charting worth studying.
Chart 7
WHY I LOOK AT THE DOLLAR ... One of our readers asked why I write so much about gold and the dollar. My initial response about why I cover gold (and gold-mining shares) so much is because I'm asked so many questions about them. The dollar is another story. I subscribe to the view that there are four asset classes -- bonds, stocks, commodities, and currencies. Wall Street has traditionally used only used two -- bonds and stocks. Over the last four years, commodities have made more money than bonds and stocks combined. That shows why it's important to follow all of the markets. The commodity bull market was based to a large extent on a falling dollar (Chart 7). Viewed that way, the dollar is an important inverse indicator for commodity prices and especially gold. That's one reason to watch the dollar. Another has to do with the fact that dollar direction determines whether investors should emphasize U.S. or foreign stocks. A stronger dollar favors the U.S., while a weaker dollar favors foreign stocks. Since the dollar is so closely tied to the direction of U.S. interest rates, its direction tells us something about the strength or weakness of the American economy. Over the last week, for example, a falling dollar suggested lower U.S. interest rates and a weaker economy. Chart 8 shows the Dollar Index dropping after failing a test of its 200-day average. That's coinciding with falling bond yields (green line). That's caused some buying of bonds, profit-taking in an overbought stock market, and higher precious metals and mining shares. That's why I cover the dollar. It can be traded as a separate asset class through various mutual funds; and it's an important indicator for the other three asset classes and the economy.
Chart 8
