QQQQ HITS A WALL -- XLE ADVANCES TO RESISTANCE -- VOLATILITY IS INCREASING THIS YEAR -- THE RISING FEAR FACTOR -- FILTERING OUT THE NOISE

QQQQ BATTLES RESISTANCE ... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor

The Nasdaq 100 ETF (QQQQ) is waging a major battle around resistance at 52. The gaps and breakouts over the last few weeks are holding, but a rising wedge is taking shape and I am watching this pattern quite closely. The rising wedge is typical for corrective rallies or counter-trend advances. In addition, the advance over the last three weeks retraced 62% of the November decline. This is also typical for retracements. If the rally is going to fail, then resistance around 52 is as good a place as any. Despite a sharp decline on Tuesday, the wedge is still rising and last week's gap is holding. A close below last week's low would break wedge support and call for a continuation of the November decline.

Chart 1

XLE CHALLENGES ITS HIGHS... Among the sector SPDRs, the Energy SPDR (XLE) was the standout performer with a 3.26% gain on Wednesday. Strength in XLE can be attributed to a surge in the United States Oil Fund ETF (USO). Chart 3 shows the ETF challenging its October-November highs. The breakout signal came with a move above the 50-day moving average and the upper trend line of the Raff Regression Channel (magenta trend lines). The blue trend line off the October-November highs did not capture the correction very well. I found it too flat. Therefore, I opted for another tool, the Raff Regression Channel, to define the downtrend. The middle line is a linear regression. The outer lines are equidistant and parallel to the linear regression.

Chart 2

Chart 3

A BULL MARKET IN VOLATILITY... Market volatility increased markedly in 2007. Chart 4 shows the S&P 500 ETF (SPY) with the 5-period Rate-of-Change indicator. This indicator simply calculates the percentage change, up or down, over a 5-day period. In contrast, the absolute change is the point change over a 5-day period. For example, a move from 100 to 110 would be 10 points or 10%. A move from 140 to 150 would also be 10 points, but the percentage change would be 7.14%. Even though the absolute change was the same (10 points), the percentage change declined because the overall level was higher (140 versus 100).

Percentage change allows us to compare volatility over a longer time period. On Chart 4, the green line is set at +3% and the red line is set at --3%. There were a few forays above +3% and below --3% in 2005 and 2006. Theses forays increased substantially in 2007 (blue arrows). Also notice the expanding blue trend lines. The lows are getting lower while the highs are getting higher. Both the losses and gains are getting bigger. This is clearly a sign of volatility.

Chart 4

Chart 5 shows two more volatility indicators: Average True Range and Standard Deviation. The formulas are more complicated than the 5-period Rate-of-Change, but they both confirm increased volatility in the S&P 500 ETF (SPY) this year. The 5-day Average True Range broke out in February and again in July. The 5-day Standard Deviation also broke resistance this year. Both indicators are at their highest levels since the second half of 2002. In the words of Buffalo Springfield: There's Something Happening Here.

Chart 5

VIX AND VXN ON THE RISE ... The S&P 500 Volatility Index ($VIX) and Nasdaq Volatility Index ($VXN) are also both on the rise. Contrarians use these two indices to measure extremes for complacency or pessimism. Low readings suggest excessive complacency that could lead to a market top. High readings suggest excessive pessimism that could foreshadow a market bottom. There is also another interpretation. Low readings reflect confidence in the market and often accompany an uptrend. Buying is a lot easier when confidence is riding higher. High readings reflect fear and often accompany a wild trading range or decline. Investors are more likely to pull the trigger (sell) in times of uncertainty. The $VIX and $VXN are both rising. This tells me that the fear factor is also rising. A rise in fear is bearish for the market because it leads to instability (volatility).

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Chart 7

DEALING WITH VOLATILITY... In addition to more weekly volatility, we are also seeing some pretty wild swings during the day. The S&P 500 ETF (SPY) declined around 3% from 2PM to 4PM yesterday, gapped up around 2% on the open this morning and then declined back to its low in the final hour (-2%). It's enough to make one's head spin. Chart 8 shows 10-minute candlesticks with the 2% ZigZag indicator. This indicator reverses only when there is a move greater than 2%. There have been three reversals in less than two days. Note: the last reversal does not count.

Chart 8

Moving averages can help tame volatility by filtering the noise. Chart 9 shows SPY as a 5-day SMA and 20-day SMA. The actual price plot for SPY is invisible (Chart Attributes>Type>Invisible). You can click on the chart to see the indicator details and save it to your Favorites. The major swings are still there, but the intraday moves have been eliminated. The moving average crossovers caught a few good moves this year, but also got whipsawed during the June-July trading range. Chart 10 shows SPY as a 13-day SMA and 34-day SMA, which are two of John's favorites. Notice that the longer moving averages produce fewer signals. The 5-day SMA moved above the 20-day SMA for a bullish signal in early December, but the 13-day SMA has yet to follow suit with a break above the 34-day SMA. I would not use these moving average crossovers as a stand-alone trading system, but they can be used to augment other indicators and techniques.

Chart 9

Chart 10