DOW LEADS MARKET LOWER - VIX REMAINS AT HIGH LEVELS -- VOLATILITY INDICES CONSOLIDATE

DOW BREAKS TO NEW LOWS... Today's Market Message was written by Arthur Hill. - Editor

With a sharp decline in early trading on Thursday, the Dow Industrials broke below the January-February lows. Chart 1 shows the Dow Industrials trading at its lowest level of the year today. In fact, the key average is around 300 points from its late November low and may be the first major index to test this low. Failure to follow through doomed the Dow. After the January decline, there were two attempts to break back above the 50-day moving average (8400-8500). Both attempts were fueled by hope for the stimulus package and the bank bailout. More importantly, there was no follow through or breakout. Instead, the Dow plunged below 8000 on Tuesday and broke to new lows today.

Chart 1

THE THREE STAGES OF VOLATILITY... Chart 2 shows the S&P 500 Volatility Index ($VIX) remaining at relatively high levels. Looking back over the last three years, I can identify three stages for the VIX. Low volatility shows confidence in the stock market that gives way to a bull market. The yellow area shows an 18-month period of low volatility. The S&P 500 moved steadily higher as the VIX fluctuated between 10 and 18. Extremely low volatility can reflect complacency, but complacency does not always translate into lower stock prices. There was a volatility breakout in July 2007 when the VIX moved above 25 for the first time in years. A trading range then ensued as the VIX traded between 17 and 32. This higher range showed a sustained increase in the "fear factor". Fear begets selling and this paved the way for lower prices in the S&P 500. Another breakout occurred when the VIX surged above 70 in October. Since this surge, the VIX has traded above the prior range and remained at a higher level. Even though the VIX has come down from its highs, this crisis level volatility has yet to fully subside. At the very least, a move into the orange zone is required to move from crisis levels to normal bear market levels. Boy, now that's encouraging. At current levels, the fear factor remains extremely high and a sustainable advance in stocks is unlikely until fear subsides.

Chart 2

NOOSE TIGHTENS FOR THE VXN... With the Nasdaq Volatility Index ($VXN) narrowing in 2009, the direction of the breakout will likely offer important clues for Nasdaq direction. As pointed out above, increasing volatility is usually accompanied by weakness in stocks. Conversely, decreasing volatility usually coincides with strength in the stock market. Chart 3 shows the Nasdaq Volatility Index ($VXN) with the Nasdaq Composite below. VXN rose as the Nasdaq declined (Sep-Oct-Nov) and fell as the Nasdaq edged higher (Dec-Jan). VXN bounced off the rising 200-day moving average in early January and again in late February. The indicator also met resistance at the falling 50-day moving average this year. You could say that the Nasdaq Volatility Index is caught in a moving average sandwich. A decisive break could be coming soon. A move above 50 would break the 50-day line and this would be bearish for stocks. A move below 40 would break the 200-day and this would be bullish for stocks. Chart 3 shows the S&P 500 Volatility Index ($VIX) with similar characteristics.

Chart 3

Chart 4