DOW CHOPS LOWER - VIX SURGES AND STAYS ELEVATED - VOLATILITY AND STOCK MARKET REMAIN INVERSELY CORRELATED - DEFENSIVE SECTORS PERKING UP - OIL SURGES AS GAS INVENTORIES CONTRACT - GOLD AND METALS ALSO BOUNCE

VOLATILITY REIGNS SUPREME... Video Link (click here) For the second time in six days, the stock market plunged and recovered - though todays plunge-recovery was much quicker than the previous. Chart 1 shows the Dow Industrials plunging after the FOMC policy statement last Wednesday afternoon. The Dow stalled for a few days and then recovered on Monday. Todays plunge was attributed to the Chicago PMI (purchasing managers index). Consensus estimates were around 52, which would show economic expansion. Instead, Chicago PMI came in at 46.1, which shows weakness in manufacturing. Basically, readings above 50 reflect economic expansion, while readings below 50 reflect economic contraction. Despite this initial plunge, the stock market came roaring back. After being down over 100 points in early trading, the Dow moved into positive territory in the early afternoon. However, these gains proved fleeting as sellers pushed the Dow into negative territory by the close.

Chart 1

Overall, the Dow remains within a falling channel over the last six days. This pattern looks like a falling flag on the daily chart (Chart 2). A move above 9800 is needed to break the upper trendline. This means we need to see follow through to todays rebound rally. Otherwise, it looks like a dead-cat bounce. Chart 1 also shows the S&P 500 Volatility Index ($VIX) at the bottom. Notice how the VIX surged with the post-Fed plunge and remained high the last five days. Even with Mondays surge back above 9800, the VIX remained at relatively lofty levels. This reflects an increase in the fear factor. I consider this bearish for the stock market. Why? Increasing fear is conducive to selling pressure. The next section underscores this point.

Chart 2

VIX REMAINS IN OVERALL DOWNTREND... The stock market has been rising as volatility (fear factor) falls. Chart 3 shows the S&P 500 Volatility Index ($VIX) with the S&P 500. Notice that the VIX peaked in March and the S&P 500 bottomed in March. Clearly, these two have been inversely correlated over the last seven months. Earlier this month, the S&P 500 recorded a new reaction high as the VIX hit a new reaction low. Judging from this correlation, it seems that the bulls like falling volatility. The August-September highs mark downtrend resistance for the VIX. A break above this resistance zone would be bullish for the VIX, but bearish for stocks. In a similar vein, the August-September lows mark support for the S&P 500. A break below this support zone would reverse the uptrend. Chart 4 shows the Nasdaq 100 Volatility Index ($VXN) for reference. Chart 5 shows the S&P 500 VIX Short-Term Futures ETN (VXX) with a small inverse head-and-shoulders pattern.

Chart 3

Chart 4

Chart 5

DEFENSIVE SECTORS START SHOWING RELATIVE STRENGTH... Even though the medium-term trend for the major indices and the key sectors remains up, the defensive sectors are starting to show some relative strength that could foreshadow a correction or pullback. Chart 6 shows the SPDR Sector Perfchart since September 1st. On an absolute basis, all nine sectors are up this month. However, this chart shows performance relative to the S&P 500. Even though the offensive sectors show relative strength for the month, they are not as strong as they were in the middle of the month. As the red arrows show, relative performance for the Technology SPDR (green) peaked around September 10th. Relative performance for the Materials SPDR, Energy SPDR and Industrials SPDR peaked in mid September. Relative performance for the Financials SPDR peaked around 22 September.

Chart 6

While relative performance for these offensive sectors is waning, relative performance for the defensive sectors is picking up. Notice that the relative performance lines for the Utilities SPDR, Healthcare SPDR and Consumer Staples SPDR bottomed over the last 1-2 weeks (green arrows). In fact, chart 7 shows these defensive sectors outperforming the S&P 500 over the last five days.

Chart 7

OIL BOUNCES ON SUPPLY CONTRACTION... Oil plunged after an unexpected increase in oil inventories last week. Today, an unexpected decrease in gasoline inventories triggered a buying binge in gasoline. Chart 8 shows the US Gasoline Fund ETF (UGA) finding support at 30 and surging above 32 today. The bottom indicator window shows how close oil and gasoline track. With buying enthusiasm spreading to oil, chart 9 shows the US Oil Fund ETF (USO) moving back above its support break. Wednesdays big surge put in a reaction low that calls for a reassessment. It is now possible that a triangle is taking shape with resistance around 38-39. A break above the August highs would be bullish for oil. Right now, we have a failed support break and move back into the consolidation zone. Lets see some follow through before considering it more. The situation with Iran is also likely affecting the oil market and will continue to weigh in the coming weeks/months.

Chart 8

Chart 9

OTHER COMMODITY ETFS SURGE... Strength in commodities was not limited to oil and gasoline. Chart 10 shows the Agriculture PowerShares (DBA) advancing over 1% and challenging the triangle trendline. Chart 11 shows the Base Metals ETF (DBB) bouncing off support from the September lows. After the July-August advance, DBB consolidated with an ascending triangle and a break above the September highs would signal a continuation higher. Chart 12 shows the Gold ETF (GLD) finding support at broken resistance around 97 and moving back towards 99.

Chart 10

Chart 11

Chart 12