VIX IS TESTING BOTTOM END OF SHORT-TERM TRADING RANGE --RISING VOLATILITY IS GOOD FOR DEFENSIVE STOCKS -- NASDAQ RETESTS BROKEN SUPPORT NEAR 2600 -- GERMAN DAX IS BOUNCING FROM OVERSOLD CONDITION BUT REMAINS IN BEAR MARKET
VIX STALLS AT PREVIOUS RESISTANCE LEVEL ... Two Thursdays ago (September 1) I wrote about the CBOE Volatility (VIX) having reached previous resistance formed during the spring of 2010 near 48. Chart 1 shows that the VIX has backed off from that overhead barrier which has helped stabilize the stock market (green arrow). In fact, the only time that the VIX moved significantly above the area around 48 was during the 2008 market meltdown when it reached 90. So this is an important test of whether the market is just in a normal downside correction or something more serious. Needless to say, a VIX close above 48 would have very negative implications for the market.

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Chart 1
VIX TESTS SUPPORT... Chart 2 shows the VIX trading between overhead resistance near 48 and underlying support near 30. Support near 30 is derived mainly from the previous peak formed during March (red arrow and line). A broken resistance level usually becomes new support on downside corrections. You can see the red resistance line turning into a green support line during August. You can also see the VIX bouncing off that support line twice over the last month. Chart 3 shows the VIX nearing a possible retest of that support area. That's an important test for the S&P 500 (above chart) which trends in the opposite direction of the VIX. Right now, both are in short-term trading ranges. The ability (or inability) of the VIX to stay above its August lows near 30 should help determine the short-term trend of the SPX. It would take a VIX close below 30 to give a bigger boost to stocks.

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Chart 2

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Chart 3
DEFENSIVE TIES TO THE VIX... The direction of the VIX also has some bearing on sector rotation. The three lines on the main chart below are relative strength ratios of staples (top line), healthcare (green line), and utilities (red line). Those three defensive stock groups were market underachievers during the bull market that started in spring 2009. More importantly, the jump in the three RS lines this year (which we pointed out during April) showed a clear rotation into defensive stocks as investors correctly anticipated a market downturn. That's where the VIX comes in which is the bottom line in Chart 4. Since utilities have been the strongest performers during 2011, let's use them as an example. The red line in Chart 5 is a relative strength ratio of utilities (XLU) divided by the S&P 500. The black line is the VIX. The tendency for both lines to trend in the same direction is very clear. Both bottomed together at the end of April and turned up sharply together during July (as the market weakened). That makes sense. Rising volatility pushes investors into defensive categories like utilities. Hence, defensive stocks are a good place to be in a climate of rising volatility. The fact that those sectors pay dividends is also helpful in a weak stock market.

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Chart 4

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Chart 5
NASDAQ RETESTS 2600 RESISTANCE... Coincidentally, my September 1 message also showed the Nasdaq Composite retesting resistance at 2600. Chart 6 shows broken support at the March/June lows (green arrows) being retested for the second time in a month. Notice how the green support line drawn under previous lows turns into a red resistance line once those previous supports are broken. The Nasdaq is also testing its (blue) 50-day moving average. This is the first significant test of overhead resistance by any of the major market indexes and bears close watching. By comparison, Chart 7 shows the S&P 500 still trading well below its late August peak and 50-day line. The SPX would have to clear to clear both levels to improve its short-term outlook.

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Chart 6

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Chart 7
GERMAN BEAR IS OVERSOLD ... It's no secret that events in Europe are helping drive events in the U.S. Germany is the largest economy in Europe and has lot of influence. The bad news is that the German DAX has fallen 30% from its spring high and is in a bear market. The good news is that it's retraced 62% of its 2009/2011 uptrend and is in an oversold condition. The 14-week RSI line (below chart) is in oversold territory under 30 for the first time since late 2008. This week's upside reversal has produced a 6% price jump which is helping support markets around the globe, including the U.S. Problem is that it's going to take a lot of market work and time to reverse the German bear market. So while the short-term outlook is improving a bit, the longer-range trend remains down.
