Two Important Areas To Watch- $VIX and Financials

• 10-day ROC for the VIX may have a message for traders
• Close that gap on your way out
• Financials, a canary in the coal line for stocks in general

Last week I wrote about the $VIX and concluded that a low reading, such as we recently saw, usually precedes a market top by many months. Extremely low readings therefore, are not much help as timing devices. On the other hand, I also featured Chart 1, which demonstrated that when the $VIX reaches an extreme and reverses, it often signifies an impending correction. Chart 1, by the way, plots this indicator inversely in order to correspond with price movements in the S&P Composite. Moreover, the displayed series are 10- and 20-day EMA’s as an attempt to smooth out, what would otherwise be, a very volatile series. By these measures the VIX is now caught in a bearish trend.

Chart 1

10-day ROC for the $VIX may have a message for traders

Having said that, Chart 2 shows that the inverted 10-day ROC, calculated from the raw $VIX data, has already reached the buying zone. This is identified by the horizontal green line. The arrows show that reversals from at or above this level have typically been followed by a rally of some kind. The dashed arrows were also followed by a small advance, but these signals were, in all honesty, false positives, except for traders with a really short time horizon. We do not know at this point whether the ROC has peaked or not, but this exercise does suggest that yesterday’s selling squall may well be close to the end of the decline. Remember, surprises typically fall in the direction of the primary trend and that is clearly up. From a contrary aspect, the recent widespread media attention using this indicator as a bearish factor also supports the bullish view.

Chart 2

That conclusion may seem to contradict the high and falling reading as shown in the first chart. However, it’s important to remember that, for the $VIX, the trend is equally, if not more important, than the actual level. If the ROC is peaking, then that could have the effect of triggering a trading range. In that respect, Chart 3, which plots an earlier period, uses several rectangles that show trading ranges in the VIX that developed at relatively high levels. In these instances, the market, on a short-term basis, escaped relatively unscathed.

Chart 3

Close that gap on your way out

Gaps are created in charts when prices respond emotionally to unexpected good or bad news. They literally show up as blank spaces between one day’s trading range and that for the next day, as traders rush to buy or rush to the exits, depending on the nature of that news. Whenever, you have a heated argument with a loved one, or anyone else for that matter, time has the effect of calming down those feelings. One party may even revisit those emotions by apologizing to the other, thereby giving the relationship a fresh start. Gaps, being emotional parts of a chart, are similar in nature. Once the excitement dies down prices often retrace ground gained or lost by “closing” the gap. It’s a fact that pretty well all gaps are eventually closed. Alternatively, a good attempt at closing them is made. The problem, is that we do not know when it will happen.

Chart 4 features some gaps that developedon the DIA ETF in the February/April period. They were all closed pretty promptly. Wednesday’s action created a large downside gap, and that, of course has yet to be filled. It seems to me, that the odds are far better than 50/50 for some kind of a gap closing rally to develop. The problem is we do not know when.  My bet, given the ROC action of the $VIX is that it will be sooner rather than later. There is another point.

Chart 4

Wednesday’s gap action is not that far above current prices, so it doesn’t imply much of a rally. However, Thursday’s action partially does. That’s because it almost completed a bullish piercing white line. These short-term patterns are best formed after a decline, when the price of the “piercing” candle opens below the low of its predecessor and closes more than half way up its real body. In this case that would be above the green horizontal line. Usually, these formations occur after a lengthier decline than took place earlier this week. Wednesday’s sell-off though, was very well publicized in the general purpose media. That attention reflected the kind of extreme concern that is consistent with a short-term bottom. The final point about DIA on Chart 5, is that this price action was associated with a mini-selling climax, in which the rising second candle volume was higher than that of the previous declining one.

Chart 5

In conclusion, there are several factors that suggest that this week's decline may not be as bad as it may first look. However, with the short-term KST for the Dow (Chart 4), turning down there is little margin for error. Consequently, if Thursday's low is taken out, all bullish bets on the near-term trend should be put aside for later.

Financials, a canary in the coal line for stocks in general?

Financials moved up earlier this year in anticipation of Trump induced deregulation and the expectation of improved profit margins due to rising interest rates. Now however, Chart 6 indicates that the Spider Financials (XLF), may be tracing out, a possible head and shoulders top. The KST is also precariously balanced. Until the “top” is completed we should not jump the gun. However, since prices remain above their 200-day MA the benefit of the doubt should be given to the bull, especially if a decisive daily close above the green down trendline at $23.75 takes place.

The outcome will obviously be important for financials themselves. However, since a favorable environment for this sector is generally bullish for the overall market, there are wider implications. Chart 7 shows the relative strength for the Spider Financials (XLF). It recently broke out from a major base, but has since retraced some of that ground. So far, the breakout and the 65-week EMA remain intact, but the long-term KST for relative action may have started to flatten. If the head and shoulders in Chart 6 is completed, the relative KST will likely reverse to the downside. Why is this important?

Chart 7

Chart 8 compares this relative Financial KST to the S&P Composite ($SPX). The green shaded areas indicate when the KST is rising. As you can see, there is little market danger when this is happening. That’s because, the important declines since 2005 all developed in the white areas of the chart i.e. when the relative KST was declining.

Chart 8

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.