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No Hindsight Here

Here is a portion of one of my Weekly Strategy Sessions, this one published for members last December 30th, 2012, as the futures markets were pointing to a much lower open on New Year’s Eve. Sentiment was bearish and emotions were running high. However, we observed the leading small caps and financials gave the bulls the edge with respect to resolving the S&P 500 versus Volatility Index divergence. Since then, and since the November correction lows, both of those sectors have indeed favored the bulls. 

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To put the current market moves and spikes in fear in perspective, consider the VIX (CBOE Volatility Index), which tends to be a gauge of the amount of fear in the options market–The higher the VIX, the higher the fear. Historically, the VIX tends to trade inversely to stocks (but not always in a tight correlation).

First, a daily chart look at the VIX reveals that it is riding along outside its upper Bollinger Band. Recall that Bollinger Bands are useful for measuring relative tops and relative bottoms, as well as expansions in volatility on a given chart. Here, the VIX riding along outside its upper Bollinger Band several days in a row is an exceedingly rare occurrence. Historically, this spike in fear tends be erased rather quickly. However, keep in mind the market’s increased sensitivity to news flow at this time means that the spike in fear can spike higher yet.

The interesting divergence presents itself when we observe the weekly charts. Recall back in my November Strategy Sessions when I noted that the VIX was not indicating much fear at all compared to prior broad market price corrections since the March 2009 bull run began.

Currently, the VIX has exceeded levels it reached during the November 16th lows in the stock market. And yet, the overall market is still nowhere close to breaching those lows. Thus, we have a clear divergence here, with the amount of fear in the options market not necessarily lining up with prices in equities.

By nature, divergences either resolve one way or the other, meaning price will follow the VIX and the market will sell-off much further, or instead the VIX will follow the market and fear will quickly abate as stocks probably rally. Again, this headline-driven holiday market forces us to remain agile in our approach as we work through another holiday-shortened week that is bound to be defined by whether or not the federal government offers any type of solution to the Fiscal Cliff which the market deems appropriate.

2. In Looking for Clues as to Which Way the S&P/VIX Divergence Will Resolve, Focus on the Whether the Resilience of the Small Caps and Financials Continues.

While we know many large cap technology stocks, such as Apple, continue to struggle to sustain a bounce, and retail/consumer discretionary stocks faced some heavy selling last week, the leaders off the November 16th correction lows continue to defy the bears’ sharp claws.

As an example, the high beta small market capitalization stocks housed in the Russell 2000 Index held their rising 20-day moving average after an expected consolidation. After puncturing its upper Bollinger Band on the daily timeframe, the Russell pulled back to its “middle Bollinger Band,” which is simply the 20 period moving average on any given timeframe. Despite Friday’s late-day sell-off, the Russell held above Thursday’s lows, not to mention the 20-day moving average. Also note the 50 and 200-day moving averages on the Russell are both inclining, adding credence to the bull case. All-time highs remain not far above, at 868. Finally, the inverse head and shoulders bullish setup remains intact.

This type of relative strength is impressive, particularly given the spike in fear and market volatility. Logically, you would think the small caps would be leading the selling to the downside. Instead, they remain resilient and give the bulls the best chance at resolving the S&P/VIX divergence in their favor.

As a result, I am closely watching the small caps into next week to see if Thursday’s lows hold.

Moreover, the financials have been another major leader off the November correction lows, not to mention for all of 2012. Observing their sector ETF chart below, we can see a similar resilient pattern–Upper daily chart Bollinger Band puncture, followed by a pullback to the rising 20-day moving average that held true. Here, again, we have a rising 50 and 200-day moving average to give the bulls some credibility.

Should these bullish setups weaken next week, with last Thursday’s lows meaningfully breached, then the case for becoming increasingly defensive (raising even more cash, looking at some quick shorts) grows stronger. Thus far, though, these leaders are weathering the Fiscal Cliff storm well.

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