Friday, January 27, 2012

The Slow Train Wreck Difference

In two earlier articles (The Market Technicals - Get Back In The Water? and The Fear Roller Coaster - Are We There Yet?) I pointed out some striking similarities between now and mid-2008 - the lull before the annihilation. Here, I'd like to add some more similarity, but then consider a major difference.

Technical formations have predictive power because they resolve themselves up or down at a rate much better than 50%. How useful they are depends on how far away from 50%. The head and shoulders formation, for example has about a 65% success rate for predicting a trend change. One of the formations with the highest success rate is the descending wedge at about 90%. This is a bullish signal where a quieting down trend breaks strongly to the upside. If you apply it to the VIX, the market's fear index, you get another bullish signal (bearish for the stock market).

If you look at what the VIX did during 2008, you see not one, but two descending wedges:

The formation was 2 for 2 over this time with both breaking sharply to the upside. Both ran the VIX briefly below the critical 20 level that typically divides bull from bear markets, but it couldn't stay there for long. And they both dropped the VIX below the 140/200 day ema moving average pair for a short time and induced a negative divergence between them.

So what's the VIX doing now?

Egad ! The very same thing. We're definitely in a descending wedge and it has put us below a VIX 20 and the moving average pair. So are buyers of the present rally chumps being set up for the kill? Is it the end of the world again once this formation breaks?

Well, let's just curb our apocalyptic fervor. The market is way overextended on the upside and a correction is likely not too far away. But there are powerful fundamentals at work that make now much different than 2008. There is the basic and powerful economic cycle that tends to overrun a lot of other concerns. In 2008, it was on the downside. Now it is going the other way, albeit in a very subpar recovery so far.

But maybe more important than that is something that Michelle Caruso Cabrera of CNBC points out about the European banking crisis, which presumably would be the catalyst for another end of the world sell off. She is CNBC's guru on the scene in Europe, and she calls what is happening there now a very slow train wreck version of the very fast and surprising train wreck that hit the US in 2008. And Jim Cramer has said that, even though half-measures being implemented, the kicking of the can down the road, is reviled by us all, it buys time for the banks to collateralize and capitalize and do whatever needs to be done - critical time that they did not have in 2008. What made the sell off of 3 years ago so bad was the prospect of a lockup of the financial system, but now the Germans and others have made it clear that they will print money as needed to prevent that.

A market correction is very likely soon, which will break the wedge on the charts and carry out a repeat of the downturn, but how severe that downturn will be is very uncertain. That will all depend on how well the banks and governments in Europe are using their time to ready themselves for defaults, CDS kick-ins and who knows what. The shape of the upcoming correction will give us a clue as to how severe it will be. As in May of 2008, we now have poked our nose above the 140 day ema, but the turn out of the first VIX wedge back then sent the S&P decisively back below the 140. If a correction now looks to be holding near the 140 nicely, then we may have some clear sailing ahead. It would be a very positive sign for the market.

But if it breaks strongly back below the 140, batten down the hatches. Europe's troubles don't seem to matter lately, investors are fatigued with it. But in the next major correction, they will revisit what they're doing over there, and if they like what they see, we may derail from the 2008 path to apocalypse - the slow train wreck difference. A sell off to a little below the 140 on the Russell would be your 10% bull market correction, so how the next significant downturn behaves around this critical moving average pair is going to be critical. One should be cautious until then.

1 comment:

  1. nice to find your blog.

    like to comment on this?