This rally may have legs.
joefrocks.com Oct 11, 2002 6:00:00 AM
trading-ideas.com
VIX (OEX (S & P 100) Volatility Index (basically represents value stock volatility)) rose above 50 early on Thursday (closed at 46.29) and ignited a very sharp rally in the major averages (The NASDAQ Composite (COMPX rose 49.26 points (+4.42%) to 1163.37) with an assist from a sharp rise in VXN (NASDAQ 100 Volatility Index) which rose to 64.38 early on Thursday from Wednesday's close of 62.38. VIX rising above the extreme level of 50 in late July led to a rally in the major averages lasting nearly a month because investors/traders and some of the smartest people in the investing business mistakenly thought an intermediate term (3+ months) cycle low had occurred. This time I doubt the rally will last four days let alone four weeks.
The problem was that growth stocks hadn't reached an extreme of fear at that time (VXN rose to 72 or so in late July versus 91 when the last cycle low on 9-21-01 occurred) so a true cycle low didn't occur. The same was the case on Thursday with VXN peaking at 64.38 which is a high but far from extreme level of fear.
Despite a very sharp rise in the major NASDAQ averages on Thursday the NASDAQ Advance/Decline Ratio wasn't overly impressive at a bit more than 20:13. Also, the better than 6:1 ratio in favor of up volume can largely be attributed to a few stocks such as Cisco Systems (CSCO) with 138 million shares and Yahoo (YHOO) with 62 million shares. Also, the NASDAQ TRIN spent nearly the entire session in overbought territory below 0.35 (indicating overwhelmingly more activity in rising issues) on Thursday which is a negative.
The NASDAQ Composite (COMPX) opened modestly higher on Thursday, briefly fell into negative territory as the primary growth stock indicators correctly foretold at Wednesday's close (VXN (NASDAQ 100 Volatility Index) was little changed during the last two hours of trading on Wednesday as COMPX fell sharply which was a sharp jump in complacency late in the session that portended weakness early on Thursday), then the very sharp "VIX 50.00" rally in the major averages began when VIX rose to a session high 50.48 and VXN rose above 64.00. The major averages were firm the remainder of the session.
A major degree of fear crept into the NASDAQ on Thursday with VXN (NASDAQ 100 Volatility Index) rising 0.44 (+0.71%) to 62.82 despite a very sharp rise in NDX (NASDAQ 100) of 42.15 points (+5.22%) to 849.57 which is a major rise in fear given that NDX rose very sharply and VXN also rose when it normally would have declined very sharply given a very sharp rise in NDX.
Since a "VIX 50.00" rally is underway and VXN revealed a major rise in fear on Thursday this rally may have legs. However, I doubt it'll be more than a 2-3 day affair, but, it might be since VIX rising above 50.00 is a major buy signal as the very strong rally following the July 24 low proved. The fact that the CBOE Put/Call Ratio closed at 0.97 on Thursday means there may be weakness early on Friday, but, unless VXN/QQV reveal a sharp jump in complacency early on Friday it's likely to be a good trading opportunity.
A technical buy signal occurred on Thursday with RSI (Relative Strength Index) for QQQ (NASDAQ 100 Tracking Stock) rising well above 30 (to 50) and the fast stochastic rising well above the slow stochastic from a level below 20 to close at 24. Follow through on Friday will confirm the buy signal but this is another buy signal that is likely to fail. That is, RSI and/or the stochastics will probably fail to reach overbought territory (RSI above 70 and the fast stochastic above 80).
VIX, the OEX Volatility Index (basically represents value stock volatility), closed at 49.48 on Wednesday which bordered on an extreme level of 50.00. Once it rose above 50 (as occurred on Thursday) it sparked a very sharp rally.
In order for cycle low conditions to occur (extreme fear marked by VXN near or above 80 as occurred during last year's cycle lows in April and September), the major NASDAQ averages would have to fall substantially from current levels.
QQV (QQQ Volatility Index) fell (Delta QQV of -1.21 (-2.23%) to close at 53.03) on Thursday while QQQ (NASDAQ 100 Tracking Stock) rose +1.02 (+5.09%) to 21.08 which was a sharp jump in fear being that QQV fell much less in percentage terms than QQQ rose.
In this treacherous market one needs to err on the side of caution and wait for both VXN and QQV to reveal a very sharp rise in fear (as occurred early on Tuesday 10-1 just prior to the very sharp rally) before beginning to get excited about the prospects for a decent rally. Also, a very oversold condition should be present before looking for a decent rally (present at Monday 9-30's close). Therefore, since VXN and QQV revealed a major/sharp jump in fear on Thursday and a "VIX 50.00" rally is underway, it's reasonable to expect strength early on Friday though it may not occur until after brief weakness shortly after the open. The NASDAQ TRIN closed at an overbought level of 0.23 (indicating overwhelmingly more activity in rising issues) on Thursday.
The CBOE Put/Call Ratio closed at a high (at or above 0.90 but below 1.05) level of 0.97 on Thursday which points to a weak NASDAQ Composite (COMPX) early on Friday because it's a reliable non contrarian indicator of the next session's early action (except at extremely high (at or above 1.05) or extremely low levels (at or below 0.50) where it becomes a contrarian indicator).
Tuesday 9-17's very high CBOE Put/Call Ratio of 1.20 and Monday 9-30's very high CBOE Put/Call Ratio of 1.09 correctly indicated that a sharp rally was near just as it correctly portended a sharp rally previously when it rose to 1.15. It appears at a very high level at or above 1.05 (as opposed to 1.00) that the CBOE Put/Call Ratio becomes a reliable contrarian indicator. 1.05 seems to be the level which indicates fear has become extreme very short term and a sharp short term rally is near.
The NASDAQ TRIN closed at an overbought level of 0.23 (indicating overwhelmingly more activity in rising issues) on Thursday which is negative technically but the "VIX 50.00" rally probably has legs. A level between 0.35 and 0.80 is a bullish range for the NASDAQ TRIN because it indicates much more activity in rising issues. A NASDAQ TRIN above 1.00 indicates more activity in declining issues. A NASDAQ TRIN between 1.20 and 1.50 is a clearly bearish "red zone" range because it indicates much more activity in declining issues but not a very oversold condition. If the NASDAQ TRIN rises above 1.50 you can begin to look for a rally and if it rises above 2.00 that tends to be a reliable short term buy signal (very oversold condition). Keep in mind that capitulation has begun in earnest so COMPX generally won't rally (when it does rally in this sharp downtrend) nearly as much as under normal (non cycle low capitulation phase) circumstances.
Given the increasingly muted/short lived nature of the rallies in recent sessions even when preceded by an extremely oversold condition and a sharp rise in fear, it's difficult to predict when a sharp sustained rally will occur though a CBOE Put/Call Ratio at or above 1.05 has been a reliable indication that a sharp rally is near. The best that can be expected (until a cycle low occurs) is a sharp one or two day wonder rally.
Look for gold to soon resume trending higher as the major averages are likely to decline toward a cycle low by the end of October. $330.00 is the next major resistance level likely to be broken given that the major stock indices appear to be headed substantially lower before a cycle low occurs. After $330.00, $340.00 is another important resistance level. There might be a lot of money to be made in the gold stocks during the next few weeks but keep in mind they can be extremely volatile as they have been recently.
The HUI (AMEX Gold Bugs Index) stochastics are in the oversold "buy" area as of Thursday. However, waiting for a clear buy signal (fast stochastic breaking well above the slow stochastic) makes sense now since the gold/silver stocks are still acting on a short term sell signal and gold/silver broke down on Tuesday with gold falling to $318.20 and silver falling to $4.35.
The likely Iraq war may present an outstanding trading opportunity. The start of the war could coincide closely with the cycle low in the major stock indices which makes for a possible change in my trading plans. I had planned on switching entirely out of gold stocks (I'm about 20% gold stocks and 80% cash now) and entering a large QQQ position at the cycle low. Now I may hold most or all of my gold stocks and possibly even add a bit to them and still enter a large QQQ position at the cycle low. Between the Iraq war and a cycle low occurring at about the same time gold could have a very impressive move up and may slice through major resistance levels such as $330.00 and $340.00 like a knife through butter which would rally the gold stocks in a big way.
Value stock volatility (VIX, OEX Volatility Index, is mostly value stock volatility because the S & P 100 appears to be about 75-80% value stocks. VIX largely reflects value stock volatility) is running well ahead of growth stock volatility as it did when the July 24 quasi cycle low occurred with VIX at a very high level (above 40) of 46.29 as of Thursday's close and VXN at a high level (above 60) of implied volatility/fear at 62.82. For VXN to be at an equivalent "very high" level of implied volatility/fear it would be at or above 70 which is where it was (at 70ish) when the July 24 quasi cycle low occurred. Growth stocks are much more volatile than value stocks hence the differing levels for "high" implied volatility and "very high" implied volatility for VIX and VXN.
The disparity between growth and value stock implied volatility/fear is making timing the cycle low more difficult and more interesting. I think VXN must at least reach 75 and probably 80 before a true cycle low can occur. It reached 91+ when the last cycle low on 9-21-01 occurred as I've discussed previously. It also spiked above 80 when the April 2001 cycle low occurred. We may get another "VIX headfake rally" that will prolong the cycle low process but it's unlikely it will be as strong as the rally that ensued after July 24. I am confident however that a true cycle low will occur by the end of October thanks to mutual fund tax loss selling ahead of their October 31 fiscal year end.
The enormous rise in complacency which occurred during the major headfake rally after the July 24 quasi cycle low (Thursday 8-8's being the most notable (VXN (NASDAQ 100 Volatility Index) plunged 9.49 points (-13.79%) to 59.35)) portends a very sharp drop in the major NASDAQ averages in the near future (correctly portended the current sharp decline which began on Friday 8-23). All the major stock indices are likely to fall sharply in the near future since a cycle low appears to be fast approaching and a seasonally weak period for stocks is at hand (September/October). Also, earnings warning season for the third quarter has begun in earnest which is adding to the already strong selling pressure this time of year (mutual fund tax loss selling and seasonality jitters) and at this late stage of a market cycle.
Nova Fund Assets/Ursa Fund Assets closed at 0.219 on Thursday which is bearish (very low and trending lower indicating rising fear - the cycle is heading down). Also, NASDAQ/NYSE Composite NH (New Highs)/NH+NL (New Lows) closed at 0.134 on Thursday which is bearish (trending lower - breadth is deteriorating which indicates the cycle is heading down). NASDAQ/NYSE Composite NH/NH+NL is definitely a primary indicator being that it's a breadth indicator. Also, the Rydex Nova/Ursa Ratio is a primary indicator because it's a fundamental measure of wether investors are bearish (more money in the defensive Ursa Fund) or bullish (more money in the aggressive Nova Fund).
The NASDAQ 100 (NDX) put in a nice double bottom at the end of July/early August which was another major trigger for traders in addition to VIX reaching an extreme level above 50. But, growth stock fear/volatility didn't rise far enough (VXN peaked a bit above 70. Rose to 91+ when the 9-21-01 COMPX cycle low of 1387 occurred.) for a true cycle low to occur. Value stock volatility was far ahead of growth stock volatility (growth and value have separate cycles but they bottom at the same time) which led to the big rally that began after July 24.
The quasi cycle since the July 24 low strongly supports my view that VXN must approach or exceed 80 as it has in recent cycle lows (fear must become extreme) in order for a true cycle low to occur. July 24 came very close to being a cycle low and was a great test of my work. My work has clearly been vindicated. The cycle which began on September 21, 2001 is still in effect and is clearly headed lower. The major market sell signal (occurs near an extreme of complacency) that occurred in March when VXN fell below 40 (COMPX was at 1950) is still in effect.
To get a good idea of the enormous degree of complacency that crept into the market (prior to Friday 8-23's technical sell signal) since the 7-24 Bear Market low of 1192 (COMPX) consider this: Since 7-24 the NASDAQ 100 rose about 22% as of Thursday 8-22 which was a very nice gain. However, VXN fell from about 70 to 45.00 on Thursday 8-22 which is a 35.71% decline. So, a very large degree of complacency crept into the market during the rally from the 7-24 Bear Market low of COMPX 1192 which correctly portended a sharp decline. After less than a month's time VXN approached a level (40) which is a major market sell signal because it indicates an extreme of complacency/low volatility is near (occurred in March when COMPX was at 1950).
At true cycle lows fear becomes much more extreme than it did on 7-24 (VXN at about 70. Spiked to 91+ at the September 21, 2001 cycle low and well above 80 when the April 2001 cycle low occurred). Also, complacency doesn't creep back into the market as quickly as it did during the recent rally since 7-24. The recent rally was a nice trading rally (or maybe a phantom quasi cycle) as opposed to a new intermediate term cycle, which has reversed course in a major way due to the enormous rise in complacency which occurred during the headfake rally (Thursday 8-8's being the most notable (VXN (NASDAQ 100 Volatility Index) plunged 9.49 points (-13.79%) to 59.35) and the fact that the cycle is still headed lower (July 24 was NOT the start of a new 3-6+ month cycle) as well as the fact that mutual funds do their tax loss selling in September/October ahead of their October 31 fiscal year end. In other words, buckle up!
People who mechanically rely on one indicator such as VIX tend to get into trouble. This is why I look at a variety of primary indicators such as VXN, QQV, VIX, Advance/Decline Ratio, Up/Down Volume, total volume, money flow, Investor's Intelligence survey of advisor bullishness, etc. I would call the July 24 Bear Market low a quasi cycle low at best because VIX reached an extreme level of 50+ but VXN fell well short of an extreme 80+ (it rose to about 70 on 7-24. Spiked to 91+ on 9-21-01). Kind of an unusual occurrence.
Intermediate term cycles tend to be 3-6 months in duration in recent years. There were two cycle lows in 2001 (April and September). However, the current cycle began on September 21, 2001 and will probably end in the next month or so which will be about a one year cycle.
Since there was an enormous rise in complacency during the headfake rally after July 24 (there was a huge jump in complacency on Thursday 8-8 (VXN (NASDAQ 100 Volatility Index) plunged 9.49 points (-13.79%) to 59.35) and breadth was overwhelmingly negative on Tuesday 8-13, was negative on August 20, 23, 27, 28, 30, was overwhelmingly negative on September 3, 5, 12, 16, 17, 18, 19 & 23, was negative again on September 27 & 30, and was very negative on October 2, 3, 4, 7, & 9, the primary growth stock indicators portend a continuation of the sharp downtrend toward a cycle low during the next few trading sessions, however, the "VIX 50.00" rally could persist for a few more sessions. With the cycle clearly headed lower it's much safer to be cautious.
I see three scenarios for the cycle low. The most likely I still feel is the extreme cycle low such as occurred in April and September of last year when VXN spiked above 80 (spiked to 91+ on the 9-21 cycle low). The second is a moderate cycle low where VXN falls short of 80 with a likely retest and double bottom formation occurring. The third scenario is an unlikely crash with VXN spiking well above 100.
Breadth, a primary indicator, was very positive on Thursday with NASDAQ A/D at better than 20:13 in favor of advancing issues and NASDAQ Up/Down Volume was in favor of up volume by better than 6:1. Once the cycle low occurs and a new upcycle begins breadth should turn convincingly positive during the early high fear part of the cycle. Growth (NASDAQ is mostly growth) will be more timely than value (NYSE is mostly value) but both should rise sharply during the early high fear (VXN > 60, VIX > 30) part of the cycle.
In this capitulation phase of the cycle low process large increases in fear don't generally lead to the same magnitude, duration, or frequency of rallies though a nice rally resulted from July 24's "pseudo" cycle low (VIX above 50 and an NDX double bottom formation). Total capitulation followed by extreme fear/volatility could result in a cycle low during the next few weeks so stay focused and have your strategy mapped out.
There just hasn't been the extreme fear, panic, and volatility yet that marks cycle lows. VXN is at 62.82 as of Thursday and I expect it to briefly spike above 80 and possibly even 90 the day the cycle low occurs. It's likely that will be the only day that VXN spikes above 80, especially if it rises above 90. The more extreme fear becomes the more likely a "V" shaped cycle low occurs as opposed to a "W" shaped retest cycle low occurring probably as a result of a more moderate peak level of fear.
A great trading opportunity may be at hand. Keep in mind that from the September 21 COMPX cycle low of 1387 to the cycle high in early January of about 2100 COMPX gained about 50% in three and a half months. So, a very nice gain will probably result if one buys QQQ near the cycle low and exits once a complacent, fairly low volatility market arises (VXN below 50).
Capitulation has become the dominant factor now and a respectable sustained rally (more than a one or two day wonder due to a very oversold condition/jump in fear) generally will not occur until the cycle low is put in. This is a market desperately in need of a cycle low (marks the start of a new cycle).
The very steep drop in Investor's Intelligence from 48.9% of advisors bullish nineteen weeks ago (53.0% bullish twenty weeks ago) to 42.9% eighteen weeks ago (released Wednesday 6-12 but reflects advisor sentiment of the prior week) to 36.7% on Wednesday 8-21 (38.0% on 10-2) is further dramatic evidence of the major capitulation in the market and that a cycle low is fast approaching. A level below 40% is a major intermediate term buy signal (occurred 7-10 when Investor's Intelligence fell to 39.8% of advisors bullish) but wait for VXN (finetunes intermediate term timing) to spike above 80 or at least approach that level prior to buying.
Given that Investor's Intelligence fell a sharp 4.1% of advisors bullish on Wednesday 6-5, a very sharp 6% of advisors bullish on Wednesday 6-12, a sharp 4.2% of advisors bullish on Wednesday 7-10, and a sharp 4.4% of advisors bullish on Wednesday 7-17 which points to major capitulation, breadth was extremely weak on Monday 7-1 (weak most of the past eighteen weeks) which is another sign of capitulation, I rate growth stocks (really all the major averages because they are approaching a cycle low) untimely for the next 2-3 days as well as the next 2-3 weeks.
Investor's Intelligence % of advisors bullish has flashed a major buy signal (39.8% on 7-10 vs a 40% or below level for a major intermediate term buy signal.) but wait for VXN to spike above 80 before entering QQQ in a long position. Also, VIX (at 46.29) and VXN (at 62.82) are below levels (VIX well above 50 & VXN > 80 (major intermediate term buy signal because it indicates an extreme of fear/volatility is imminent)) that indicate the end of the cycle low phase is imminent in terms of price levels. I expect VIX to spike well above 50 so VIX is below a cycle low level. VXN will probably spike above 80 and could spike above 90 when the cycle low occurs as it did on September 21, 2001. Timewise, as volatility increases the process accelerates dramatically.
Normally the recent sharp decline in Investor's Intelligence % of advisors bullish would have indicated that a strong NASDAQ rally is at hand. However, given that the major averages are in the capitulation phase of the cycle low process we can expect Investor's Intelligence % of advisors bullish to continue falling as the major averages fall until the cycle low occurs and possibly for a short while thereafter as occurred during recent cycle low phases such as those in March/April and August/September of last year. The recent precipitous drop in Investor's Intelligence % of advisors bullish is a clear sign of capitulation on the part of advisors.
Sharp declines in Investor's Intelligence % of advisors bullish on March 8, 2001 (3.8% decline) and August 2, 2001 (6.2%) revealed major capitulation on the part of advisors and cycle lows occurred less than two months later in both cases. The major technical deterioration of the NASDAQ (13:1 in favor of down volume) and the NYSE (10:1 in favor of down volume) on Monday 6-3 as well as the fact that fear is rising sharply without the usual corresponding sharp rise in the NASDAQ (NYSE/value is adversely affected by a sharp rise in fear so the NYSE Composite, Dow 30, etc. would tend to decline sharply even under normal circumstances) indicates that the capitulation phase of the cycle low process has begun.
Once capitulation begins in earnest a lag time arises between declines in Investor's Intelligence and rallies in COMPX. The same is basically true for VXN that sharp moves up in VXN (rise in fear/implied volatility) won't generally lead to the same magnitude rally seen under normal circumstances. The market is "sick" and the cycle is headed lower. Capitulation has begun in earnest but it will get even worse before the cycle low occurs.
Surprises now will tend to be on the downside so keep that in mind. Monday 6-3's huge disparity between up/down volume on both the NASDAQ (13:1 in favor of down) and the NYSE (10:1 in favor of down) as well as Wednesday 6-19's NASDAQ 9:1 ratio in favor of down volume, Tuesday 8-13's better than 7:1 (NASDAQ) ratio in favor of down volume, Tuesday 9-3's nearly 15:1 (NASDAQ) ratio in favor of down volume, Thursday 9-19's nearly 14:1 (NASDAQ) ratio in favor of down volume, and the fact that breadth has generally been weak the past eighteen weeks is a major deterioration technically that points to further substantial downside in the next few weeks.
One needs to keep in mind that the sentiment picture can change drastically in a few hours or even less from what I discussed using the previous close's sentiment figures. It's important to look at VXN intraday and compare it to the figure I discuss from the previous session's close. If fear rises substantially (large + Delta VXN) that portends a rally and if complacency jumps (large - Delta VXN) substantially that portends weakness. An unexpectedly large jump in fear or complacency can dramatically change the very short term sentiment picture.
It's important to remember that when capitulation becomes a major factor that fear/volatility (VXN) can rise dramatically and though that normally would portend a nice rally (as recent VXN spikes above 70 did), a lag time arises and one has to wait for the cycle low to go long QQQ once serious capitulation begins. The steep drop and quick snapback at NASDAQ cycle lows tends to form a V (a retest of the cycle low is a possibility also which is a W). I suspect that the more extreme fear/volatility becomes (VXN spiking above 90 to 91+ as it did on 9-21-01 when the last cycle low occurred) the more likely a "V" will occur and a more moderate peak level of fear/volatility (VXN spiking well above 70 but failing to reach 80) greatly increases the likelihood of a "W" pattern (retest and potential double bottom formation) cycle low occurring. From here on traders should generally be trading QQQ short or gold/silver stocks long as I am.
The high level of fear has a high correlation with a high level of volatility. Daily moves in COMPX on the order of 5%+ or so aren't surprising. Volatility (VXN) may rise sharply in the next few sessions.
There should be some good day/short term trading opportunities in the gold/silver stocks until the cycle low occurs. The gold stocks are acting better than the silver stocks recently so it makes sense to trade the gold stocks. Once the cycle low occurs the dollar and the major stock indices should have a nice sustained rally for over a month so traders shouldn't be long the precious metals stocks during that time. However, the looming war with Iraq that may start at about the time a cycle low in the major stock indices occurs means that one should give serious consideration to maintaining a significant position in gold stocks even after the cycle low occurs.
I plan to go long QQQ near the cycle low for the V (possibly W) shaped recovery. Keep in mind that trading can be very risky and I am NOT recommending that anyone do this. Don't decide to do this at the drop of a hat just because it's my strategy. For example, if you buy QQQ at the wrong time you might experience a substantial downside. Buying very near the cycle low takes nerves of steel and is only for highly skilled traders due to the extreme volatility. Don't try this at home unless maybe you are a highly skilled trader or you can live with a great deal of risk. For neophytes IF you try to trade the gold stocks now you should only be using a very modest amount of risk capital.
Happy trading, may the force be with you,
Joe F. Rocks!
To all... If you are not checking the links that Les Horowitz is sharing on his News Links and Chart Links thread you should be. The link to the article above was provided by him there. He also keeps track of a number of major indices and breaks down the percentage of stocks in the semiconductor group above major moving averages on that thread:
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