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S&P 500: Looking at Probable Outcomes

Currently, the S&P 500 (SPX) is consolidating near its recent all-time highs. The index has not been at these levels since the end of February 2017.

Since then SPX consolidated through time by around -3.00%. A pull back of this magnitude is perfectly normal for a market in an uptrend. In fact, the lack of damage done to the price trend during this decline could be seen as a sign of strength. That is, sellers are not aggressively offering prices lower but buyers are eagerly bidding into any countertrend move.

Moreover, two weeks ago SPX gapped up two days in a row. During this move the price exhibited strength as the gap up over both days absorbed a meaningful amount of the pull back in only two days. Additionally, the upper boundary of the SPX’s Bollinger Bands was penetrated by closing price both days.


When price penetrates a Bollinger Band it is often a precursor to an extended trend in the direction of the penetration. No indicator works all the time. However, depending on the asset, when establishing or extending an uptrend price will likely touch its upper boundary of the Bollinger Band without reversing touch the lower boundary for some time. The converse is usually true for downtrends as well.

Coinciding with the double-gap up days in SPX was one of the largest one-day declines in the CBOE Volatility Index (VIX). The VIX reflects investors demand for buying protection against declines in SPX. By its nature VIX is mean reverting, however the magnitude of this decline in VIX was noteworthy.

That is, history suggests that a low VIX precedes a calm period for SPX. For example, after looking at the lowest 22 monthly closes in VIX since 1993 the forward 12-month returns were higher in 19 of the cases by an average of +10.80%.

Aside from the bullish perspective, there is divergence developing between SPX and the leading Nasdaq and Nasdaq 100 (NDX) indexes. Both the Nasdaq-based indexes have proceeded to make new highs while SPX has yet to follow through.

The longer this divergence persists, the more concerning since SPX is more representative of the broad market economy.




Additionally, some analysts have argued that SPX is forming a double top pattern. This analysis may be strengthened by possible divergence in daily SPX Relative Strength Index (RSI). However, until price makes a decisive move lower a sell signal has yet to emerge.


Conversely, it could be argued that the SPX is on the verge of completing a cup with handle pattern. This price behavior, used extensively by William O’Neill, is a bullish set up that often leads to continuation of an existing trend.

O’Neill describes the psychology of price action that forms this base in having the buyers and sellers fight for new territory after price retests a previous high. At some point one of them will win.

Overall, the tight consolidation at the highs in SPX over the past two weeks remains constructive for the bulls.

Of course, seasonal tendencies may also be weighing on stocks as the “sell in May and go away” mantra is recalled by market participants. Typically, May marks the beginning of an annual period where stock returns are less favorable than they have been for the previous six months or so.

In the end, as traders we must look at probabilities not just possibilities. That said, with SPX in a prolonged uptrend, displaying bullish price action consolidating near the highs, strong sectors holding up or breaking out, as well as leading names within leading sectors breaking out to new highs or at least consolidating at their respective highs it would be better to continue to align yourself with the uptrend in place until proven otherwise.

As always, please feel free to contact me with any comments or questions. Thanks for reading.


John

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