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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