Is the Stock Market Headed Lower?

Over the past year, investors have been lulled into a complacent state by the exceptional returns in the market accompanied by low volatility in price action.

However, as of Tuesday the S&P 500 (SPX) experienced its largest recent one-day drop of -1.09%.

Daily Perspective

On the daily chart today’s drop in SPX is clearly defined as it deviates from the uptrend that has formed since the beginning of 2018.

While we navigate through earnings season, the gap-down in SPX represents a meaningful difference in sentiment among market participants relative to the rest of January. As constituents of SPX continue reporting earnings, expectations are being repriced into the index.

In the meantime, there are some noticeable developments on the daily chart.

For example, the gap lower was so pronounced that the daily Relative Strength Index (RSI) finally closed below its overbought level which SPX had maintained throughout all of January 2018. At the very least this signals that the market may take a timeout for a few days or weeks. Investors should monitor RSI over this time period to see if it can hold its mid-range of 50 which would indicate less internal price weakness than may be displayed in the chart.

Additionally, while today’s drop in SPX may appear to have damaged the uptrend neither SPX’s daily Moving Average Convergence Divergence (MACD) nor its daily Average Directional Movement (ADX) displays reason for concern yet. Traders should watch for a bearish crossover in MACD which could signify the short term trend is down and monitor for continued decline in ADX which would imply the uptrend is losing strength.

Monthly Perspective

Of course, one day does not change the tone of the market after a multi-year advance. Rather, identifying changes on multiple time frames is the key to sizing up large, strategic moves in the market.

That said, while the daily price action suggests that risk appetite may be shelved for the short-term the long-term uptrend remains intact.

The extension in SPX since emerging from range-bound action throughout 2015 and 2016 has been impressive by many measures.

Looking at the long-term uptrend since the 2009 bottom from the context of RSI we can see that after emerging from oversold conditions in 2008-2009 SPX then proceeded to reach overbought levels heading into 2015. However, during its subsequent pullback that lasted into 2016 SPX’s monthly RSI never dipped meaningfully below its mid-range before advancing to new highs. This resiliency in RSI indicated that price internals were still strong. Consequently, SPX proceeded to breakout and form the impressive uptrend we have been experiencing for over a year now.

Conversely, we can see how after being overbought in 2007 SPX’s monthly RSI dipped below 50 in early 2008 which represented weakening long-term price action. At the very least this would have encouraged investors to lighten up on equities before the Global Financial Crisis.  

The VIX as a Stock Market Indicator

A high level in the CBOE Volatility Index (VIX) is often cited as a cause for concern for stock prices.

The level of the VIX is determined by the price of options contracts on SPX. When SPX experiences a pullback in price the implied volatility on the options rises as demand for the options increases. As a result, this causes the value of the VIX to increase. Consequently, VIX and SPX move inversely.

However, VIX and SPX also differ in their price action over time. That is, SPX is a market-cap weighted index that will trend over time. In other words, there is no reason that a stock-based index like SPX cannot sustain extreme overbought or oversold levels for months or years.

Conversely, by its nature VIX is a mean-reverting instrument. That is, as implied volatility, the main input for calculating the VIX, expands or contracts the value of the VIX will increase or decrease, respectively.

Typically, the VIX will transition into a higher range and the volatility of the VIX will remain high for a short period of time after a price shock. As time passes, volatility tends to reverse back toward its long-term average level.

Presently, the current level of the VIX can be viewed as elevated on a relative basis. In each of the previous instances over the past year when VIX closed over 14.00 it reversed lower in the coming days and weeks. Accordingly, traders should position for a decrease in VIX that will be driven by an increase in SPX at some point in the relatively near future.

Given the mean-reverting nature of VIX, tactical traders may find this to be an attractive entry point for a short trade in VIX as it tends to decline faster than stock prices rise. Moreover, VIX is generally used as a short-term rather than long-term indicator.

Key Points

While the short-term price drop in SPX may appear concerning in the moment, investors should not lose sight of the big picture.

For example, since emerging from its consolidation in 2016 SPX has built an impressive uptrend confirmed by ADX and MACD as well as sustained overbought levels in RSI.

Accordingly, from a strategic point of view it is unlikely that any pullback in SPX over the near-term will change asset allocation decisions.

Nonetheless, investors should be mindful of price developments as they appear on various timeframes since a change in the long-term trend will begin to show itself on the daily chart before the monthly chart. Thus, multiple timeframes should be used in conjunction with each other to make appropriate timing decisions for your investments.

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

John