The Winds of Change

(An except from the Financial Tap Weekend Report – See here for more detail)

Friday’s 2% + decline in the equity markets was impressive.  After a record run of low volatility and muted price action, equities suddenly awakened and exploded lower.  This is exactly the sort of action I expected (although favoring upside price move) when I titled last week’s report Expecting Volatility. The market had been setting up for a big break for quite some time.

Extended periods of a lifeless, low volume trading range usually give way to volatility and significant moves in price.  Going forward, at least over the short term, I expect we will see a series of 1% (plus or minus) moves in the daily indices.  Although Friday’s break has significant bearish technical implications, it is too early to assume that the next extended move will be lower.  What we can assume, and with a high degree of confidence, is that the next major market move has started.

The primary problem with being more definitive on direction is uncertainty around the Daily Cycle (DC).  In a traditional DC (40-45 days), the low on September 1^st – day 47 – could easily mark the DCL, especially with price subsequently jumping back above the 10 and 20-day moving averages.  On the other hand, the September 1^st low was not particularly deep, nor was the following rally of any real strength or duration.  Further, a move back above the 10-dma was no big feat; the lack of a significant preceding drop and the sideways consolidation meant that the 10-dma bar was very low.  Moreover, Friday’s drop appears to embody the sort of capitulation that we’d expect at the end of a DC.

For a number of weeks, I’ve maintained that a major market move was coming.  Based on Friday’s action alone, I believe the move has started, so we need to be prepared for some serious volatility.   The million-dollar question, of course, is whether the eventual move will be higher or lower.

Turning to the VIX, my research uncovered an interesting, and potentially telling, relationship.  Whenever the VIX reached a low and then spiked higher, it appears that a) volatility continued to expand, and b) the S&P topped and began a move lower toward a DCL or ICL.

If the above chart holds, we should probably assume that the markets have entered a corrective mode.  That doesn’t mean that a major selloff is necessarily at hand, but we should expect a decline that spans more than just a single trading session.

So the Daily Cycle question becomes important.  If we are seeing an extended Daily Cycle that capitulates for a few days before bottoming, the longer term move could be higher.  On the weekly chart, we would likely see a back test of the breakout, with the rising 10-week moving average as the floor.

The bearish case, however, is a new Daily Cycle, one that will cascade lower out of the recent tight trading range.  This would leave behind a very clear week-7 IC Top and a comfortably Left Translated IC that would have cyclical bear market implications.

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Bob.