Stocks: Beware Rising Volatility

S&P thinks big moves in key indicators like the VIX index could spell trouble for the market

From Standard & Poor's Equity Research

From Standard & Poor's Equity Research

The stock market rebounded off strong support last week, and it appears that there is at least a short-term bottom in place. Bond yields bounced off resistance in the 5% area, while crude oil bounced off of support in the $68 zone.

The S&P 500 fell into an area of multiple support last week, between 1245 and 1258. We have mentioned many times, that when there is a confluence of support or resistance in one concentrated zone, the chances for at least a short-term reversal are very high, in our view. In this instance, the stock market was extremely oversold with respect to price, internals, and some sentiment indicators. We believe this added to the probability of a bounce.

We were targeting the 1245-1246 range as major chart support for the S&P 500. This range came from the low at the end of December and from important highs in August and September. On an intraday basis on Wednesday, May 24, the S&P 500 hit 1245.34, in what appeared to be capitulation selling as volume on the NYSE and Nasdaq were extremely high.

Also on Wednesday, the major indexes traced out a candlestick formation known as a hammer. While it was not a perfect hammer, it did signal to us that the market was reversing to the upside. A hammer is identified by a small real body (small range between the open and close) and a long lower shadow (the low is significantly lower than the open, high and close). This indicates bullish action if it occurs after a steep downtrend.

Other key supports that may have helped put at least a temporary floor for the S&P 500 included the 200-day simple moving average, which came in at 1258 on Tuesday, May 23. The closing low for the index on Tuesday was 1256.58. Long-term trendline support, drawn off the August, 2004, April, 2005, and October, 2005 lows, was at 1247 this week. This trendline is very important because it represents the bottom of the channel that the index has traded in since August 2004. A 50% retracement of the advance from October 2005 to May 2006 targeted the 1251.30 level.

With the latest downward spiral in the stock markets around the world, we believe the dynamics of equity investing have taken a turn for the worse. We do not see a major problem in the short to intermediate term, but we do see trouble later this year. We think volatility is back and here to stay, and in our view, this is a big negative.

Because the price action during the latest correction was so sharp, and very different from what we have seen over the last couple of years, we think the short-term bottoming action will take on a different look. The bottoms in April and October, 2005, were very concentrated in one area, with a lot of churning but no real progress.

We think that the bottom this time will take on a more traditional formation, and we think the probability of a double bottom is fairly high. This would mean a decent bounce followed by a test of the most recent lows. We are targeting the 1290 as a potential interim top. There is a decent amount of chart resistance in this zone from the short-term bottom in April and short-term peaks in February and January.

In addition, a 50% retracement of the decline from May 5 to May 23 targets 1291.17. The 65-day exponential and 80-day simple averages also sit in this area. If we continue to rally and then roll over and retest the lows down at 1245 - 1258, it would be positive technically if the test occurred on a decrease in volume relative to this first bottom. In addition, we would like to see better internal statistics on the test as well as some positive divergences with respect to price.

The washout in price momentum and internal data has been dramatic over the last couple of weeks. The 10-day price rate-of-change for the S&P 500 hit -5.17% on Tuesday, May 23, the weakest 10-day period since February, 2003. The 10-day price ROC on the Nasdaq hit -7.7% on Tuesday, the weakest performance since January, 2003. The Russell 2000 fell 8.9% over the same 10-day period, the weakest since the bear market low in October, 2002. The 5-day summation of NYSE TRIN hit 7.46 on Monday, the highest and most oversold that this internal indicator has been since January 2005. The 10-day summation of Nasdaq up/down volume fell to 0.44 on Tuesday, the lowest level since September, 2001.

Put/call ratios continued higher last week, with some historic readings being posted. The 10-day exponential CBOE put/call ratio soared to 1.21 on May 24, the highest in our database. We have records back to 1989. The 5-day simple P/C average hit 1.27 on May 23, also the highest in our database. The 30-day exponential average of the CBOE P/C ratio rose to 1.04 on May 24, also a record in our books.

The VIX, or volatility index, almost hit 20 on Wednesday, topping out at 19.87 on an intraday basis. This is the highest VIX reading since August 2004. As of May 23, the VIX had skyrocketed over 52% in 10 days, the largest expansion in volatility since September, 2001.

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