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Here comes the retest

Summary:
Mid-week market update: I wrote on the weekend (see Where’s the fear?) that the relief rally that began last Thursday was unconvincing and my base case scenario called for a retest of the lows. The retest appears to be underway.   Spikes of the VIX Index above its upper Bollinger Band (BB) were signals of an oversold market. Such episodes were resolved in two ways. Strong market rallies were characterized by price momentum and definitive violations of the VIX 20 dma (blue arrows). On the other hand, if the VIX was unable to fall below its 20 dma, the S&P 500 advance stalled and weakened again (grey bars). The current situation appears to fall into the latter category. Nevertheless, I believe that any pullback should be shallow and the S&P 500 is likely to successfully test its 50

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Mid-week market update: I wrote on the weekend (see Where’s the fear?) that the relief rally that began last Thursday was unconvincing and my base case scenario called for a retest of the lows. The retest appears to be underway. 
 

Here comes the retest
Spikes of the VIX Index above its upper Bollinger Band (BB) were signals of an oversold market. Such episodes were resolved in two ways. Strong market rallies were characterized by price momentum and definitive violations of the VIX 20 dma (blue arrows). On the other hand, if the VIX was unable to fall below its 20 dma, the S&P 500 advance stalled and weakened again (grey bars). The current situation appears to fall into the latter category.
Nevertheless, I believe that any pullback should be shallow and the S&P 500 is likely to successfully test its 50 dma. It is already exhibiting a positive RSI divergence, and other market internals are tilted in a bullish direction.

A shallow pullback

Consider, for example, small-cap stocks, as represented by the Russell 2000. The chart of the Russell 2000 has been stuck in a trading range. Moreover, it is showing ambiguous formations of both a possible bearish head and shoulders (black), which is bearish and inverse head and shoulders (red) formations. Similarly, the 10-year Treasury yield has also been stuck in a tight range.
Here comes the retest
The technical pattern of growth stocks, which have suffered the brunt of the selling, is also constructive. The NASDAQ 100 is also exhibiting a positive RSI divergence. The high-octane ARKK ETF recently bounced off a relative support level and it is beginning to outperform again.
Here comes the retest
If and when the market recovers, the odds favor a growth stock revival over the next 1-2 weeks.

More weakness ahead

Tactically, there may be a little more weakness ahead before this pullback is over. The Russell 1000 Value Index violated a rising trend line, which is a sign of technical damage that needs to be repaired by way of a period of sideways consolidation and basing. By contrast, the Russell 1000 Growth Index is now testing a key support level.
Here comes the retest
Sentiment is deteriorating, but panic hasn’t set in yet. The Fear & Greed Index is falling, but readings haven’t reached the sub-30 target zone yet.
Here comes the retest
The latest AAII sentiment survey shows the bull-bear spread narrowing, but the bulls still outnumber the bears.
Here comes the retest
The same could be said of Investors Intelligence. The number of bulls edged down, but bearish sentiment hasn’t spiked.
Here comes the retest
A similar level of complacency can be seen in the options market. The term structure of the VIX hasn’t inverted, which indicates fear. At a minimum, I would like to see the short-term 9-day VIX rise above the 1-month VIX.
Here comes the retest
I conclude from this analysis that the bottom is near, but not yet. The odds favor one more flush downwards in the next few days before a durable bottom is made. However, I am open to the possibility that today’s approach of the 50 dma represents a successful test of that support level. Watch for bearish follow-through in the next couple of days. If the market were to decisvely rally from here, then today was “the bottom”.
About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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