The stock market is in a short-term pullback within a longer-term advance. These types of pullbacks are typical of a bullish market environment.
Of course, any minor pullback has the potential to morph into a major correction. As a technician, I analyze markets daily to distinguish between the two.
With that in mind, I want to share a few charts that I am monitoring. Below is a chart of the S&P 500 Index. Notice that the index has fallen to the first level of support that I mentioned in my September 7, 2020 newsletter. This is support that is being provided by the 50-day moving average. If the index can advance above the highs of last week without falling decisively below this area, it would be bullish for the broader stock market.
If the index falls below this level, the next level of support is about 3.25% below where it’s at currently. This would not necessarily signal that the market is bearish, but it would suggest a much higher level of weakness. Then if it fell below that level, the 3rd level of support would be the 200-day moving average which is about 6.5% below Friday’s close. A drop below the 200-day moving average would suggest that the market is rolling over and risk is very elevated.
One reason that I feel it is important for the S&P 500 to not fall decisively below that first level of support is it would push the NYSE Common Stock Only Summation Index below zero. This index is a breadth indicator and one way to interpret it is that the stock market is bullish when it’s above zero and bearish when below.
As you will notice, it is currently sitting right at zero so any further market weakness is going push it below this important level. On the other hand, a market advance should turn the indicator up which would be a buy signal much like the previous times it reached this level and turned up (annotated with a circle).
One reason that I feel the odds may favor a bounce here is that the VIX, which is commonly referred to as a fear index, is positively diverging with the market. Below is a chart of the VIX (orange line) which I have inverted to make it easier to compare with the S&P 500.
There are three things I look for when analyzing a chart of the VIX. One, is there a divergence either positive or negative? Two, is the VIX above or below its 20-day moving average? And three, is the moving average trending up or down?
In the chart below, notice how the VIX has been diverging positively with the S&P 500. While the market has been bouncing on support recently, the fear index has been trending higher, suggesting that investors are getting less fearful. Also, it is sitting right above its 20-day moving average.
At this point, the VIX is suggesting the market is likely to advance here.
I always evaluate markets from an if this then that perspective. So, if the market falls below this level, market breadth deteriorates and volatility increases then what? How does that change my bullish market thesis? How will I alter my investment allocations to account for these events?
The market still looks bullish but what happens in the coming days will go a long way in determining the underlying strength of the stock market.
Craig Thompson, ChFC
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