Apr 07, 2003

I keep track of a proprietary model which tracks various reversals in the CBOE Volatility Index (VIX). As an example of what type of inputs go into the model, if the VIX makes a new 50-day low, then reverses back up through the previous low, the model gets -1 point. If the VIX both opens and closes in the top 20% of its range, and the range is more than 5% of the closing price of the VIX, then the model gets -1 point once again. The model is then normalized to give readings between 0 and 100, with 0 equating to maximum overbought on the VIX, and by inference (since the VIX is a contrary indicator), maximum oversold in the OEX. Conversely, a reading of 100 in the model would equal maximum oversold in the VIX, and maximum overbought in the OEX. The model can be quite effective when giving contra-trend signals (i.e. overbought in a downtrend or oversold in an uptrend). As of today's close, the model is giving the most overbought reading since mid-January, as seen below:

The highlights show each time over the past year where the model gave a reading over 70. With today's reversal session in the VIX, this model is giving a current reading of 72, enough to be considered extreme. We can see quite clearly that each instance of the model reaching this level lead to weakness in the underlying OEX index, either immediately or within a few days. This should have us on guard that today's VIX action may portend a further decline in equities in the short-term.

Last Thursday, I showed a chart that was a combination of the 21-day moving averages of the up issues ratio (a.k.a. advance/decline line) and the up volume ratio. At the time, the combined indicator was at 108%. Over the past few days, it has actually RISEN and become more overbought, to currently read 111%. Here is the current chart, with peaks in the indicator over 110% marked by a red vertical line:

By looking at the reaction of the S&P 500 immediately following each red line, we can see that such overbought breadth readings did not often lead to dramatic market advances, but quite a few dramatic declines. Here are the stats for the S&P 500 after those instances of the indicator reaching 110% or greater from January 2000 - Present:

With the average return negative across all time frames, the minimum return greater than the maximum return across all time frames, and the percentage of time the S&P was positive hovering around 30%, this does not appear to be a time to be going aggressively long for more than a very short-term trade. Of course, by extrapolating these results to our current situation, we are assuming that the market has not entered a new phase that will make these statistics less relevant. However, I find that arguing "this time is different" is much less effective than simply assuming that what has worked in the recent past will continue to work.

Today was an "outside" day in the S&P 500, which means that today's high was higher than yesterday's high, and today's low was lower than yesterday's low - this is a sign of increased uncertainty and volatility. It also came on increased volume than yesterday - showing more investor participation - and obviously it closed lower. This is a bearish trifecta that is fairly rare. Since 2000, there have been only 22 days which meet all three criteria (i.e. outside day which closed negatively on increased volume), and we haven't seen one since December 26th of last year. The average return the next day averaged (0.50%), and closed lower 72% of the time. After 3 and 5 days, the market was still usually down, but it actually showed a bit better probability of being higher than random periods, suggesting the market often retraced a little of its losses after a few days had gone by. After 10 days, however, the bearish implications kicked in again, as the average return dropped to (1.0%) with a 71% chance of being lower than the initial outside day. Once again, this should have us expecting lower prices going forward.

All evidence so far continues to point lower, and we still have a bit more room to go before the idea of a continued trading range would be violated. If we decidedly break the 840/850 area on the S&P, then the selling will very likely accelerate, so that will be an extremely important level to watch. I said on Monday that support for a sustained rally is sorely lacking, and that continues to be the case. If we decline enough over the coming day(s) to reach a short-term oversold condition, then as long as we remain above the 840/850 level there may be an opportunity for short-term traders to look for a bounce. However, it appears now that any bounce we do get is more likely to fail than not.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.

Since March 26th, I've been suggesting that we were most likely to see a trading-range environment. We would have spikes higher and spikes lower, but we could be relatively unchanged weeks later. Since that point, the S&P has traveled a total of approximately 130 points, but is less than 10 points higher from the close on the 26th. The NDX, meanwhile, has traversed 175 points, yet is 13 points LOWER than it was on the 26th. This is what I meant when I suggested a trading range, and that breakout/breakdown types of strategies would under-perform oscillators with a short time frame.

	March 26 through April 7
	Total Move*	% Change**
S&P 500	15.0%	1.1%
NDX	16.4%	(1.2%)
* Cumulative Daily Range as percent of price
** Close to close

Below is a 30-minute chart of the S&P 500, with a standard stochastic oscillator applied. Following these signals, in anticipation of such a trading range, would have allowed you to play the ranges with relatively low risk, a nice opportunity for profits, and a high winning percentage.

My intention here is not to do Monday-morning quarterbacking - one can make just about any strategy look good in hindsight. My purpose is to show that in the future, when the indicators line up in such a way as to suggest that a trading range is the most likely scenario going forward, then there is still a way for most traders to take advantage with relatively low risk. At some point as we begin a new trend, these oscillators will fail consistently, and that's why stop loss orders should always be used, but hopefully we can ascertain the likelihood of that new trend beginning before or shortly after it happens.

Today's reversal was quite dramatic from a historical standpoint. Although the open this morning was a gap for all intents and purposes, for some of the cash-based indexes, like the OEX, the official open was closer to Friday's close than today's "real" open. After all the dust settled, the OEX both opened and closed in the bottom 20% of its range, and the range was about 3% of the price. To get that 3%, I simply took today's high (460.44) minus today's low (447.15) and divided it by the closing price (447.25). I went back over the past 20 years and checked similar days, where the OEX opened and closed in the bottom 20% of its range, and the range was at least 2% of the closing price. Today's session had the greatest range of any of the other days during this time frame. Although the return 1 and 10 days after such an intraday reversal session were not appreciably different than random, the return 5 days after these instances showed an average return of -1.4%, with the market being higher only 30% of the time. This is significantly worse than a random 5-day period, although the sample size (10) is much too small to be entirely confident of the results. If we just look at the most recent instances, say over the past year, then the precedent does not look good, especially since they look so similar to our current situation:

DATE	1 Day Later	5 Days Later	10 Days Later
05/31/02	(2.7%)	(4.1%)	(5.2%)
09/11/02	(2.7%)	(4.3%)	(7.4%)
11/04/02	1.2%	(3.2%)	(0.7%)

The most troubling aspect of today's reversal was the high expectations going into the session. The Rydex timers, ever hopeful of trend continuation, had begun to pile into the long-side funds, pushing our short-term RSI Spread between the bullish and bearish ratios to +84, more than two standard deviations from the mean over the past couple of years. The following table shows the performance of the S&P 500 the given number of days after RSI Spread readings greater than 80:

	1 Day Later	3 Days	5 Days	10 Days
Rydex RSI Spread > +80...
Avg. Return	(0.2%)	(0.3%)	(1.1%)	(1.2%)
% Positive	53%	41%	35%	24%
Random...
Avg. Return	(0.1%)	(0.2%)	(0.3%)	(0.6%)
% Positive	46%	47%	44%	42%
High spread leads to BETTER / WORSE market than random...
	BETTER	WORSE	WORSE	WORSE

We can see that such high spreads often lead to a down market several days after the reading is given. Lending more credence to the high spread reading is the fact that our longer-term Rydex bullish and bearish flow deviations are in record territory (negative for the market), and the three-month stochastic of the bull ratio is over 0.80 (also negative for the market). This is the first time in the history of the funds - since the invention of the Dynamic funds in 2000 - that all four indicators (Bull Flow, Bear Flow, Bull Ratio Stochastic and RSI Spread) have been in extreme territory simultaneously. The only other instances which come close all preceded short-term peaks in the market. Those instances were early December 2001, mid-March 2002, early November 2002 and late November/early December 2002. Interestingly, we also saw intraday reversal sessions like today's in early November and December last year, both of which portended further downside of course.

Similar to early March (only in reverse), we have not seen a confluence of indicators reach a speculative fever that would indicate a major reversal is imminent. However, we have enough that continued downside is entirely possible. In fact, I believe it is probable. As long as it appears that we will remain in a trading range, the best risk/reward scenarios are with with selling rallies and buying declines. We have not even begun working off the overbought breadth and excessive speculation seen over the past few days, so support for a meaningful rally from this point is sorely lacking.

	1 Day Later	3 Days	5 Days	10 Days
Avg. Return	(0.4%)	(0.9%)	(1.2%)	(1.5%)
% Positive	29%	28%	32%	23%
Maximum Return	1.6%	2.7%	2.4%	4.0%
Minimum Return	(2.3%)	(5.2%)	(7.4%)	(7.4%)