Traders, Is a Correction Looming?

07/10/2017 2:57 am EST

Focus: STRATEGIES

Kerry Given, PhD

Founder and Managing Director, Parkwood Capital LLC

I remain cautiously bullish. This is no time for complacency. Watch your positions carefully. Keep your stops tight, asserts Kerry Given, PhD, founder of Parkwood Capital and a co-founder of G&L Capital Management.

The last two weeks have rattled many market analysts. As part of my effort to monitor the markets for my clients, I track several newsletters, read various blogs, and watch selected programs on the financial cable networks. The large number of analysts recommending their clients move to cash and/or hedge the markets by buying index put options has surprised me. You may ask why I am surprised? My answer follows.

The Standard and Poor’s 500 Index (SPX) closed yesterday (July 7) at 2425, up 15, but the severe dip Friday (June 30), and Thursday’s collapse down to 2423 unnerved many market participants. The bulls came back to the table yesterday,

chart 1 Standard and Poor’s 500 Index (SPX)
Chart courtesy of StockCharts.com

recovering all of Thursday’s losses, and bringing SPX solidly back to the middle of the recent trading range. The bulls have bought the dip one more time.

SPX is plotted with the Bollinger bands below. Last Friday’s trading pushed SPX to the bottom edge of the bands and yesterday left SPX actually below the lower edge of the Bollinger bands. But yesterday’s price action pushed SPX back well into the lower half of the bands.

chart 2 Standard and Poor’s 500 Index (SPX) with Bollinger Bands
Chart courtesy of StockCharts.com

The Russell 2000 Index (RUT) price chart is markedly different from SPX or the NASDAQ Composite–much choppier, as RUT has largely just traded sideways all year.

chart 3 Russell 2000 Index (RUT)
Chart courtesy of StockCharts.com

RUT traded down to the 50-day moving average (dma) this past Thursday but recovered almost all of that loss yesterday. The Russell 2000 index has been much more volatile than the other major market indices. RUT hit an all-time high in late April and then proceeded to decline to its recent trading lows by mid-May. Then RUT swung all the way back to match the April highs in early June.

The NASDAQ Composite has been the most bullish of the major market indices this year, but the Goldman Sachs critique of the FANG stocks on June 9 took NASDAQ down and this index has not yet recovered.

The NASDAQ Composite opened on June 9 at 6330 and closed July 7 at 6153, up 64 for the day, but remains well off of its earlier highs.

chart 4 NASDAQ Composite Index
Chart courtesy of StockCharts.com

The CBOE Volatility Index, (VIX), spiked on last Thursday’s decline, and exceeded 15% briefly on Thursday this past week, but closed July 7 at 11.2%, well within the range from earlier this year.

chart 5 CBOE SPX Volatility Index (VIX)
Chart courtesy of StockCharts.com

Comparing yesterday’s closing VIX at 11.2% with the minor pullbacks in April and May of 15% to 16% appears comforting, but if we look at the November 2016 correction, VIX peaked at 23%. And that didn’t happen overnight. It required nine days to climb from 12.9% to that high of 23%. We aren’t seeing that kind of volatility spike building here.

Trading volume is another critical market indicator, whether we are looking at an individual stock or a broad market index. Above average trading volume reinforces the momentum of the price move; everyone either wants to jump into this stock or everyone is trying to get out.

Trading in SPX July 7 at 1.7 billion shares was well below the 50 dma at 2.1 billion shares. The NASDAQ Composite followed suit with 1.7 billion shares, below its 50 dma at 2.0 billion shares.

This tells me that traders are not panicked and making any large moves, whether that be moving to cash or going “all in”.

I follow several broad market indicators to stay on top of the market’s temperature. Note the following statistics compared to the last major market correction in November 2016:

  • The CBOE Put/Call ratio: 0.66 compared to 0.99
  • Percent of NYSE stocks > 200 dma: 65% compared to 54%
  • NYSE New Highs less New Lows: 23 compared to -80
  • CBOE SKEW Index: 132 compared to 141 in November 2016 and 154 in March 2017.

One final comparison is worthwhile.

Pull up the SPX price chart for the flash crash of August 2015. For several days of the week preceding the flash crash on Monday and Tuesday, SPX traded lower and closed at or near the lows for the day. In recent weeks, we are seeing several long lower candlestick shadows–traders are buying when the market hits the intraday lows. They aren’t selling into the close.

Hopefully, I have made my case for why I don’t believe this current volatility is preceding a sky is falling moment. However, many market analysts are nervous, so we will continue to see price volatility. I remain cautiously bullish. This is no time for complacency. Watch your positions carefully. Keep your stops tight.

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