SPX and VIX Updates: Bears Running Out of Real Estate

Yesterday, the Fed announced that it will continue to keep interest rates low “until late 2014 or until we all get fired, whichever comes first.”  The market immediately rallied, as hopeful investors cheered the news that the Fed could get fired.  As I predicted, there was no announcement of QE3, however the Fed has effectively stated that they’re going to keep juicing the money supply as much as they feel is necessary to continue driving inflation higher.  Inflation creates higher prices in all asset classes, including of course, stocks and commodities.

It seems to me that the Fed realized some time ago that the scenario they face now is basically “inflate or die.”  The practical difficulty they are challenged with is outlined in the quote below (from Paul Samuelson’s 1948 Economics textbook):

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.

Their hope seems to be that they can keep everything afloat just long enough to move into a recovery period, at which time the economy will pick up and the banks should start lending again.  So far, it’s been a pretty tepid recovery, and it’s difficult to see what, if anything, has changed since 2011.  The market sure seems to have gotten ahead of itself — but since the money the Fed pumps to its primary dealers ends up in stocks and bonds, which drives higher prices, reality isn’t much of a factor in the market these days.  If you want some illustration of that fact, consider that the Dow is currently at the same price level it was at in early 2007 — and then compare the fundamentals between then and now.

Fundamentals don’t drive the market; liquidity does.

So, fundamentals aside, there’s a cardinal rule to Elliott Wave Theory that wave 2 cannot exceed the start of wave 1.  Several indices are still some distance away from violating that rule, however, the Dow Jones Industrial Average (INDU) is only 120 points away from its 2011 high.  12,876 would be the line in the sand for the bear count in the INDU.  And since the Dow leads, it is probably safe to assume that if the Dow knocks out its bear count, the S&P 500 (SPX) would follow soon after.

We’re not quite there yet, but it’s an awfully close shave for bears right now.  As such, today I’m going to present an alternate long-term bull count alongside the bear count.  If the Dow knocks out its bear count, this bull count is likely to become my preferred view, though I’ll have to do a lot more cross-market studies before committing fully to a new preferred count.  I’ll need to see what form the knockout takes.  However, I’m getting a bit ahead of myself here, since the market still hasn’t knocked out the bear count.  In any case, I wanted readers to get an idea of one possibility (chart below).

There are of course, always other possibilities, but we’ll burn that bridge if and when we come to it.  First things first, though. 

Part of the reason I’m giving serious consideration to the bull counts at this stage is that numerous overbought indicators have been failing to generate any sort of meaningful pull-backs in the rally.  This is usually a hallmark of bull markets.  But price is the ultimate indicator, so let’s see whether the bear counts get knocked-out or not.

Speaking of indicators, below is yet another top indicator that triggered recently.  This indicator uses the ratio of the Volatility Index (VIX), which measures one-month volatility, to the VXV, which measures three-month volatility.  The VXV is generally more stable, so low readings in this ratio indicate investors have become complacent quite rapidly, which is often a recipe for disaster for equities.  It’s not my best “top” indicator, with roughly a 64% win ratio over the prior four years — but it is yet another addition to a long list of recently-triggered top indicators.

Note the current development of this second signal trigger, about a month after the last one.  The last time this happened at a one month interval is highlighted on the chart, and in that prior instance, the second signal did nail the top.  I’ve also noted the bullish falling wedge in the VIX (bottom panel), mainly to point out that it might not mean anything.  Recall that the VIX acting bullishly is actually bearish for the broad market, as the VIX rises when the market goes down… however, I recall similar talk of these VIX patterns in the past, and indeed you can see on the chart that the prior two falling wedges both failed.  It seems that VIX traces out falling wedges with some regularity, and I think it’s an error to read too much into that pattern on VIX.

But maybe in concurrence with the sell signal trigger, this time will be different.  We’ll find out soon enough.

Last but not least, the SPX short term count.  Once again, my alternate count is the one that played out yesterday.  I keep favoring the bearish counts based on the indicators, and as the indicators fail, the bear counts fail with them.  Be that as it may, the current preferred count appeals to me a great deal.  I continue to feel that the first portion of the rally counts best as a leading diagonal first wave, and that suggests the market is now in the final stage of this leg upwards.  This might be the last hope for bears over the intermediate term.  However, until the market knocks out the long-term bear case as outlined earlier, I will continue to play this rally as a bear.

The count below suggests that the market is due one final gasp into the target zone.  If that count is correct, then the rally is finally getting ready to roll over.  Yesterday did have some hallmarks of an exhaustion day.  If that count’s not correct and the rally keeps going, then it’s likely the INDU will knockout its bear count.

     
In conclusion, if the bear case still holds water, then it’s time for the bears to make a stand.  The indicators continue to signal a top — but if this is no longer a bear market, it would not be uncommon for these indicators to fail.  The price action over the next few sessions is key.  Trade safe.