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Reflex Rally
by David Nichols

Yesterday morning I wrote this about how a new intermediate trend usually gets rolling:

Usually when a new intermediate trend starts, the market will initially move sharply in the new direction, but will then make a spirited move back, as one last echo of the previous trend. We've had a 40 point move down off the top so far, without any significant run back up. Sometimes the new trend just takes off and never looks back.

But we'll keep an open mind. It could still happen. If there is lots of put buying and a jumpy VIX, then we'll know that the speculators are trying to pile in for the downside, which could set up a move back up. It hasn't happened yet, but the jury is still out on this.

So the question is this: are all the bears already cleaned out, or will the market "do it to them one more time?"

Right on cue, we got our answer to this question, as the market reacted poorly to yet another weak economic number. The second-half-recovery fantasy is living on borrowed time, as we are actually in the second half. There hasn't been a meaningful up-tick in any economic indicator except the stock market, and the herd of investors is not exactly trustworthy when it comes to picking economic recoveries.

So the ISM number caused a "running of the stops" in the futures market, as buy orders disappeared in a flash, and the unfortunate bulls that had their sell stops under the neckline support at 965 got hit in a flurry.


Yet this proved to be a fake-out, and a springboard to a blistering rally off the lows. Following the breakdown, we did indeed see lots of put buying (high equity put/call ratio yesterday) and a very jumpy VIX. So the market instantly set out on a cleansing path for this little spark of bearishness, and ramped straight up.

Obviously this is a typical path for a new downtrend to follow, as I had written. The best time to enter an intermediate downtrend -- if you don't happen to recognize the elusive top tick, that is -- is on a failing rally back up. I think we're now going to get a great opportunity to go short on this current move back up.

If the market fails anywhere below the SPX 995 to 1000 zone, then a downtrend could accelerate quickly. We could see SPX 910 or so in just a few weeks, with sharp downward acceleration once yesterday's low at 962 is taken out.


We also have specific clues from the VIX to look for on any reflex rally back up. The VIX has been stuck in a very low range, similar to the high range it was stuck in back during the build-up to the campaign in Iraq.


Back then, the VIX was high and stayed high, as the market drifted lower in a sea of fear and uncertainty. It was a weird period. This is now the mirror-image weird period, with the market reveling in a sense of euphoric certainty that better days are ahead.

A specific trigger to watch for on the VIX would be a decisive break below this trading range, that is reversed and closes sharply back up into it. We saw such a move-out-and-back-in at the bottom in March, and that was the energy push needed to reverse the downward drift in the market.

So we should be on the lookout for a VIX dip into the teens with the market failing to rally back to new highs. Keep in mind that the market will look and feel very bullish at that point, but it will actually be a perfect time for speculative short positions.

Timing wiz and contributing analyst Tom McClellan has signals that are pointing to July as a one-way down month. Interestingly, the chart of the Nikkei from 1992-93 continues to track our current market perfectly -- in a precise echo of "anti-bubbles" past -- and a corresponding move now in our anti-bubble would take the markets down sharply into early August.

Sentiment Dashboard
by Adam Oliensis


SENTIMENT TANK: Drained incrementally to 0.7% full of negative sentiment.

SHORT-TERM: Cycled through a decline phase and then moved into an advance phase, which is now ready to turn neutral or roll over as the VIX is virtually at its 2-month lows..

MID-TERM: Has just rolled over from a neutral 75/25 reading to 26% in what may be a developing decline phase. Our Confidence Diffusion Index (CDI) remains at a bearish 1, which expresses low level of technical confidence in the decline phase..

LONG-TERM: The weekly gauge has closed the past 3 weeks at 95/5 and continues to hover there for a 4th week with a neutral (0) CDI. That's reflective of what you see in the tank, which is, in the big picture, low and flat

BOTTOM LINE: The market's lack of fear is scary on a contrarian basis. The tank has been at a normalized level of 5% or below or 11 straight trading days and in its lowest quintile for the past 50 trading days! That's about twice as long as it was able to stay in its highest quintile near the market lows of last October. But that only makes sense as bottoms are usually much "spikier" and tops more rounded and protracted affairs. Hey, maybe everything will turn out hunky-dory. Maybe. But the market is sure all-fire CERTAIN. My mind keeps moving to the Conference Board's Consumer Sentiment numbers for June in which Present Situation dipped to 64.9 while Expectations rose to 95.9. That's an awful lot of weight to put out at the far end of the plank, supported on the near end mainly by hope and the tenuous expectation of a pickup in final demand. That said, the mid-term oscillator's rolling over to the decline side of the gauge is not a sell signal yet as there is no reversal in the level of the tank (now at 0.7%. There is virtually no momentum to measure so it's a little tricky to over interpret the movements of the gauge. The tank is, though, overripe to fill up some. And both gauges show that they're ripe to react to such a move.