Still Seeking a Right Shoulder

 | Oct 12, 2011 | 6:00 AM EDT  | Comments
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If you're bullish, you probably liked the trading on Tuesday as you would considered it a consolidation day. If you're bearish, you're likely viewing it as a distribution day.

I say that, for such a nothing day in the market, the emotions were running very high. You would have thought the market moved 3% to 4%, rather than having the first move for the past few months that was under that range!

Let's begin with the put-call ratio of the CBOE Volatility Index (VIX), since it chimed in at 271%. As a reminder, a high put-call in the VIX means folks are betting on the downside. If you want to be a contrarian, this tells us there were an awful lot of folks betting on a lower VIX in the coming days or weeks. So let's go back and see what transpired the other times we saw such a reading.

We'll begin with 2010, since the final six months of that year saw three readings above 250% in the VIX's put-call ratio. On the S&P 500 chart below you can see that stocks hung around at the highs for several days following point A, and then down they went. So I suppose if you were banking on very little volatility, that's what happened for about three or four days.

S&P 500

The other two times, points B and C, are more bullish. Notice that, once again, there was low volatility for four to five days thereafter, and then the market rallied. So the bullish case is that the market will digest the move over the course of several days, especially if we use the fall of 2010 as the template. Keep in mind the fall of 2010 was a period of the second round of quantitative easing -- not what we have today.

If we move forward to the current year, we find we saw a reading just above 300% a few weeks ago. It's hard to see, but the market did rally the very next day -- only to collapse in the days following.

S&P 500

The takeaway from this is this: During this overbought period, the best the market can hope for is a consolidation.

Then there is the index put-call ratio, which crept up above 200% -- also not something we see often. It was last above that level on Sept. 28, which was two days after that last reading above 300% on the VIX put-call ratio. You can see that did not bode well for the market in the days following.

Prior to that, and again in support of the bullish case, was way back in January of this year. The very next day we saw such a high reading was that Friday, when the protests began in Egypt and the S&P lost about 2%. The good news is that was a good shake-out, since the market rallied right after that.

I keep looking for a right shoulder of a head-and-shoulders bottom, and the market doesn't seem to want to accommodate me, even though it is overbought. Considering the readings above and the overbought condition, I believe I will continue to wait for that right shoulder to develop, even it only ends up being a sideways move.


OBO -- NYSE

OBO -- Nasdaq

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