With the S&P 500 down over 11 points today – breaking an odd string of low volatility, sideways trading in a tight range price range dating back more than a month – where are the markets headed? Technical analysis off the UBS sales trading desk suggests that stocks could experience a brief sell-off. The more meaningful question, however, is regarding a long-term market top. That is a risk and certain divergences among correlated indicators are flashing warning signs.
Watch for a pullback, then rally
What is likely to occur over the near term is a stock market retracement trend, UBS sales trading desk technical analysts Michael Riesner and Marc Muller say. Last week the SPX, for example, appeared over bought and suggested a near term pullback leading into September.
The analysts say a break of the 2175 trading support range – the point at which the S&P 500 closed at today – might then foretell a further retracement to the early July breakout resistance at 2134/2120.
Ultimately this sell-off won’t last, Riesner and Muller predict in an August 23 report titled “Cross-Asset Volatility Contracting … Watch US dollar!!” The stock market will rebound leading into the end of September. On the upside, a breach of 2194 would lead the way to 2200/2260 into deeper September, they say.
But this rebound is nothing more than a dead cat bounce, they say, citing technical indicators and correlations.
“Although in the larger context we think the SPX has started its wave 5 bull cycle of a larger degree, we think that wave 1 of 5 will be finally completed in September,” the pair wrote. “It means that although the US market trades in a new bull cycle we nonetheless see the risk of a more complex and significant tactical correction, which should develop in a classic 3 wave (a-b-c) pattern.”
The good news is that when this pattern is completed the market should rally off the bottom.
A correlation divergence is a sign of internal market pressure that will be resolved at some point
The markets have been very odd since the Brexit “V” bottom, with normalized correlation patterns falling apart and measurable market volatility and fear, benchmarked by the CBOE VIX index, nearly nonexistent in the face of logical geopolitical and regional concerns.
Riesner and Muller, for their part, are looking at correlation patterns and noticing odd divergences as well – and the divergences are not sending positive market signals over the medium term, but they do suggest another bull market after a market price adjustment.
The most important of the correlation divergences is occurring in the gap between US inflation expectations and the SPX. Inflation expectations are correlated to risk and there is a “huge gap that has been forming over recent months, this is one of the few indicators that really questions the whole July (Brexit bounce) breakout campaign of the SPX.”
A correlation divergence typically represents increasing internal market pressure that will at one point be resolved. Riesner and Muller see the SPX being the one in the relationship that will change, closing the gap with a correction in equities.
But inflation expectations are not the only area where the UBS sales trade desk sees issues.
Odd correlations have been noted on numerous occasions
The Dow Jones Transportation index, a key crux of Dow Theory, is often considered a measure of US industrial strength as it rises when physical goods are increasingly moving around the nation.
Riesner and Muller note that this correlation has broken down along with a breakdown in market breadth indicators. Stocks trading above their 20 day moving averages, often a sign of a strong momentum market, is declining while the stock market advanced significantly in August.
And then there is the relatively comatose VIX index, which the UBS pair see as “at least tactically… a risk for the market” with volatility in many asset classes “deteriorating significantly over recent months,” Riesner and Muller think “we have a contrarian setup for a significant rise in volatility over the next few weeks if not even months.”