The UBS sales trading desk is continuing to watch a market in consolidation, waiting for a potential volatility early September pull-back followed by a recovery. The price pattern from the point of the Brexit vote and subsequent market rebound is like a flag pole and flag pattern, with a double top put in place. If the stock market can’t protrude above 2194, analysts Michael Risner and Marc Muller thinks it’s just a matter of time. Considering correlations between cyclical and defensive stocks is pointing to weakness on a technical level, but the pair think that ultimately the market will rebound from any selloff.

UBS 8 31 main chart

Low volatility summer correlated with odd market structure patterns

With the stock market making the second of a double top on August 23 in the SPX, some of the UBS sales desk daily trend analysis suggests that markets are in a consolidation phase. For traders, this can be a waiting game.

“After last week’s failed attempt to break its mid-August top at 2194, and with intact short signals in our daily trend work, the SPX continues to trade in its very tight consolidation range of the last two weeks,” the pair of analysts wrote.

This extended period of low volatility has been accompanied by unusual market structure patterns noted across a number of investment analysts, pointing to a summer stock market that appears as if it has succumbed to a mind-numbing drug of sorts, with many analysts pointing to quantitative easing as a market damaging influence, including those inside the central bank.

UBS 8 31 UBS VIX

UBS 8 31 bollinger bands

2070 is worst case on SPX, say analysts

When looking at low volatility as measured by the VIX index it is important to recognize volatility buy itself is not always a forward looking indicator. Low volatility today does not mean low volatility tomorrow. In fact, the inverse can be true. But when volatility starts to rise relative to stocks remaining calm, this negative correlation sometimes raises eyebrows.

“With the contracting volatility of the last few weeks the SPX Bollinger Bands have been narrowing to one of the tightest ranges of the last few years!!” they noted, pointing to volatility as a contrarian indicator of sorts. “We continue to think that this is a contrarian indication for significant higher volatility in September and into October.”

The sales trading desk pair think so long as the SPX trades below 2194, “the market remains vulnerable for more consolidation work into later this week and ideally into next week.”

Should the market selloff, they consider numerous support points for mean reversion, including those at 2150 and the 2134/2120 region.

But if these support points don’t reveal more buyers than sellers, that could imply “a temporary undershooting” with the SPX finding 2100 with 2070 being a “worst case.”

If the 2070 level were reached it would resolve the flag pattern to the downside, which in part sets up September’s market patterns.

“Given the weakness and selective breakdowns in defensive key sectors we see strength into end September more as part of a distributive top building case (with best case overshooting towards 2210) instead of expecting a new high momentum breakout.”

What the UBS technical duo point to is an opportunity to find mean reversion. “Into next week we would buy the dips in cyclical themes,” they wrote.

Volatility UBS 8 31 defensive vs cyclical

Cyclical vs defensive stocks sending a message as certain stock sectors sit on an edge

Looking at traditional stock market sector analysis can provide correlation commentary into market health. One sector of interest are defensive stocks.

In June and July, the UBS technical analysis duo highlighted several times how “constructive patterns that have been forming in the relation of cyclicals versus defensives.”

A recent technical price pattern is providing the UBS team cause for optimistic market thoughts. “In recent weeks we have seen further outperformance of cyclicals, which has finally caused the ultimate breakout of a huge inverted head & shoulder bottom versus the defensive camp,” the report said. “From a trend perspective this is clearly bullish the overall market, and it is just further confirmation that the SPX is trading in wave 5 of a larger degree, which de facto is a new cyclical bull market.”

The spread differential Risner and Muller address is one that has been influenced by energy stocks recently pulling back while technology and semiconductors have outperformed. A problem they note is weakness in defensive stocks, “which is not just a relative trade, since we see real breakdowns in utilities/healthcare and consumer staples sitting on the edge.”

This sitting on the edge highlights a differential between sector investing and the broader market averages. “So investors are losing real money, which sends out a completely different message on the SPX, where the weakness in the crowded defensives weighs, which via the increasing selectivity will cap the market on the upside going forward.”

With this conflicting market action, Risner and Muller conclude “the current sector setup is a threat for the SPX,” again playing into their market sell-off in early September theme.