Conflicting market signals kick off 2012 trading

Welcome to 2012, a pivotal year to be sure. For those of you tired of the roller coaster ride we’ve had the past 5 months one thing you can always be sure of: When market participants finally get used to a certain market condition it usually changes. Since everyone has given up on the market getting into a trend, 2012 will likely trend more than not.

However, as we start the year we are still getting conflicting signals. Witness the VIX. You are looking at the monthly chart dating back to the early 90’s. This chart covers all of the market crisis points over the past 20 years. Look at the Asian contagion, NASDAQ bubble bottom, the panic of 2008 and the recent market bottoms. You can see that all of them with the obvious exception all gave us readings near 50. Those of you looking for a repeat of the 2008 experience should take serious note of this chart. Not that it can’t happen again, but fear levels were off the chart. If it wasn’t a 100 year storm, it certainly was a generational storm and chances are we won’t be seeing anything like it again. It’s the most important lesson from 2011. Too many people were looking for that Lehman type experience. You can’t really blame them as in 2008 the challenge was saving institutions; in 2011 the challenge was saving governments. But the key point is the sequel rarely equals the original and policymakers were not taken by surprise. You can bet they won’t be taken by surprise again in 2012.

Last time I showed you the possible breakthrough in the SPX. We survived the week and the year ended right on the long term median channel. But we had a sequence in the VIX where price action dropped heading into the holiday week and the VIX never rose. The media incorrectly hypothesized it’s because traders are expecting a period of lower volatility. Sorry to tell you but market don’t work that way. If we come out of the chute on the bullish side and continue through January chances are the VIX will continue to drop. Look at where markets like to top. The April 2011 low was near 14. If the markets continue higher coming from a VIX in the low 20’s, the greatest risk and vulnerability we’ll have next year is creating a double top near the 2011 high again. The VIX is already too far down the road to give the market a total green light. The only way that could change is if for some reason the VIX stalls and fear levels somehow rise with the price action. It’s not the higher probability but it’s certainly a possibility. For instance, if the Dow were to fall 100 points and the VIX rises 2 points and then rises 200 points and the VIX only drops by a point, then we’ll be good.

Now look again at the long term SPX. We haven’t looked at this pitchfork line in a few months. As you can see we spent a whole year wrestling with the secular bear market line. We approached it, tested, broke above and then below and finally finished the year right on the line. If you consider that 2011 was a year which featured an earthquake, tsunami, nuclear meltdown, the death of Osama Bin Laden, a European crisis, a debt ceiling spectacle and the meltdown of MF Global you have to conclude that a market that can virtually breakeven after all of that is quite remarkable. But we start with the same issue; fund managers are still chasing performance while bears are still looking for a European meltdown. But this chart is telling me that’s going to change. If the thick blue line repels the action this time we are likely to drop and if it makes it through we are likely to stay above it. Why would we stay above it? Simply put, it’s a matter of physics. The further out we go the more distance we put between price action and the line. Once we pull away the greater the chance we stay above it and then the path of least resistance becomes up.

If all of this sounds a little confusing it’s because it is confusing. We start the year in an institutionally confused market. We don’t know if the VIX will stall if the price action goes up.

Next page: How will this all play out?

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