The Nasdaq Pattern That's Playing Out Again

"All bets are off" if the Nasdaq breaks below these two crucial levels

Senior Vice President of Research
Dec 4, 2017 at 8:18 AM
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"The near-term risk to bulls is the move through the respective SPX and RUT century marks proving to be only temporary, as selling accompanied the RUT's last move through 1,500 in October, and there was a notable hesitation at SPX 2,600 during last Tuesday and Wednesday's trading.

"...The Nasdaq Composite (IXIC) continues to maintain a dominant leadership role, despite being in an 'overbought' condition, according to its 14-day Relative Strength Index (RSI) reading, for much of October and November.  Previously when IXIC has been overbought, as it is now, it has led to sideways action and modest pullbacks before the trend re-asserts itself. If a short-term pullback occurs, we would expect the first level of support to be in the 6,830 area, the site of the trendline connecting higher highs. A more severe decline could push the index to 6,725, site of a trendline connecting higher lows since mid-August."

    -- Monday Morning Outlook, November 27, 2017

It was a tale of two tapes last week, with the Nasdaq Composite (IXIC - 6,847.59) declining from its overbought condition, while the Russell 2000 Index (RUT - 1,537.02) and S&P 500 Index (SPX - 2,642.22) pushed convincingly above round-number levels.

Per the chart immediately below, the IXIC low point on Friday was at 6,737 -- nearly 2% below Thursday's close, and just above the second level of support that I pointed out in last week's commentary (excerpted above). The Friday low was just above its 40-day moving average, too, in a pattern that looks very similar to the late-September and late-October lows, which are circled. If past is prologue, a rotation back into the tech group is due -- but all bets are off on a close below the channel line and moving average shown on the chart.

If the IXIC is able to push back above 6,850 -- current site of the rising channel line drawn through various highs since June -- remember that the round 7,000 millennium level lies not far overhead, marking the next site of potential resistance.

ixic daily chart since may

It was a rotation out of technology stocks, as the SPX and RUT set all-time closing highs last week, slicing above round-number levels at 2,600 and 1,500, respectively. The RUT's gains were driven by a rally in financial stocks, which make up 26% of the index, after Trump Fed chair appointee Jerome Powell indicated in a confirmation hearing that banks should be under no more regulations.

Moreover, the Dow Jones Industrial Average (DJIA - 24,231.59) set record highs, surging above 23,715 -- which is 20% percent above its December 2016 close -- and the round 24,000 millennium mark.  Meanwhile, the SPX and RUT saw their Friday lows occur near 2,600 and 1,500, respectively, implying these round numbers are now levels of potential support going forward.  But if they are breached on a closing basis, more selling is likely to follow.  

The RUT was down nearly 3% on Friday before it recovered, while the SPX was down 1.5% at its low. The price action late last week was similar for both indexes, with peaks at half-century levels (2,650 on SPX and 1,550 on RUT) on Thursday, followed by Friday lows at round century levels. The highs and lows from Thursday and Friday effectively established levels to key on in the days ahead if you are a short-term swing trader.

rut 30-minute chart since nov 17

After closing above 24,000 for the first time ever on Thursday, the Dow temporarily retreated below 24,000 on Friday morning after headlines crossed suggesting that former national security adviser Mike Flynn would testify against President Trump. For what it's worth, this was just one of several market-moving headlines, as market participants also weighted negative and then positive reports related to the prospects of the Senate tax bill.

Additionally, rumors of Brexit talks breaking down and North Korea being ready to enter negotiations about its nuclear program surfaced, but the Flynn plea deal took center stage on major news outlets. At the end of the week, however, it was another win for the bulls, with the Dow closing above 24,000, despite a more than a 300-point setback Friday morning that pushed it below this millennium level.

As equities retreated Friday morning, I was keying on the CBOE Volatility Index (VIX - 11.43), which was trading around 13.50. As you know, I tend to focus on the close -- but about one hour after I posted the tweet above, the VIX peaked above 14.00, before retreating and closing at 11.43. The good news for bulls (for now) is that the VIX did not close above the 14.07 area, which I highlighted as a key level to watch.

Moreover, keep in mind that VIX 11.25 is half the 2016 pre-election high, and a weekly close above 11.25 on Nov. 10 preceded an eventual brief surge above 14.00 by the following Wednesday. The jury is out as to whether a volatility pop/equity drop is in store to start this week based on Friday's close above 11.25. If we do get another VIX spike, continue to focus on 14.07, as the risk grows of more short-term selling when the VIX remains above 14.07.  

Above aside, a clear pattern I'm seeing is that, in the several instances since May where the VIX retreated to a single-digit 9-handle, volatility (as measured by the VIX) advanced anywhere from 30% to nearly 100% in the days or weeks following such a reading.   

For now, the short-term playbook reads as follows for those using volatility to time stocks: "Buy equities if VIX rallies into its 2017 breakeven zone at 14.07 and retreats back below this level; be cautious on closes above 11.25 or 14.07, and be on guard for a volatility pop/stock drop when the VIX reaches a sub-10 reading and crosses back above 10.00."

vix daily chart since may

My advice has not changed: continue to use call options to participate in the record-breaking equity rally. Call options give you leverage, and it is an outstanding way to minimize your dollars at risk amid uncertainties on both the political and economic fronts.

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