Doji Candles Shine Light on Cautionary Tale

Three SPX "doji-candles" has historically preceded pullbacks

Senior Vice President of Research
May 3, 2021 at 9:32 AM
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Last Wednesday, all eyes were on the Federal Reserve and Chairman Jerome Powell, as the Federal Open Market Committee (FOMC) met. For those that think the Fed has had a heavy hand in supporting the economy and the stock market, these once-every-six-weeks events are important, as any surprise change in policy could have a major impact on the equity market.

On Wednesday, there were not any surprises on the monetary front and that was evident in the behavior of the S&P 500 Index (SPX -- 4,181.17), which closed within three points of its previous day’s close and less than two points away from its morning open.

From a technical perspective, the SPX’s price action on FOMC day and the previous two days caught my eye, which I posted about on Twitter per above. Specifically, after the Fed meeting, the SPX completed a third successive day in which the open and close were roughly the same. I referred to them as “doji-like,” as the open and closes were not exactly the same, but close enough that it was easily observed.

My immediate reaction was to see if three consecutive doji candles as described occurred recently. Sure enough, I spotted similar patterns in late-January and mid-February, both of which preceded short-term pullbacks within a couple of trading days.

A visual of the three-day pattern -- known as a “Tri-Star” -- is depicted in the daily SPX chart below. The circled areas are the tri star candlestick patterns.  Investopedia does a nice job of describing and interpreting the pattern here.

Within this link, you will find these words:

A single doji candlestick is an infrequent occurrence that is used by traders to suggest market indecision. Having a series of three consecutive doji candles is extremely rare, but when discovered, the severe market indecision usually leads to a sharp reversal of the given trend

The above description and implications are exactly what occurred in January and February. It remains to be seen if last week’s reversal pattern precedes an immediate decline like we witnessed in January and February. 

SPX Doji Candle

Friday’s action could be the start of something bigger, but bears beware that Friday’s low occurred just above the top trendline of a channel in place since mid-November, when positive headlines on a Covid-19 vaccine emerged. The top of this channel line is the first level of short-term support, which is at 4,174 today and 4,194 at week’s end.

A move into the channel suggests loss of momentum since last month’s breakout and risk of a further pullback to a second line of defense at 4,131, which is exactly 10% above the 2020 close.  A third potential support level is 4,100, which is the level at which the breakout above the top of the channel occurred on April 9.

If Friday is indeed the beginning of a selloff, the most important area of support is between 4,020 and 4,060. The 4,020 level will be the approximate site of the rising 50-day moving average at week’s end.

As discussed last week, with retail traders playing a major part in the stock market’s advance, this popular moving average could be key in determining whether such investors continue to buy or run for the hills if they see a break below it.

The 4,060 level is key this week from two perspectives:

  1. At week’s end, it becomes the site of the bottom of the channel in place since November, and:
  2. It's in the vicinity of 4,057, which is six times the 2009 closing low that marked an end to a bear market. Two times, three times, four times, and five times this closing low have marked major peaks or long hesitation areas since that bear market bottom. But so far, six times this low has yet to pose a major problem for bulls. This does not mean that bulls are in the clear, as a move above five times the 2009 low early last year proved only temporary before the pandemic-driven selloff occurred.

“…during instances where you see sentiment-based risk heightened, consider hedging or ensure that you have a plan for taking such action when the charts suggest doing so. If the charts continue to look strong, as they do now, it is best to stay the bullish course, with a plan in place to hedge when technical-based risks increase due to higher levels of support breaking down.”

          -Monday Morning Outlook, April 26, 2021

Just as the candlestick pattern discussed above hints at a pullback, various sentiment indicators that we track are showing optimistic extremes that make the market vulnerable to selling. Plus, option activity on CBOE Market Volatility Index (VIX—18.51) futures continues to hint at a pullback.

For example, the 10-day, equity-only, buy (to open) put/call volume ratio is at 0.32. A reading of 0.31 preceded the pullback that began in mid-February. And according to the weekly National Association of Active Investment Managers (NAAIM) survey, the average portfolio exposure was 103.72, with 100.0 considered fully invested and 200.0 being leveraged long. The last time a reading came in above 100.0 was mid-February. The current reading implies that this group is not a huge potential source of buying power like they were coming into April, when the reading was 52.02, or only about half invested.

Additionally, market participants continue to buy VIX calls at a high pace relative to puts. As I mentioned a few weeks ago and as depicted in the graph below, such behavior in the past has preceded volatility pops as measured by the VIX. In fact, the 20-day VIX buy (to open) call/put volume ratio recently hit the highest level since the end of May 2020, which preceded a VIX pop two weeks later. These VIX pops are coincident with equity market declines as the demand for portfolio insurance increases when the market begins turning south.

Perhaps bulls can take some comfort that this ratio is not at 5.0, which preceded the huge pandemic-driven selloff in February 2020 that saw the VIX shoot up above an 80 reading.

Per my comments last week, this suggests having an action plan for hedging long positions if support levels begin to break down. As of Friday, this has not yet occurred.  But gaps below support are a risk as well, and with the bearish candlestick pattern that emerged last week, this may be the signal for some of you to implement a hedge or take some other action to guard against a selloff before it is too late.

VIX pc ratio

Todd Salamone is Schaeffer's Senior V.P. of Research

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