In music, modulaton refers to transition, for example, from a major key to minor. In applying technical analysis to today's stock market, there are technical arguments or potential cases one can make for a modulation from the current doldrums to either a bear or bull market, as the market has been in a period of lateral transition since early 2004. I will use triangulation, or three different charts with accompanying analysis. In applying Technical Analysis, one can see a set of criteria for a bear market, and then a compelling case for a bull market. Neither should be dismissed. I will attempt to flesh out cases for both possibilities and will conclude with my assessment for the more likely of the two. In building my case for each, I will use annotated charts from StockCharts.com, with which I have no professional affiliation other than my membership.
The Bear Case
To build the bear case, let's begin what I mean by bear: a severe market decline of more than 30% over a period of 2-3 months. Some might call it a crash, and we will explore such a possibility. We will examine the history of the SML, the NDX:VXN Ratio, and make a comparison between today's SML and the crash of 1987 to show the worst-case potential consequence.
Let's begin pawing over the bear case with the weekly S&P 600 Small Cap Index (SML). In the following chart, I have noted a colossal formation I have dubbed the Giant Rising Wedge to exist and is now nearly done with a retest of support-turned-resistance culminating in the latest buying frenzy sending the tech charts nearly vertical over the past three weeks. This chart contains some valuable information which gives clues of future market direction. Note the negative divergence on the MACD indicator along with a small hook, eerily similar to that which formed on the retest of the formation labeled Rising Wedge #1.
Preceeding the stock market decline of 1998 in the wake of the spectacular collapse of LTCM, the market had completed another Rising Wedge highly similar to the one today. Notice Rising Wedge #1 broke support and then retested it as resistance before its decline past its point of origin in April 1997. Based upon this concept, I have annotated probable targets for the decline in today's SML Index. Should this decline to the ultimate target, it will take the rest of the indicies down with it.
The second formation on this chart, dubbed Rising Wedge #2, formed and broke as the stock market finished crushing the last of the tech titans in one of the final legs of the tech stock meltdown. That this chart is bullish in the time frame the Nasdaq chart was mostly in freefall is a testament to the strength of small caps in bear markets, though they are not immune to its wrath. I have attatched labels to highlight reasons the mass media attributes as justifications for the market declines. The point in doing so is that people search for reasons for why the market does what it does, though in the bigger picture it really doesn't matter what the excuse is this time. Technical analysis shows that the market sends clear signals of its intent to those who heed them.
Next, let's examine a fascinating chart which is a ratio of the NDX divided by the VXN which is the Nasdaq 100's volatility index. Ratio charts are somewhat of a dark art within the field of technical analysis as many people don't quite know what to make of them and rightfully question the veracity of any claims to patterns found in them. Investors don't want to be duped into salting the tail of a snipe, or speculating with their hard earned capital on a Rorschach test.
I have had some success with one as my friend Adam Hamilton at the Zealllc.com website was kind enough to publish a finding I had shared with him in the weeks preceeding the market bottom in 2002 in an essay entitled, Trading Volatility Ratios. The ratio I showed him, which he dubbed "Basch's Ratio", was done using the SPX:VIX and compared the formation of the market to that which created a market bottom in 1998 and the formation which developed before our eyes was nearly identical. We were both giddy with excitement leading up to the formation's breakout on October 9, 2002, just days after his essay was published and began what would become a spectacular bull market through 2003. The point here is not to toot my own horn, but rather to show that there is merit to using ratio charts effectively if one can correctly deduce patterns contained therein.
This chart is rather self-explanatory and shows that today's pattern looks awfully similar that leading up to the last point of the cliff before initiating the capital crushing bear market as it did in September 2000, and note the level is above 100 which is where the previous decline began. The CCI also looks highly similar to a time in the market before a severe decline and the ADX is popping into territory not seen in the past half decade at least. Consider this another triangulated point in our bear hunt.
Lastly for our bear case, I'd like to show a pretty inflamatory pair of charts which might upset some viewers, but in order to show the full spectrum of possibilities here is the worst case scenario of fallout from a Rising Wedge. Parental discretion advised. There is a correlation between the current formation on the SML and what I call the "spectacular and legendary" crash of 1987. People tell me that a crash of its kind couldn't possibly happen because everything is different now due to curbs and circuit breakers instituted as a result of the 1987 sentinel event, and while that's all well and good, these market speed bumps merely prolong the time it takes to reach the bottom. Whether the VIX spikes to matching highs or not is relatively inconsequential, the point is the charts are indicating an outright crash is a possibility and therefore should be included in our universe of possibility.
The Bull Case
To clear the air after the grim scenario just portrayed, we can consider a rather sunny possibility that the market has already had a major breakout which will lift it to marvelous new highs. Our triangulation of the bull case will be done with three comparisons to the bull run which started in 1995: The Nasdaq price chart, the Nasdaq New Lows (NALOW) chart and lastly the S&P 500 Volatility Index, (VIX).
Let us begin our triangulation of the bull case with a chart which depicts a comparison between today's market and a breakout in 1995 which lead to a spectacular five year run of phenomenal gains. The primary consideration is the "Pivot Line" which formed support for a bullish Falling Wedge leading to the breakout and eye-popping run.
Today's Nasdaq chart highly similar to that in 1995 in that it shows a similar "Pivot Line" and bullish Falling Wedge with the distinct possibility that the market is now in the early stages of what will become a real bull market.
This next bull chart shows the Nasdaq New Lows chart is now at similar level as in 1995 at which that bull market started. The "V" shape of the formation is also similar, although the apex was lower at the climax of the market in late 2004.
Lastly, let's look at the VIX, the gold standard for market volatility. It is at levels not seen since 1995 which is also an argument for our bull case that having reached this starting point, it is beginning to move up as the market does. Concurrent moves are seemingly illogical as one would expect the VIX to move inversely proportional to the market as volatility indicators usually do, but as we can see this was the market action in 1995 which lead to a bull market, and it could be sending us signals that it's about to do it again.
I guess this is where I can do my impression of a CNBC pundit and say that the market could go up or down, or not. Either way it is important for one to see why this is a period of modulation and hence one should use caution with market equity investments. My guesstimate is that there is a 66% probability of the bear rending the market to shreds based on the completed retest of the Giant Rising Wedge on the SML, but that's not a reason to dismiss the 33% possibility of a brand new bull to ride to new highs. The 1% left over is for a meteor striking the earth in which case the market will be the least of your concerns.
So what to do with your money in this time of market uncertainty? Since I am not a professional investment advisor, and am merely a garden variety retail speculator and I'm absolutely not qualified to give investment advice of any kind, my non-advice would be to wait for new highs on the SML before going long, or wait for new lows below 300 to go to cash or short. Either way, the market is sending conflicting yet compelling signals on its direction and I hope this exploration of bull and bear cases will stimulate you to view market behavior in their context order make wise decisions with your capital.
Best regards to you.