What is one of the Key Elements seen in all Stock Market Corrections?
Market drops and corrections all have one central element ... fear. When fear levels increase significantly, investors go into a selling mode. One of the best measures of fear levels is the Volatility Index (Symbol: VIX).
Key market correction elements of importance on the VIX are:
- Its trending direction.
- Where the VIX is in relationship to support and resistance lines, and ...
- Increasing Fan Lines.
So, this morning, let's take a look at where the VIX and discuss where it is relative to points 1 and 3.
First, the Volatility chart below goes from July 2006 to January 10th. 2007. A Volatility peak was made on July 13th. of last year. That became the point where we draw fan lines from, after the primary trend ended. The primary trend ended on November 24th of last year.
After that, we started drawing fan lines on the VIX. Each time a fan line is drawn higher on the VIX, it depicts a sequential increase of rising upper resistance levels. The higher the resistance levels increase to, the higher the fear level rises for investors.
We have now worked our way up to a Fan Line Resistance Level of 4 as seen on the chart. That means that there is a long term trend in the VIX that is slowly working itself higher. After each Fan Line is broken to the upside, the VIX moves to a new, higher ceiling level of fear. If the trend of increasing Fan Lines continues, we will reach a "critical level" on the VIX where investors will have a shift from confidence and bravery to "fear". When the shift goes into a "fear modality", investors start selling their stocks and we have a pull back or market correction. (Paid subscribers: You can view the exact VIX number where that critical level is reached on your daily update pages.)
We covered Fan Lines, now what about its Trending Direction?
If you look at the December to January 10th. period on the chart, you can see two blue channel lines trending to the upside. Since the December 15th. low, the VIX has been moving up to the channel's resistance line, and then down to the channel's support line. Each time it has done this, it has made a higher/high followed by a higher/low. This is the definition of an up trend. So the short term trend is also moving up.
The bottom line of this VIX action, is that investor confidence is slowly eroding over time. If the VIX trend is not reversed to the downside, then we will surpass the "critical level" where investors will shift to a fear mode.
From a risk evaluation standpoint, as long as the VIX continues its up channel, your risk of losses on your invested capital is increasing.
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