Has the Market Topping Process Ended?

With the action yesterday in stocks not seen since Primary Wave 1 down in March, for asset allocators it begs the above question.

The top part of the below chart reflects the S&P 500 price pattern since before the March 23 market bottom.

The bottom half of the chart illustrates the bear market rally and the trend in NYSE Up Issues Ratio outliers since the market bottom. With the 5 to 2 ratio of lower highs/higher lows appearing to run its course, the bear market rally appears to have come to a potentially important point given the change in narrative and a probable change in aggregate mood.

Especially since Primary wave 2 topped on April 29th

Are larger declines for stocks ahead?

Yesterday the CBOE VIX volatility measure jumped from 27.57 to 40.79, up 13.22 points, or up 47.95%. Why does this matter? Because of volatility clustering.

Volatility clustering: as noted by Mandelbrot in his 1963 paper, The variation of certain speculative prices, “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.”

This means that returns themselves are uncorrelated, however, if volatility and volume pick-up so will larger absolute declines.

The following chart of the S&P 500 weekly moving average and the CBOE VIX weekly moving average shows the clustering of volatility and the inverse relationship to the absolute price direction of the S&P 500.

The correlation of these two data series over this chart period from January 8, 2020, through yesterday’s close, is -0.59.

Clearly the back to normal narrative has shifted to back to uncertainty if volatility is picking-up. This may shift the aggregate mood back to negative.

With the new question of a second virus wave and the recent Fed Chairman Powell’s comments on an economic path that sounds more like a greater potential for an L shaped recovery, this could also be a catalyst for a mood shift.

What this all means is that If large deep declines are ahead, they’ll be accompanied by greater volatility, volume, and a pick-up in lower lows and lower highs. This is consistent with a Primary wave 3 down.

Primary Wave 2 Completion

When there are material changes in the following measures, it will be a signal that the bear market rally that started March 24th is over.

An eye must be on the look out for:

  1. The Elliott Wave Oscillator turning negative
  2. A combined pick-up in volatility, volume, and breadth
  3. NYSE Up Issues Ratios hitting new lower lows
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