foxex: Bulls Fizzle at Week's End

Focus on the Price

Friday, December 28, 2018

1. Emerging bullish technical signal on S&P 500

2. Oil price/rig divergence becoming more dramatic

3. Emerging markets still surprisingly defensive

Major Moves

There are a lot of theories about what contributed to the market's reversal this week. Some analysts believe this could be the doing big pension fund managers who are having to rush at the end of the year to balance their portfolios. Reassurances from the White House that the Treasury Secretary, Steven Mnuchin, and Federal Reserve chair, Jerome Powell, are both safe in their jobs might have also driven prices higher.

I still believe that the underlying fundamentals, which are very strong from an earnings perspective, is the most likely driver of higher prices in the near term. However, traders should be careful about drawing conclusions in either direction during the week between Christmas and New Year's Day. Volume tends to be light and temporary factors can have a greater than expected impact on the major indices.

From a technical perspective, there is an interesting pattern beginning to form on the VIX index. A study published by the CMT Association a few years ago showed that when the VIX reached an extreme and then failed to repeat that extreme within five trading sessions there was an unusually high probability of a continuation to the upside.

The extreme used in the study was for the VIX to close beyond a 10-period Bollinger Band price channel, but then failed to close above that price channel again within five trading sessions. In the following chart, I have compared the S&P 500 (top) with the VIX (represented by line chart on the bottom) and I've included a Bollinger Band study to illustrate the first half of the signal that has emerged so far.

While it's not perfect, this trading signal has had a good track record over the last several years. The subsequent rallies are usually big and short-term. For example, the same signal was triggered earlier this year on February 9th, which I've highlighted on the chart. For the signal to complete successfully this time we would need to see the VIX spike up a little and drop again very quickly next week.

Even if the pattern doesn't play out this time, I doubt we've seen the last of the market volatility, and there may be another opportunity for a signal like this early in the first quarter of 2019.

Read more:
Understanding Bollinger Bands

The CBOE Volatility Indicator (VIX)
Top Five Materials Stocks of 2018

Source: finviz.com

Risk Indicators: Oil Rigs Rising

Along with the rest of the market, oil prices also jumped higher on Wednesday. Frankly, I've been surprised at how far oil has dropped and that it hasn't recovered further because production numbers are still rising. According to Baker Hughes, the US rig count is up another three rigs this week and is up 154 rigs for 2018.

A rising rig count is historically correlated with higher energy prices and higher stock prices in the energy sector. As you can see the following chart, there has been a dramatic divergence between the rig count in the price of the SPDR Energy Sector ETF (XLE) over the last few months.

We assume that the correlation exists because if energy professionals expect higher prices in the future, they will respond to that by increasing production. There are other factors (e.g. cost of production) that can affect this relationship but not usually this dramatically in such a short period of time. So, what can we assume about the data coming from the energy sector? I would suggest that US producers are expecting prices to rise: either because OPEC will continue to cut production, or demand will start to increase. If they are right on either or both counts, the rising rig population would make sense and it would indicate that the energy sector is undervalued.

To be fair, energy producers are wrong from time to time. For example, they continued to add rigs in 2014 even while oil prices were dropping fast. The decline in 2014 and 2015 created a major disruption in the energy market and likely led to the "earnings recession" of 2015. However, because rising rig counts usually lead higher prices, I think this has the potential to be a big sector for the bulls in early 2019.

Read more:

Oil Rig Utilization Rate

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Top Five Industrial Stocks of 2018

Bottom line: Emerging Markets Still Defensive

The market started out strong on Wednesday but lost a little momentum today with the S&P 500 closing at virtually breakeven. Investors can get a little skittish before a holiday weekend, and the major market unknowns remain frustrating. I think some investors may also be trying to price in the impact of lower consumption by employees of the federal government who have been furloughed during the shutdown. However, as I have mentioned before in recent Chart Advisor issues, emerging markets continue to outperform. This is a new trend that will be very encouraging if it continues next week.

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