More Signs Of Market Risk Ahead

As intermediate to long term investors we often ignore the daily gyrations of the market. We don’t pay a lot of attention to what happens during the day because most of the time it just doesn’t matter. In fact, a lot of times we’re flat out bored and have difficulty finding things to talk about.

Our days are usually filled with waiting for weeks on end for something that changes the underlying technical structure of the market enough to change our portfolio allocations. Those changes are usually in small increments so they’re boring events too. I’ll even make the confession that I don’t have CNBC or Fox Business on TV during the day. I have Fast Money in my DVR, but only because it runs an hour after the market closes so it covers earnings announcements.

Long story even longer, most of the time what we see on a daily basis is irrelevant. However, once in a while we get near an inflection point where things can get exciting very quickly. The next few days may provide that excitement.

First let’s take a look at the chart we highlighted last week. The market is now sitting on its 50 day moving average, our target projected from a cluster of consolidation, and the 50% Fibonacci retracement level of the rally from April’s consolidation.

A break of this level will bring the 1600 area on SPX into play which is a major Twitter support level and near the 61.8% Fibonacci retracement. A move to that level will break the trend line from closing prices out of the November/December lows which will provide the first warning that something is amiss.

A break of the 1600 area would not bode well at all. From a price perspective these are important levels to watch:

Last week we mentioned that we were seeing event risk rising. Yesterday, while the market was higher in price, we saw even more signs of risk. Our market risk indicator is just a whisper away from signalling. All but one of its components is in negative territory. Based on its current trajectory it appears that a break of the 1600 or 1575 level on SPX will create a warning that the market is likely to accelerate to the downside.

Next, the ratio between 1 month volatility and 3 month volatility is getting back to an area where the market either puts in a short term low or begins an acceleration to the downside. Last week this ratio turned back down (bullish), but is currently above the level of the previous two weeks. If this ratio continues to rise it will be another sign that the current consolidation may turn into a correction. We want to see it fall below .9 to signal a resumption of the rally.

Last we have a chart of our Twitter sentiment indicator for VIX. It is currently painting a negative divergence from price, however it is still well above its confirming up trend line. A break above the short term negative divergence will be the second reaffirmation of the buy signal created at the first of April and most likely a very bearish indicator for the general market.

All of the items we’ve listed above are looking at event risk and not a fundamental breakdown of market internals. Market internals are still in an area that should point to higher prices. That’s what makes this so exciting.

The market will either bounce fairly close to here on good internals or external events in Japan and Europe will take control taking the market down. Needless to say, we’ll be adding aggressive hedges to our portfolio if our market risk indicator signals. In that event our Long / Cash portfolios will diverge with the core portfolio staying 80% long (until market internals dictate otherwise) and our other Long / Cash portfolio will go to 100% to cash.