Volatility Suggests Falling Stock Prices

Volatility over the past six months has been off the charts. Volatility is more than just the performance of the Volatility Index or VIX (Chicago Options: ^VIX). Volatility includes the volume and conviction associated with the recent roller coaster.

Over the past six months, the Dow Jones (DJI: ^DJI - News) has seen 38 (almost every third trading day) 90% days. A 90% up day means that 90%+ of trading volume and point moves were to the up side (a 90% down day is exactly the opposite).

Of those 38 90% days, 16 happened to be to the up side, 22 to the down side. That is highly unusual. I've read interpretations stating that high volume, 90% up days (also called breadth explosions), are bullish for stocks.

Before drawing conclusions, let's try to decipher the emotions that cause 90% days. Fear, panic and certain news events cause severe down days. Most up days seem to be caused by positive news rather than a fundamental change.

In summary, we have erratic news-based buying and panic-inspired selling with 58% of the 90% days being down days (December 19 was the latest). This doesn't look like the beginning of a new bull market to me.

No Change = No Improvement

The U. S. financial system (NYSEArca: XLF - News) got into trouble because of falling real estate prices (NYSEArca: IYR - News). The European financial system got hammered by sovereign debt defaults.

U. S. real estate prices continue falling and entire European countries continue to struggle with pure survival. Neither the U.S. nor the European debt crisis has been dealt with properly.

QE2 was all the rage at the beginning of 2011, but its effect was limited and short-lived. The European Central Bank's (ECB) charter prohibits outright QE where newly printed money is given to banks.

However, the ECB has expanded its repurchase operation to 3 years. For 1% European banks can borrow money from the ECB. With the borrowed money, banks can now do what the ECB isn't allowed to - buy more toxic bonds from Greece, Italy, Spain, etc.

At first glance this looks like a profitable symbiosis. Banks pay 1% and get paid 3%, 4% or more via their bonds. Unfortunately, banks forget that they should be concerned about the return of the money more than about the return on their money.

Banks buying more unstable sovereign debt is a short-term Band-Aid but a long-term recipe for disaster. The expiration date of the 'long-term disaster' label may well run out early and bite banks and investors in the butt sooner than expected.

KISS - Keep It Simple S...

The past two years have made one thing painfully clear: I can't predict the news and how the market reacts to news. Often there's no rhyme and reason, that's why I don't even try.

What I can do is extrapolate the market's signals via technical analysis. This may sound abstract but is more accurate than any other market forecasting approach I've encountered (the chart below shows some of the trend lines and Fibonacci levels I follow). The S&P 500 (SNP: ^GSPC - News) shows remarkably consistent respect for trend lines, Fibonacci levels and other support/resistance points.

Earlier in 2011, the S&P got close to a multi-decade trend line that ran through 1,378 in May. Slightly lower was important Fibonacci resistance at 1,369. Additional Fibonacci resistance was found at 1,382.

Based on this resistance cluster, the April 3 ETF Profit Strategy update stated that: 'In terms of resistance levels, the 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions.'

The May top at 1,369 - 1,382 made sense because sentiment was very bullish and seasonality was turning bearish (sell in May, go away).

In October, once again seasonality, sentiment and technicals were lining up for a major buying opportunity. The September 23 ETF Profit Strategy Newsletter predicted that:

'From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter trend rally. The plan is to square short positions and buy long positions around 1,088. The rally, once underway, will probably re-inspire a certain degree of confidence into the market before it runs out of steam. The most likely target for this rally is S&P 1,266 - 1,282.'

2012 Outlook

The outlook for 2012 doesn't look good. Only some version of QE3 and more aggressive ECB intervention can mask up the technical damage visible on all major charts.

The rally from the October lows is still within the confines of a counter trend rally and has yet to move above common Fibonacci resistance and two major trend lines.

Short-term December/January Outlook

Trading volume has been tepid and unlike the Dow and S&P, the higher beta Russell 2000 (Chicago Options: ^RUT) and Nasdaq (Nasdaq: ^IXIC - News) have not been able to best their October highs. This doesn't prevent higher prices (in fact I'd like to see at least one more push higher) but it suggests that stocks are losing steam.

It seems like the generals (S&P and Dow) are marching ahead while the troops (Nasdaq, small caps and euro) are following behind. An army in disunity can't conquer and a fragmented market is a weak market.

Seasonal tailwindw will calm significantly in early 2012, sentiment is once again turning bullish (a contrarian indicator) and technicals are looking weak. It seems like another high probability set up (like in May and October) is in the making.