The Final Plunge Ahead
When we combine the deteriorating investor sentiment profile toward the bank stocks with that of the overall broad market, it provides an even bigger possibility for a sharp plunge in the major averages to be followed by an equally sharp recoil rally. Sentiment as measured by the American Association of Individual Investors (AAII) provides one such clue that investor psychology is ripe for a short-term trend reversal.
Only one important indication that sentiment has reached the capitulation stage has been missing lately. I’m referring to the lack of a sharp spike in fear as measured by the popular volatility gauges. My favorite fear gauge, the CBOE S&P 100 Volatility Index (VXO), measured the volatility of large cap stocks and has been surprisingly subdued since its initial rise in October. Notice that investor fear as reflected by the VXO is nowhere near as high as it was during the early February market decline. Accordingly, we should witness a final spike higher in VXO in the next few days to let us know the final correction bottom has been established. Given how investor sentiment has rapidly worsened since last week, we can reasonably expect to see a volatility spike in the coming week.
Source: BigCharts
A final consideration which points to the end being near to the selling pressure is the oversold nature of this market. As measured by the 20-day price oscillator for the S&P 500 Index, the stock market is fast reaching a sold out condition and is technically vulnerable to a "bull raid." As of Dec. 14, the 20-day oscillator has reached one of its lowest (and most oversold) levels of the past year. What's more, this important gauge of the stock market's near-term internal condition has established a series of higher lows in recent weeks (see arrow below). This is in contrast to the lower lows recently made by the S&P 500 Index and is a positive technical divergence. Internal divergences like this one often occur immediately prior to market bottoms.
Source: WSJ
Until the final low is confirmed, investors should remain on the defensive as the stock market’s short-term technical profile is still very weak. For this reason I don’t recommend initiating any new long positions in stocks and ETFs right now. However, I anticipate that the latest global market-related fears will soon pass and that equity prices will then resume their upward path. On a strategic note, investors can maintain longer-term investment positions to the stock market via ETFs and outperforming individual stocks in strong sectors.