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Does This Rally Have Legs?

By Jeff Clark
Thursday, November 19, 2015

We got a broad stock market buy signal on Monday.
Stocks had been selling off hard in November. The S&P 500 closed Friday at 2,023, down 4.3% for the previous two weeks. Technical indicators, like the McClellan Oscillator for the New York Stock Exchange (NYSE) and Nasdaq, reached oversold levels that typically mark short-term market bottoms.
And the Volatility Index ("VIX") – the stock market's fear indicator – closed above its upper Bollinger Band. This is an extreme condition that indicates that the VIX is overbought and the broad stock market is oversold. So it often marks the end of a decline phase.
On Monday, the VIX closed back inside of its Bollinger Bands. This triggered a broad stock market buy signal. You see, broad stock market buy signals occur when the VIX closes above its upper Bollinger Band and then declines back below the band. This is only the fifth VIX buy signal we've seen this year...
Take a look...
Now, here's how the S&P 500 performed following each previous signal...
As you can see, the stock market rallied each time. The S&P 500 gained as much as 6% in a few days following the VIX buy signal in late August. The smallest gain was 0.9% in four days in late June. That modest gain was followed shortly by another VIX buy signal in mid-July, which produced a 4% rally in one week.
The S&P 500 has rallied nearly 3% off of last Friday's bottom. The buy signal has already burnt up a lot of energy. So the question now is...
Does this rally have legs?
Right now, the bulls seem to have the advantage. Stocks often perform well during the week of Thanksgiving. So the seasonal pattern tends to support higher stock prices.
BUT... The current setup in the VIX looks most similar to what occurred in June/July. Back then, the VIX spiked above its upper Bollinger Band while a steep decline occurred in the S&P 500. Then the VIX fell back inside its Bollinger Bands, triggering a broad stock market buy signal. That signal produced only a small gain before the market turned lower and the VIX turned higher once again.
The S&P 500 dropped to a lower low, and the VIX rallied to a higher high – closing above its upper Bollinger Band for the second time in a few weeks. That action set the stage for a VIX "double buy" signal that led to a fast, 4% rally in the stock market.
If that situation plays out this time around, then this week's rally could be short-lived. The S&P 500 could come back down and retest last week's low – or perhaps drop to a slightly lower low – wiping out this week's fast gains.
At this point, seasonal influences favor the bulls. But based on the chart of the VIX, stocks could suffer a strong setback before those influences kick in.
As a trader, this is not the time to take an aggressive stance on either side.
If you bought into the oversold conditions on Friday, then you have solid gains. Be sure to set stop losses to protect them, and raise the stops if the rally continues higher.
Otherwise, it's too risky to chase higher stock prices right here. It's better to wait and see if the VIX chart plays out the same way it did in July. That would produce a "double buy" signal and give traders a chance to get in at lower prices.
Best regards and good trading,
Jeff Clark

Further Reading:

"It's not a buy-and-hold environment anymore," Jeff writes. "It's a scalping environment – play only the best setups and take profits quickly." Learn how to trade today's market right here.
"If the S&P 500 falls 20% in the next year, how will your stock holdings perform?" Brian Hunt and Ben Morris write. "If the S&P 500 climbs 20% in the next year, how will your stock holdings perform?" Thankfully, there's a stock market strategy that allows you to make good money in either of these outcomes. You can learn all about it right here.

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