Though we had four down sessions last week and a 2% drop in the SPX 500, the market action had a more “normal” feel to it. Normal? Really? Let’s take a look at recent market behavior, and you’ll see what I mean.
Market sentiment is not being driven by Greece for the first time since mid-June. When loan payment deadlines for Greece passed, it was all but assumed the worst would happen. As a result, volatility shot through the roof in a short period of time. But now, the unpredictability over a resolution that had investors and traders in a panic is gone.
China’s unorthodox approach to “controlling” a very sudden bear market (down 20% or more) is working. Their policy methods combine intervention, coercion and force; these methods are unconventional at best. Though their issues are complicated and far from resolved, at least China is no longer a worry – at least for now.
The markets are reacting to “normal” stuff – the economy, worries about interest rates and Fed policy changes, demand/supply for commodities and currency concerns. Not that these are easy issues to resolve, but when you’re not listening to political rhetoric from a nearly bankrupt country, it makes the analysis less complicated.
Earnings season began last week, and given the lousy growth in the economy, we were due to see some mixed results. So far this has been a case of the “haves vs. the have nots,” but that has been a theme for the last few quarters. Commodity names are struggling, which was first seen in the results of Alcoa. They reported mixed earnings and weak guidance, and the stock has dropped about 10% since.
As for the indicators, we had been warning that a potential drop was due and it happened last week. The SPX 500 fell 2%, the Dow Industrials was down 2.77%, and the Russell 2K down even more – 3.12%. The drop did not take us by surprise. T market was overbought on several measure and some pressure needed to be relieved. Of course, these steep drops tend to get everyone overly concerned. While the drop was sharp, we are seeing encouraging signs that the market may turn HIGHER. 
Let’s start with the VIX. It reached under 12% again last week, a level that has often been a danger sign. It doesn’t mean stocks cannot move higher, but that level has been marked as a point where markets lose altitude – if just temporarily. As if on cue, the decline started on Tuesday and the market could not recover the rest of the week. The VIX climbed but “only” made it back to 13.74%. Then, the spot VIX separated from the futures on Wednesday when the July future expired, and that needed to be corrected. See the chart here from Jay Wolberg of www.tradingvolatility.net.
The skew index, which measures tail risk option trades (looking for big moves down), started to get jumpy. When the index rises to certain levels, it tends to mean that a move down is coming. (This article explains more about the skew index.) By this measure, the move up toward 130 on skew was a time to lighten the load, and sure enough, this was a good predictor. The skew index is here. 
The McClellan Oscillators were at elevated levels last week, with the NYMOT flashed a reading of 150. We have often seen this zone to be a warning sign as well; specifically, that the markets were way overheated.
Commodities have taken a big whack, especially gold and oil. Other commodities have also been clipped, as it appears global demand is easing while supplies (especially crude) continue to rise.
The dollar remains strong, while other world currencies continue to falter. This may have ramifications down the road, but a strong dollar is good for the US economy.
So, for the coming week, we now have an oversold market, the VIX higher but not outrageously high, put/call ratios elevated (showing greater fear), the McClellan Oscillators now very negative (nearly extreme), the skew index lower, and the fear/greed index at the extreme fear level. Much like after the July 4th holiday when the indices breached the 200 ma, markets may be ready to reverse gears. Sentiment is bearish enough that a contrarian move is highly probable – and we’ll be ready.
