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Technical Nuggets: The Market is in “The Dead Zone”

By Joe Duarte on October 24, 2016

Stephen King fans may remember “The Dead Zone”, a suspense science fiction novel that morphed into a TV show in the late 1970s about a young man, John Smith, who is involved in a car accident and emerges from a coma with clairvoyant powers. Smith used his powers to solve crimes and eventually gets involved in a weirdly coincidental presidential race involving an “emotionally disturbed” and unscrupulous former bible salesman turned politician named Greg Stillson, who eventually wants to run for president. The plot then turns to Smith’s saga to stop Stillson from turning the country into a dysfunctional mess based on his neuroses.

Indeed, all is not what it seems.  The “Dead Zone” was the part of Smith’s brain that physicians thought had suffered irreparable damage and was no longer functional. But as fate would have it, it was this “dead” zone which gave Smith his clairvoyance. And just as the doctors failed to understand what was happening to Smith whose “damaged” brain was more alive than anyone could know, so are investors likely to be underestimating the danger in this market and what may eventually happen as the election, and the madness of the moment becomes even more dramatic.

Waiting for the Election

Only one thing is clear at the moment: The stock market is likely to remain range-bound until the outcome of the election becomes known. But external appearances can be misleading, and under the relative calm of the fairly steady indexes there is activity which may be a prelude to something very meaningful after the election. I’ll tell you more about that in a minute. Now, I want to discuss the big picture which is indicative of a market that will eventually break out decisively, although the direction is uncertain at this point.

SPX 2016 10 21

Figure 1 – S & P 500 in the Dead Zone

After the Brexit decline and subsequent rally, the S&P 500 (SPX) has remained in a trading range roughly between 2120 and 2190, and currently has a slight downward tendency which is meaningless unless the bottom of the range is pierced meaningfully. Because of this generally dull activity, it’s important to understand the potential for a breakout of this range and if there are any clues about the timing. Thus, this week’s indicators are all designed to measure both implied and future volatility.  

The Bollinger Bands (green lines around prices, upper panel) shrink when a big move is imminent. You can see how the bands tightened right before the Brexit vote in late June and again in September before the most recent attempted breach of the downside, which failed. Currently, they are again shrinking. A longer term view – the period from August until the present – is more important, as it shows that the bands have not broadened meaningfully for any significant period of time. Since longer periods of subdued volatility coincide with longer lasting directional moves, the Bollinger Bands are predicting that when the market breaks out – up or down – from the current trading range, it is likely to be a long-lasting, one-way move.

Next, we’ll look at the two uppermost panels in the lower indicator section, the Average True Range (ATR) and the Standard Deviation (SD) indicators. ATR measures the average distance that prices travel on a daily basis. Standard Deviation measures the variability of prices related to the mean. Together, they provide an excellent picture of current volatility. Note the spikes in both indicators around the Brexit period, and compare that to the current subdued picture they provide.

Finally, let’s look at the Rate of Change (ROC) indicator, the lowermost section in the indicator panel. ROC measures the expected change in future momentum, thus it signals when implied volatility becomes current volatility. Note the late June and July bottom and top spikes in ROC and how they correctly predicted key changes in market momentum. It is currently bouncing along the bottom of its own range suggesting that momentum is dormant, at least for now.

When you put these four indicators together you see that the market is likely to stay in the current trading range for some time. When these indicators start to show more signs of life, we would expect that to be a meaningful signal that predicts the market is about to make its move.

Wall Street Seems to be Betting on Mrs. Clinton

It should not come as a shock to investors that Wall Street is putting not only its political contributions, but also its investment dollars behind Mrs. Clinton. For example, Goldman Sachs (NYSE: GS) CEO Lloyd Blankfein recently noted that he supported Mrs. Clinton. And while it’s a free country, it’s interesting to see that Mr. Blankfein may not be alone.

NYAD 2016 10 21

Figure 2 – NYAD compared to S&500 (SPX), the Pharmaceuticals Index (DRG) and the Banking Index (BKX)

First, let’s look at the NYSE Advance Decline line (NYAD), which continues to trace a negative path that suggests the market, barring a startling upside reversal, may have seen its highest levels for a while. That said, given that traditional analysis is less reliable with central banks and high frequency traders still in business, we could get new highs any day. Still, it’s worth noting as far as things go that every major market top since 1987 has been preceded by a top in the advance decline line that happens some time before the major indexes. It could be happening again.

Now, on to Wall Street’s election bet. The bottom two panels of the NYAD chart show the Pharmaceuticals Index (DRG) and the Banking Index (BKX). Note that Mrs. Clinton is on record as being anti-pharmaceutical companies. Also note that Wall Street has given Mrs. Clinton lots of money, inside and outside the campaign, the latter via paid speeches. Finally, further note that the drug stocks have been decimated and that the bank stocks recently made new highs.

Conclusion

The stock market is in a Dead Zone, going nowhere as investors wait for the election results before deciding which way it will break out of the current trading range. Wall Street is betting on a Clinton win, but what it all means is beyond me at this point since the time from now to the election is likely to be one of the strangest periods in the history of American politics. Stay patient, but do not be surprised at anything you see or hear, inside and outside the markets. 

 

 


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