Yesterday, VIX experienced its 4th biggest drop ever, plunging 25.9% from Friday’s close even though France’s election delivered the very same results that just about everyone expected.

It has dropped even more this morning, and is now off 33.3% from Friday’s highs — despite the fact that there’s the potential for war on the Korean Peninsula and the probability of a government shutdown later this week.

Is there any logic to this?  What should we take away from the behaviour of the “Fear Index?”

Between 2014-2016, VIX very rarely tagged the bottom of a huge, rising channel (shown below in yellow.)  When it did, this meant that fear was unusually low.

Without fail, however, every tag on the yellow channel bottom meant that stocks were at or very near a significant top.

Things changed, however, following the US election.  VIX plunged right in the middle of stock futures’ 5.7% mini-crash.  This was beyond ridiculous.  Selling VIX as futures are plunging is the equivalent of cancelling your homeowners policy as a tornado is ripping the roof off your house.Who would do such a thing?

It would have to be someone with unbelievably deep pockets — someone for whom ensuring that stocks continued to march higher was more important than the many billions of dollars they might lose in the process.  In other words — central banks.

In a note on Apr 21, Merrill Lynch reported that central banks have already “invested” over $1 trillion YTD — an amount on track to top 2008’s $2.8 trillion by 25% and more than double last year’s $1.7 trillion.

Some central banks, like the BoJ and SNB, invest directly in equities in order to manipulate stock prices higher. It’s more effective than big, clumsy measures like QE.  Over the years, however, they’ve discovered they can get more bang for their buck by using more refined measures like the yen carry trade, oil futures and VIX to drive algorithms.

Simply put, algorithms look to a variety of indicators to tell them when to buy and sell stocks.  If oil spikes higher, stocks will too.  If USDJPY rallies, you can bet that stocks will be close on its heels.  And, if VIX sheds 25% in a day, well…we’ve seen what happens, haven’t we?

Machine trading is gradually replacing real, live people — traders in pits who might look up, scratch their heads and ask “wait a second, does that make any sense!?”  Just a few weeks ago BlackRock, the world’s largest investment manager with $5 trillion under management, announced it was laying off human traders and increasing its emphasis on machine trading.

When VIX drops, algos don’t ask why.  They simply read it as a reduction in risk and trigger buy orders.  However, as VIX approaches long-term support such as the huge, yellow channel, algos know that the rally is almost over.  At least, that’s what they used to think.

In its last “normal” tag, on Aug 9, 2016, VIX correctly signaled a drop in ES that extended to 163 points at its election night lows.  But, as mentioned above, VIX was hammered that night and, by mid-November, had broken down through channel support (the white arrow) in order to produce new all-time highs in stocks.

The next time VIX tagged the yellow channel line, on Dec 21, it produced a very modest 34-pt drop in ES.  Were the algos learning?  Was VIX signalling a fundamental change in the level of risk in the markets?Since Dec 21, VIX has dipped below the yellow channel bottom 27 times — an astounding one out of every four sessions.  More importantly, the dips always come at crucial moments, when ES and SPX are in danger of breaking trend (thin purple lines below) or need a boost to get up over resistance.

The latest example, of course, is this week.  ES and SPX have both been locked in a falling channel since their all-time highs on Mar 1.  Yesterday, based largely on VIX’s historic plunge, futures broke out of that channel and are threatening to make new, all-time highs.  Improbably, this has occurred during a week of highly elevated geopolitical and macroeconomic risks.

At 10.22 this morning, VIX almost reached the Feb 1 lows of 9.97 (the day it plunged 23% to convince algos that the Fed’s rate increase was no big deal.)  The last time VIX was this low was in Feb 2007, just months before the S&P 500 peaked and crashed 58%.  I’m not suggesting that a crash is imminent. But, I think it’s important to realize that the “market” is broken, and that its gains (e.g. the “Trump Rally“) possess all the integrity of a campaign promise.

There was a time when VIX was a great indicator of fear in the markets.  Now, it’s just another tool with which to drive stocks higher.  Put simply, the tail is wagging the dog.  And, the people doing the tail-wagging are not only determined, they have access to an unlimited amount of free money.

Now, on to today’s forecast.  SPX backtested to within .79 of our target at the yellow neckline yesterday before deciding that appearances aren’t all that important.

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SPX has seen two bullish IH&S Patterns busted over the past two weeks.  They came close enough.  The latest even completed last Thursday before fizzling after the overnight ramp fell apart under scrutiny of the mounting risks in the markets.

But, there’s nothing like a 1%+ gap higher over a weekend when investors are already on edge, to complete an IH&S —  which is exactly what we’re facing this morning.  While the French election results were a relief to the status quo, there are still other significant risks out there.  This week.

Sure, they can hammer VIX back down below support (-32% in the past week!) and break USDJPY out of its latest bearish pattern; but, will the breakout hold this time?  Last I heard, the Korean situation hadn’t gone away, and the US government still faces a potential shutdown Friday night.

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SPX reversed at the very last possible moment, yesterday, before the meltup could be labeled a breakout.  For now, we remain nervously short from 2361.32 for what should be at least a 10-pt gain.

Why “nervously”?  As we discussed yesterday, the good news for bulls is they’re at the cusp of a strong breakout.  The good news for bears is they’re at the cusp of a breakdown.  That’s right.  This is one of those critical turning points that will determine the course of the next few months — and, who gets to celebrate come Monday.

Of course, the French election is only one in a list of several potentially landscape altering events scheduled for next week.  There’s also the possibility of a government shutdown, potential nuclear war in North Korea, and the very real and expanding wars in Syria, Afghanistan and wherever else we’re about to bomb.

One thing’s for sure…real, live investors, speculators and traders have woken up to the risk.  Remember the string of VIX plunges (the yellow arrows) below the yellow channel bottom?  As of a few weeks ago, it was averaging one of every four sessions.  Not so much, any more. Might markets exhibit a little nervousness in the lead up to the week ahead?  Stay tuned.

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Our first quarter total came in at 26.17% versus 5.53% for the S&P 500.  This brings our average monthly return to 8.39% for 2017 YTD and to 14.58% for the period since Jan 2015.

While Q1 returns were lower than those earned in 2015 and 2016, there has been significantly less volatility these past few months, and much fewer opportunities to short.

Discussion

This quarter was arguably the most challenging in recent memory.  Coming on the heels of the algo-driven post-election ramp job, stocks rallied strongly into the year end.  This was in keeping with our analog first posted on Aug 3 [see: A New Analog] which called for SPX to reach 2297 by Jan 5.

From the Dec 9 Analog Update:

SPX was a little late, reaching 2297 on Jan 25 and then reversing.  But, two weeks later, it shot up through 2300, breaking out of a sharply rising channel and tacking on an additional 100 points before finally running out of steam.

This was unexpected, and we spent much of January and February getting head faked by frequent weak closes which were then followed by strong gaps higher the following morning (11 of 39 sessions.)

March was more fruitful, as the sharp decline in oil prices we had forecast finally played out, driving stocks lower in the process.  This was a nervous few weeks, as speculative long positions had reach all-time record highs.  But, it worked out nicely, and we were able to maintain higher conviction on our positions throughout the month.

As we’ve discussed often, VIX took up the mantle of chief market manipulation tool following the US election [see: Why the Trump Rally is a Fraud.]  Between Dec 21 and Apr 5, it dropped below the bottom of a long-term channel that used to warn of impending corrections an astonishing one out of every four sessions (the yellow arrows.)

While VIX has moved off the yellow channel bottom these past few weeks, USDJPY and CL are still quite active in propping up stocks.  Just today, USDJPY completed an IH&S Pattern that drove SPX nearly 1% higher.

There will no doubt be many head fakes and trap doors ahead. In the next week alone, we face the prospect of war, the next step in the dissolution of the EU, a budget showdown and government shutdown, and the continuing oil price collapse.  Our latest forecast indicates plenty of fireworks!

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Sometimes you’re the windshield,
Sometimes you’re the bug.
Sometimes it all comes together baby,
Sometimes you’re a fool in love.
Sometimes you’re the Louisville Slugger,
Sometimes you’re the ball.
Sometimes it all comes together baby,
Sometimes you’re going lose it all.

Mark Knopfler, Dire Straits

It seems another hedge fund bites the dust almost every day.  It’s hardly surprising, given the state of the “markets” lately.

It used to be that having a strong grasp of macro- and microeconomics and financial statements was enough to generate respectable investment returns.

Now, it seems that funds have essentially three choices:

1)  become a closet indexer — hopefully, with alpha thrown in from brilliant stock picking
2)  be extremely nimble — avoid or take advantage of seemingly random rips/plunges
3)  be one of the manipulators (or shadow them)

Being a closet indexer doesn’t work very well in a 2/20 structure.  While there are certainly some great stock pickers out there, even great picks suffer along with everything else when the market is plunging.

And, it’s challenging to be nimble if you’ve got anywhere north of $1 billion — or, even $100 million. Given how low volume has become, stocks are sensitive to big moves into and out of markets.

This leaves our manipulators — central banks, their lackeys and big, data-driven firms which are able to shadow or emulate them: Renaissance, Citadel, etc. (some have even accused these firms of being able to help write the daily script via their ability to drive the algo drivers.)  If you’ve got $20+ billion and like to throw your weight around, you can make your own luck.

Bottom line, stocks are driven all day, every day, by algos which feed off three primary drivers: the price of oil, USDJPY and VIX.  Each of these is manipulated on a daily basis, primarily by central banks but almost certainly by other large players.  If you haven’t noticed this, you haven’t been looking very hard.  Together, they were entirely responsible for the election night recovery and subsequent Trump Rally [see: Why the Trump Rally Is a Fraud.]

Yesterday, I forecast a pop and drop, calling for a short at 2351.52 (within a point of the top) which we then rode down to 2336.75 (within 2 points of the bottom.)

VIX, which was hammered over 12% off yesterday’s highs, is curiously on the rise.  Could it be that this ramp job isn’t meant to stick?  It’s been a while since we had a nice pop and drop… Note that the IH&S has completed, so this is a make or break moment for SPX.  I’d short here at 2351.52 with tight stops.

We picked up 0.6% for the day only by watching and anticipating the price action and interplay between CL, VIX and USDJPY.  It wasn’t an amazing day.  But, string enough 0.6% days together and you get a nice month.  Those who ignore chart patterns and technical analysis were left scratching their heads.

It works around 90% of the time.  When it doesn’t, it’s because: (1) something big is happening that can’t be contained by a timely hammering of VIX or a USDJPY ramp; (2) those doing the manipulating have their signals crossed; and, (3) the move is imminent, but is delayed multiple times while the big boys position themselves ahead of time.

Last month, this approach generated 13.15% — a little below our average of 14.58% since Jan 2015, but better than the two previous months (meltups are challenging.)  [see results.]  While I generate medium-term and swing targets, about half of our returns are the result of intra-day swings — many of which are head fakes.

The worst are those at the end of the day.  Yesterday’s close, for instance, saw a three-day old channel break down.  In the old days (pre-2010) this would have been a bearish development, particularly since stocks are likely headed lower over the next week.

From yesterday, just before the close:But, a timely push above resistance by USDJPY and a timely after-hours dip by VIX ensured that SPX opened back inside the rising white channel.  They can just as easily push SPX up and out of its falling purple channel.  So, as is often the case, forecasting this beast involves discerning the intent of those who are doing the manipulating and contrasting it with inherent limitations they face.

A simple example is the USDJPY.  By hammering the yen (an increase in the USDJPY) it’s easy to drive stocks higher.  But, at some point, a cheaper yen hurts Japanese consumers and businesses who must pay higher prices for imported oil and food.

If you’re thinking “hey, wait a minute; this is the tail wagging the dog!” you’re absolutely correct.  In fact, I’ve had even better results in forecasting currencies and commodities, as they usually wear their motivations on their sleeves.

If you’re thinking “hey, wait a minute; this is easy!” you’re dead wrong.  I watch 10-12 charts on six monitors all day, and the interplay between them often defies logic. For example, we’ve had several instances, lately, of VIX and stock prices both rising or falling at the same time.

It’s also quite common for large moves to be delayed all day long, only to take place after hours.  And, don’t get me started on intraday ramps in USDJPY that are unwound after the close each evening, when futures are more easily propped up (watch it tonight.)  Even worse: ramping VIX overnight so it can be hammered during market hours when stocks need a boost.

All this to say…if trading has been tough lately, you’re in good company.  If a $3 billion hedge fund with dozens of insanely smart analysts and traders backed up by world class research and computers can’t hack it, maybe it’s not them.  Maybe it’s the market that’s broken.

Now, on to today’s forecast.

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Another ramp job last night, this one courtesy of USDJPY – which is conveniently back above its SMA200.

VIX, which was hammered over 12% off yesterday’s highs, is curiously on the rise.  Could it be that this ramp job isn’t meant to stick?  It’s been a while since we had a nice pop and drop.

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The trouble with low-volume meltups driven entirely by algos is that they lack a strong foundation.  So, troubling economic, political or military news often unwind them — after hours, of course.  Such was the case with yesterday’s melt-up.

There’s no shortage of bad news this morning: a new UK election, horrid factory output, oil’s production cut in danger, disappointing housing starts…oh, and the backdrop of potential thermonuclear war.

USDJPY dutifully ramped back above the SMA200.  And, WTI studiously avoided completing a bearish H&S Pattern.  VIX, of course, shed over 8% intraday — just because.  It was enough to run some stops and put bears on edge.  But, it wasn’t enough to break the negative trend that’s pervaded since the 2400 top.

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Despite an initial 10-pt surge, SPX came within 0.48 of our next downside target on Thursday — despite attempts by USDJPY, VIX and CL to prop it up.

Now, even with the futures up several points, it appears the downside might not be done.  After tagging the SMA200, USDJPY has dropped below it to our next lower target. And, CL has ignored an easy opportunity to break out.

Could we be in for a replay of last Thursday, with our next downside target in play?

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Trump, who rode to the White House on promises to fix healthcare, avoid foreign wars, embrace Russia, dis NATO, label China a currency manipulator, rebuild infrastructure, slash taxes and upend the Federal Reserve is well on his way to reverting to the same stance as nearly every other mainstream politician in recent memory.

Yesterday, he declared that the US dollar was too high.  And, after criticizing Yellen for artificially depressing interest rates to aid the (then) incumbent, it turns out he’s a fan of them (and, her.)  Could it be that with all those ex-Goldman bankers running around the White House, someone sat him down and explained that he, too, could benefit from low rates?

USDJPY dropped right to our next downside target a full week ahead of schedule, but not without a bit of theatrics.  Tuesday’s drop through the yellow line of support at 110.15 yielded, as expected, a drop to the falling white channel bottom. What happened next speaks to the continuing manipulation of USDJPY which, in turn, manipulates equity prices.  The initial breakout above the yellow TL busted a rapidly falling channel in eminis.  From there, USDJPY bounced back and forth in a series of headfakes above the purple trend line and below the red in order to fine tune equities.The primary purpose, of course, was to delay hitting the SMA200 until after the close — so as to avoid the rapid selloff that would otherwise have occurred.  Mission accomplished.  The yellow arrows below indicate where downtrends were interrupted.

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I’ve had occasional capacity issues that my web hosting service assures me can be fixed with a little maintenance on their end.

Hopefully, everything will go smoothly.  But, I’d like to know asap if it doesn’t.  If you encounter any issues logging in or navigating the site over the next few hours, please take a moment to contact me with specifics.

Thanks,

Michael