What Went Wrong?

It was a pattern you could see from space.  SPY was making significant new lows every 80 sessions or so. Each one followed a tag of the top of the falling white channel and, in several cases, the 200-day moving average. And, each one came after SPY retraced about 71% of its recent losses.

But, on Dec 22, the pattern stopped. SPY bottomed out at 374.79 and started an improbable climb back above the 200-day moving average and broke out of the channel, putting in a golden cross for good measure.

What went wrong?

The short version: low-volume holiday trading in a heavily shorted market was easily overwhelmed by algorithmic trading tied to a series of sharp collapses in volatility.

Consider the chart of VIX – the fear index, as it is sometimes called. Over the past few years, it has repeatedly bounced off a trend line dating back to Jan 2018. Those bounces in volatility typically reflected or resulted in pullbacks in equities.

Conversely, when VIX fell sharply, equities advanced – particularly if VIX dropped through a trendline of support.  Several can be seen in the chart below. ES, illustrated in purple in the background, consistently responded not only to breakdowns in VIX, but VIX’s failures to break out such as occurred in late September.

VIX spiked above the dotted red trend line, only to fall back and enter a steeply dropping channel that kept stocks on the rise through the end of the year. The reversal (the purple arrow below) stopped SPY’s October decline well short of a backtest of the Feb 2020 highs that other indices experienced.

Incidentally, VIX’s final thrust lower (white arrow) on Dec 2 ultimately broke down below a trendline connecting the two previous lows, allowing SPY to reach its 71% retracement (407.23) for that cycle.  It was a little earlier than the cycle suggested, so it was no surprise when SPY pushed back up to that level on Dec 13th before plunging lower.VIX’s reversal from its Dec 2 lows ultimately led to the creation of a new falling white channel to prop up stocks.  It only required a few breakdowns along the way, including the Jan 27 lower low (yellow arrow) which helped SPY break out of its falling white channel, and the Feb 2 plunge below the dashed red trendline (from 2018) which enabled SPY to make new cycle highs.

Since it broke out of the year-long white channel, SPY has made consistently higher highs – in accordance with VIX’s very clear signals.

The latest test of the rising channel bottom came yesterday, after Powell suggested investors are perhaps a little too optimistic about a Fed pivot. The 2% intraday reversal… …was halted by – you guessed it – VIX’s simultaneous reversal at the top of its falling white channel. After all the dust settled, SPY had made new highs anyway. Today, it’s back to the channel bottom yet again.

There are several morals to the story, along with a few implications to consider. Breakouts can be easily engineered by those with enough capital – particularly over low-volume holiday periods. It doesn’t much matter who instigates one: central bank, large hedge fund, market maker, etc. They can and they will under the right circumstances. The key is being able to anticipate them and position accordingly.

It’s also important to understand that while markets can be manipulated, it’s usually a delaying the inevitable. The corrections between 2014-2016 are a prime example. By breaking the pattern, an instigator can wriggle out from under a painful options position, ramp prices higher in advance of an anticipated selloff, etc.

Don’t count on the financial media to point out the manipulation. If they were interested, they’d hammer Jay Powell every press conference with questions re the Fed’s and other CB’s trading activities – which remain shrouded from public scrutiny.

Do count on the financial media to interview dozens of analysts and PMs whose prognostications and explanations completely ignore the obvious – most of whom wouldn’t know a bear market if it bit them. The majority of these closet indexers find it safer/easier to talk their book, concurring with the official narrative and ensuring they’ll look no worse than their competitors when the selloff eventually materializes.

Are Powell et al. really satisfied with the loose financial conditions underpinning the current inflationary environment?  They’re either comfortable enough waiting for the reversion to the inflationary mean or are too nervous to fess up (remember transitory inflation?) and allow true price discovery.

Keeping a lid on inflation and interest rates has never been more important. I don’t fault central bankers for trying, even when it means obfuscation or outright manipulation. They have a nearly impossible job given the disconnect between the economy and the markets.  I believe, however, that this locks us into a never ending pattern of booms and busts – each of which will be greater than the last.

And, it sure gets tiresome.





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