Why the Market Will Crater…and, Why it Won’t

Once upon a time (1896), there was an index of 30 industrial stocks. It included such household names as the American Cotton Oil Company, the National Lead Company, and the US Rubber Company.  Since then, the components have changed 51 times.

Today, it contains many non-industrial companies such as Disney, Intel, Goldman Sachs and Apple.  It’s price weighted, so only high-priced, high-flying stocks need apply.  Losers are quickly jettisoned — which is why the only original cast member, GE, might get kicked to the curb if it doesn’t shape up soon.

Because the Dow can be reconfigured whenever need be, it often outperforms broader indices — making it a favorite of the cheerleading financial press.  Plus, it just sounds more bitchin’ to say “the Dow is up 300 points” than “the S&P is up 20 points.”

Because of its increased visibility, the Dow serves as a bell cow — the one everyone focuses on to get a handle on market health.  So, it’s a big deal when it makes major moves: breakouts, breakdowns and reversals.  Looking at the weekly chart below, we see plenty of each.Not to get into the weeds, but the Dow broke out of the rising red channel and above its 1.272 Fib extension — which would have been a natural turning point — back in 2014.  It struggled a bit, as the S&P completed a huge Butterfly Pattern and reversed in 2015.

But, after a couple of years of consolidation, it was off to the races — slicing through its 1.618 extension like nobody’s business.  When it popped through the 2.24 Fib at 23781, it also broke out of a Rising Wedge — a very, very bullish thing to do.  It only ran out of gas when it reached the 2.618 Fib at 26702 in January.Since then, it has not only been fighting to remain above the 2.24 Fib and its 200-day moving average, but it has been struggling to remain “broken out” of the purple Rising Wedge.It has had much help over the past few years.  We’ve documented the various machinations at play in Nov-Dec 2016 that rescued the market from the US election night near-disaster [see: Why the Trump Rally is a Fraud.]   But, the early 2018 spike through resistance was no less impressive.

In addition to VIX plumbing new lows on a daily basis, that’s when oil and gas broke out of long-standing channels.  The algos which account for the lion’s share of volume these days aren’t picky.  But, the oil and gas breakout was manna from heaven.It drove the Dow through that 2.24 Fib and up to its 2.618.  At the same time, the inflation implications sent interest rates soaring and bolstered the dollar at a time when it really needed a lift.But, as we’ve discussed ad nauseum, there is such thing as too much of a good thing.  Interest rates above 3% rightly scare folks who worry about balancing budgets and overleveraged families, corporations and governments.  A quick glance at the latest economic data tells the story.  We delved into the interplay in detail in Oil & Gas, Inflation and Interest Rates: A Delicate Balance or Goal Seeking?.

For the past few months, our premise has been that the economic powers-that-be would not allow the oil and gas rally to continue.  At some point, the interest rate pain would become too much and we’d see a correction that would bring CPI back down to 2%ish.  It appears to finally be under way.

The previous instances of CL or RB dropping through important trend lines of support and short-term moving averages sent stocks scurrying for shelter — i.e. the case for stocks cratering.  The extent of this drop will surprise traders, who are overwhelmingly long.

But, I would be remiss if I didn’t remind members that VIX is sitting right at important support – the top of the purple channel which marked all of its important tops (market bottoms – aka stick saves) between Jan 2016 and Jan 2018.

As such, it is just one good shellacking away from dipping back below the bottom of the long-term yellow channel.  Recall that dipping below this long-term support was a key go-to strategy for driving stocks higher ever since Dec 2016 (the yellow arrows, previously a once-a-year occurrence.)This, of course, is the case for the market not cratering.  If volatility can be (artificially, or otherwise) suppressed during the course of the oil & gas correction, it will go a long way toward supporting stocks.  If things get out of hand, the USDJPY stands ready to spike higher.

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