Safehaven | It's Risky Business: Chart Two of Three Important Charts

October 22, 2008

It's Risky Business: Chart Two of Three Important Charts
by J.D. Rosendahl

On October 19th, I posted an article: A "PUT" on the US Government: Chart One of Three Important Charts. Now, I would like to present the second chart in that series. It's my all time favorite chart. What I call, "The Risk Chart".

The risk chart is the SP500 ($SPX) divided by the volatility ($VIX). And yes, you can use the NYSE or DOW instead of the SP500. It's a chart I've rarely seen, and frankly it's a chart I believe all stock traders or investors should review on a periodic basis. Why?

First, It prices the market in terms of volatility not dollars thereby providing a risk based view of the markets in general, and as equity owners or traders risk assessment should be the first thing we consider before making or continuing with an investment or trade. Secondly, at extremes this ratio provides valuable input on possible trend changes within the market.

Above is the risk chart on a monthly basis from 1989. Unfortunately, that is all the data available for the $VIX (volatility), but the chart does provide a useful tool as a reflection of the past and gauge on the future.

What does the risk chart say about the past?

The first thing I notice when looking at this chart is a broadening top or expanding wedge (ABCDEFG) pattern. This is a concerning pattern on the long run view of the stock markets and our economy. Such topping patterns usually prelude significant corrections, and this pattern has been building for years, hence the timing and size of the current sell off.

I believe wave E (peak 2000) represents the top of wave 3 of the long Elliott Wave Cycles, and the move down into wave F (2002 low) represents the bottom of wave 4 of the same long cycle. I believe this because if one looks at a monthly chart of the stock markets from the early 1980s through the 2000 peak the MACD lines never fell below zero during that massive up move, which is typical behavior of the largest wave of a cycle, and that wave is usually a wave 3. The stock market price bottom in 2002 experienced the first drop in the monthly MACD lines below ZERO in decades, which I also feel confirms a wave 4 bottom of the same cycle.

The final wave G (2007 peak) in the risk chart represents a possible wave 5 completion of the long Elliott Wave Cycles and/or K-wave. The possible reason confirming this belief is the expanding wedge pattern itself. That's the kind of terminal pattern I would expect to see completing the long cycle. And, the new low in the risk chart in 2008, which easily has taken out the 2002 low (support) creating a bearish divergence confirming the completion of the wedge pattern and thus wave 5. Also, there is bearish divergence in the monthly MACD of the SP500 for the first time in decades, which may also confirm the wave 5 completion.

What does the risk chart say about the future?

If the above view is correct, then we should be in the correctional phase of the long Elliott Wave Cycle or K-Wave that will last easily into 2012-2014, as we move into deflation.

However, the markets are wildly over sold, which is also confirmed by the risk chart. In fact, had one bought the markets when this risk chart was at these levels in the past, one would have had very strong returns. So, the question is have we seen the low in this leg down?

My primary view is the current low in October 2008 is not the low of this leg down, which I feel will happen in November 2008 for the following reasons:

I see no bullish divergences on the daily or 60 minute MACD so far. So another low might finally create those divergences. The weekly MACD also needs more time to turn up and cross, which leaves the window open for new lows to support those divergences on the daily and/or 60 minute time frames.
When I look at the move down, we had 8 straight losing days in October into the price low, and I don't think we've seen enough smaller moves exhausting the total move, nor does the existing structure of the move down look complete on an Elliott Wave basis.
It's very possible; we could see year end tax loss selling pulled forward into November. Concerns as we move into the election period and worries over the health of the Christmas sales seasons.
Lastly, I'm not convinced we've seen enough panic selling by Joe Public. I don't want to confuse that kind of selling with forced hedge fund selling and margin calls on executives we've seen. Joe is usually last in my book.

In my primary view, I'm looking for the DOW to close the month of October between its 200 month moving average (8,500) or its 20 day moving average (9,500) with 8,500 as my primary target. Since we have broken below the support line (around 22) on the risk chart, I believe the ratio will test the 1990 lows around 10 on this current leg down. To do so, we will need to see higher $VIX levels and low stock prices. We might even test the SP500 lows of 2002 on this leg down before it is completed.

Regardless of my primary view, I do believe the markets will bounce and provide a possible long side trading opportunity at some point, as the risk chart is pointing to that opportunity. Markets can stay oversold far longer than expected, and patience for that bounce seems warranted. I do not view the next bounce as part of a new long term bull market cycle, but a bear mark rally. It could be quite healthy in size and possibly provide a profitable trading vehicle, as bear market bounces are typically sharp. During the expected bounce, I look for the ratio on the risk chart to top out (40-70) somewhere in the middle of the Wedge Pattern. Then I feel we will see the beginning of another sell off:

In conclusion, I hope you find this chart to be a valuable resource and add it into your analysis for future investing or trading.

J.D. Rosendahl

J.D. Rosendahl is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.