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Market Outlook: Is Volatility Signaling Lower Prices Ahead?

Michael J. Carr

Stocks drifted higher last week after suffering a sharp pullback. The question now is whether that pullback is over.

Volatility Contracts as Stocks Inch Higher

SPDR S&P 500 (SPY) ended the week with a gain of 0.85%. The ETF is now 5.12% below its all-time high reached in May. Pullbacks of 5%-10% have usually been considered normal in the stock market, but it seems that all declines since 2009 have been accompanied by warnings that the end of the bull market is near.

For a longer-term perspective, the monthly chart of SPY is shown below.

This is the sixth significant decline since the bull market began in 2009. There is no way to know if any pullback will develop into a bear market. But we do know this market is very sensitive to the actions of the Federal Reserve.

The latest sell-off was sparked by comments from Fed Chairman Ben Bernanke. However, the chart below shows that Bernanke's words did not result in an immediate change in policy. Money supply (shown as the monetary base) continues to grow, and since 2009, stocks have risen along with the money supply. Until Fed policy changes, stocks should continue to move higher.

For a shorter-term perspective, we can look at a 30-minute chart. Stocks opened lower last Monday, and the stochastics indicator quickly fell to an oversold extreme. Prices moved higher from that low as volatility contracted.

In the chart below, volatility can be seen as the distance between the Bollinger Bands. Trading ended Friday with the Bands moving closer to each other, indicating volatility was contracting.

Volatility tends to move in cycles with high volatility following low volatility. With volatility ending near the low last week, we should expect to see an expansion this week. High volatility is often associated with lower prices.

Last week's short-term trade to buy Monday's open and sell Friday's close resulted in a gain of 1.91%. Unfortunately, there is no clear signal for a trade like that this week, and I recommend sitting on the sidelines in the short term.

Gold is Also Oversold

SPDR Gold Shares (GLD) fell another 4.75% last week and ended the month with a loss of 11.06%. GLD is now more than 35% below its all-time high set almost two years ago. While in a bear market, GLD is oversold and has been for weeks. Traditional momentum indicators such as stochastics, shown in the chart below, have been oversold for most of the year.

Daily charts also show that GLD is at an oversold extreme. Last week, the fast stochastic fell below 3 and the slow stochastic fell below 5. Readings like that occurred only one other time in GLD's history. GLD was higher in the days and weeks after that signal, but a sample of that size cannot be considered reliable. Using gold futures for testing, gold has become this oversold more than two dozen times and the subsequent price action is mixed.

After a similar decline in the stock market, we would expect to see a rally for at least a few days and the formation of a bottoming pattern. Unlike stocks, gold has no intrinsic value and there is no reason to expect a rally like that. Gold is worth only as much as someone is willing to pay for it in the form of jewelry or insurance against economic catastrophes.

A rebound seems possible in GLD, but this is probably not the best time to enter new positions. Bottoms in commodity markets like gold tend to form over weeks or months.

This Week's News

As always, the first week of the month brings important economic reports. Strength in the economy could lead to renewed selling in stocks as traders worry that the Fed will stop easing.

Editor's note: June's ISM report came in at 50.9, slightly above forecasts.

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