A very profitable trade over the last few years has been to buy weakness in the face of rising volatility. A simple study has shown this to be the case. Since 2012 when the VIX is above 20, the average S&P 500 5, 10, 20, and 50 day returns are listed below versus the whole sample size.
| S&P +5 | S&P +10 | S&P +20 | S&P +50 | ||||
| VIX > 20 | 1.290% | 2.098% | 3.715% | 6.761% | |||
| All Period Avg | 0.319% | 0.644% | 1.289% | 3.112% |
These studies are great for historical context but we can't bet the farm on them. Simply put, they work until they don't and making outsized bets or bets without defined risk are gambles we're not willing to make. Position sizing and risk management are still critical even when historical odds are heavily in your favor.
These are a few of the things we're tracking closely in response to today's harsh pullback:
1. Where is support in the indices?
Next area for the S&P would be the 2000 level followed by the December lows. How does the market react around these areas of support. Is another V-bottom in the cards or is the market signaling a bigger correction this time?? For a longer term perspective the S&P remains in a tight channel vacillating between the top (resistance) and lower (support) areas.
2. Where are the pockets of strength?
On a day like today where most of my screen is red I always look for the pockets of strength in sectors and individual stocks. The obvious safe havens of bonds, gold and silver were up but continued strength resides in biotechs still as the IBB finished flat when the S&P was down 1.83%.
3. Are there any positive divergence?
With oil in a free fall and hitting new lows daily, it's interesting to see the XOP and OIH holding up below prior lows. If oil stabilizes these could be ready for a quick and rapid oversold bounce.
The S&P, Dow, Nasdaq, and NYSE all broke below their 50-day moving averages. However, the Russell 2k finished above its 50-day. Is the Russell ready to exert leadership after lagging all of 2014 or was the end of 2014 a false breakout and now ready to test the bottom of support? The sideways choppy action is very visible in this chart.
4. How are correlations playing out?
This heat map from Finviz does a nice job of laying out the various asset classes by way of their underlying etfs. It's a great resource for a quick synopsis of daily strength and weakness.
We tackle questions like this on a daily basis in hopes that they shape a theme for potential trades and/or clues on the next trend.
