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Market Forecast: Does Sentiment Indicate Choppy Waters Ahead?

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October 3, 2016
Calm waters: Does the Market Forecast chart from thinkorswim indicate rough waters ahead for the markets?

September has historically shown more stock market volatility than other months. Typically, investors take it easy in July and August with vacations and baseball games before sending kids or grandkids back to school and themselves back to the grind. This year was no different. After breaking above resistance in early July following the late June Brexit vote, the S&P 500 stalled for the next six weeks in a very tight range.

Volatility, measured by $VIX, dropped to significant lows, and volatility skew rose to show low anxiety in the short term, compared to a longer time frame. Of course, September’s Fed meeting, October earnings, and a November presidential election loomed large. But short-term complacency hit a peak in the summer months, and the long-term Market Sentiment indicator (orange line on the Market Forecast chart, figure 1 below) reached elevated levels. In last month’s article, we discussed the expectations for stocks when Market Sentiment extends beyond the 80th percentile. Let’s take a look to see how markets reacted in September.

Rough Seas Ahead?

Figure 1 shows a daily chart of the Market Forecast on the S&P 500. You’ll notice that heading into September, the intermediate posture (green line) had been strongly bullish for most of August and was starting to show some weakness with Market Sentiment approaching the 80th percentile (overbought territory). During the past few weeks, the intermediate trend has fluctuated between bullish and bearish twice as the S&P 500 broke out of its tight August range to hit technical support near 2125. With Market Sentiment falling, stocks’ path of least resistance is to the downside. During this past month, there have been 12 down days and only 7 up days in the S&P 500. The momentum line (red line) hit extreme lows multiple times (versus only once for all of July and August). This is typical of a “choppy” trading environment when Market Sentiment peaks at high levels.

market forecast SPX

FIGURE 1: MARKET FORECAST FOR S&P 500.

Falling Market Sentiment leads to more choppiness and makes stocks’ path of least resistance to the downside. Image source: the thinkorswim® platform by TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Bear Sightings

After the Federal Open Market Committee (FOMC) decided to hold the Fed fund target rate steady, the NASDAQ Composite broke to new all-time highs on September 22. This day is notable in that all three Market Forecast lines closed above the 80th percentile on the same day. This pattern is called a bearish cluster.

Figure 2 shows a weekly chart of the NASDAQ Composite. You’ll notice this chart also formed a bearish cluster the week of September 19. The confluence of clusters on multiple time frames strengthens the overbought signal. The last time $COMPQ formed a weekly cluster was November 2015. Eventually, the tech-heavy index broke out to the downside six weeks later. Although the current signal doesn’t guarantee a bearish breakout, it does signal headwinds for stocks that may make stocks struggle for new highs in October. 

bearish cluster, NASDAQ Composite

FIGURE 2: BEARISH CLUSTER ON WEEKLY CHART OF $COMPQ.

Bearish clusters are overbought signals that are stronger when they align at the same time on different time frames. Image source: the  thinkorswim® platform by TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Volatility picked up in stocks this month, and this month’s Market Forecast chart reflected increased choppiness with multiple trend changes, extreme lows in short-term sentiment, and bearish clusters on the outperforming NASDAQ Composite. The clusters and falling Market Sentiment suggest up-and-down swings may continue—especially with the seasonality of higher volatility extending into October and big event risks in the November election and December FOMC meeting looming. Stay tuned to the daily educational Market Forecast videos (see below) to learn how to apply this indicator in developing your market posture.

Want More Market Forecast from Investools?

Market Forecast is a proprietary tool in paperMoney®. Learn more about how to apply this tool with David Settle’s instructional videos on YouTube.