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The intersection of real life events and the stock markets is always interesting, sometimes surprising, and often frustrating to many market participants. The way that technical valuations and fundamental economic valuations of stocks interact is something that many of us try to figure out. Those who succeed, and are able to act on this success, can do quite well for themselves. It is also potentially in the interest of many providers of information (particularly those with large positions) to confound other market participants in such a way that they may sell at the highest highs and buy at the lowest lows to obtain maximum profit. This inherent incentive to deceive for profit adds to the inherent difficulty in predicting market direction and price targets.

I have been tracking the technical picture of the Dow Jones Industrial Average (NYSEARCA:DIA) daily since November. I noted on November 5, 2012 that the Dow had formed a rising wedge pattern dating clear back to 2008. Due to the failure of Federal Reserve and U.S. government actions over that time to stimulate the real economy such that the U.S. would have positive GDP growth in the absence of massive deficit spending, my take has been that the stock market has been trading on sugar highs of QE money filtering into equities (which has been explained in an excellent article by Seeking Alpha contributor Colin Lokey.) Due to my youthful inexperience with technical analysis, I immediately got excited and sensed that a big breakdown had to be on its way. I successfully managed to short various markets with a number of instruments on the first leg down, and got out of the shorts at the first inflection point around November 15th, reasoning that a bounce was likely since the index was not wanting to break below the rising wedge. So far, so good. It was then that I started to make mistakes, because I became convinced that every little drop had to be the start of "the big one." The fiscal cliff fracas in particular seemed to be the thing that would break the Dow out of this wedge to the downside. As it turned out, the Republicans decided to surrender, and the markets rebounded viciously to touch the upper trendline of the rising wedge. At the same time, the VIX has in the last three weeks undergone its largest percentage drop in history... and this was from a VIX high of only about 23, which is not a particularly extraordinary value. What this means is that options sellers are a lot more eager to sell than options buyers are to buy, as the price of options has fallen through the floor.

When we put these things together, this is a strong indication to me that we will remain trapped in the rising wedge for the foreseeable future. Continued volatility (VIX) compression every day suggests that the volatility over the next 30 days will be lower. This makes sense if we look at the Dow Rising Wedge Chart -- the lines converge, so if the market stays between the lines, volatility should go down. By about July 20, 2013, we come to the end of our rising wedge lines, and the pattern cannot continue. It will take some significant macro event such as the fiscal cliff or the debt ceiling (or perhaps the implementation of the sequester cuts) to break the pattern before then. I am sure actually going over the fiscal cliff more than technically by a few hours would have broken the pattern and thus, signaled a broad decline in equities for some time. The fact that the market was that sensitive to some tax increases and spending cuts (which still wouldn't have come close to eliminating the U.S. deficit) makes me think that an upside breakout is unlikely. However, if an upside breakout does occur (say, if the Dow crosses 14,000), then I think that this would actually signal further gains. However, I don't think an upside breakout from this inflection point is very likely. Nothing has fundamentally changed from the lows of 2009. The U.S. economy is still on life support -- to the extent that taking part of it away threatened to send markets plunging.

THE RISING WEDGE IN THE DOW (2008-2013)

(click to enlarge)

The combination of Dow technicals and the plunging VIX readings are therefore telling us that markets are not likely to move violently within the next 30 days. This means that it is likely that the Dow will stay within its wedge (or perhaps slowly break above its wedge) for the foreseeable future. However, since the trendlines of the rising wedge intersect about 7 months from now, the Dow must break either to the upside or to the downside by then, as the pattern cannot continue past the point of trendline intersection. From the current point, that means that there is about 650 points of downside on the Dow to the next inflection point at 13,000. Judging by the speed of previous bounces, we should expect this downside target to be achieved within approximately 1 month. Barring a significant macro event or sudden loss of confidence, 13,000 Dow should be the level to go long again safely, with ~700 points of upside possible. The VIX should be closely watched at this time, as a rise in it from these levels should be indicative of a break of the pattern. I continue to believe that despite the endless money printing, this will be a downside break, as the real economy will trump anything the Fed is likely to do within its mandate.

THE VIX FALLS OFF THE FISCAL CLIFF

(click to enlarge)

Chart source: Bloomberg.com

These are interesting times, and rarely if ever has the market provided such clear signals of its likely course. A sudden rise in the VIX is a real danger sign, but what I suspect will be a coming market correction from these levels may simply be an opportunity to go short now, and then go long when we have reached the 13,000 Dow target again. However, I think that a downside break could be very violent, and all it will take to touch it off at this point is some significant macro event. If the U.S. does not enact spending reforms, we will get another credit downgrade or downgrades, and if we do enact spending reforms, then GDP growth may well go negative and we may enter a second recession. In either case, the medium term outlook for the markets seems dim for here, and the biggest opportunity that I see to make money now is to be long volatility or short the markets on the eventual downside break. If, however, we see an upside break of the Rising Wedge from these levels, it is possible that the markets will continue to trade higher all year.

Options trades might be an especially interesting way to play this. The $132 Feb 25th put option on DIA trades at $0.49 now and could be worth around $2 if the Dow fell to 13,000, which seems reasonable enough. The low VIX means cheap options, but being able to predict where the market is likely to be in a month improves odds of a successful trade.

Good luck to everyone out there, and hopefully this information will help some SA readers out there make some money.

Source: Markets At Inflection Point

Additional disclosure: I am long volatility.