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‘Fear Index’ Shows Dow 12,000 is Doomed

The VIX shows resistance to more gains


The Dow Jones Industrial Average pushed to new highs on Wednesday, closing above the emotional 12,000 level for the second day. Traders were encouraged by the “first day of the month” phenomenon that pushed stocks to big gains on Tuesday and that has helped push stocks higher throughout most of 2010. In fact, 61% of the entire rally in 2010 can be accounted for by gap up openings on the first day of each new month.

anthony mirhaydari chart

While large cap stocks move to new heights, a different story is being told by smaller, riskier stocks as well as the options market. Over the last few days, small and mid-cap stocks have merely moved back to the top end of their recent trading range. You can see this in the chart of the Nasdaq above — which is mired in a downward channel on weakening momentum not unlike late April 2009.  Now the question is whether this is a continuation of a typical “dead cat bounce” in the wake of Friday’s hard selloff; or the start of a fresh new uptrend.

T o be sure, Tuesday’s advance was stronger than I had expected. But there were still signs that my medium-term expectation for lower prices is still valid. For one, the latest move to new highs by the Dow wasn’t confirmed by options traders with the CBOE Volatility Index (NYSE: VIX) or Wall Street “fear gauge” continuing in its pattern of higher lower and higher highs. The VIX remains nearly 12% higher than where it was last Thursday, when the Dow last flirted with 12,000. And to my eye, it still looks like the VIX is breaking out of its long nine-month downtrend.

Translation: Wall Street traders continue to snap up protection against downside losses. And that suggests that fear is still rising.

At the same time, sentiment remains very high. According to Merrill Lynch, their Sell Side Indicator held steady in January and remains at its highest levels since May 2008. In their words: “The last time Wall Street strategists were this bullish on equities was a few months before the collapse of Lehman Brothers.”

This is a contrarian indicator that is calculated based on the average recommended equity allocation of Wall Street strategists.

And finally, recent buying power has failed to eclipse the selling pressure seen on Friday. The stocks in the S&P 600 small cap index gained nearly 13 net points during Tuesday big rally vs. the 16 points lost last Friday. And only 88% of the S&P 500 constituents moved higher; compared to the 94% that moved lower on Friday.

So for now the market continues to give the appearance of steadfast resistance to doing anything but move higher. But based on what what’s happening among smaller stocks and in the options pit, this just isn’t true.

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned. He has recommended BZQ and EUM to his newsletter subscribers.

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