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Sliding down the flag pole

Lesley Beath  |  13 Sep 2011Text size  Decrease  Increase  |  

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The views expressed in this report are those of Lesley Beath and may differ from Morningstar's views.


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Disclaimer: To the extent that any content in this report constitutes advice, it is general advice that has been prepared by Lesley Beath without taking into account the particular investment objectives, financial situation and particular needs of any individual investors. If necessary, you should consult with a licensed investment adviser or dealer in securities such as a stockbroker before making an investment decision. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.


Global equity markets continue in their volatile fashion and are behaving as one would expect in this uncertain period. In the US, the VIX and the US T-Bond/ S&P ratio continue to trade in the range that has been in place since early August, with both suggesting that risk for the equity market over the next few weeks remains to the downside.


S&P 500 index (Spot) vs US T-Bond/S&P ratio chart

(click image to enlarge)


The S&P 500 and the Dow Jones Industrials are tracing out what appears to be a 'flag formation'. This type of pattern is described by Investopedia as a "pattern that looks like a flag with a mast on either side. Flags result from price fluctuations within a narrow range and mark a consolidation before the previous move resumes" thus they are viewed as continuation patterns and in this instance suggest that the direction of the next major move is to the downside. The action on both indices since the August sell-off has been contained to a well-defined upward sloping range which is typical of the formation. A break below last week's lows would be the first indication that the pattern was valid. But I think that a break below the August lows would be the main indication that another sell-off was imminent.

But markets are tricky things and if the August lows were violated on the S&P and the Dow Industrials but not confirmed by breakdowns in the Nasdaq and the Dow Transports, then we could be at the beginning of a short-term reversal. The World Morgan Stanley index is also currently sitting on a solid support level; if this gives way, in conjunction with a breakdown in the US, which at this stage I think is highly likely, then we could be in for another sell-off, which could take the S&P back to its July 2010 lows at 1040.

This possibility was talked about a few weeks ago, in relation to the activity in the VIX. It was suggested that if the VIX pushed above the highs of August 8 that would be the trigger for such an event. If the US market does fall to test the 1040 level, then that would equate to the Australian market testing its recent lows. I think that scenario is the most likely at this stage. There is very little to suggest that a positive reversal is imminent.