The Market Is Giving Us A Rare Signal Right Now…

Last week was surprisingly boring based solely on the price action of the S&P 500. But if we look under the surface, we can see that something unprecedented has happened.

Let me explain…

First, we need to take a look at the chart of SPDR S&P 500 ETF (NYSE: SPY) below.

My Profit Amplifier Momentum (PAM) indicator for SPY is shown at the bottom of the chart.

For those who may be unfamiliar, PAM is specifically designed to change from bearish to bullish slowly. This reduces whipsaw signals which are quickly reversed. It focuses on the longer-term trend. This means it is unlikely to turn exactly at a top or bottom but is likely to be on the right side of significant trends.

I’ve been highlighting PAM for the past few weeks because its readings have been unusually low.

PAM has now been between -1 and 1 for eight consecutive weeks. Looking at 120 years of history on the Dow Jones Industrial Average, this has happened just 15 times.

Last week, after seven consecutive low readings, I noted, “…after this signal, there is a tendency toward high volatility — about three times the average level of volatility. The probability of decline over the next month is twice as high as average.”

This tendency is now even more pronounced. History tells us there is a 67% probability of a decline in the next two weeks. This is important when we consider that, on average, there is a 57% probability of a gain in any two-week period.

I’ve also included blue shaded areas in the chart above. These areas highlight inside bars. An inside bar indicates times when the price action, the difference between the high and low, lies completely within the price action of the previous bar.

Inside bars are relatively rare and generally precede expansions in volatility. In 2020, all inside bars preceded expansions in volatility that was in the direction of the trend. With last week’s trend being down, there is now evidence that the downtrend will accelerate.

My Other Indicator Confirms…

Now, if there was just one indicator pointing to a downtrend, that’s one thing. But it’s always important to look for confirmation. So let’s turn to another indicator to see what else we can learn…

As it turns out, my Income Trader Volatility (ITV) indicator also confirms the high potential for a short-term pullback, as shown on the chart below.

ITV is designed to mirror the behavior of the VIX. One way it differs from VIX is the fact that ITV offers precise “buy” and “sell” signals. “Buy” signals come when the indicator falls below its moving average (MA). In the chart, ITV is the solid line, and the dashed line is the MA.

ITV is based solely on the price action. I published the formula for ITV and details on how to use the indicator in 2015. I had started using it to help my subscribers profit two years before that. Over the years, it’s proven to be an excellent tool for determining the direction of the trend.

ITV is on a “sell” signal after moving above its MA. This indicates volatility is likely to rise and that should coincide with a price decline.

Action To Take

Now, none of this is reason to panic. But it’s important to keep in mind that the market has been rallying at a very rapid pace. And these indicators seem to be pointing to a period of profit-taking at the very least.

Whether that’s all it ends up being is anybody’s guess for now. But we’ll stay tuned to what these proven indicators are telling us for further guidance.

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