About 30 years ago I was helping a friend write his PhD dissertation on multiple personality disorder. At the time, little was known about the condition and very few documented cases existed. I mention this because right now the financial markets appear to exhibit two distinct personalities.

Based on both technical and fundamental indicators, one can make a pretty good case for a continued market rally as well as for an impending market collapse. In such a situation, our personal beliefs about what is likely to occur matter little. As managers of market risk we must guard against the worst-case scenario. Right now that means maintaining an allocation that is heavily weighted toward very low-risk options like money market funds.

The chart below shows performance of the New York Stock Exchange composite (NYSE) over the past six months. The gold line is a simple 50-day moving average. I added the blue line to show that the NYSE appears to be forming a double top.

Although I think technical analysis of the markets can help forecast what might occur, I do not believe chart patterns are predictive. I compare it to looking for images in the clouds. It might be interesting, but it doesn’t usually mean anything. But for adherents of the study of chart patterns, a double top is usually a negative indicator and it could show that the next most likely market move is down.

The middle portion of the chart is a stochastic oscillator. This tool is designed to measure random market cycles. High levels (above 80) are an indication that stocks are overbought and will soon correct downward. At levels below 20, stocks are oversold and an advance is likely to occur. Recently this indicator turned down but after a few days, abruptly reversed. That usually occurs during strong market advances. But this time it continued its new up move for only a couple of days before reversing again and heading back down. Right now it is difficult to forecast what the market is likely to do based on this indicator.

The bottom portion of the chart is a moving average convergence divergence (MACD). About a week ago this indicator turned positive and started moving up. In the past couple of days, it has also turned downward.

Whether these indicators are forecasting just a few days of negative market action or a new major downturn remains to be seen. We could see another reversal that resumes the uptrend that began in March 2009.

That is the trouble with split personalities. It is difficult to predict which one will eventually emerge as dominant.

F.S.

Measuring market volatility is one of the more commonly used methods to assess market risk. The presumption is that risk is much higher when the market is more volatile.

One tool used to measure risk is an index called the “VIX.”  According to a description in Wikipedia, “VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. A high value corresponds to a more volatile market and therefore more costly options. … Often referred to as the fear index, it represents one measure of the market’s expectation of volatility over the next 30 day period.”

In other words, as traders anticipate higher volatility, the value of the VIX rises. The title of “fear index” results because high volatility causes fear or anxiety for traders and investors.

Below is a chart showing the level of VIX over the past five years. For most of 2005 and 2006—years that were fairly normal in terms of market volatility, the VIX spent most of its time hovering between 10 and 15. Volatility increased dramatically in 2007 and VIX twice peaked at higher than 30. In 2008 the VIX soared to a never before seen level of 80.

This year has been interesting. Many reports from the media and government sources are reporting that the recession is over and the economy is back on track. The S&P 500 so far has a double-digit gain for 2009. But in October the VIX again topped 30 and is even now hovering near 25. That is a sign that traders are still concerned about the risk and volatility of this market. VIX eclipsed its current level only twice in 2007—the second of those instances coincided with the beginning of the worst bear market in recent history.

Another simple way to examine market volatility is to simply compare monthly gains or losses of the S&P 500 over the past five years. As the chart below shows, monthly gains and losses over the past two years have exhibited dramatic swings when compared to the three previous years.

While March, April and May of 2009 produced three months of solid gains, many investors would not have been comfortable about being in the market during that period. A look at the VIX chart shows that while the VIX was dropping then, it did not fall below 30 until late summer.

Many investors have short memories. After a few months of market gains, the times of significant losses are easily forgotten. But successful lifetime investing is a marathon, not a sprint.

Right now many investors with money on the sidelines might feel that a rising market is leaving them behind. In reality, since July major stock indices have gained very little. In October the S&P 500 lost 2% and many technical indicators like relative strength are showing that positive momentum is failing. Bullish sentiment is at an extremely high level—something that usually occurs at market tops.

And as we have mentioned repeatedly, economic fundamentals such as unemployment simply do not support a continued major market rally.

Last week the government reported that the nation’s jobless rate reached 10.2% in October. This is only the second time in the post-World War II period that the rate surpassed 10 percent. In a speech this week, Janet Yellen, president of the Federal Reserve Bank of San Francisco, said: “With such a slow rebound, unemployment could well stay high for several years to come.”

In spite of all these negative factors, major stocks indices have staged a significant rally. This divergent advance could continue, or it could end tomorrow. Investors who take positions at this time need to do so with the understanding that by virtually any method of measurement, market risk remains at an abnormally high level.

F.S.

Although the stock market seemed to struggle a bit over the past week, the overall trend remains up. An improved jobless claims number and improved retail sales in October are likely to boost stocks over the short-term and technical and cyclical indicators seems to be showing the same.

Regular readers probably know that I do not believe that the economy is in recovery mode. I am convinced that the fundamental factors remain weak and that it will be years before the economy is back to the levels of strength we saw in 2006 and early 2007. But obviously Wall Street and the investment world in general does not care what I might think.

For now, I think traders are short-sighted and focused on any positive data that is of the “less bad” variety—as in “the latest report still shows poor numbers, but it isn’t quite as bad as we were expecting.” As a result, the markets continue to advance because many investors are buying on the hope that things will soon return to normal.

One of the strengths of technical indicators is that they do not account for emotion or even for fundamental economic data. All they do is reflect what has happened in the markets. And while some argue that this is like trying to deduce what is ahead by looking in a rear-view mirror, that is often the most accurate information available.

Take a look at the chart below of the New York Stock Exchange Composite. From the black line showing price movement of the past year, we can see that stocks pulled back over the past couple of weeks but started advancing again over the past few days. We can also see that a similar situation occurred four times since July.

Stocks have risen steeply since March. While the pace of that rise has slowed, (as indicated by the blue and yellow trendlines) so far there is nothing to indicate that the rally is over.

The middle portion of the chart is a slow stochastic oscillator. It is a tool designed to measure random cycles. It is very reliable at identifying when stocks have reached overbought or oversold extremes. In other words, when the oscillator climbs above 80, a downturn in stock prices is likely. When it falls below 20, an upturn in stock prices usually follows. This oscillator turned positive in late October and is now rising. It is about the 50 level, indicating that we should see several more sessions of rising stock prices before it eclipses the 80 mark.

The bottom section of the chart is a relative strength indicator. It has just crossed back above the 50 mark. Normally that indicates a situation where stocks are gaining strength and should continue to rally for at least a few sessions. I added the red line to show that while stocks have been rallying to successive highs over the past few months, those rallies have shown declining strength. The disparity between what the indicator is showing and what the market is actually doing is called negative divergence. Changes in market trends are sometimes preceded by negative divergence.

Based on these indicators, I would not be surprised if stock prices keep rising for another couple of weeks before the next downturn begins. Whether or not that downturn will become a major correction I cannot predict. But I still believe that market risk remains high and a significant double-digit decline will occur sometime in the next several months.

F.S.