Chart Advisor: Volatility Contracts

Articles From: Investopedia
Website: Investopedia

By J.C. Parets & All Star Charts

Wednesday, 17th May, 2023

1/ Volatility Contracts

2/ Communications Sector Breaks Out

3/ Tech Suggests Potential for Higher Bond Prices

4/ Healthcare Trends

Investopedia is partnering with All Star Charts on this newsletter, which both sells its research to investors, and may trade or hold positions in securities mentioned herein. The contents of this newsletter are for informational and educational purposes only, however, and do not constitute investing advice.

1/ Volatility Contracts

Asset prices trend.

Volatility, on the other hand, tends to mean revert. And the market is reaching levels of low volatility that often precede an expansion in volatility and price.

Check out the S&P 500 (SPY) with the Bollinger Bandwidth in the lower pane:

Source: All Star Charts, with data provided by Optuma

The Bollinger Bands® are constricting to levels corresponding to the blue highlighted areas on the price chart. Notice that past contractions in volatility led to explosive price action.

To be clear, this data point is neither bullish nor bearish. Instead, it simply suggests that the next directional move in the stock market will likely be forceful—up or down.

But based on the strength of the technology and consumer discretionary sectors, we could see an upside resolution for stocks.

2/ Communications Sector Breaks Out

Earlier this month, we mentioned that the SPDR Communications ETF (XLC) was on the verge of breaking out of a bearish-to-bullish reversal pattern.

Today, XLC soared 1.20%, making a valid upside resolution from the base:

Source: All Star Charts, with data provided by Optuma

Notice that momentum, as measured by the 14-period relative strength index (RSI), has remained in a bullish regime for some time now, adding conviction to the breakout. We are on the lookout for an overbought reading for confirmation.

With price pressing against 11-month highs, it is possible that a trend reversal is underway for this group of stocks.

3/ Tech Suggests Potential for Higher Bond Prices

What do technology stocks have to do with the bond market?

Growth stocks in general have a strong correlation with bonds due to the fact that both are long-duration assets. For this reason, changes in interest rates affect their prices more than other equities.

You can see the tight relationship between these assets in the overlay chart of the Technology Sector SPDR (XLK) and the Long-Term Treasury ETF (TLT):

Source: All Star Charts, with data provided by Optuma

Notice how these two ETFs moved very closely throughout 2022, peaking and troughing together in a primary downtrend. However, since the lows last fall, a multi-month divergence has taken place, as bonds are making lower lows this year while tech stocks keep trucking to new highs.

With technology and communications indexes completing reversal patterns and indicating that new uptrends are underway, we’re thinking about what this means for bonds as we head into the summer months.

We don’t want to assume that this divergence will continue for any longer than it already has. As the evidence continues to pile up in favor of bullish resolutions for growth stocks, it looks increasingly likely that bonds will play catch-up.

When it comes to the healthcare sector, price action remains mixed beneath the surface. 

While some stocks and groups are trending well, others remain under pressure. Meanwhile, the large-cap Healthcare Sector SPDR (XLV) is trapped in the same range it’s been in for two years now.

Here is an illustration of the dispersion we’re seeing using two of the world’s largest pharmaceutical conglomerates as examples:

Source: All Star Charts, with data provided by Optuma

While Merck (MRK) recently made new all-time highs, Pfizer (PFE) hasn’t been able to stop falling. Pfizer is shown in the lower pane, down almost 30% on the year to its lowest level in over two years. 

Despite these stocks being as close of a competitor to one another as possible, the charts couldn’t look any different. We’re seeing similar behavior not only within healthcare but also in the broader market.

Originally posted 17th May 2023

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