As Stock Markets Swing Wildly, Technical Analyst Warns: Mind the Gaps

The financial news, and market participants' reactions to it, are becoming increasingly schizophrenic and erratic: Negative news triggers a big drop one day, then positive news the next unleashes a wave of euphoric buying that sends the market right back up.

Just recently, we have seen markets plummet on worries about Ireland's debt crisis, and then rebound rapidly on news of a big bailout. New home sales and durable goods orders have experienced worrisome drops, but declining new claims for unemployment and increases in personal income caused the market to leap up enthusiastically.

Technical analysis seeks to look under the hood of the market's actions, allowing investors to avoid the ebb and flow of daily emotional reactions to the news. Today, the technical picture is decidedly mixed, and the catchphrase of the next few months might well be "mind the gaps."

What gaps? Allow me to explain.

Let's start with a chart of the QQQQ, the exchange-traded fund of the 100 largest companies in the tech-heavy NASDAQ.

Technical market watchers have noticed that over time, the gaps caused when a market opens significantly higher or lower than the previous session are almost always "filled" at a later date. That is, price retraces back to the gap zone.

A series of open gaps can indicate extremes of sentiment, either over-enthusiastically bullish or panic-stricken bearish. Either way, the gaps are usually filled when price returns to those levels.

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This chart shows that the strong rally that began Sept. 1 left three open gaps in early September. When stocks leap in premarket trading and stay at elevated levels all day, traders refer to it as "ramp and camp": The market gaps upward (the ramp) and then remains near its high all day (the camp).

This kind of giddy behavior is thrilling, but generally not sustainable. If we look at markets motions as proxies for human emotions, then euphoria and panic alike are generally short-lived phenomena. This is one way to understand why gaps are filled: They reflect extremes of emotion that don't last.

On the chart of the QQQQ, we can see how such rising gaps were back-filled a few weeks later, most recently in early November.

The recent recovery in prices from the mid-November swoon should worry bulls, as it opened up two significant gaps. If history is any guide, then those gaps up will be filled in sometime soon -- meaning stocks will slide down to those levels.

Though bulls might think the prices levels of early September are safely in the rear-view mirror, technical analysts are aware that those gaps are likely to be filled, and generally sooner rather than later. And a slide far enough back to fill those open gaps would require a 17% decline in stocks.

Facing Our Fear Index

Our next chart is of the VIX -- the volatility index, also called the "fear index." What really pops out from this chart is the huge spike in fear that resulted from the first eurozone debt crisis in May. Now, with those same systemic concerns coming to the fore once again, the reaction in the VIX is muted. It's as if the market is shrugging off Europe's debt worries.

But chart aficionados can discern a more troubling pattern in the apparently aimless ups and downs: an expanding triangle known as a "megaphone" pattern for its elongated, widening shape.

Megaphones reflect an increase in mood swings -- what we expect to see in a manic/depressive market, prone to increasingly erratic swings between euphoria and fear. Generally, megaphone patterns are broken in a big way, either up or down.

One clue as to which way the VIX might go is the divergence in the MACD indicator (moving average convergence-divergence). The MACD has been slowly working its way higher even as the VIX has drifted down to levels which reflect complacency.

Such complacency in the face of what is widely regarded as a profound debt crisis in Europe should worry bulls, as the megaphone trend suggests that market is becoming increasingly prone to wild mood swings -- not a healthy symptom.

Our last chart is a one-year chart of the S&P 500. Prices have become trapped between the support offered by the 50-day moving average (MA) and the resistance of the 20-day MA.

Recent market action has been typified by big declines followed by one-day rallies back to the 20-day moving average. This kind of volatility reflects the tug-of-war between bulls and bears, and is generally not a healthy development. Indeed, such wild swings often indicate a weakening market as bulls are unable to break out to recent highs or new highs.

This weakening is also revealed in the MACD and stochastic indicators, both of which have been sharply declining even as prices have remained in a trading range.

Though the S&P 500 reached a new annual high in November, from the perspective of the one-year chart, it looks like a classic bear-market signal might have been put in place: a double top. The explanation of this as a bearish indicator is straightforward: If bulls were unable to capitalize on a strong rally and break decisively to new highs, then participants will soon realize the upside is over and it's time to book profits and limit risk: In other words, sell.

To keep the rally alive, bulls will have to push prices decisively above the resistance offered by the 20-day moving average. If prices stay range-bound, the risks of a downturn increase dramatically.