Technician sees absence of fear leading to stock market top in late May

The stock market knows no fear.

The CBOE Volatility Index

VIX, -1.89%

a measure of the market’s expectation for volatility over the coming 30 days, has been trading near record lows for days, closing at a level not seen in 23 years earlier this week.

The absence of market turbulence and the subdued VIX has sparked concerns about complacency. It comes amid murkiness on the policy front due to increased political turmoil following President Donald Trump’s firing of Federal Bureau of Investigation Director James Comey earlier this week.

Read: Here’s why the stock market isn’t freaking out about the Comey firing

Yet technical analyst Tom McClellan of McClellan Oscillator fame said a string of very low VIX readings doesn’t mean the top is in.

“The most important point about a low VIX reading like this is that major price highs do not usually coincide with the lowest VIX lows. So as long as we are seeing the VIX continue to make lower lows, we have some assurance that we are not yet at a major high,” he said, in a report earlier this week.

To be sure, there is always the risk of a selloff as a sudden drop in the VIX can indicate a momentary price top. But McClellan said his research has shown that such a selloff likely won’t be of a magnitude to make investors dive for cover.

“Major bear markets typically start from a point where the VIX has already made its low ahead of the final price high. The two are typically separated by a few weeks to a few months,” he said.

In a study he conducted a few years ago—the result of which he charted below—McClellan discovered that when the VIX is trading at subdued levels, the potential for upside is greater than the potential for downside.

Tom McClellan

“We also find a big bullish imbalance at extremely high readings—above 40, which makes sense because those instances come at extremely scary market bottoms,” he said.

With this in mind, McClellan predicted a bottom for the market this week, followed by a top “due May 22-25,” ahead of a more significant bottom in the middle of June.

He declined to specify how high the market will go or for that matter, how much it will drop.

“Price magnitudes are funny things, not lending themselves to accurate forecasting—the last two weeks are a good example of that. I try to just get the direction right, and let the magnitude take care of itself,” he told MarketWatch.

The VIX jumped nearly 4% on Thursday to 10.60 as weak retail stocks pressured the SP 500

SPX, -0.15%

That sign of life from VIX, according to McClellan, fits right in with his outlook and indicates that the stock market will follow the trajectory he had forecast.

“This is the dip I have been looking for into the May 8-11 time window,” he said. [It] should wash out the worrywarts, and set up for a rebound into the May 22-25 top.”

Meanwhile, Wall Street is likely to continue fretting over the disconnect between policy uncertainty and the VIX.

Goldman Sachs on Thursday predicted that the gap between the market and political reality will continue to diverge and that the prolonged lack of clarity on key policy issues will hurt mergers, capital spending, and lending.

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