Reading storm warnings

MARKET analysis helps to define the potential reactions to the outcome of the US election, even an election as unique as this year's. This helps to set upside and downside targets and identify the trigger levels where investors will shift to long or short.

Unlike previous Presidential elections there is a low probability that the outcome will be known by the end of the day and that is reflected in one of the primary market indicators.

The VIX Index is often called the Fear index and its value has been rising in the last weeks. It measures the market's expectation of future volatility.

Calling this the Fear Index is incorrect. The VIX provides a measure of the expectation of change as this is always accompanied by increased volatility. The VIX doesn't provide a solution to the direction of the change. A high VIX reading means the market is anticipating a significant change in either the direction of the trend, or an acceleration of the trend.

VIX values greater than 30 are generally linked to increased uncertainty. VIX values below 20 generally correspond to stable, stress-free periods in the markets. Three weeks ago, the VIX values were within a stable range around 28 suggesting markets did not anticipate a significant change or disruption no matter who won the election.

In the past 10 days VIX values have risen to near 40 and this now suggests the market reaction will be much more volatile. Chart analysis provides a means to set both trigger points and targets for these changes.

The S&P 500 is the most accurate index to use for this analysis because of its depth. It includes 500 stocks. The analysis methods can be applied to the Dow with its 390 stocks, and to the Nasdaq.

There are three potential outcomes. A clear victory, a narrow but accepted victory that takes weeks to confirm, or a contested outcome and chaos.

A clear victory has the potential to drive the market up in a rally from 3,230 towards the immediate resistance level near 3,550.

It's not who wins that matters. It's the stability offered by a clear-cut victory that soothes market nerves. Normally this would develop into a good uptrend, but this US election result is weighted down by the persistent uncontrolled increase in Covid-19 cases.

A narrow but delayed victory in the short term is not much different from the first outcome. It simply delays the market reaction, so the S&P continues to trade in the broad sideways trading band with support near 3,230 and resistance near 3,550. It's a continuation of the sideways trading pattern that prevailed in the months leading up to the election.

A contested outcome unleashes the bear so the focus is on downside targets. A sustained fall below 3,230 has a downside target near 2,930. This is calculated by taking the width of the trading band and projecting downwards. The 2,930 target is also the most recent resistance level in May 2020 as the uptrend developed.

Some commentators argue that none of this matters because the historical lesson for long-term investors is clear: The market verdict over the past 60 years has been a consistent trend of broadly appreciating equity prices, with brief interludes of negative performance.

It's true that the 'market' as represented by the Dow is continually rising because the Dow, like all market indexes, only includes winners.

The rise is a product of survivor bias. Underperforming stocks are dropped from the Dow index and are replaced by stocks that outperform the index. The result is that the market always appears to rise over time.

The stocks in the Dow of 2020 are 100 per cent different from the members of the Dow in 1960.

This means claims that the market is always rising are dangerously incorrect because individual stocks rise and fall dramatically, or in many cases, are simple delisted from the exchange.

The only way to benefit from the rising markets' survivor bias is if you invest in an exchange traded fund but they have only been available for 20 years.

The first two of the potential presidential outcomes provide buying opportunities for a resumption of the uptrend.

The third outcome tells investors to stand aside until the market reaches the downside targets, and only then to consider entering when the index develops a rebound.

• Daryl Guppy is a financial technical analysis specialist, an equity and derivatives trader, and an author. He has developed several leading technical indicators used by investors in many markets.