On Monday I said the stock market was setting up for a bounce. And we got that.

Now, though, it looks to me like the bounce has run its course. The market is now setting up for a decline.

Let me explain…

The last time we looked at the Volatility Index (VIX), the chart was forming a potential inverted head and shoulders pattern. The VIX merely needed to break above the neckline of the pattern in order to create the possibility of a sharp spike higher in volatility – which usually means a sharp spike lower in the stock market.

That hasn’t happened… yet.

The VIX tagged the neckline of the inverted head and shoulders pattern last Friday. And it has turned lower from that resistance level. Take a look…

Stock market bulls will look at this chart as bearish for the VIX – which is bullish for the stock market. The VIX failed to break above the neckline of the pattern. So, maybe the pattern is now invalid.

I’m not so sure. The VIX still looks to me like it wants to go higher.

Yes, the VIX has pulled back after hitting resistance last Friday. But remember, last Friday we had short-term oversold conditions on several stock market indicators. And we were looking for a lower opening for the stock market, leading to a short-term, two- or three-day bounce in stock prices.

That’s exactly what has happened.

So, we shouldn’t be too surprised by the VIX backing off from its resistance level. But, until the VIX dips below the “head” of the inverted head and shoulders pattern (which is about 11.50), the pattern remains valid.

Plus, the recent action has formed another potentially bullish pattern for volatility. Here’s another way to look at the VIX…

In this chart, the VIX is tracing out an ascending triangle pattern – which is a series of higher lows running into resistance at the same highs. This pattern usually breaks out to the upside. And if that happens here, then the upside target is still at about 18 or so.

The VIX can decline slightly more from here – which could coincide with the S&P 500 running as high as 2900 – and still stay inside the pattern.

This is what’s still keeping me cautious on stocks.

If Tuesday had been a big down day – which would have created extremely oversold conditions on a number of technical indicators – then I’d be looking to buy in anticipation of a strong, multiweek rally. The VIX likely would have closed above its upper Bollinger Band, and we’d be on the verge of a buy signal.

Instead, Tuesday’s rally has punished the bears who aggressively purchased put options over the past few days (the put/call ratio is at a high level). And it’s relieving the modestly oversold conditions we had on the technical indicators.

I think the market is setting up for another quick decline once it squeezes everybody out of their short positions.

Best regards and good trading,

Jeff Clark

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