Volume 14 Issue 13
Stampede Trigger

Like in the cowboy movies from the 50s, a shot into the air sets off a cattle stampede just as the herd is passing through a box canyon. Only those bulls in front running the fastest are able to get through the mouth of the pass without injury. Will the hot IPO market be the trigger?

Here is something to consider. The last IPO market bubble ended on March 24, 2000 (just over 14 years ago), when the S&P 500 Index made an intraday high of 1552.87, reaching a bottom two and a half years later on October 10, 2002 at 768.63, for a 50.5%% decline. While other conditions are never exactly the same, a rush to get thorough the IPO door before it slams shut has been a reliable market top indicator in the past and the current profit taking rotation out of small caps into large caps could be a desire for market liquidity just in case it’s needed.

Following our market review, in the strategy section below we have more on the current cyclical rotation featured in Digest Issue 12 “Rotation Challenge” last week, and the relationship to IPOs. Then joining the rotators, we have long ideas for Halliburton Company (HAL) and Caterpillar Inc. (CAT).

S&P 500 Index (SPX) 1857.62. Last week we were focused on the potential Double Top pattern that could have been set off with a close below 1839.57. Thursday it came close declining to 1842.11 but then reversed up Friday putting the double top pattern in doubt. Updating the SPDR Dow 30 ETF (DIA) 162.85 chart, shows it being relatively stronger, which would be consistent with rotation into large capitalization stocks. The potential small Head & Shoulders Top activated on a close below the neckline, is now at 160 but Friday’s upward reversal seems to have diminished the prospect that the pattern will be set off. So far, it looks as if weakness in Cloud, Social, Mobile, and Biotech “growth at any price stocks” selling on price to sales multiples is being offset by strength in the previous large capitalization laggards selling on price to earnings multiples. While not necessarily industry specific, the strength in actual industrials and energy seems to indicate a preference for stocks that should do better when the economy picks up steam.

CBOE Volatility Index® (VIX) 14.41. VIX seems to be unconcerned about the sector rotation, declining .59 for the week.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months.

The day weighting applies 60% to April and 40% to May for an average premium of 10.06% shown above. Our alternative volume-weighted average between April and May, regularly found in the Options Data Analysis section on our homepage, is slightly lower at 9.82%. We consider premiums less than 10% to be cautionary while the premiums for a normal term structure are 10% to 20%. Quantifying the current market uncertainty, for the last 15 days, the volume-weighted premium has been less than 10% every day with the exception of last Tuesday when it was 13.46%.

VIX Options

With a current 30-day Historical Volatility of 101.20 and 80.69 using Parkinson’s range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.

Comparing the range historical volatility of 80.69 implies slightly underpriced April options while the May options are even less expensive suggesting there was no hurry Friday to buy VIX options for portfolio protection.

CBOE S&P 500 Skew Index (SKEW) 124.98. SKEW measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move.

On Friday March 14, SKEW suddenly declined 15 points closing at 112.66 taking it back down near the May 28, 2013 low of 112.47. Then the next Monday it advanced 30.61 to 143.27 making a 52-week high. We suspect a data problem, however if correct the close is now just under the mid-point of the range in neutral territory.

US Dollar Index (DX) 80.18. The dollar downtrend noted in Digest Issue 11 “St. Patrick’s Day” came to an abrupt end on March 19 when Federal Reserve Char Janet Yellen suggested interest rates could rise in about 6 months after the end of QE. Understandably, dollar strength was most noticeable against the Euro and Yen changing previous expectations for a slowing global economy.

10-Year Treasury Notes (TNX) yield 2.71 after reaching 3.03 on December 31. After spiking up to close at 2.79 on March 7, rates were declining until Janet Yellen’s comments on March 19 abruptly turned them higher to close at 2.77. Since then they have drifted lower again in a range between 2.6 and 2.8.

iShares Barclays 7-10 Year Treasury ETF (IEF) 101.72. Checking the chart it appears the potential Head & Shoulders Top identified in Digest Issue 11 “St. Patrick’s Day” remains intact with the neckline right at 101. Alternatively it would take a close back above the March 3 high at 102.83 to negate the pattern meaning bond prices could continue higher reflecting expectation for a weaker economy and lower equity prices. Continue watching IEF for clues that may further support the rotation into more economically sensitive equity sectors along with higher interest rates.

iShares Dow Jones Transportation Average Index (IYT) 133.19. The new high of 136.94 made on March 7 redrew the upward sloping trendline, USTL from the June 24, 2013 low of 106.32 that touches the February 5 low of 125.50. For now, the transports are supporting the cyclical rotation into economically sensitive sectors, as it would need to close below 130.25 to challenge the uptrend. Unlike the S&P 500 Index or the Dow Jones Industrials, there is no indication either of a possible Head & Shoulders or of Double Top pattern. The transports seem to suggest “all aboard.”

NYSE McClellan Summation Index 768.38. The summation index is an intermediate indicator comprised of a running total of the McClellan oscillator, a leading indicator, which is the difference between a 19 period and a 39 period exponential moving average of the net difference between the advancing and declining issues on the New Your Stock Exchange.

Since our last review in Digest Issue 11 “St. Patrick’s Day”, the summation index declined 169.95 points with 128.80 points last week. A healthy advancing market needs more issue to advance than those declining and the current condition reflects rotation into fewer large capitalization stocks that could reflect liquidity preference as well as more exposure to economically sensitive sectors. If the major indexes are able to breakout above their recent highs and resume trending higher without more issues participating, the divergence will be a serious concern.

This is a confusing time for equities strategists since some proceeds from profit taking in secular growth stocks seem to be going into the fuel cell and marijuana stocks along with the overwhelming supply of new initial public offerings, IPOs. Now however, there is evidence industrial and energy stocks are getting some attention. As stated above, the risk is in the IPO market as more and more issuers rush to take advantage of a perceived market top, one that they may be responsible for creating. It is like a game of musical chairs where everybody wants to stay in game fearing the loss of more upside if they don’t while waiting for the music to stop. While some funds are now going into more reasonably priced cyclicals, institutional investors and hedge funds that are able to get allocations for new public offerings see them as a way to boost their short-term performance numbers while seeming to ignore the risk.

“Perhaps the most striking example of overconfidence among professionals is their general belief that they can outsmart everyone else-effectively, get in before everyone else and get out before the herd dashes for the exit.” James Montier, The Little Book of Behavioral Investing.

Since most of us are unable to participate in the lucrative IPO game, we can follow the rotation into cyclicals for as long as it lasts.

Cyclical Rotation

Halliburton Company (HAL) 59.46. This oil service provider of completion and production equipment and services just broke out above the February 28 high of 57.42 and appears to be going higher with a well-defined uptrend from the January 29 low of 48.56. While there is no guarantee the breakout is sustainable, there is well-defined support at 57. The 1Q earnings report is due on April 21 with a consensus estimate of .73 per share.

Here are the option details,

The current Historical Volatility is 19.68 and 19.14 using the Parkinson’s range method, with an Implied Volatility Index Mean of 24.53, up from 22.99 the week before. The 52-week high was 36.79 on April 18, 2013 while the low was 19.84 on January 22, 2014. The implied volatility/historical volatility ratio using the range method is 1.28 so the option prices are about right just below the middle of the 52-week range. The put-call ratio at .50 is slightly bullish with 2 times more calls traded than puts. Friday’s volume was 20,895 contracts traded compared to the 5-day average volume of 17,720 contracts so there is reasonable options liquidity.

Here is a call spread to consider.

With a reasonable risk to reward ratio and sufficient time to expiration to reach the short call strike, use a close below support at 57 as the SU (stop/unwind).

Caterpillar Inc. (CAT) 99.39. This cyclical worldwide heavy equipment-manufacturing favorite has been in an uptrend since November 21, 2013, ignoring the brief quick decline it made on the January 24 earnings report. The next earnings report for 1Q is due April 24, with a consensus estimate of 1.27 per share.

The current Historical Volatility is 11.69 and 13.37 using the Parkinson’s range method, with an Implied Volatility Index Mean of 21.59, up from 17.34 the week before. The 52-week high was 27.56 on April 18, 2013 while the low was 14.53 on November 26, 2013. The implied volatility/historical volatility ratio using the range method is 1.61 so the option prices are high using this method and in the upper part of the 52-week range. The put-call ratio at 1.375 is bearish with more puts traded than calls, but since it is in the Dow Jones Industrial average and an institutional favorite a lot of the put activity could be hedging. Friday’s volume was 19,856 contracts traded compared to the 5-day average volume of 32,500 contracts with reasonable options liquidity.

As a further test of the cyclical rotation premise, here is another call spread to consider.

With a reasonable risk to reward ratio and sufficient time to expiration to reach the short call strike, use a close below well-defined support at 97 as the SU (stop/unwind).

The suggestions above use the closing middle prices between the Friday bid and ask. Monday option prices will be somewhat different due to the time decay over the weekend and any price change.

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Summary

The IPO rush along with rotation confusion going on in the equity market fogs up the current outlook since both may continue for quite awhile. While it is too soon to tell if rotation into the cyclicals will be able overcome the expanding bubble in the IPO market, the risk of a stampede for the exit is increasing.