Volume 14 Issue 31
Bonds Trigger Slide

Although caution signs began to appear after the 4th of July holiday the +4% 2Q GDP report released July 30 triggered a bond market slide most noticeable at the long end of the curve that removed support from some of the last standing equity sectors as the confounding sector rotation continues. Bonds recovered slightly Friday on a weaker employment report, but for equities, the momentum is downward and like boulders rolling down the mountain they may not stop before reaching the base.

After our regular market review, we look at ProShares Ultra 20+ Year Treasury (TBT), our long-term interest rate indicator for some specific numerical ideas for assessing the threat of rising long-term Treasury rates and then offer some ideas about possible equity support levels.

S&P 500 Index (SPX) 1925.15 the decline began Friday July 25 when a potential symmetrical continuation pattern underway disappointed with a 9.64-point decline. Then after a brief attempt to stabilize, it fell apart Thursday in reaction to higher long-term interest rates after the GDP report perhaps with the assistance of increasingly negative geopolitical news.

E-mini S&P 500 Futures (ESU4) 1918.50 a check of open interest could confirm the decline underway as a sustained decline in the open interest indicates existing long liquidation to existing shorts that begin covering. At the top on July 24 at 1980.75, basis September, open interest was 2,968,520 contracts and by Tuesday July 29 although the futures contract had declined to 1963.00 open interest continued higher reaching 2,972,352. However, with Thursday’s 40.25-point decline, open interest declined 5,996 contracts. With the release of Friday’s open interest number on Monday, it will likely show a further decline suggesting more short covering as hedgers reduced long stock positions.

iShares Russell 2000 (IWM) 110.68 on July 1 after making an intraday high at 120.51 and closing at 120.08 exceeding the previous high of 119.81 made on March 4, 2014, closing at 119.56, it abruptly fell apart rapidly declining to below 113 on what seems to be a desire for less risk and increased liquidity offered by larger capitalization stocks. The close below the neckline at 108, now not that far away, will set off a potential double top, with a measuring objective at 95. While now appearing oversold any short-term bounce could be an opportunity to establish a short position anticipating it will eventually close below the neckline and then accelerate to the downside to the delight of the bears.

CBOE Volatility Index® (VIX) 17.03 up 4.33 for the week and approaching the previous highs made in February and April.

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 48% to August and 52% to September for -5.60% shown above. Our alternative volume-weighted average between August and September, regularly found in the Options Data Analysis section on our homepage, is slightly lower at -5.65%. Premiums for a normal term structure are 10% to 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Premiums less than 10% suggest caution and negative premiums, like now are unsustainable suggesting an oversold condition.

As measure of the rush to hedge positions and perhaps a further oversold indicator, Friday’s preliminary volume was 530,794 contacts compared to Friday July 25 at 163, 249 contracts.

VIX Options

With a current 30-day Historical Volatility of 140.80 and 110.54 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.

Compared to the range historical volatility of 110.54 August options are in line with implied volatility. Friday’s volume at a whopping 893,603 contracts compares to the weekly average of 639,830 and only 264,486 contracts the week before.

CBOE S&P 500 Skew Index (SKEW) 128.93 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. The CBOE explains further, a Skew value of 100 means the perceived distribution of S&P 500 log-returns is normal so the probability of outlier returns is negligible. As Skew rises above 100, the left tail of the distribution acquires more weight increasing the probability of outlier returns.

In Digest Issue 29 “Sector Conflict” when SKEW was 141.19 we noted. “In the past, higher SKEW prices have been associated with short-term market tops” and it appears the out-of-the-money put buyers got it right and are now less enthusiastic to retain their put positions as the market declines.

ProShares Ultra 20+ Year Treasury (TBT) 58.73 here are two charts to put the recent advance and quick retreat in context to the long-term decline underway since the start of the year.

First, the long-term chart shows the downward sloping trendline in sold black that begins on December 31, 2013 that requires a close above 60.50 to change the downtrend. A second confirmation requires a close above 64 as indicated by the dotted line. The small detail chart on the right shows the quick July 30 advance on the 2Q GDP report followed by the retreat Friday on the employment report.

This leveraged ETF, very sensitive to long bond price changes, helps to put the recent interest rate jitters in context. It will take a close back above the downward sloping trendline to change the trend, but equities could continue declining in anticipation.

iShares Dow Jones Transportation Average Index (IYT) 145.47.

As the sector rotation challenge continues we look again at one of the most widely watched economically sensitive groups that usually outperforms early in market cycles. The chart in Digest Issue 29 “Sector Conflict” gave no indication of any threat to the upward sloping trendline that began on September 3, 2013 at 110.54. Now the situation is less encouraging as the short-term trendline from April 15, 2014, the dotted trendline on the chart below has been broken. However, the more important long-term trendline from September 2013, the sold trendline remains intact. If the current market decline continues, expect a challenge of this trendline as it may provide support for any attempt to halt the downturn.

There could be support at the long-term upward sloping trendline now 142.

Sector Performance

Last week’s sector results

In addition, the decline for the Dow Jones Transports was -3.52%

While some equity sectors appear oversold and could bounce this week others like the PowerShares QQQ (QQQ) 94.67 and the large capitalization biotechs such as
Gilead Sciences Inc. (GILD) 91.50 are still holding up relatively well as money continues to rotate into the large capitalization stocks with good liquidity.

Following the same trendline procedure for the S&P 500 Index used for the iShares Dow Jones Transportation Average Index (IYT) above provides some support level ideas that could slow the decline. The current operative upward sloping trendline begins from the November 16, 2012 low of 1343.35 touching the February 5, 2014 low at 1737.92. This important upward sloping trendline now crosses at 1897.20, only 27.95 points lower, and could be a shelf on the mountain that may contain the downward momentum set off by the bond market anxiety.

The first signs of support could come from the oversold iShares Russell 2000 (IWM). However, in order to preclude being whipsawed it is probably better to wait until midweek before attempting to add hedges.

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Summary

Interest rate sensitivity was the driving force last week that ended the uptrend for both the S&P 500 Index and the DJ Transportation Average Index while there was continuing evidence of rotation into a select number of large capitalization stocks. Our indicators suggest several sectors are oversold and could bounce this week providing an opportunity to open new hedges in the event the slide has yet to reach the bottom.