Volume 14 Issue 25
Inflation Jitters

Last week the markets responded to Janet Yellen’s comment that recent inflation data is just ‘noise’ by scrambling to cover short positions in gold and silver. While both are small markets compared to crude oil, Treasury Notes and Bonds, the immediate response from the futures market seemed to cast doubt on the premise that inflation will remain as low as the Federal Reserve’s forecast especially since crude oil is challenging 110 once again.

After our regular review of futures and options, where we see signs of increasing hedging activity, we explore the relationship between the Consumer Discretionary Select Sector SPDR ETF (XLY) and the Consumer Staples Select Sector SPDR ETF (XLP) and since the price of crude oil seems headed higher, we have another United States Oil (USO) idea.

S&P 500 Index (SPX) 1962.87 the 14.99 point advance last Wednesday, closing at 1956.98, cleared the previous high made June 9 at 1955.55 and then continued higher on both Thursday and Friday apparently confirming the sanguine view of the US economy as expressed by Janet Yellen Wednesday. However, not all participants agreed as divergent signals began appearing as detailed below.

iShares Russell 2000 (IWM) 118.25 as we suggested in Digest Issue 24 “All About M&A Activity” deal enthusiasm supported the small caps and “growth at any price” stocks come back into fashion as IWM turned higher last Monday closing the week above the 117.48 high that defines the left shoulder of a potential a Head & Shoulders Top. Any decline now will again raise the possibility of a right shoulder forming with the neckline way down at 107.50.

CBOE Volatility Index® (VIX) 10.85 Wednesday’s decline of 1.45 points closing at 10.61 was quite bullish and almost as low as February 23, 2007 when it closed at 10.58.

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 85% to July and 15% to August for an average premium of 20.28% shown above. Our alternative volume-weighted average between July and August, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 22.39%. We consider premiums less than 10% to be cautionary while the premiums for a normal term structure are 10% to 20%. Premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. From a contrary regression to the mean perspective, it suggests complacency.

VIX Options

With a current 30-day Historical Volatility of 76.61and 60.63 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 60.63 to the implied volatilities show the July at-the-money options as slightly higher than fair value while August are slightly lower. Friday’s volume was high at 982,119 contracts compared to the weekly average of 981,890 contracts as the increased volume along with increasing open interest at 15,216,940 contracts suggests more hedging enthusiasm while options are still inexpensive in implied volatility terms relative to the 52-week historical range of 44.89 – 117.20.

On a cautionary note, the VIX put call ratio closed Friday at .12, the lowest level in a year indicating considerably more call volume relative to put volume and since an advancing VIX implies a lower S&P 500 Index means hedging with VIX call options increased significantly, but may have been due to June futures and options expiration Friday.

CBOE S&P 500 Skew Index (SKEW) 143.26 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.

SKEW had remained relatively stable in the lower part of our arbitrary relevant range of 127.97 defined by the rapid decline to 112.66 on March 14, followed by the spike higher to 143.27 on March 17. Last Thursday the situation changed as it advanced 9.08 points to close at 138.61 followed by another 4.65-point advance Friday to close at 143.26, just under the one day March 17 spike. Previously we suggested a close above 130 was an important sign of increasing out-of-the money put buying on the same day as large advances in gold and silver.

Here is the chart.

In the past, higher SKEW prices have been associated with short-term market tops.

US Dollar Index (DX) 80.37 advancing as high as 81 it appears to have defined a new range between 70 and 81 with solid resistance 81.50. The subsequent decline back below 80.50 seems unlikely to be responsible for Thursday’s gold advance as DX only declined .27 to close at 80.32.

iShares Barclays 7-10 Year Treasury ETF (IEF) 102.78 there is little to suggest that Thursday’s gold price advance was related to declining interest rates since IEF declined .26 meaning interest rates closed the day higher at 2.62 up one basis point. IEF remains below the current multi-point upward sloping trendline defined by the low of 100.86 made April 2 so interest rates remain stable and continue to favor the “risk on” view that would change should it advance back above the trendline around 103.60.

iShares Dow Jones Transportation Average Index (IYT) 147.32 remarkable is the best way to describe the resilience of the transports after pulling back to close below the multipoint upward sloping trendline from the April 15 low it turned higher once again last Wednesday closing back above our defining trendline. As one of the most economically sensitive groups that usually outperforms early in market cycles there is no sign here to suggest any economic weakness despite higher crude oil prices.

One way to investigate sector rotation is to compare the Consumer Discretionary Select Sector SPDR ETF (XLY) 66.08 to the Consumer Staples Select Sector SPDR ETF (XLP) 45.22. Dividing the discretionary index by the stapes creates a comparative ratio helping to identify the relative flow of funds into these sectors. The discretionary sector usually performs better in the later stages of market cycles while the stapes perform best during early contraction. In practice, it’s more complicated since sector performance may be contradictory like now. Here is the chart.

From the low at 130 on April 19, 2013 until the top at 160 on March 6, 2014 discretionary outperformed stapes before suddenly declining in early March until early May when discretionary made an attempt to rebound. However, on June 9 at 1.49 it again turned lower as crude oil advanced 1.65 basis August futures closing at 103.59, now 106.83 confirming concerns that higher crude oil prices are likely to depress discretionary spending.

Normally the rotation out of discretionary into safer consumer staples is a sign of a weaker market but that has not been the situation to date as the transports continue to be strong. However, if crude oil continues higher to challenge 110 or beyond the transports could also be in for trouble.

Crude Oil WTI 106.83 basis August futures has been in backwardation, when the near term futures are priced higher than the deferred, for 24 weeks now at 2.98. Backwardation is usually associated with inventory shortages, which appears to be the current situation as inventory accumulates on the gulf coast leaving a shortage at the Cushing WTI delivery point. Adding fuel to the fire last week the Commitment of Traders report revealed Large Speculators increased their net long position by 39,145 contracts to 457,156 as open interest expanded 62,286 contracts to 2.28 million.

While some may consider the current crude oil price unsustainable and attempt to fade the advance remember the situation in Iraq gives longs the justification for their record long speculative futures positions and since cash crude was 110.54 September 2, 2013 and as high as 113.93 in early 2011, these could be the Large Speculator’s targets.

United States Oil (USO) 39.32 until there is a clear breakdown in price we suggest remaining long
USO since crude oil remains in backwardation adding some positive carry to the ETF using futures and this is seasonally the time when crude oil is relatively strong. A long August 40/43 call spread around .55 should be about right with a SU (stop/unwind) on a close below support at 38, just in case.

The suggestion above uses 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

While the S&P 500 Index makes all time highs, along with the VIX at the lowest since February 2007 signs of increased professional hedging are starting to appear as the VIX put call ratio declined to .12 and the CBOE S&P 500 Skew Index spiked higher. In the meanwhile, higher crude oil prices that may continue advancing are again starting to hurt the stock prices of consumer discretionary companies.