Volume 14 Issue 19
Rotation Appraisal

While the possibility of Head & Shoulders Top patterns forming in the S&P 500 Index and Dow Jones Industrial Average has diminished the divergence with the NASDAQ and small capitalization stocks represented by the iShares Russell 2000 along with “growth and any price stocks” continues to widen. Eventually it will be resolved either by the big capitalization Indexes declining, or by the laggards finding support and turning higher.

We add our options perspective and expand somewhat more on the rotation struggle below followed by a hedging suggestion for iShares Russell 2000 (IWM).

S&P 500 Index (SPX) 1878.48, while remaining relatively strong, the inability to continue above 1880 and thereby challenge the April 4 high at 1897.28 continues to raise the possibility of a Head & Shoulder Top, although it is looking less likely. However, a close below 1840 could activate it and if so, the measuring objective would be down about 1780.

PowerShares QQQ™(QQQ) 86.80, the “NASDAQ-100 Index Tracking Stock®”, is relatively stronger than the broader NASDAQ and still exhibits a well defined potential Head & Shoulder Top activated on a close below a well defined neckline at 83 after developing a right shoulder on April 24 at 88.21.

iShares Russell 2000 (IWM) 110.03. Of the widely followed indexes, this one representing small capitalization companies appears the weakest and depending upon the location of the right shoulder may have tested and rebounded off the neckline at 109 Friday. A continuation higher would suggest and effort to close the divergence. However, a close below 109 next week would activate the pattern with a measuring objective down at 98. If so, it is hard to imagine the major large capitalization indexes would continue to be immune to the selling pressure. Therefore as a precaution to any further decline, we offer a hedge idea below.

CBOE Volatility Index® (VIX) 12.92, up only .01 for the week VIX implies very little concern about an imminent SPX decline.

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 28% to May and 72% to June for an average premium of 15.15% shown above. Our alternative volume-weighted average between May and June, regularly found in the Options Data Analysis section on our homepage, is slightly lower 12.36%. We consider premiums less than 10% to be cautionary while the premiums for a normal term structure are 10% to 20%. Last week the premiums were above 10% every day so the professional hedges were not bidding them higher in anticipation of a SPX decline. For more see the Skew section below.

VIX Options

With a current 30-day Historical Volatility of 81.67 and 77.65 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 to the range historical volatility of 77.65 to the implied volatilities show both the May and June at-the-money options are underpriced. Friday’s volume was moderate at 580,511 contracts compared to the weekly average of 414,630 contracts. Like the VIX futures above, the options are giving no indication that a decline is looming.

CBOE S&P 500 Skew Index (SKEW) 125.60, 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.

Up 1.47 for the week, SKEW is not exhibiting the type of enthusiasm normally associated with market tops as it remains 2.37 below the midpoint of our arbitrarily defined relevant range between the rapid decline to 112.66 on March 14, followed by the spike higher to 143.27 on March 17. Until is advances above 127.97 we consider SKEW to be confirming the sanguine views suggested by the VIX futures and options. Indeed using SKEW and the VIX futures together could make a short-term timing tool.

For example, here is the data comparing SKEW and the VIX futures three days before, until the end of the 5.7% decline that began January 23 ending February 5, 2014, a 10-day pullback.

In a contrary manner SKEW advanced in anticipation of the decline followed shortly thereafter by the VIX futures premium declining below 10% the level that has been associated with caution in the past. When the premium goes negative it is a sign to begin looking for a turn up and in this example to took 9 days before turning positive in the meanwhile the SKEW declined as some long out-of-the-money puts were closed.

Here is another, the more recent 4.37% 6-day pullback that began April 4 ending April 11.

In this case, SKEW did not provide the same degree of warning although the 4.83 advance on April 1 was in addition to other advances up from 117.96 on March 27, but in context of the range would not have been noteworthy by itself. However, once again the VIX premium drops below 10% as the decline begins and ends negative on the last day of the decline.

While the VIX premium appears to be a coincident indicator, rapid advances in SKEW indicates significant increases in out-of-the money put buying normally near the top of advances in a contrarian manner by these seeking to hedge gains.

Here is the SKEW chart marked A & B for the January 23 to February 5 decline and C & D for the April 4 to April 11 pullback.

See tables above for SKEW values marked A & B, C &D.

Admittedly, the sample size is not statistically significant and it would be difficult to conclude very much from SKEW by itself. However, when used in conjunction with the VIX futures premium and with traditional bar charts, it could be the basis of a short-term timing tool.

US Dollar Index (DX) 79.90, Thursday it tested the important chart level at 79 going back to last October and quickly made a key reversal followed by a significant gain Friday. A close below 79 would be been a technical breakdown that may have caused a commodities like gold and crude oil to advance, but neither seemed responsive to the test of 79 or the key reversal Friday.

iShares Barclays 7-10 Year Treasury ETF (IEF) 102.73 after failing a recent declining wedge, IEF reversed again advancing back to the top of the newly well defined trading range between 100.86 and 102.83, representing interest rates of 2.80% and 2.59%, closing at 2.62%. Any further advance would add support to the utility and other interest sensitive sectors.

iShares Dow Jones Transportation Average Index (IYT) 138.17, continuing reports of accelerating rail traffic along with upbeat earnings reports and guidance, are helping to support the transports, now in a well defined uptrend adding confirmation to the new closing high in the Dow Jones Industrial Average (DJI) 16,583.34. Although DJI is still below the intraday high made April 4 at 16,631.63, so technically a Head & Shoulder Top is still possible, but now seems less likely.

Rotation out of overvalued “growth at any price stocks”, along with other small capitalization issues represented by the iShares Russell 2000 (IWM) continued last week. Although some analysts are now beginning to sound the alarm that the Consumer Staple sector is overbought with many companies selling at unusually high price to earnings multiples the Consumer Staples Select Sector SPDR (XLP) 44.51 remains in a well defined uptrend from the February 3 low at 39.88. A break below this trendline would be a sign that the rotation may be moving to another sector, such as energy. The question remains unanswered if it’s possible to complete the sector rotation without a market correction.

Here is the sector breakdown from last week.

Strength in the transportation sector, usually an early expansion indicator would seem to support the view that so far, the rotation out of high price to earnings ratio stocks is proceeding without taking down the broad based high capitalization stocks.

As noted above the risk to the market is a continued decline in the small capitalization stocks. Friday’s trading seemed to offer a glimmer of hope that the small caps may have found support, but just in case it may be a good idea to put on hedge for the next week or so.

Hedge Suggestion

iShares Russell 2000 (IWM) 110.03. As detailed above here is the “just in case its needed” hedge for this week since a close back below 109 could be very negative for the markets.

The current Historical Volatility is 18.19 and 18.06 using the Parkinson’s range method, with an Implied Volatility Index Mean of 17.94, down from 18.43 the week before. The 52-week high was 23.88 on February 3, 2014 while the low was 13.62 on January 22, 2014. The implied volatility/historical volatility ratio using the range method is .99 so the option prices are reasonable relative to movement of the ETF and just below the 18.75 midpoint of the 52 week range. The put-call ratio at 1.80 is bearish, but not surprising since this ETF is a hedging favorite. Friday’s volume was 993,202 contracts traded compared to the 5-day average volume of 871,810 contracts, representing good options liquidity.

With a good risk to reward ratio use a close back above 111 as the SU (stop/unwind) in the event it appears to start trending higher.

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

Rotation out of “growth at any price stocks” along with weakness in small capitalization stocks creates concerns about the successful exit from high price to earnings ratio stocks without causing an overall market decline. While a potential Head & Shoulder Top in the S&P 500 Index remains a possibility the probability has declined since the SKEW and the VIX futures and option indicators remain favorable suggesting the odds for an upside breakout have increased. However, until that occurs hedging with inexpensive options still seems like a prudent course of action.