Volume 14 Issue 35
Dollar Update

The combination of light summer trading volume and the ongoing “flight to safety” over lingering concerns about Ukraine brings the US dollar back into the spotlight raising questions about the sustainability of the current dollar strength. Perhaps it represents a fundamental change or maybe it will quickly fade away when geopolitical tensions moderate and trading volume returns to normal.

We have a US Dollar Index (DX) chart including a guideline that may be useful to help determine if the dollar strength is likely to continue and some comments about possible trading ideas included in our regular market review.

S&P 500 Index (SPX) 2003.37 indeed August proved to be a record breaker dispelling concerns about this August being seasonally weak. Now we wonder if Thursday’s brief decline to a low of 1990.52 was enough to qualify as a retest of the breakout above the July 24 high at 1991.39. Since the volume was low all last week, there is a chance it will attempt another retest of the breakout as trading volume returns to normal. In addition, unresolved geopolitical concerns are a reason for some caution.

iShares Russell 2000 (IWM) 116.56 relative to SPX last week’s record was mixed with 3 days slightly underperforming and two days outperforming. Although advancing in a narrow up channel it remains well below the July 1 high of 120.97 needed to breakout out above the current range thereby establishing a new uptrend. In the meanwhile, a potential double remains the operative technical pattern. If the dollar continues higher, domestic oriented small capitalization stocks should do better.

Powershares QQQ (QQQ) 99.78 last week the performance of the relative strength leader came in mixed with two days better than SPX and two days weaker with Friday being equal. Since breaking out above the July 24 high at 97.51 it remains the leader advancing 2.3%, compared to .6% for SPX.

CBOE Volatility Index® (VIX) 11.98, up .51 for the week, but closings below 12, options participants appeared unconcerned about possible geopolitical developments before the long weekend.

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 September and 40% to October for 17.48% shown above. Our alternative volume-weighted average between September and October, regularly found in the Options Data Analysis section on our homepage, is a bit higher at 17.63%. 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 are unsustainable suggesting an oversold condition. Last week, the premiums were positive, above 10% every day, averaging 17.33% for the week. However, from Friday’s preliminary report the volume at just 100,561 contracts reflects light August trading that was less than average for the four previous Friday’s at 696,954 contracts.

VIX Options

With a current 30-day Historical Volatility of 109.22 and 94.03 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 94.03 the September and October options are undervalued. Friday’s volume at 207,559 contracts was considerably lower than the Friday before at 496,895 contracts, and 557,563 for the previous four-week Friday average.

CBOE S&P 500 Skew Index (SKEW) 127.01 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.

Friday SKEW made a sudden 10.93-point decline taking it back below the middle of the current range between 143.26 and 120.36.

In addition, kurtosis made a noticeable 52-week high at 4.098. We explained skew and kurtosis in Digest Issue 27 “Skew Review,” briefly: higher values indicate a higher sharper peak with more of the variability due to few extreme differences rather than many small differences in the price changes from the mean. Most markets have positive kurtosis with a large number of price changes less than one standard deviation along with a large number of three standard deviation price changes.

US Dollar Index (DX) 82.75 while the dollar is again getting attention the weekly chart below adds some perspective. While trending higher since the May 8 low of 78.91 we suggest the advance could be more a function of “flight to safety” along with some seasonality rather than a long-term trend change.

The current uptrend, shown by the green upward sloping trendline in the lower right starts at 78.91. While the close above the previous September 5 high at 82.67 has our attention, the July 9, 2013 high at 84.75 is more important since a close above that level would change the intermediate trend up.

In the meanwhile, the recent advance is in conflict with both crude oil and the CRB Index since both are up as well. Perhaps it will follow the same pattern as last year and begin declining next week. While that seems unlikely due to the current geopolitical uncertainty along with comments from the European Central Bank (ECB) about further stimulus measures that could further weaken the euro to as low as 1.20 as suggested by some analysts who are also speculating the ECB will add stimulus this week. Perhaps last week’s advance will not hold since trading volume was light. For now, the euro/dollar is the primary focus. Will it decline from here or challenge 84.75?

Comments about dollar strength benefitting the emerging markets that began last week got our attention, so we began updating our emerging market files separating those with current account surpluses from the ones with deficits or the ones in the process of political change with fiscal adjustments. However, until the European Central Bank does more than jawboning we will wait and watch the dollar index.

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Summary

Although the S&P 500 Index is in new high ground, some caution may be prudent since trading volume was light last week. In addition, US Dollar strength is likely reflecting “flight to safety” as geopolitical tensions remain unresolved. The question now facing the markets is what action, if any will the European Central Bank take that would further strengthen the US Dollar while benefitting emerging markets. We should get more clues this week as market participants return to business.