Volume 14 Issue 39
Breadth Notice

Last Thursday one portfolio manager commented he didn’t see any reason for the 32.31 point decline in the S&P 500 Index. Perhaps he had not recently looked at the Advance-Decline Summation Index chart, one of the tools used to measure market breadth. In addition, the Stock Trader’s Almanac reports September is the worst month of the year. Further, the week after September futures and options expiration is statistically the worst week of the year. While there may have been no in specific fundamental news, perhaps an answer can be found in the technical indicators.

In our market review, we explore the current market breadth including charts along with some thoughts about hedging.

S&P 500 Index (SPX) 1982.85 last week we noted the Friday key reversal after making new highs so last Monday’s decline was expected however, Thursday’s 32.31-point drop to close below support at 1980 was unexpected. For reference, the upward sloping trendline from the November 16, 2012 low defining the intermediate term trend now crosses at 1946.48, about 1.8% lower. If the decline should continue, we expect to see support at this level.

iShares Russell 2000 (IWM) 111.12 remaining relative weak and diverging from the big capitalization indexes it continues to reflect deteriorating market breadth despite dollar strength that favors domestic small capitalization stocks. Since an unlikely potential double top continues as the operative technical pattern, activated on a close down near 108 just over 3 points lower, stay focused on IWM.

Powershares QQQ (QQQ) 98.78 since breaking out above the July 24 high at 97.51 it remains the relative strength leader. The bullish interpretation says it successfully retested the breakout above 97.50 and will now resume trending higher. The operative short- term uptrend from the April 15 low at 83.28 now crosses at 98.82 so a further decline will challenge the bullish view suggesting it will accelerate lower to close the relative strength gap with the S&P 500 Index.

CBOE Volatility Index® (VIX) 14.85, up 2.74 for the week, it appears to be trending higher from the August 24 low of 11.24 reflecting increased market uncertainty.

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 68% to October and 32% to November for a 4.29% premium shown above. Our alternative volume-weighted average between October and November, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 4.52%. 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 remained below 10% every day, except Wednesday averaging 6.50% for the week. Friday’s preliminary volume report was 192,276 contracts, but much less than Thursday’s at 330,803 on the unexpected market decline.

VIX Options

With a current 30-day Historical Volatility of 95.81 and 97.57 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 97.57 the October and November options are slightly undervalued. Friday’s volume at 660,260 contracts was lower than the previous regular expiration Friday September 19 at 755,155 contracts.

CBOE S&P 500 Skew Index (SKEW) 130.49 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.

Now just below the new midpoint of the range between 146.98 made on Friday September 19 giving an early warning signal, and the August low of 120.36. Once again, the spike up above the operative range preceded last week’s decline adding credibility to SKEW as a short-term countertrend indicator.

US Dollar Index (DX) 85.64 the close on Wednesday at 85.04 exceeded the July 9, 2013 high at 84.75 as shown in the Digest Issue 37 “Interest Rate Jitters” chart, confirms the intermediate uptrend. The next target for the advancing dollar is the June 7, 2010 high at 88.71. Since there was no consolidation around 84, as expected, the upward momentum seems strong. The markets discounting higher interest rates along with the stronger dollar apparently explains the continuing preference for large capitalization stocks with good liquidity and unless breadth improves soon they may have an opportunity to test the liquidity preference strategy.

ProShares UltraShort 20+ Year Treasury (TBT) 56.58 in Digest Issue 37 “Interest Rate Jitters” we identified the downward sloping trendline that begins at the December 31, 2003 high at 80.28 touching the July 3 high at 63.92. The important resistance point to watch was the July 31 high at 60.22. On September 17, it advanced up to close at 59.97 just short of 60 before retreating to retest the downward sloping trendline. Once above 60.22 the next objective will be the July 3 high at 63.92 and with both equities and corporate bonds apparently discounting higher interest rates Treasury bond rates are likely to follow before long.

Market Breadth

Deteriorating market breadth is a sign of an anxious equity market seeking liquidity over concerns that interest rates are about to begin an up cycle.

First, the NYSE Summation Index of advancing issues minus declining issues.

Another method to determine market breadth is the summation index of the McClellan oscillator, which is the difference between a 19-period exponential moving average and the 39-preiod exponential moving average of the net result between advancing issues minus declining issues creating an intermediate indicator. It generally fluctuates between 0 and 2000 while neutral at the 1000 level.

When the NYSE makes new highs as the summation index declines a divergence exists that often proceeds market trend changes.

Greg Morris, the author of “The Complete Guide to Market Breadth Indicators,” says the McClellan Summation Index as the most valuable breadth indicator of the 80+ ones he researched and “is the best single indicator available. If you had to pick one this would be it.”

He adds,

“Its primary component, net advances, provides an excellent measure of the market’s liquidity. The direction and level of this indicator are exceptional at identifying good and bad investment climates. For example, research from PMFM, Inc. showed that whenever the McClellan Summation Index is above zero, rarely do any “bad things” happen in the market; most of the ‘bad things’ happen when it is below zero. This is a valuable piece of information and should be part of every analyst’s technical model.”

On Friday, McClellan Financial Publications reports the summation index was 808.76 just below the neural 1000 level.

Now for the regular NASDAQ Summation Index,

With recent highs in both the NYSE and NASDAQ, diverging breadth since early July is a reason for some caution.

Looking back in history the current condition resembles the spring and summer of 1989 when the indexes were rising but breadth was deteriorating before the 6.01% decline on October 13, 1989.

Although TBT, our preferred interest rate indicator, has yet to close above 60.22, high yield corporate bonds and other interest sensitive sectors are under noticeable selling pressure. One hedging strategy employs near term VIX at-the-money call options. However, unless the S&P Index declines immediately a significant loss could result from time decay. Alternatives include a long TBT call spread where there is good options volume. As for the current relative strength of the Powershares QQQ, there are two approaches to consider. The first is to presume the relative strength leaders will also decline closing the gap with the iShares Russell 2000. SPY and QQQ put spreads are two to consider. The second assumes the weakest will remain relatively weak on any decline so use an IWM put spread. Regardless of the strategy selected, use a trade plan with a defined SU (stop/unwind) in case the September weakness soon becomes a fading statistical memory.

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Summary

Although geopolitical tensions seem to be waning, continuing US Dollar strength reflects expectations for higher interest rates increasing the desire for equity market liquidity reflected by diverging breadth that increases the risk of a significant market decline.