Volume 14 Issue 41
Rollercoaster Ride

For those who may not have recognized the 33.79 point advance in the S&P 500 Index last Wednesday as short covering and added long positions on the Federal Reserve news it was a tough week since a trend change confirmation came Friday on big downside volume accompanied by negative signs from the volatility indicators.

In our market review, we update our indicators followed by a hedge suggestion for Powershares QQQ (QQQ).

S&P 500 Index (SPX) 1906.13 last week began with a slight decline, but it made an encouraging higher high and higher low on moderately increased volume. However, alarm bells sounded Tuesday as it closed below the upward sloping trendline from the November 16, 2012 low that defines the intermediate term trend, followed by the short covering reversal Wednesday exceeded by Thursday’s decline on increased volume. Finally, Friday’s 22.08-point decline into oversold territory confirmed the trend change. For the week, the loss was 61.77 points or 3.14%. See the chart in the Strategy section below.

iShares Russell 2000 (IWM) 104.74 unlike the S&P 500 Index that made a higher high and higher low last Monday the relative weakness continued with a lower high and lower low. Like other indexes, Wednesday’ advance was exceeded by Thursday’s decline back below the crucial 107.50 level that defines activation of a technical double top or an alternative Head & Shoulders Top with a measuring objective down about 94 or another 10 points lower.

Powershares QQQ (QQQ) 94.44 although it remained the relative strength leader until Friday and although it made closes below support at 97.50 there was a possibility it would accelerate lower to close the relative strength gap with the S&P 500 Index. The selloff in the semiconductor sector Friday sealed the deal for the large capitalization NASDAQ group. See the hedge idea below.

CBOE Volatility Index® (VIX) 21.24, up 6.69 for the week, spiking higher Friday suggesting the market may now be approaching an oversold condition.

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 October and 72% to November for a negative 10.70% 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 -9.21%. 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 slightly positive Monday and Wednesday, but negative Tuesday and Thursday closing most negative Friday with a preliminary large volume of 509,653 contracts compared to 234,567 on Friday October 3.

VIX Options

With a current 30-day Historical Volatility of 131.16 and 110.90 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 110.90 the October options are expensive while the November options are fair value. Last week the October call implied volatility was 87.92 based on the October 15 call while this week, at 156.84 based on the October 20 call it reflects significant hedging activity as the volume expanded from 747,643 contracts to 1,345,558.

CBOE S&P 500 Skew Index (SKEW) 130.82 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.

After giving a prescient sell signal on September 19 at 146.98 it declined to 120.85 last Tuesday before recovering 7.24 Friday when out-of-the money put buyers returned.

US Dollar Index (DX) 85.64 after exceeding the July 9, 2013 high at 84.75, the next target for the advancing dollar is the June 7, 2010 high at 88.71. Reaching 86.75 Friday October 3, it retreated to 84.94 on Thursday before rebounding into what may become a symmetrical continuation pattern. While some analysts proclaim the dollar advance is over, economists in Europe say the euro will likely continue falling from the current 1.26 to 1.20 or even 1.15 by year-end and since the euro represents the largest weight in the dollar index the advance is likely to continue.

ProShares UltraShort 20+ Year Treasury (TBT) 52.43 as long interest rates continue declining, TBT is nowhere near 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 points are the July 31 high at 60.22 and the September 17 high at 59.99. Until then comments that the dollar strength is due to the markets discounting higher interest rates are inconsistent with lower interest rates that seem to be declining due to concerns about slowing economic growth rates and the desire for less risk exposure noticeable by the decline of the iShares iBoxx $ High Yield Corporate Bonds (HYG) 90.62 following equities lower.

Market Breadth

Deteriorating market breadth is a sign of an anxious equity market seeking liquidity and risk reduction, but no longer over concerns that interest rates are about to begin an up cycle any time soon.

Updating the summation index of the McClellan oscillator, detailed in Digest Issue 39 “Breadth Notice” when the summation index was 808.76, just below the neutral 1000 level, on Friday McClellan Financial Publications reports the summation index was -522.23 well into negative territory.

In Digest Issue 39 “Breadth Notice,” we explored some alternative hedging approaches. Now that the implied volatility of near term VIX at-the-money calls options have increased by 78% this week as VIX spiked above 20 chances increased there will soon be an oversold bounce, so VIX call options will decline.

Until Friday the Powershares QQQ maintained relative strength, but with Friday’s 2.50% decline compared to a 1.15% S&P 500 Index decline it may now accelerate lower as the large capitalization technology stocks come under selling pressure touched off by the semiconductors. The large capitalization stocks were previously the recipients of capital flows out of consumer cyclicals, then industrials and energy and now the technology sector. It seems as if there is no place to hide as the sector rotation continues. Like musical chairs when the music slows, there is a rush for a place to sit down while somebody is left standing, wondering what happened.

Since it seems likely the Powershares QQQ will accelerate lower relative to both the S&P 500 Index and the iShares Russell 2000, we suggest it for a hedge, but because the markets appear oversold and could make a short-term bounce, we also suggest making it conditional as detailed below the updated S&P 500 Index chart.

As we noted in Digest Issue 39 “Breadth Notice,” 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. If this pattern repeats, the decline so far from the September 19 high of 2019.16 to Friday’s close of 1906.13 has been 5.6% so there is not much more to go, at least for the first leg down. Earnings reports this week will either provide support or add downward momentum especially Thursday and Friday.

S&P 500 Index Trendline Update

Here’s the updated operative chart.

This weekly chart defines the current intermediate term multipoint chart from the November 16, 2012 low of 1343.35 touching lows made on February 5, 2014 at 1737.92 and the latest on August 7, 2014 at 1904.78. There are also four other times it acted as support before reaching the upward sloping trendline market USTL above. We will assume the trend is lower until it closes back above the trendline that will most likely act as resistance. A new trendline will be established when the S&P 500 Index makes a new high above 2019.26.

Conditional Hedge

Powershares QQQ (QQQ) 94.44.

First the options data,

The current Historical Volatility is 16.20 and 12.74 using the Parkinson’s range method, with an Implied Volatility Index Mean of 21.55, up from 16.04 the week before. The 52-week high was Friday at 21.55 while the low was July 3 at 10.04. The implied volatility/historical volatility ratio using the range method is 1.69 so options prices are fairly expensive relative to movement of the ETF and are probably anticipating a further decline of the underlying. The put-call ratio at 1.87 is bearish, but understandable as it hedges long positions. Friday’s option volume was a whopping 1,308,739 contracts traded compared to the 5-day average volume of 771,670.

Presuming QQQ will now accelerate lower relative to the S&P 500 Index, consider this long put spread on the first sign of an oversold rebound.

Using the ask price for the buy and middle for the sell, the debit is .88. Use a close back above 97 as the SU (stop/unwind). Of course, the prices and implied volatility will be somewhat different depending upon when opened since we suggest waiting for an oversold bounce before opening.

The suggestion above uses the closing ask prices for the buys and middle prices for the sells presuming some price improvement from indicted prices is possible for liquid stocks. Monday’s option prices will be somewhat different due to the time decay over the weekend and any price change.

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Summary

With declining interest rates along with US Dollar strength, higher interest rate expectations are less important than risk reduction especially since the intermediate term trend has turned down as measured by the upward sloping trendline that began on November 16, 2012. However, equities now appear oversold and could bounce to provide another opportunity to establish hedge positions.