Volume 14 Issue 43
Overhead Resistance

Last week in Digest Issue 42 “Tradable Bounce,” we thought the major indexes could continue higher but the advances were much greater than anticipated returning the S&P 500 Index to the operative upward sloping trendline that should now act as overhead resistance. See the SPX chart in the Strategy section below.

First a few comments along with our updated indicators and some thoughts about what to watch for this week to determine if the major indexes will soon be making new highs once again.

S&P 500 Index (SPX) 1964.58 advancing 77.82 points or 4.12% for the week the reversal up from the October 15 low was remarkable. While declines just before earnings releases began have occurred in the past this one was extraordinary with short covering probably adding to the upward momentum. The challenge now is to continue back above the upward sloping trendline, see below.

iShares Russell 2000 (IWM) 110.07. Previously we explored the possibility that the relative underperformance of the small capitalization stocks could be resolved by catching up with the larger capitalization indexes. However, this seems less likely since several well-known value mutual fund managers report that small capitalization stocks remain expensive and one even said they would need to fall an additional 30% to 50% to bring their valuations down to normal historical levels. If so, this diminishes the possibility their underperformance will improve anytime soon. On the rebound last week, it exceeded the first resistance at 109.86 while 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, remains the active area of concern.

Powershares QQQ (QQQ) 98.62 the bounce back by the relative strength leader was even more impressive gapping up Tuesday to exceed the first overhead resistance at 93.89. It is now just 1.92 points away from the September 19 high at 100.56, which will be an important test to see if it can breakout and continue higher or struggle at the old high setting the stage for a possible double top.

CBOE Volatility Index® (VIX) 16.11, down 5.88 for the week and down 14.92 from the spike up high to 31.03 on October 15.

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 November and 15% to December for a 5.20% premium shown above. Our alternative volume-weighted average between November and December, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 5.40%. 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 in the cautious zone despite the market rebound opening Monday at -1.02% and closing Friday at 5.40%.

VIX Options

With a current 30-day Historical Volatility of 169.31 and 132.71 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 132.71 both the November and December options are inexpensive.

CBOE S&P 500 Skew Index (SKEW) 125.57 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 declining 16.47 points to 111.31 at the market bottom on October 15 it rebounded 16.66 points the next day to close at 127.97 back near the middle of the range, makes us wonder if there may have been a data collection problem on October 15.

US Dollar Index (DX) 85.73 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 84.47 on October 15 before stabilizing above 85 that now appear to be support. While some analysts proclaim the dollar advance is over, economists in Europe say the euro will likely continue falling from the current 1.27 to 1.20 or even 1.15 by year-end and since the euro represents the largest weight in the dollar index the dollar advance is likely to continue.

Interestingly here is the volatility chart from our Advanced Futures Options service using DX for the symbol and ICE for the exchange and then setting the historical volatility to 21 days.

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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 -124.61 after gaining 870.01 points for the week as the market rebounded.

Along with the relative underperformance of the small capitalization stocks that may not improve anytime soon due to valuation concerns despite a stronger dollar that should benefit domestic companies over the large capitalization stocks with considerable international exposure, the rotation out of cyclical stocks that began several months ago continues. For example, the one, three and six month relative strength leaders included health care, utilities, and consumer staples all near the top of the lists. Referring to the market cycle chart below, we see they outperform in the early part of market contractions, suggesting the market may now have some trouble exceeding its previous highs.

iShares Transportation Average (IYT) 153.44. However, the notable exception is the Transportation sector, usually an early expansion group showing no signs of slowing and is just 2.84 points or just 1.82% below the high made on September 19 at 156.28, having declined to 137.05 on October 15.

Keep in mind, the upcoming congressional elections on November 4, just over one week away, may also be influencing the current market advance adding another reason to question the rebound sustainability since markets often sell off after expected events occur.

S&P 500 Index Trendline Update

Digest Issue 41 “Rollercoaster Ride,” included a chart of the S&P 500 Index showing the close below the operative multipoint intermediate upward sloping trendline from the November 16, 2012 low of 1343.35 touching lows made on February 5, 2014 at 1737.92 and on August 7, 2014 at 1904.78.

In addition, we noted the trend is lower until it closes back above the trendline that will most likely act as resistance. On Friday, the slope of the trendline crossed at 1968.48, just 3.90 points higher than Fridays close and today it will be 1971.12. In the event it exceeds this resistance, it will likely continue up to challenge the September 19 high of 2019.26 where it will encounter additional resistance at the previous high. See the chart below.

A new trendline will be established when the S&P 500 Index makes a new high above 2019.26.
In the event SPX is unable to close back above the USTL, it will put the uptrend in doubt. Then when considering the continuing underperformance of the small capitalization stocks and the relative outperformance of early contraction issues such as consumer staples, health care and utilities shown in the cyclical rotation chart above along with the VIX futures premium under 10% the situation remains cautious despite the strong advances seen last week.

Accordingly, we suggest keeping hedges in place until SPX closes well above the USTL and the VIX futures premium now at 5.40% returns to the normal 10% – 20% range.

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Summary

An equally rapid advance likely helped by some short covering followed the quick S&P 500 Index decline down to 1821.61 on October 15 after closing below the upward sloping trendline on October 9. The S&P 500 Index is now right up against overhead resistance created by the upward sloping trendline that may contain the advance however expectations for results of upcoming congressional elections could also be a factor in last week’s advance.