Volume 15 Issue 7
Cyclical Optimism Returns

With better macro news coming from Europe relating to both Greece and Ukraine the equity market pushed higher perhaps on some short covering before the long weekend, but there seems to be more going on as the cyclical sectors have been doing better than the consumer staples and healthcare sectors for the last two weeks. The combination of improving economic reports from the US along with the ECB’s quantitative easing announcement has started increasing risk appetite again.

Our market review confirms a more bullish outlook led by cyclicals such as technology, materials and crude oil that we focus on more below. On the assumption the optimism continues, despite some lingering concerns that the Ukraine situation could still sidetrack the upward momentum, we have a sector idea for Energy Select Sector SPDR ETF (XLE).

S&P 500 Index (SPX) 2096.98 the new closing high negates the potential small Head & Shoulders Top described in Digest Issue 3 “Risk Reduction Underway” while redrawing the operative upward sloping trendline from the October 15 low at 1821.61 to the February 2 low at 1980.90 as the uptrend resumes. See the chart in the Strategy section below. In the meanwhile the new three point intermediate term upward sloping trendline from the November 16, 2012 low of 1343.55 crosses at 1910.71 about 186 points lower.

iShares Russell 2000 (IWM) 121.53 like the S&P 500 Index the new high on the break out to barely close above the December 31 high of 121.41 negates a potential triple top starting with the March 3, 2014 high at 120.58.

Powershares QQQ (QQQ) 106.91 the breakout above the November 28 high of 106.25 is better defined than the IWM so a new two point operative upward sloping trendline from the October 15 low at 90.24 to the February 2 low of 99.75 is now in place representing the large capitalization technology group.

CBOE Volatility Index® (VIX) 14.96 the concerns described in Digest Issue 6 “January Review” keeping the VIX elevated, seem to have dissipated last week as VIX retreated to close at the lowest level since the beginning of the year. Concerns like Greece and Ukraine along with crude oil prices as well as the continually improving US economy will prompt the Federal Reserve to begin hiking interest rates sooner than previously expected seem less important. However, worry that a stronger dollar will reduce earnings for many large capitalization stocks with international operations continues so volatility may increase again this week.

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 10% to February and 90% to March for a 22.43% premium shown above. Our alternative volume-weighted average between February and March, regularly found in the Options Data Analysis section on our homepage, is slightly lower at 18.83%. Premiums for a normal term structure are 10% to 20%, while premiums above 15% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition. The premium began the week at 6.44% while ending unsustainably above 15%. February futures expire Wednesday February 18 with the last trading day today.

VIX Options

With a current 30-day Historical Volatility of 135.04 and 114.51 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.

The implied volatility index was 66.36 and declining so compared to the range historical volatility of 114.51, also declining both the February and March options appear inexpensive however, puts with limited downside may still attract selling in combination with long calls.

All of the Implied Volatilities along with the Historical Volatilities and Greeks for the VIX options based upon the futures prices are on our Advanced Options page, found by clicking on the “market close” link shown near the top of the page

CBOE S&P 500 Skew Index (SKEW) 126.04 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.

For the week, SKEW remained in a narrow range between the Monday high of 129.85 and the Friday close at 126.04 suggesting little enthusiasm for purchasing out-of-the-money S&P 500 Index puts. The best signals are at the extremes so the current reading just below the current range midpoint of 128.70 provides little useful information about increased put buying.

Market Breadth

For the week, the McClellan Oscillator Summation Index of market breadth reported by McClellan Financial Publications closed at 2542.48 advancing every day last week for a 224.19 gain as breadth improved moderately.

US Dollar Index (DX) 94.20 is now just below the current operative upward sloping trendline that begins at the December 16 low of 87.63 touching the January 15 low of 91.51 and the January 21 low of 92.15. It would need a close back above 94.97 to resume trending higher. It may now stall as crude oil advances.

Since the uptrend resumes with the new high here is an updated S&P 500 Index chart with the new operative upward sloping trendline from the October 15 low. In an effort to keep it simple and not complicate the picture we did not include the new three point intermediate term upward sloping trendline from the November 16, 2012 low of 1343.55 that would cross at 1910.71 about 186 points lower that would act as support in the event of a significant decline.

Until SPX closed above the December 29 high of 2093.55 shown above there was still a chance it would turn lower and activate the previously defined small Head & Shoulders Top although it had become less likely. Now with the new closing high a new upward sloping trendline is in place. The probability increased the advance will continue since cyclical sectors such as Technology and Materials broke out above their previous highs.

Crude Oil Update

Since V bottoms are very unusual, up until last Thursday, there was still a chance that crude would decline again to retest the January 29 low of 43.58, basis March futures. In addition, in Elliott wave terms the January 29 bottom would be labeled the end of the 3rd wave down followed by a 4th corrective wave back up before a final 5th wave to test the previous low.

Using classical barcharting techniques here is the symmetrical triangle pattern through Friday. Since 80% of the time, they are continuation patterns it was reasonable to expect a drop below the lower boundary and continue lower to 40. After making a high of 53.99 on February 9 marked point 4 it promptly declined to test the lower boundary. The next day it dropped below the pattern marked with the upward arrow thus validating the move lower. However, Thursday it rebounded to close at 51.21 up 2.37 for the day confounding the bears. Friday the pattern was negated as it continued higher to close up another 1.57 at 52.78 and since it has now moved too far into the apex of the triangle the pattern has been negated. While there is still a chance it will retest the low in the future for now it appears headed higher so watch for a close above 53.99 basis March futures or 55.05 at point 2 basis April futures.

Despite analyst from several prominent banks calling for lower prices, some as low as 20, it appears to be headed higher.

Turning to the CFTC data for confirmation there is one interesting interpretation based upon Non-Reportable trader positions. Since they have a bias toward the net long side, any time they actually go net short, it is usually a sign of a bottom for crude oil prices. Here is an excellent article by Tom McClellan explaining this approach.

As of December 9, the Non Reportable position was net long 12,122 contracts or .53% of the open interest. Interestingly as of the February 3, CFTC reported the net position as -380 contracts or -.01% thus suggesting capitulation. The most recent report dated February 10 shows a net long position again at 3,889 contracts or .14%. Based upon this the low has been made.

Long Crude Oil

On the presumption the conclusions above are valid here is one idea.

Energy Select Sector SPDR ETF (XLE) 82.04 represents the larger oil companies such as Exxon Mobil, Chevron, EOG & Anadarko as well as others, selected since the implied volatility is lower than an alternative ETF, there is a well-defined Head & Shoulder Bottom pattern and a new upward sloping trendline with good options volume.

The current Historical Volatility is 29.21 and 22.03 using the Parkinson’s range method, with an Implied Volatility Index Mean of 22.92 down from 26.81 the week before. The 52-week high was 37.41 on December 16, 2014 while the low was 11.21 on August 29, 2014. The implied volatility/historical volatility ratio using the range method is 1.00 so option prices are reasonable compared to the recent movement of the ETF, but since the implied volatility is likely to decline back toward 15 in the next few months it’s best to partially hedge the decline using a call spread. Friday’s option volume was 65,571 contracts traded compared to the 5-day average volume of 49,850.

While there is no implied volatility edge it does partially hedge a further expected decline. Using the ask price for the buy and middle for the sell, the debit is 1.39, about 35% of the distance between the strike prices. Use a close back below the upward sloping trendline at 75 as the SU (stop/unwind).

The suggestion above uses closing ask prices for the buy and middle price for the sell presuming some price improvement from indicted prices is possible. Tuesday’s option prices will be somewhat different due to the time decay over the weekend and any stock price change.

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Summary

With the new higher close for the S&P 500 Index as well as the other major indexes, the near term outlook is positive presuming no macro events from Europe alters sentiment. Most encouraging is the relative outperformance of cyclicals suggesting expectations for improving global economic fundamentals.