Monday Morning Outlook: VIX Pendulum Swings in the Bulls' Favor
However, familiar resistance could keep stocks in check
by Todd Salamone 7/16/2011 12:25 PM
schaeffersresearch.com
Ramped-up anxiety was the theme on Wall Street this past week, as traders promptly overreacted to nearly everything Ben Bernanke said during his two days of testimony on Capitol Hill. Then, just as the QE3 rally gave way to the QE3 sell-off, ratings agencies started tripping over themselves to issue U.S. debt downgrade warnings. But by the end of the week, John Boehner and Nancy Pelosi agreed about only one thing: They definitely don't want to take a Camp David budget retreat together. With major fiscal risks still looming, stocks suffered yet another negative July expiration week -- and the CBOE Market Volatility Index (VIX) skyrocketed more than 22% along the way.
However, after crunching the numbers, Todd Salamone explains why this latest VIX spike may actually provide some short-term relief for weary bulls, even as the S&P 500 Index (SPX) remains sandwiched between support and resistance. Meanwhile, Rocky White uncovers an encouraging trend among recent five-week expiration cycles, as August-dated options prepare for their extended run as the front-month series. Finally, we wrap up with a preview of the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: Keeping an Eye on SPX Retracement Levels
By Todd Salamone, Senior VP of Research
"The 'VIX premium' ratio, which measures the percentage by which the VIX is trading above 20-day historical SPX volatility, currently favors the bulls... The risk here is that the current signal was triggered at a level where the VIX has tended to trough in 2011. This is unlike the previous buy signal in March, when the VIX was trading in the 20 area."
"Since 2000, July expiration week has tended to cater more to the bears than the bulls, with seven of the last 11 ending in negative territory."
-- Monday Morning Outlook, July 9, 2011
Last week, we focused on three indicators that favored the bulls: Evidence of hedge fund managers showing interest in equities after weeks of selling; an improving technical backdrop after a relative extreme in pessimism; and the CBOE Market Volatility Index (VIX - 19.53) trading on par with SPX historical volatility, which is a set-up that has preceded market strength during the past couple of years.
Unfortunately for the bulls last week, the accompanying risks that we outlined -- specifically, the low absolute level of the VIX and the historical tendency toward weakness during July expiration week -- trumped the three favorable factors we discussed. The market was weighed down by disappointment after Federal Reserve Chairman Ben Bernanke, in his testimony to Congress, indicated that another stimulus was not on the immediate horizon -- not to mention a couple of threats by ratings agencies to downgrade U.S. debt, due to continued gridlock on the budget compromise. In the short term, the debate over the debt ceiling and deficit reduction could continue to be a headwind for the market, as could the ongoing fiscal problems in Europe (with Italy now in the spotlight).
Familiar resistance levels on the S&P 500 Index (SPX - 1,316.14), Russell 2000 Index (RUT - 828.78) and S&P 400 Midcap Index (MID - 976.11) continue to present major roadblocks for equities, as has been the case since late April. At the risk of sounding like a broken record from week to week, these levels are as follows:
* SPX 1,333-1,340: The 1,333 level is double the March 2009 low, and the 1,340 area has acted as resistance on four different occasions this year
* MID 1,000: The first-ever attempt to break above this key millennium mark was in April
* RUT 850-855 : The 2007 peak
That said, we still think the probability of a sustained breakout above major resistance levels is higher now relative to earlier this year, given that there is currently more sideline money and short-covering potential to fuel such a rally.
The absolute level of the VIX is now a risk to the bears, after posing a threat to the bulls just one week ago. In the 2011 calendar year, a strategy of selling equities when the VIX approaches 15 and buying equities when the VIX advances above 20 has proven to be a rewarding timing approach. This could be related to the growing trend among institutional investors to keep portfolio insurance in place. So, when index options are deemed "cheap" by this crowd, demand for protective puts suddenly increases. This activity applies coincident pressure to stocks, as those selling the puts to these option buyers turn around and sell stock futures to hedge their put sales. Conversely, when index options are deemed "expensive," the appetite for portfolio protection decreases, thereby removing this headwind.
In fact, the VIX spike above 20 last week was quite notable, as the index closed 18% above its 10-day moving average. There is a clear mean-reverting behavior in the VIX after such spikes, as described in the table below. The VIX often moves inverse to the SPX, and the data indicates that the SPX has a greater-than-usual probability of closing higher in the immediate days following a spike of last week's magnitude or more.
The SPX's low last week occurred at a 50% retracement of its post-holiday July 7 peak at 1,356.48 and its June 16 low at 1,258.07. This retracement level is at 1,306.90. With the 1,300 century mark immediately below, and the 61.8% retracement of these highs and lows at 1,296.10 (the site of a short-term low on April 18), we'll call the 1,295-1,305 area support heading into this week. Resistance levels are the usual suspects discussed above.
We continue to emphasize consumer discretionary names, and would avoid financials. JPMorgan Chase (JPM) and Citigroup (C) posted earnings reports well above analysts' lowered expectations this past week, but neither stock was able to sustain the positive price action through Friday's close.
Indicator of the Week: Five-Week Expiration Cycles
By Rocky White, Senior Quantitative Analyst
Foreword: Last Friday was the final trading day before July-dated equity options expired. So, this week starts the August expiration cycle. Most cycles are four weeks long, but a few times every year, you get five-week cycles -- which is what we have to look forward to with the August options series. Below, we'll take a quick look at how the market usually fares during each monthly expiration cycle, and compare those oddball five-week cycles to the more common four-week cycles.
Monthly Expiration Cycles: The table below summarizes S&P 500 Index (SPX) returns for each monthly expiration cycle since 2000. The August expiration cycle is the third-best return of all the months (only April and December are better). However, the median return is not as impressive, with August weighing in at just 7th -- and neither is the percent positive, when compared against all other months. That healthy average return is boosted by a couple of outsized returns of more than 9% in 2002 and 2009.
Four- and Five-Week Cycles: As I mentioned earlier, this particular August happens to be a five-week expiration cycle. The first table below shows how the extended cycles have performed against four-week cycles. Since 2006, the five-week cycles have underperformed, averaging a significantly negative return of -0.43%. Four-week cycles are far better, averaging a gain of 0.51%.
SPX Returns - 4-Week vs. 5-Week Cycles
While the longer-term cycles have been bearish since 2006, this has not been the case more recently. Below is a table showing all expiration-cycle returns since 2010, with the five-week cycles bolded. After a couple of tough cycles in February and May 2010, the last four extended cycles have been positive, and the last three have been positive by at least 1%. Hopefully, this more recent trend continues for us.
Expiration Week Breakdown by Month
This Week's Key Events: Housing Data and Blue-Chip Earnings on Deck
Schaeffer's Editorial Staff
Here is a brief list of some of the key events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.
Monday
* The economic calendar kicks off with NAHB's housing market index for July. IBM (IBM), Charles Schwab (SCHW), Gannett Co. (GCI), Halliburton (HAL), Hasbro (HAS), Steel Dynamics (STLD), and Zions Bancorporation (ZION) are expected to report earnings.
Tuesday
* Housing data continues on Tuesday, with the release of home starts and building permits for June. The day's earnings docket includes Apple (AAPL), Coca-Cola Co. (KO), Bank of America (BAC), Goldman Sachs (GS), Chipotle Mexican Grill (CMG), Johnson & Johnson (JNJ), Peabody Energy (BTU), UnitedHealth Group (UNH), and Yahoo (YHOO).
Wednesday
* Existing home sales for June will hit the Street on Wednesday, along with the usual update on U.S. petroleum supplies. On the earnings front, we'll hear from American Express (AXP), Altria Group (MO), Intel (INTC), eBay (EBAY), F5 Networks (FFIV), Qualcomm (QCOM), and Xilinx (XLNX).
Thursday
* A flurry of data will be released Thursday, including weekly jobless claims, the Philly Fed index for July, and the Conference Board's index of leading economic indicators for June. Notable earnings reporters include AT&T (T), Microsoft (MSFT), Advanced Micro Devices (AMD), Eli Lilly (LLY), Morgan Stanley (MS), PepsiCo (PEP), Travelers Companies (TRV), and SanDisk (SNDK).
Friday
* There are no major economic reports scheduled for Friday. Caterpillar (CAT), General Electric (GE), Honeywell (HON), Verizon Communications (VZ), Xerox (XRX), Reynolds American (RAI), and Schlumberger (SLB) are scheduled to confess their quarterly earnings. |
