Like a broken clock that is right twice a day, those who have been calling this market overextended and due for a correction will eventually be right. The tide will turn the question is when.
In this issue we look at our indicators and conclude a corrective retest of the breakout is about to begin and those who have been warning are about to be proven correct.? But first, We begin with our market review.
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S&P 500 Index (SPX)
The current uptrend, measured from the November 16 low at 1343.35, with the December 31 reversal low of 1398.11 making the second trendline point, continues higher as noted in Digest Issue 4. However, like one of the new electric cars, the batteries are running low so the momentum is waning. Last week, as the trading ranges narrowed the volume declined dramatically until Friday when it accelerated on a down day. While options expiration could explain the volume increase, it is just as likely bidders lost interest at the higher prices.
S&P 500 Index Implied Volatility (IVXM)
Since our last review, the Implied Volatility Index Mean declined from 10.50 to 10.28, returning toward the noteworthy low of 10.20 made on January 24, while the CBOE Volatility Index? (VIX) declined from 12.90 to 12.46.
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 88% to March and 12% to April for an average premium of 17.45% shown above. Our alternative volume weighting between March and April is 19.42%. Compared to our last review the premiums are up again, but still under the 20% where they suggest extensive professional hedging and foretold price declines in the past. Some argue higher premiums are contrary indicators, but we are not sure at what level they become reliable.
iPath S&P 500 VIX Short Term Futures ETN (VXX)
The five-day average volume was 31.54 million shares without a noticeable increase Friday as it declined .19 points.
VelocityShares Daily Inverse VIX Short Term ETN (XIV)
The 5-day average volume for the inverse was 10.38 million shares along with a .18 increase Friday.
When the term structure is in contango, or it slopes upward over time, the advantage goes to a long XIV position since it represents a short futures position and VXX continuously sells the near term contract and buys the next longer term contract at a higher price. The spread between March and April is -1.12 compared to the week before when it was -1.21 and -1.09 in our last market review.
VIX Options
With a current 30-day Historical Volatility of 69.03 and 50.13 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.
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Using the IV Index Mean of 56.64, again near the 52-week low of 54.23 made January 18, the IV/HV ratio is .82, using the range method for Historical Volatility the ratio is 1.13. The VIX put-call ratio at .35 is bullish for VIX, but not for the SPX with a put-call ratio of 2.05, up .45 for the week, since they move in opposite directions. Friday’s options volume was 428,197 contracts compared to the 5-day average of 550,780.
The equity only put-call ratio was .59 making the spread between the SPX put-call ratio and the VIX put-call ratio .24. As the SPX put-call ratio increases it becomes more bearish while the VIX put-call ratio is more bearish (for the SPX) as the ratio declines making the spread between them wider.
CBOE S&P 500 Skew Index (SKEW)
We are returning SKEW to the lineup again as it 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 a greater expectation for an extreme down move. Now near the upper end of the 114-130 range it confirms increased interest in OTM put buying. The last close above 130 was September 21, 2012 about two weeks before the market decline that ended in the middle of November 2012. Although it lacks timing precision, SKEW seems to be sending a cautionary signal.
iShares Barclays 7-10 Year Treasury (IEF)
IEF is right on support at 106 with interest rates at 2.00%. The next important support to watch (resistance for 10-year rates) is the March 19 low at 101.83 or 2.39%
US Dollar Index (DX)
The dollar index is just above the 80.08 midpoint of its 5-year range between the March 17, 2008 low at 70.70 and the March 9, 2009 high of 89.46. On any further decline, watch the 74 level where it found support from April to September 2011. For now, the short-term trend is higher undermining support for equities.
iShares Dow Jones Transportation Average Index (IYT)
Advancing in a narrow channel without any sign of hesitation, if there is a fearless flyer, it is the transports. In addition to being an important Dow Theory confirming indicator, they deserve close attention as a leading indicator as they continue trending highDer having surpassed the previous high of 101.60 that defined the 10-year trading range from the March 2009 low at 38.28. While the transports imply the equity uptrend will likely continue, they are still vulnerable to a market correction.
NYSE McClellan Summation Index
Confirming the loss of momentum noted above in the SPX volume, the market breadth indictor declined 34.25 points since our last market review two weeks ago. On February 10, 2012, this index was 1325.47 when the SPX was 1342.64 or 177.15 points lower. Ideally, the market breadth should confirm the major indexes highs and since it has been a reliable precursor of corrections in the past, the divergence is a concern.