Last weeks’ media chatter about sequestration and the anticipated effects of reduced spending seemed to be overlooking the dollar as it increased against the currencies that make up the US Dollar Index, especially Friday, the first day of implementation. If exchange rates move primarily in response to news that alters expectations about the future economic environment, as theory proposes, then less government spending is good for the economy. We expand on this a bit more while reviewing our market indicators.
Week in Review
S&P 500 Index (SPX)
Two weeks ago we noted waning momentum had increased the probability that the long overdue retest of the January breakout was near. Since then it declined and quickly rebounded almost back to the highs of 1530.94 made on both February 19 and 20 perhaps forming an early symmetrical triangle continuation pattern. Another possible interpretation is a small Head & Shoulders Top that would be negated with a close above 1530.94 thus confirming the continuation pattern. Another couple of weeks of bull and bear struggling should provide the answer.
S&P 500 Index Implied Volatility (IVXM)
Since our last review two weeks ago, the Implied Volatility Index Mean increased from 10.28 to 12.50, while the CBOE Volatility Index? (VIX) increased from 12.46 to 15.36.
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 48% to March and 52% to April for an average premium of 8.50% shown above. Our alternative volume weighting between March and April is 8.00%. As we noted in Digest Issue 7 when the day-weighted average was 17.45%, rising premiums suggest increased professional hedging activity that seems to have peaked at just under 20% before the futures were bid higher closing the gap with the cash VIX as the SPX declined.
iPath S&P 500 VIX Short Term Futures ETN (VXX)
The five-day average volume was 84 million shares up substantially from 51.8 million last week and 31.5 million in Digest Issue 7 bidding VXX higher, which in turn pushes the futures prices higher toward the cash VIX narrowing the spread.
VelocityShares Daily Inverse VIX Short Term ETN (XIV)
The 5-day average volume for the inverse was 23.7 million shares making the VXX/XIV ratio 3.55 the highest in many weeks.
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 current spread between March and April is -.53 compared to the week before when it was -.82 and -1.12 in our last market review.
VIX Options
The current 30-day Historical Volatility was 134.96, up substantially since last week when it was 88.53 and 69.03. Using Parkinson’s range method, the comparable historical volatilities measures were 92.51, 60.34 last week, and 50.13 two weeks ago, all reflecting the increased movement. 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.
Using the IV Index Mean of 79.38, the IV/HV ratio is .59, using the range method for Historical Volatility the ratio is .86. The VIX put-call ratio at .53 is bullish for VIX, but not for the SPX with a put-call ratio of 2.00, up .20 for the week, since they move in opposite directions. Friday?s options volume was 507,806 contracts compared to the 5-day average of 721,980.
The SPX equity only put-call ratio was .74 making the spread between the SPX put-call ratio and the VIX put-call ratio .21. 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)
SKEW 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. In Digest Issue 7, we noted it was above 130 and when it previously ventured above this level, such as September 21, 2012 it preceded a market decline. The close at 130.46 on February 15 as reported in Digest Issue 7 turned out to be valid sell signal once again. It is now in the upper quartile of the 113-130 range and heading higher. We suggest watching for any additional closes above 130.
US Dollar Index (DX)
The dollar began advancing on rumors that the Fed would end monetary easing early, but last week when the rumors were mostly dispelled by Chairman Bernanke, the dollar continued higher, this time apparently in response to implementation of the sequester that will begin reducing government spending. The dollar strength took its greatest toll on commodities, including crude oil, gold and copper. In the past, dollar strength was also negative for equities, but if it begins to reflect better economic conditions, weaker commodity input prices should eventually be positive for equities other than raw material producers. In the meanwhile, equities are working on resolving their overbought condition as we described above.
iShares Dow Jones Transportation Average Index (IYT)
Correcting along with the SPX the transports are approaching an important crossroad. One is a potential double top implying a meaningful decline if set off by a close below 103. The other interpretation has it back to the center of its upward channel thus implying the advance will continue higher. A close above the previous high of 107.46 will confirm the advance alternative. In addition to being an important Dow Theory confirming indicator, the transports deserve close attention as a leading economic indicator.
NYSE McClellan Summation Index
Since our last market review two weeks ago, the breadth indicator declined another 175.21 points with 92.84 of them last week providing the best argument that the equity decline is likely to continue lower. Breadth needs to start improving for a sustained healthy resumption of the equity uptrend. So far, this is not the case.