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After seemingly relentless declines both crude oil the S&P 500 Index turned higher before the long holiday weekend most likely due to short sellers reducing positions especially after the S&P 500 index rebounded after retesting the January 20 low. More details follow in the market review including some pertinent observations from our friends at WhatsTrading.
Market Review
S&P 500 Index (SPX) ended down 15.27 points or -.81% for the week after retesting the January 20 of 1812.29 by declining down to 1810.10 Thursday to form a potential small double bottom with a measuring objective up at 2083.20 should it be activated on a close above the 1947.20 pivot high. After advancing 35.70 Friday it?s likely to continue higher for a few days since it not only retested the January 20 low but also met the small bearish rising wedge minimum objective (MO) at 1830 before turning higher.
CBOE Volatility Index? (VIX) advanced 2.02 the week after spiking as high as 30.90 on Thursday. Based on real-time prices of options on the S&P 500? Index, VIX reflects investors’ consensus view of future (30-day) expected stock market volatility.
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.
With one trading day until the February monthly expiration, the day weighting applied 10% to February and 90% to March for a -.37% premium shown above. Our alternative volume-weighted average between February and March regularly found in the Options Data Analysis section on our homepage was slightly higher at 1.97%.
While day-to-day VIX changes offer little forecasting insight following the VIX futures premium helps since it measures expectations of tactical professional traders and money managers using VIX futures and options for hedging long portfolio risk.
Premiums for normal term structures during uptrends are 10% to 20% while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging often occurring around market highs suggesting overbought conditions associated with pullbacks. Alternatively, premiums less than 10% suggest caution and negative premiums indicate oversold conditions. Last week the volume-weighted premiums were negative every day until Friday when it closed slightly higher at 1.97%, still in the caution zone.
VIX Options
With a current 30-day Historical Volatility of 137.06 and 131.92 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?sclosing option mid prices along with their respective month?s futures prices, since the options are priced from the tradable futures.
Compared to the current range historical volatility of 131.92 March at-the-money options remain inexpensive relative to recent movement of the VIX futures.
Foremost Indicators
Once again the there is little doubt that Crude Oil and US Dollar Index were important drivers of the S&P 500 Index last week. However, after a long absence SPDR Gold Shares (GLD) returns to the lineup. First updates for Crude Oil and the US Dollar.
US Dollar Index (DX) ?down 1.09 or -1.12% for the week and now rapidly declining after the 1.58 drop on February 3 on fading dollar sentiment and renewed dollar commodity/price linkages. Since crude oil currently has excess supply issues gold along with selected other commodities seem to be assuming their traditional inflation warning role and regaining prominence suggesting concerns about deflation may be receding.
United States Oil (USO) as a proxy for WTI Crude Oil declined .58 or -6.51%for the week. WTI crude oil futures basis March declined 1.45 or -4.69%, closing at 29.44 after trading as low as 26.05 Thursday. Friday?s gain of 3.23 points or 12.32% was likely short covering after another hint that about production cuts. The latest comment, this time from United Arab Emirates energy minister, came early Friday morning was just enough to set off risk reducing short covering in the event other large producers confirm production reduction plans over the long weekend.
Disaggregated Commitments of Traders – Options and Futures Combined or Commitment of Traders (COT) report provided by the CFTC for Crude Oil, Light Sweet – New York Mercantile Exchange as of Tuesday February 9, but released Friday show the Managed Money group increased their percentage of the open interest from 3.94% to 4.07% as the total open interest increased 48,645 contracts.
Since reference prices are determined in the “paper” futures market, tracking the change in the net long position of the Managed Money group in the weekly Commitment of Traders (COT) reports can provide some insight. A “money manager,” for the purpose of the COT report, is a registered commodity trading advisor (CTA), a registered commodity pool operator (CPO), or an unregistered fund identified by CFTC. So called “hedge funds” are included in this category, regardless of whether they are registered. With the most at risk at turning points, changes in the net long position of this Managed Money group are usually associated crude oil price changes.
However, last week Managed Money increased their net long positions as the price declined 1.75 to 27.94 so their increase was inconsistent with the price decline. It was the undefined “Other” and Producer Merchant Processor (PMP) categories the made the difference. The “Other” category greatly increased their shorts thereby reducing their net long position while the PMP group added to the selling by reducing their longs pushing the price lower.
The many moving parts makes the analysis complicated especially since the current cash prices are below the costs for some producers who may decide to stop producing and unwind their short hedge positions. In the past the net change in the long positions of the Managed Money group although a small percentage of the open interest represented change at the margin with high correlation to price changes.
Since finding a price bottom is a process not a place pay attention to when prices no longer decline on bad news such as inventory and production increases and the total open interest declines as shorts who have been right begin covering as they likely didFriday.
SPDR Gold Shares (GLD) up 6.04 or +5.38% for the week and +17.86 or +17.77% from the low made December 17, 2015. While gold has been gradually moving higher from the December low, it was the abrupt decline in the US Dollar index on February 3 that seems to have spurred renewed interest. Then Thursday it gapped up on the open above the previous October 15?high of 113.99 closing up 4.60 to 119.06 on volume about four times the average for the last year.
With earnings declining as the global economy slows while central banks continue pumping in more and more money and the traditional slower growth defensive sectors like telecom and utilities become fully valued it seems gold may again be assuming an inflation hedge role previously played by crude oil.
As for considering new long call spread positions watch for it to pull back toward 115 filling the gap made Thursday. With reasonable options volume and open interest the Implied Volatility Index (IVXM) was 22.36 Friday about 5 percentage points higher than the average for the last year reflecting renewed call buying interest. As it pulls back toward 115 consider a long April 120/125 call spread, long the April 15 120 call and short the April 15 125 call priced around 1.50 Friday. Using a call spread partially hedges both time decay and implied volatility currently above average while providing considerable upside.
A few weeks ago?we identified a possible downside target for the S&P 500 Index based upon the historical norm price-to-earnings ratio of 17.5 according to Crestmont Research. Since then based upon reports received to date, S&P reduced their 2015 earnings estimated from 95 to 91.17. Using Fridays? close this equates to a price-to-earnings ratio of 20.45. Should it continue lower, which seems likely, it would need to decline to 1595.48 to reach the historical average. As the current bounce runs into selling consider new put spreads perhaps in combination with GLD call spreads.
Options Sentiment Check
2016 surprised many equity traders particularly after such a strong bounce off the lows last August. So far, realized volatility for the broad market near 24%, equates to daily moves in the range of 1.5 to 2% about double for most of 2014 and 2015. Gold has regained its role as a safe-haven this year- outperforming SPY by nearly 20%.
Timing of the current downdraft is important because many year-end hedges expired in January so fewer hedge funds and money managers have downside protection. Even though broad averages are down only 6% this year, many widely held names are in much worse shape. Some examples, BAC, DIS, JPM, AAPL, and many energy companies are down 30% or more since last summer. For some traders and hedge funds, this has been a bloodbath. On top of a flat 2015 it’s no wonder people are freaking out a bit. A trader at one bank this week told us they were worried their hedge fund clients were all blowing up at the same time.
Declining prices suggest we are likely to stay at this elevated volatility state for a while, maybe even years to come. Long-term implied volatility for SPY options are currently near 23%, unusual by recent standards.
Long opportunities do exist, especially for those planning to wait it out. We saw heavy call buying in McDonalds earlier this week when the stock was under 114, nearly 25K total contracts were bought and now the shares are up 4.
Despite the selloff, we continue to see bullish pockets despite a relatively bearish tape. We suggest focusing on blue chips for a while and avoid energy, speculative ‘new economy’ names like FIT, GPRO, and TWTR because there is currently just too much uncertainty.
Summary
With high price-to-earnings multiple growth stocks under selling pressure as earnings decline and with the usual defensive groups such as telecoms, utilities and consumer staples also considered fully valued money began flowing into gold and silver suggesting the deflation scenario may be ending as the US dollar pulls back from recent highs.