Like the Aesop’s fable, those who have been calling for a correction these last few weeks have lost credibility as the market continued marching higher although most everybody knows a correction will come eventually.
After reviewing our indicators for this issue, we found some remain favorable while others are worrisome leading to the conclusion it continues being good strategy to have a hedging plan ready when the wolf or the bear eventually does come calling. Therefore, we added an iShares Russell 2000 Index (IWM) hedging idea and updated our conditional VIX options hedge suggestion below.
Review
S&P 500 Index (SPX)
Two weeks ago, we said it was likely to reach the upside measuring objective at 1582 and close above the October 11, 2007 high of 1576.09, which occurred last Wednesday on good volume. While this should be a sign the uptrend will continue, there are some developing undercurrents to consider.
E-mini S&P 500 Futures (ESM3)
Thursday, the second day at a new high of 1580.75, up 5.00 on the day the open interest declined 968 contracts. This suggests longs are selling out their positions into the strength and taking profits while the shorts are buying back their positions covering hedges or taking losses as declining open interest means the trend has become unstable. We suggest checking Friday’s open interest change when released Monday morning to see if the decline continued.
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 April and 90% to May for an average premium of 15.87% shown above. Our alternative volume weighting between April and May is a bit lower at 11.53% putting them near the middle of the normal range. Tuesday is last trading day for the April Futures contact.
iPath S&P 500 VIX Short Term Futures ETN (VXX)
The uptrend and the contango roll continues taking its toll while the five-day average volume was 42.2 million shares down from 49.5 the week before and 46 million two weeks ago.
VelocityShares Daily Inverse VIX Short Term ETN (XIV)
The 5-day average volume for the inverse was 14.4 million shares down from 15.2 the week before making the VXX/XIV volume ratio 2.93 compared to 3.26 the week before and 3.34 two weeks ago.
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. Friday the spread between April and May was -1.36, while the May – June spread was -1.17.
VIX Options
With a current 30-day Historical Volatility of 101.37 and 83.87 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 60.01 the IV/HV ratio is .59, using the range method for Historical Volatility the ratio is .72. While historical volatility usually exceeds the implied volatility, the current spread remains noticeable as we mentioned in Digest Issue 13. In the past the difference narrowed as the historical volatility declined to meet the implied volatility as reflected by the ratio returning closer to 1.00 and even briefly declining below the implied volatility.
The VIX put-call ratio at .77 is bearish for VIX, but not for the SPX with a more modest put-call ratio of 1.35 since they move in opposite directions.
The CBOE equity only put-call ratio at .70 was unchanged from the week before, but with a VIX put-call ratio of .77 the spread was -.07. As the CBOE 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. For the week, the spreads remained narrow and closed the week negative.
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. Now in the lower quartile of the 113-130 range and declining this indicator does not reflect concern that a correction is imminent.
US Dollar Index (DX)
The dollar advance stalled and turned lower after approaching 84 where it turned lower last summer so it did not follow the major equity indexes higher challenging the positive correlation theory proposed in a few weeks ago.
iShares Dow Jones Transportation Average Index (IYT)
In addition to being an important Dow Theory confirming indicator, the transports deserve close attention as a leading economic indicator. From a trendline perspective, the transports are right on the long-term upward sloping trendline but lagging the new highs made by the S&P 500 Index, having made a high of 112.30 on March 19 before declining to 107.48 on April 5. A close below the active trendline would be negative. With its sensitivity to the economy, we continue to suggest checking the transportation index before making any market direction decisions.
NYSE McClellan Summation Index
Since our last market review two weeks ago, the breadth indictor declined another 164.32 points including a slight 6.67 advance last week. The lagging breadth divergence continues to be a concern since it demonstrates much of the price advance in the last two weeks was in fewer large capitalization stocks, those with good liquidity and dividend support consistent with defensive positioning.
iShares Russell 2000 Index (IWM)
As the S&P 500 Index continued up to make new closing highs, the broader Russell 2000 Index did not follow as it failed to advance above the recent 95-resistance level setting up a potential classic double top. Watch for a close below 90 that would set off the double top pattern with a minimum measuring objective back down at 85 or about a 10% correction.