Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Since last week?s digest?introduced cyclical counts to S&P 500 Index analytical process, this week includes an update along with another progress report on our ?Four Horsemen of the Apocalypse? including details on the fading breadth, all right after our regular bi-weekly market review.
Market Review
S&P 500 Index (SPX) closed the week up 24.19 or +1.16% after making what appears as a cycle trough last Monday after closing once again below the neckline of the already activated Head & Shoulder Top only to quickly turn higher the next day as shown in the chart below in the Cycle Count Update section. The next upside challenge is to close above the 2132.82 high made July 20 marked RS2 (Right Shoulder 2) on the chart.
CBOE Volatility Index? (VIX) was down 1.62 for the week on the SPX reversal once again approaching the 52-week low of 11.47 made on August 22, 2014. Seasonal factors are at work here since volatility is usually low in August as trading volume usually declines after the July nonfarm payroll report and unless the report due Friday is much better than expected another volatility low is likely.
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 applied 60% to August and 40% to September as of Friday for a 19.80% premium shown above. Our alternative volume-weighted average between August and September regularly found in the Options Data Analysis section on our homepage was slightly lower at 18.38%.
Premiums for normal term structures 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 premium began Monday at 2.09% and then advanced every day to close the week in the normal zone at 18.38%, neither too hot nor too cold.
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.
VIX Options
With a current 30-day Historical Volatility of 162.63 and 106.07 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.
Compared to the current range historical volatility of 106.07, both the August and September at-the-money option prices reflect a lack of enthusiasm to pay higher prices confirmed by low volume of?224,066 contracts compared to the 5-day average of 406, 930. Low volume and declining implied volatility is likely to continue presuming the Friday non-farm payroll report is consistent with market expectations.
Four Horseman Update
Last week we introduced four important equity markets risks to follow. Last week the back and forth continued, some advanced, others faded. First, the leaders representing the most risk for the bulls.
Market Breadth
The McClellan Oscillator Summation Index reported by McClellan Financial Publications improved as well advancing from -280.99 to 324.37 for an impressive 605.36 point turn around making this the second charging infamous rider to stumble, lost in a cloud of dust.
The red and black Summation Index line usually follows the SPX while divergences are a cause for concern. The red arrow above indicates the extent of current divergence. A June 10, USA Today article says 100 of the S&P 500 Index stocks were down more than 20% highlighting the importance of the divergence.
iShares Transportation Average (IYT) up 5.91 or 4.09 % for the week making a noticeable reversal from last Monday?s low and breaking out above the downward sloping trendline DSTL Wednesday from the March 20 high of 165.00 where the downtrend began. Although the apparent trend change is significant it has also been volatile recently and could quickly turn lower once again so it will remain a part of the group awhile longer awaiting further confirmation.
Considered a leading economic indicator, this ETF tracks the important Dow Jones Transportation Average Index and according to the widely followed Dow Theory, the transports and the Dow Jones Industrial Average should move in the same direction while divergences signal a possible trend change.
US Dollar Index (DX) up .14 for the week after making a long trading range lower Friday it closed off .22 but right on the upward sloping trendline from the June 18 low and the double bottom at 93.56 thereby confirming slightly lower interest ratesFriday. Any further decline below the trendline will question its continued membership in this infamous group.
ProShares UltraShort 20+ Year Treasury (TBT) our preferred interest rate indicator ended the week lower by .90 points or -1.95% as interest rate risk declined ahead of the Friday nonfarm payroll report. Now below support at 46 and heading lower suggests diminishing expectations for an interest rate hike anytime soon. However, since volatility often increases before the nonfarm payroll often reversing direction after the reports, and since Janet Yellen says a rate hike depends upon the data, it?s better to retain membership in the group awaiting further confirmation that interest rates are declining once again.
Cycle Count Update
S&P 500 Index (SPX) ? Head & Shoulders Top pattern remains active
The current uptrend defined by the upward sloping trendline USTL originates at the October 15 low of 1821.61 (below the left corner of the chart) extending upward to the right closing Friday at 2173.25 in the upper right corner, considerably higher than the current close. Since the previous uptrend has apparently ended, the cyclical patterns are becoming more prominent as detailed last week.
Comparing up days to down days should help confirm the current trend status while projecting future turning points assuming the cycles continue lacking trend. Ideally, cycles last for 20 days although few if any cycles will be exactly 20 days as other influences override the cyclical tendencies.
After briefly declining to close back below the neckline NL of the Head & Shoulders Top pattern last Monday, SPX quickly reversed higher making a pivot trough that became cycle point 7 sooner than expected.
Based upon a 20-day cycle count, the next trough was due on or about August 4, 2015, however it came sooner.
Beginning March 11, 2015 trough at point 1, on the chart above, here are the cycle counts.
The translation turned bearish between points 4 and 5 since this is where the S&P 500 Index first crossed below the upward sloping trendline USTL. However, since the cycle turned up sooner than expected thereby cutting the length of the decline to only 5 days from the expected 7 or more the cyclical translation turned bullish once again. Now the focus will be on the July 20 high at 2132.82 and the next cycle peak. It still takes a close back above the May 20 high of 2134.71 to negate the Head & Shoulders Top with the measuring objective MO down at 2007 shown above at the red arrowhead.
Summary
Both the equity and fixed income markets improved again last week as the S&P 500 Index bounced right back up after declining below the important neckline of the active classical barchart Head & Shoulder Top cutting short a down cycle while pushing implied volatility lower once again although the oil & gas sector extracted a heavy toll. While encouraging for the bulls, market breadth still suggests caution ahead of the Friday nonfarm payroll report.