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As technical conditions of the S&P 500 Index deteriorated last Wednesday, the breakdown Friday on news of liquidity issues in the high yield bond market related to the continuing decline in crude oil prices completely alters the outlook and greatly reduces the likelihood of reaching a new high by yearend. There is more below along with our regular VIX futures premium review followed by a ProShares UltraShort S&P 500 (SDS) hedge idea to consider.
Market Review
S&P 500 Index (SPX) declined 79.52 points or -3.79% for the week with half of the decline occurring Friday on news that a high yield bond mutual fund suspended withdrawals due to a lack of liquidity in the high yield debt market. From a technical perspective hopes for a new upward sloping trendline ended as SPX closed below the prospective trendline for the second time and below a similar consolidation pattern that occurred between July 24 and August 20, thus greatly reducing the probability of reaching the previous double bottom upside measuring objective at 2172. Indeed, after the lack of liquidity news in the high yield debt market, odds have increased for an imminent retest of theSeptember 29 low at 1871.91.
CBOE Volatility Index? (VIX) up 9.58 for the week, based on real-time prices of options on the S&P 500? Index, constructed to reflect 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 2 trading days until the December monthly expiration, the day weighting applied 10% to December and 90% to January for a -9.42% premium shown above. Our alternative volume-weighted average between December and January regularly found in the Options Data Analysis section on our homepage was slightly higher at -6.41%.
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 in the cautious zone Monday and Tuesday then turned negative Wednesday reflecting increased hedging activity.
Friday VIX futures traded 457,846 contracts compared to 270,887 on Friday December 4. Options on the futures traded 1,498,676 contracts compared to 493,615 the previous Friday.
Including substituting iShares iBoxx $ High Yield Corporate Bond (HYG) for ProShares UltraShort 20+ Year Treasury?(TBT), our usual interest rate indicator, there were three members of our Foremost Six in the spotlight last week.
United States Oil (USO) 11.07 as a proxy for WTI Crude Oil declined 1.39 or -11.16% for the week while the January WTI futures declined 4.35 or -10.88% to close at 35.62 continuing the rapid decline after the after the OPEC news on December 4. Should the dollar stabilize or reverse course after the Federal Reserve finally announces a long awaited interest rate increase and accumulated long dollar positions continue unwinding, inflation hedging in the crude oil futures market could return, but some of the dollar decline has already occurred without helping support crude oil.
Last week we?introduced the inflation hedge role of crude oil into the supply and demand equation suggesting the possibility that crude oil could find support if the dollar declines after the long anticipated interest rate hike. However, there was no support last week as the dollar declined ahead of the Wednesday?announcement.
Updating the CFTC Commitment of Traders report for December 8 shows the ?Managed Money? group joined the sellers as their longs declined 10,289 contracts and their shorts increased by 9,935, pushing cash crude oil to 37.67. For details on the importance of the “Managed Money.”
iShares iBoxx $ High Yield Corporate Bond (HYG) declined 3.14 points or -3.80% last week with 1.62 points of the decline taking place Friday as it gapped lower on volume about four times normal. As crude oil continued declining anxiety increased about possible defaults by E&P firms with 66 billion of debt and interest due in 2016-2018 according to an excellent July 4, 2015 Economist article about shale oil production. Friday?s decline may have been the first sign of long lasting liquidity problems in the high yield bond market or just a reflex reaction that will soon pass like th e China yuan devaluation scare in August.
US Dollar Index (DX) down another .78 points or -.79% for the week in addition to a 1.67-point decline the previous week, the overbought dollar may have already made the expected correction or there may be more to come when the Federal Reserve announces an interest rate increase as expected. However, since the decline has yet to provide support for equities or crude oil, other concerns are more important.
Strategy Idea
Since the seasonal odds for an advance into yearend appear to be at risk while valuations remain high with economic fundamentals deteriorating, perhaps the time has come to consider hedging long positions. However, last year the S&P 500 Index declined 106.90 points or -5.14% between December 5 and December 16 only to come roaring back on December 17 to finally close up 120.13 points or +6.09% higher by December 26. While conditions may not be not be comparable markets are expecting an interest rate hike announcement after FOMC meeting Wednesday, but if the statement includes language that one small hike is sufficient the S&P 500 Index may still attempt another seasonal advance into yearend as portfolio managers engage in “window dressing”.
ProShares UltraShort S&P500 (SDS) up .77 Friday seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the S&P 500 Index. In the event the HYG and the high yield bond market drags equities lower early in the week here is a hedge idea to consider.
The current Historical Volatility is 29.14 and 21.91 using the Parkinson’s range method, with an Implied Volatility Index Mean of 42.80 up from 25.83 the week before. The 52-week high was 74.37 on August 24, 2015 while the low was 20.96 on July 22, 2015. The implied volatility/historical volatility ratio using the range method is 1.95 so option prices are expensive relative to the recent movement of the ETF. Friday?soption volume was 38,275 contracts traded compared to the 5-day average volume of 18,910 with reasonable bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit would be .62, about 21% of the distance between the strike prices with a good implied volatility edge. Use a close back below 20 as the SU (stop/unwind).
SPDR S&P 500 ETF (SPY) a comparable January put spread hedge using would be 1.58, long the January 200 put, short the 195 put, with only a slight volatility edge and 32% of the distance between the strikes. SDS offers a better implied volatility edge and while the options volume is considerably less than SPY options the bid/ask spreads are reasonable.
Summary
The technical condition of the S&P 500 Index deteriorated last week reducing the probability of reaching a new high by yearend. However, assuming the US dollar continues to decline after the December 16 interest rate hike announcement as expected followed by comments that further hikes will be limited the S&P 500 Index could find support unless more negative liquidity news from the high yield bond market starts a stampede for the exit.