Updating the January Barometer, also called the January Effect adds another lower January close to the tally. According to the?Stock Trader?s Almanac January?s S&P 500 Index close, up or down determines the likely direction of the for the year. Adding last year?s close to the record puts another ?Right? in the result column increasing the probability for this year to 54%.
Market Review
S&P 500 Index (SPX) up 30.34 or + 1.75% for the week with 46.88 points or 2.48% occurring?Friday making an upside breakout from what appeared to be a classical barchart Rising Wedge or perhaps Pennant. Either way the breakout to the upside is important since both are usually continuation patterns while reversals are very unusual. Should it continue higher it might define a significant turning point considering the action taken by the Bank of Japan to implement negative interest rates that could preclude the Federal Reserve from rising interest rates further thereby relieving the current upward pressure on the US dollar, ? good for equities, emerging markets, commodities and crude oil.
CBOE Volatility Index? (VIX) declined 2.14 the week. 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 12 trading days until the February monthly expiration, the day weighting applied 60% to February and 40% to March for a 6.47% 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 6.53%.
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 premium started the week negative, turned positive Tuesday, then continued higher to close Friday at 6.53% still in the caution zone, but after Friday?s unusual reversal SPX is likely to continue higher at least for the next few days.
VIX Options
With a current 30-day Historical Volatility of 149.87 and 127.90 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 127.90 both February and March at-the-money options are inexpensive relative to recent movement of the VIX futures.
Foremost Six Update
Since there is little doubt the most important indicators last week, in addition to the S&P 500 Index, were the US Dollar and Crude Oil, updates follow.
US Dollar Index (DX) up.04 for the week and until Friday it appeared to be turning lower having closed below the upward sloping trendline from the December 15 low at 97.19. After the abrupt 1.09-point advance Friday, last Thursday?s low at 98.43 now makes the second point of the new upward sloping trendline from the December 15 low. The dramatic turnaround resulted from the Bank of Japan?s announced negative interest rate unconventional monetary policy that immediately reduced the yen exchange rate by 1.94% to 121.12.
While it?s not clear why the Bank of Japan thinks doing the same thing over and over will produce a different result. For now, the dollar index suddenly turned higher again. However, since the Federal Reserve may now defer further interest rate hikes equities made an unusual upside reversal. Watch the newly established upward sloping trendline and the previous December 2 high at 100.51. Should this most important indicator continue higher, it would be inconsistent with higher equity and commodity prices.
United States Oil (USO) as a proxy for WTI Crude Oil gained .38 for the week or + 4%. WTI crude oil futures basis March gained 1.43 or 4.4% closing at 33.62 continuing the advance from the January 20 low of 27.56.
Since prices are determined in the ?paper? futures market, tracking the activity of the Managed Money group in the weekly Commitment of Traders (COT) reports provided by the CFTC could confirm that the price low made on January 20 at 27.56 represents the low for this long secular decline. The latest COT report dated January 26, shows Managed Money reduced their shorts by 5,443 contracts while adding to their longs by 23,032, for a net long increase of 28,475 contracts in addition to a net long increase of 12,202 contracts the week before. While the open interest increased by 114, 219 contracts the Managed Money long percentage increased to 4.39% from 3.41% for the week ending January 19 and 2.75% for the week ending January 12. While there has yet to be a significant decline in open interest reflecting short covering by other categories, the increasing long position by the Managed Money implies the cyclical low and perhaps even the secular longer-term low was 27.56 on January 20.
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.
S&P 500 Index Downside Objectives
Last week?the focus was on downside-measuring objectives. After the unusual reversalFriday, after the action taken by the Band of Japan the focus now shifts to how high it may go, keeping in mind the long-term trend is still down, breadth is weak, and the important transports continue suggesting a slowing global economy.
Since SPX returned to the 1900-2000 range, and there is little resistance before 2000, at the top of the previous range, it makes a likely target where selling could resume. However, should the Federal Reserve do the unlikely and confirm there will be no further interest rates hikes in the near future it could attempt to retest the November 3 high back up at 2116.48. However this would do nothing to resolve the overvalue issue based on the long-term price to earnings ratio, but in the current environment equity prices seem to be more influenced by expectations for changing money supply than earnings. For example, according to Etf.com, Jeffrey Gundlach at DoubleLine Capital, said last Monday “Either the Fed dials down its hawkish rhetoric or ‘markets will humiliate them by going down.'”
Strategy Idea
With VIX in the 20 range, higher implied volatility that may continue for a while creates opportunities to sell option premium while maintaining neutral or near neutral directional risk. Some examples include out-of-the money call spreads on stocks in well-defined downtrends or out-of-the-money put spreads on the more defensive stocks currently in favor, such as telecoms, utilities or consumer staples. An alternative would be out-of-the-money Iron Condors, short both sides and therefore with less directional risk, but at the cost of less return in the event of an unexpected more where one side goes in the money and needs closing before expiration. Look for those with IV/HV ratios, using the range method for HV, of less than 2 as guide for stocks that are unlikely to make large unexpected moves in either direction.
Summary
The Bank of Japan negative interest rate announcement last Friday was a game changer as the yen immediately declined, the S&P 500 Index and the US Dollar Index both made an unusual upside reversals. Now the focus will turn once again to the Federal Reserve to confirm their intention to increase interest rates further or suggest they are willing to reconsider due to changing macro conditions.