Two weeks ago, the question was “How Low Can It Go, and” this week it is how high can the oversold bounce go?
Beginning with a market review including crude oil and a long-term semi-log S&P 500 Index that should have been included two weeks ago, we offer some thoughts about valuation and what to watch for this week
Market Review
S&P 500 Index (SPX) rebounded 26.57 points or + 1.41% for the week, after making a reversal Wednesday when it traded as low as 1812.29 before turning higher on increased volume sufficient enough to form a well defined pivot. From a classical barchart perspective, now it needs to form some type of consolidation pattern, perhaps a flag, a symmetrical triangle or perhaps a rising wedge. In the meanwhile, an estimate based upon historical price-to-earnings ratios in the ?S&P 500 Index Downside Objectives? section below should be helpful.
CBOE Volatility Index? (VIX) ended down 4.68 for 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 26 trading days until the February monthly expiration, the day weighting applied 85% to February and 15% to March for a 1.33% 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 lower at .98%, but also slightly positive.
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.
Caution
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 except Friday closing at .98% in the caution zone.
VIX Options
With a current 30-day Historical Volatility of 164.22 and 133.35 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.
United States Oil (USO) as a proxy for WTI Crude Oil gained .48 for the week or + 5%. Since the start of the year, it is lower by 1.73 or – 16% after being as low as -28% on January 20. WTI crude oil futures basis March recorded a similar decline and rebound from the January 20 low of 27.56 closing Friday at 32.19, up 2.66 for the day.
Since prices are determined in the “paper” futures market, watch for signs of short covering by the Managed Money group in the weekly Commitment of Traders (COT) reports provided by the CFTC. Should they begin profit taking by short covering joined by additional Producer/Merchant/Processer (PMP) longs as open interest declines it could signal a potential bottom even if just temporarily. The latest COT report dated January 19, one day before the price low, shows Managed Money reduced their shorts by 16,782 but also reduced their longs by 4,580 for a net long increase of 12,202 while the PMP longs declined by 5,074. While the open interest declined 137,428, it was one day before the February futures contract expired on January 20 when open interest normally declines, and the price low making the analysis inconclusive. Next week?s report including the January 20 price low activity should be more insightful.
S&P 500 Index Downside Objectives
Two weeks ago, we?suggested two downside-measuring objectives. The first based upon the previous 100 point trading range using the height of the range subtracted from the breakdown or 2000 less 100 for a minimum measuring objective at 1900, however since the August 25 low at 1867.30 made a tempting target we concluded it will likely test the lower level. It did indeed test the lower level multiple times with the lowest one at 1812.29 last Wednesday forming a reversal pivot.
The second downside-measuring objective based upon the long-term uptrend from the March 2009 low concluded a decline to the trendline at 1750 would equate to a price-to-earnings ratio of about 18.4 times trailing 12 month earnings based upon based upon the Crestmont Research earnings estimate of 95 while the long-term historical norm is 17.5 according to Crestmont. However, there is doubt the 1750 objective has any relevance since charts with terms of more than 2 years should be semi-log not arithmetic according to many technical analysts. A logarithmic chart plots price by percentage change. While not all technical analysts agree, it does make a big difference when determining when a long-term trend ended. Here is the S&P 500 Index semi-log chart from the March 6, 2009 low with the upward sloping trendline.
From this perspective, the uptrend from March 6, 2009 ended even sooner than August 20, 2015 using the previous trendline that began from the low on October 4, 2011. Using this method renders our previous estimate of 1750 almost useless as a downside-measuring target.
If not a trendline, the remaining alternative is to use fundamental historical price-to- earnings ratios. Using the Crestmont earnings estimate of 95 and the long-term historical price-to-earnings norm of 17.5 produces a downside-measuring objective of 1,662.50. While the Crestmont estimate of 95 could be too pessimistic, an average with the Goldman Sachs? recent 2016 earnings forecast of 106 produces an estimate of 100.50 so the average objective becomes 1,758.75 creating a downside measuring target range. There will be an opportunity to update the estimate after tallying up the 4Q earnings reports in a few weeks time.
Oversold Bounce
As for how far to expect the bounce to continue, the S&P 500 Index is likely to follow the direction of crude oil prices as a leading indicator of deflation, slow growth, too much debt and excess capacity. If crude oil stabilizes along with favorable earnings reports and forward guidance this week, it could attempt to test resistance up at 2000 before encountering more selling pressure. Keep in mind the situation would become more bullish should the Federal Reserve announce a delay in further interest rate hikes?Wednesday after the Federal Open Market Committee meeting, but that seems unlikely.
Summary
Crude oil prices turned higher providing enough support for the oversold S&P 500 Index to make a well defined pivot turning higher perhaps motivated in part by short covering before the Federal Open Market Committee meeting Wednesday should they announce deferring further interest rate hikes. While the current direction appears higher, it needs help from positive earnings reports and forward guidance to sustain the bounce.