Selling Fear with a DryShips Bear Call Spread

About a week and a half ago Condor Options suggested an excellent mantra for those whose investing universe is populated by the likes of fear, greed, implied volatility, and the VIX: “Sell your fear to somebody else!”

It’s a simple concept, really, and one that shares much of what I try to do with the VIX. The hard part, of course, is to have the composure to calmly sell fear while others are panicking to such as a degree as to threaten to drive the price of fear even higher.

One obvious way to implement the selling fear strategy would be to do something like sell VIX calls whenever the VIX rises 15% above its 10 day simple moving average.

Consider a similar approach for individual stocks. For example, Adam at Daily Options Report posted an implied volatility chart that shows how implied volatility in DryShips (DRYS) has increased almost 50% in the past few days, as the stock hit an air pocket and fell 14% in a matter of minutes, a feat captured and analyzed nicely by Tim Knight at The Slope of Hope. Buoyed by Cramer, the continued bull market, and other more benign forces, DRYS has rallied almost 10% today, but now has some new battle scars.

It is possible that DRYS has put in a top and is now broken and vulnerable to bear attacks. Then again, this may be just another brief moment in time where the rocket ship shifts gears (see Tim Knight’s historical perspective above) before accelerating to the moon. I’m not brave enough to be long or short DRYS at the moment, but I will sell volatility at the current level. There are many ways to do this, but one way to harvest premium is with a bear call spread (aka short call spread, vertical credit spread, etc.) Thanks to the prodding I have received from several readers, I have provided an example of a bear call spread trade below from optionsXpress. Note that the trade consists of selling slightly out of the money calls and hedging/reducing risk by buying an equal amount of calls that are farther out of the money at a lower price. This trade is done for a credit, with the difference in cash in the trader’s account up front. Time decay is on the side of the trader, but the position should be actively managed, so that losses can be cut if DRYS moves sharply over 120 and threatens to go after its previous 52 week high. This is a high risk trade (a split of 120/130 or 125/130 would decrease risk significantly), but a lot less risky than a directional play on a stock with a triple digit implied volatility.

Now, did someone say something about an FOMC meeting…?

Update on ‘People Trading BIDU Also Traded…’

Apropos of my earlier comments on China and the FXI, I feel compelled to made two additional observations:

ProShares just announced a new ETF that targets double the inverse of the FXI. The UltraShort FTSE/Xinhua China 25 (ticker FXP) is slated to launch sometime in November – and should provide a wild ride for anyone tall enough and brave enough to get on this roller coaster.

Given that BIDU is trading up some 14 points as I type this, I have updated the optionsXpress Trading Patterns feature (“People Trading BIDU Also Traded…”) which I first posted about a month ago. Many of the names are the same; this also has the appearance of a who’s who of speculative momentum trading.

Finally, I am officially neutral going into tomorrow’s FOMC announcement, but whichever side you are playing, be sure to fasten your seatbelt and cut your losses before they run away from you.

Greenspan and the China Bubble

Once again, Alan Greenspan is predicting that the Chinese stock market is a bubble that has a limited life on the upside before things take an ugly turn. I have no doubt that Greenspan is correct on this count, but then again the Chinese markets could continue to go parabolic up to and beyond the Beijing Olympics, which means at least another 9 ½ months. Of course Greenspan has a mixed legacy in calling bubbles. His famous “irrational exuberance” comment of December 5, 1996 came when the NASDAQ had just crossed 1300 and the bull market still had more than three years left to run. If he’s risking his credibility here, does he have a stop loss plan?

Getting back to the primary issue, I wonder whether the Chinese government can maintain double digit economic growth for another year while keeping investment speculation under control and avoiding a stock market panic. If they believe they can accomplish this tall order, will they try to let off some steam now and have the economy coast into the Olympics or try to keep the freight train barreling down the track and tighten the screws on the economy only after the closing ceremonies are behind us?

I have no idea where how the Chinese markets will trade in the coming year, but as their influence continues to grow and a broader group of global investors seeks to participate in some of the gains, this is a story that I find myself spending more time following. In this regard, I have found two web sites in particular that have been helpful in providing news and data about various Chinese stocks: China Analyst is a site that has a wealth of tables, stock rankings and news (their recent coverage of BIDU’s earnings was extremely comprehensive); Cougar Jump is a highly informative data-oriented blog run by CH Tan.

Finally, since I’m more of a chartist than a fundamentalist, I offer the current chart of FXI, the iShares FTSE/Xinhua China 25 Index of stocks listed on the Hong Kong Stock Exchange. I’ll have more to say about this chart later. As a matter of fact, there is a temptation to make this space into an “All China, all the time!” media outlet, but for now at least, I’ll keep China as a sub-plot.

Volatility in a 130/30 Era

Kudos to Adam at Daily Options Report for highlighting a Barron’s article by Dennis Davitt of Credit Suisse in which Davitt makes some interesting predictions about volatility going forward.

Speaking about one of my favorite subjects, VIX macro cycles, Davitt predicts that the key factor in the next few years will be the influx of money from 130/30 funds that will create significant new demand for options products:

“In the past, when the market made new highs, the VIX trended lower. Today, the S&P 500 is up 6.5% on the year and the VIX is up 80%, and the newest user hasn't even shown up to the party yet. That user is the 130/30 money (a type of leveraged long-short investment strategy), which now stands at $100 billion and is projected to grow to $1.5 to $2 trillion over the next three years. With these new entrants using derivatives to hedge their portfolios, option-buying is sure to take a jump.”

Adam’s commentary on the subject closely approximates my own thinking (I’m glad he gets up three hours earlier to figure all this options and volatility stuff for me…):

“I think an underlying theme of all this is that different eras have different characteristics, and it's important to look at volatility within it's own context. In other words, a 15 VIX was actually fat a couple years ago, the market itself had trouble trading at double digit volatility. Today 15 might be as low as it gets.”

Not only do I agree with Adam here, but I think it is important to note that if the projections about new 130/30 money are on target, this could be one of the biggest stories of the next few years.

Mosaic (MOS) Continues to Lead Portfolio A1

The title is probably a considerable understatement, but what else can you say about a stock that is up 91% in only ten weeks in the portfolio?

The amazing run of The Mosaic Company (MOS) has helped to push Portfolio A1’s performance to a cumulative return of 14.15% since the portfolio inception on February 16, 2007. This is 8.67% better than the 5.48% returned by the benchmark S&P 500 index during the period.

Mosaic’s performance has triggered a number of thoughts about portfolio design, backtesting, and the likelihood of catching lightning in a bottle. Simply stated, in the 8 ½ months that Portfolio A1 has been up and running, it has purchased 27 stocks. Almost half of these stocks are up 50% during this period and 30% (MOS, DRYS, BRP, PCU, PBR, RIO, CNH, and SNDA) are up an astonishing 100% or more. The bottom line is that I believe it is possible identify stocks that have a high likelihood of doubling or tripling in one year (with attendant risk, of course) and build portfolio rules to maximize the probability of capturing those gains during the time they are held in one’s portfolio. I will expand upon this going forward, but Portfolio A1 should provide some evidence to support that contention.

There is one change to the portfolio: Navistar International (NAVZ) has been dropped and is being replaced by returnee PepsiAmerican (PAS), the beverage bottler. There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI at Zero Pre-FOMC

As the markets settle in for what will likely be 2 ½ days of waiting and mostly sideways action in advance of the Fed decision, the futures are suggesting that a 0.25% rate cut is in the works.

The VWSI is not tipping its hand vis-à-vis volatility expectations, moving back to zero after registering a fairly extreme -6 last week. The -6 VWSI reading preceded a week in which the VIX fell 3.40 points (14.8%), bringing the volatility index back down to the levels of most of the short and medium-term moving averages.

Recall from previous VIX and More research that the VIX has a tendency to anticipate higher volatility than the post-FOMC frenzy actually delivers, drop on the day of the announcement and perhaps one additional day, then take two weeks or so to attain pre-FOMC levels. In the absence of any compelling reason to expect something different this time around, keep an eye on the typical scenario to see if it plays out once again.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For a VWSI of zero, I continue to recommend an inexpensive Rhone blend. Some of my recent favorites include the following New World wines: Oakley Five Reds; Robert Hall’s Rhone de Robles and Tablas Creek’s Cote de Tablas Blanc; Wrongo Dongo, the contrarian favorite from Spain; as well as The Hermit Crab and The Stump Jump (I prefer the white over the red) from D’Arenberg in Australia. If you are looking for additional ideas, I encourage you check out the Rhone Rangers.

NASDAQ 100 Taking NASDAQ Composite for a Ride

This is probably just stating the obvious, but in keeping with the recent theme of a handful of generals and market breadth analysis, I thought I should highlight a comment from yesterday by Ben Bittlrolff who points to a recent observation by Mike Shedlock that half of the gains in the NASDAQ so far this year are from only three stocks: AAPL, RIMM, and GOOG.

Expanding a little on that thought, I have constructed a weekly chart of the ratio of the NASDAQ-100 (NDX) to the NASDAQ Composite. For visual simplicity, I have eliminated the weekly values and included only the four week and 39 week simple moving averages. The storyline is fairly straightforward: ever since the February 27^th selloff, the NASDAQ-100 [listing of the components of the NASDAQ-100] has been pulling the broader composite along for the ride. Scroll back to Mike Shedlock’s comments about the big three horses and it appears that these three en fuego large caps have been pulling both the NASDAQ-100 and the 3000+ stock composite index.

As I see it, one of two things is about to happen: either some other fresh horses are about to appear to help pull the sled or AAPL, RIMM and GOOG are going to run out of energy trying to get up one of these upcoming hills. Be sure to watch the ratio of the NASDAQ-100 to the NASDAQ composite for some clues on how this story is developing.

Two Thoughts on the McClellan Summation Index

For the most part, my trading time horizon is one of hours and days, yet I do have a long-term portfolio that helps motivate me to periodically check out trends and themes that may take months or years to play out.

One of my favorite indicators to assist in looking at intermediate and long-term trends is the McClellan Summation Index, which I have talked about here on several occasions in the past. Lately I have been looking at a weekly version of the chart that goes back to 1998 (the farthest StockCharts.com has to offer) and two things have been gnawing at me.

(Of course I should probably preface my remarks by noting I have some concern that once my gut starts to go bearish – which it does not do very often, but has done lately – I wonder whether my chart reading starts to suffer from confirmation bias.)

The first concern I have is the possibility that the trend of lower highs in chart (represented by the blue line that conveniently ignores the data from late 2006 through early 2007) may turn out to be significant, particularly if the relatively low peak of 421 earlier this month cannot be surpassed in the near future.

The second concern I have is the amount of time that the Williams %R indicator has spent below the -20 line. Looking back at the chart, the only other time I can see that the Williams %R failed to generate these high values for at least nine months or so was in the last nine months of the 1999-2000 bull market top.

It seems like a long shot, but each of these two observations continues to bother me.

Four Generals Will Tell the Story

I am a big fan of market breadth indicators, but when considering whether or not the markets may be at a turning point, I prefer to focus on a handful of leaders rather several thousand small caps whose fortune is never to make it to CNBC’s scrolling ticker. Jeopardy may have “foods that begin with the letter Q” (one of my favorite movie scenes, for reasons I’m still not entirely sure of), but somehow I don’t think we’ll ever hear, “I’ll take micro-cap tickers for $200, Alex.”

Cramer has his “Four Horsemen of Technology” (RIMM, AMZN, GOOG, and AAPL), but this sector focus, while important, is a little too restrictive for my liking. I do think, however, that it is possible to get some meaningful information from watching only four stocks.

Right now, four areas of the economy that I am watching most closely are China, technology, global trade, and consumer spending. These areas just happen to coincide with four stocks that have been market leaders over the past few months, are current or recent members of my OHFdex (Overripe High Fliers Index), have recently made new highs, and probably need to continue to make new highs for this market to continue to the bull march.

In order of recent price strength, the four generals I am focusing on are Apple (AAPL), Baidu (BIDU), Southern Copper (PCU), and MasterCard (MA). Interestingly enough, it is possible that each of these stocks has already made an intermediate-term top. Apple has been the strongest of the group, but following an impressive earnings report on Monday evening, the stock gapped up and has slowly been drifting down since then. It would be hard to proclaim a top in AAPL right now, but the short-term momentum appears to have left the stock. Baidu’s earnings are tomorrow, but the high of October 11^th is already starting to look like a possible top, as BIDU trades about 30 points below that high at the moment. Southern Copper has also been drifting down since an October 11^th high; yesterday’s earnings report has done nothing to change the trend. Lastly, MasterCard’s high water mark dates from July 13^th. The company has been a consistently impressive performer since it’s May 2006 IPO, during which time it has quadrupled in price. For the past three months the action has been mostly sideways, with the stock rising and falling over concerns about the impact of the credit crisis on retail spending.

My personal belief is that all four stocks will continue to come under pressure as the markets grapple with the possibility that the October 11^th highs will be hard to take out. I am not a kiss and tell trader and I prefer not to talk about my trading and positions, but since many have asked, at present I am short all four generals, though I will not be short BIDU when it reports earnings tomorrow. For the record, anything less than a blowout quarter and BIDU could be the catalyst that turns the current small market correction into some longer term bearishness.

Now it’s your turn, readers. If you could only follow four individual stocks to divine the direction of the market, which stocks would those be?

Fibonacci Retracements and Trading Ranges

Most traders are reasonably knowledgeable about Fibonacci retracements, which predict the likely percentage retracement of any preceding up or down move. The details of Fibonacci retracements are discussed in many places on the web, so I won’t repeat them here other than to note that the most commonly used Fibonacci numbers are the retracement percentages of 38.2%, 50%, and 61.8%. When markets move sharply in one direction, then turn around, the first question traders tend to ask themselves is how long the move will last. The usual suspects are previous closes, moving averages and “Fibs.”

Even if you don’t believe in what some consider to be the equivalent of numerical astrology, the important thing is that other traders do and right or wrong, they can make Fibs a self-fulfilling prophecy.

Part of the reason I mention all of this is that the NASDAQ composite just retraced about 61.8% of the recent drop and now is finding resistance at the Fibonacci level. The chart below tells much of this story, but the pressing question is what happens next. There is a temptation to assume that the bulls will eventually win out once again or that this time it looks like the bears finally have the numbers…but there is a third possibility, that we may be entering into a trading range. Once again, it is way too early to determine whether this may be the case, but today’s stalemate (so far) opens up that possibility. IF we are going to be in a trading range for awhile, expect Fibonacci levels to play an important role in defining the trading range, along with the other usual suspects.

Also, keep in mind that if we are in a trading range and volatility expectations continue to be on the high side, a covered call (or buy-write) fund, like market leader BEP, is an excellent low risk way to beat the market.

How Fearful Were We Last Week?

Wild weeks sometimes call for wild graphs. By the same token, what fun would it be to have a bunch of VIX data lying around if you didn’t have an opportunity to force it to play Twister at gunpoint from time to time?

So…with those two thoughts placed firmly tongue in cheek, I set out to find yet another way to show just how fearful the markets were – or were not – this past week. This time around I have plotted a diagonal black line that represents a best fit of all VIX and SPX daily changes since 1990. Above and to the right of that line represents more fear per unit move in the SPX; below and to the left of that line represents more complacency per unit move in the SPX. The blue diamonds are the end of day plots for the changes in the VIX and SPX for last week

A look at the graph shows a notable lack of fear from Monday through Thursday, with Friday’s market selloff generating a spike in the VIX that was out of proportion to a typical VIX move for a -2.56% drop in the SPX. Going forward, I will keep track of how much time the SPX-VIX relationship spends on the fear side of the best fit line and the magnitude of that divergence. Today, for instance, we are back on the complacency side of the line with the Dow down 91 points and the SPX off 8.5 points.

For more information on the relationship between daily changes in the VIX and SPX, see my previous post, “SPX-VIX Daily Correlation.”

Portfolio A1 Pulls Away from SPX

It was a crazy week, but when all the dust had settled, the 3.0% loss in Portfolio A1 was less than that of the 3.9% drop in the benchmark S&P 500 index. With last week in the books, the cumulative return for Portfolio A1 since inception sits at 9.2%, almost three times that of the 3.1% return for the SPX during the period.

DryShips (DRYS) led the way up from Monday through Thursday, before falling 8.9% Friday. The only stock to finish the week in positive territory was The Mosaic Company (MOS), which added 1.3%, but as it is the portfolio’s largest holding (28.7%), the gain provided the portfolio with a disproportionate boost. Going forward, this dry bulk carrier and fertilizer producer should provide important clues about not only the health of the economy, but about pricing power in these two sectors as well.

Since the rules of this portfolio are such that it is long only, I expect Portfolio A1 to be tested once again in the coming week. If the bulls return before the week is over, I think this portfolio is well positioned to continue to outperform. If we have another week selling and a whiff of an extended bear, I suspect this portfolio will have difficulty continuing to outperform the SPX with the current holdings.

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Drops to -6 as Markets Ponder a U-Turn

For four days last week, the VIX show hints of coming back to life and on Friday it roared back, posting a 24.1% gain, the third largest single day move since May 2006. Friday’s VIX spike capped off a week in which the VIX gained 5.23 points, or 29.5%, to 22.96. This also happens to be the VIX’s highest close in over a month.

From Monday through Thursday, the VWSI stuck stubbornly to a zero reading, but Friday’s action moved the indicator to -6, suggesting that the broader market indices may be oversold at this stage.

Just as I was last week, I am more bearish on the broader markets than the VWSI would suggest. In my view, the relevant time frame for the bears has now been extended: instead of merely having to prove that a selloff was more than a one day wonder, now the task at hand is to string together two ugly weeks in a row in order to take the wind out of the bull’s sails. Tomorrow is almost certain to open down as continued selling pressure from Friday carries over to the open. The question is whether the selling can be sustained or if enough buyers will be brave enough to jump in to ease the selling pressure. The second half of tomorrow’s session and all of Tuesday’s action – unhindered by government data, but still at the whim of corporate earnings – should have a great deal to say about how the rest of the week will go. The bull market may be long in the tooth, but the bulls still have a good case for a continuation of the five year bull trend – at least for now.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: When the VWSI hits -6, you need a big wine to balance it out. My recommendation is a zinfandel. For those who may have missed it, in addition to VIX and More, I occasionally blog at Zin and Pinot, a blog dedicated to my love of wine – and evidence that I am quite partial to zinfandel. As this is the first time we have hit a VWSI of -6 since August 2006 – well before I began blogging about volatility and vineyards – I will refer the reader to a set of links to eleven of my favorite zinfandel producers that I maintain on Zin and Pinot.

In the last week or two I have sampled several zins from Hartford Family Winery, including a 2003 Highwire Vineyard and a 2004 Dina’s Vineyard. Alas, I am afraid I am down to my last bottle of the 2004 Fanucci-Wood Road Vineyard, which is probably my favorite of the Hartford zins from the past few vintages. The winemaker generally favors dense fruity wines from old vines of up to a century or more in age. Expect a lot of alcohol here too, usually in the range of 16% (one in my cellar has 17.1% alcohol, according to the label) though you would be hard pressed to identify it amidst a silky smooth mouth feel.

A Small Pimple

If you ever desire a better picture of what is really going on in the markets, just zoom out in time a little. This means that if you spend almost all of your time looking at daily charts and intra-day charts, step back and look at some weekly charts.

Take this week, for instance. It certainly has been a painful one for longs, particularly those who have been adhering to buy-on-the-pullback strategies. At some time, however, the bulls need to ask themselves when a pullback may be turning into a full blow bear market. We aren’t there yet – in fact it's not even close – and a glimpse at the weekly chart makes this week’s action look like little more than a pimple on a bull’s butt. More importantly, it’s just one week and a lone week of action is rarely decisive enough to mark a turning point with any degree of confidence – even if it generates three Hindenburg Omen signals.

Things will get interesting if and when some of the recent market leaders start to roll over in their short-term moving averages. With the exception of perhaps Mastercard (MA), I haven’t seen this happen yet, but I have my eyes on a few of the China stocks just in case, most notably: China Mobile (CHL); China Southern Airlines (ZNH); China Life Insurance (LFC); and, of course, Baidu (BIDU).

Random ‘Crash’ Generator

On the heels of my Tuesday link-a-thon mention of Ian Woodward’s comments on the Hindenburg Omen, I noticed yesterday that Ian had another post up which mentioned a second Hindenburg Omen signal.

I figured it was about time to comment on Ian’s work, so I entered the requested information in the comment form below and when I went to check the anti-spam randomizer box to see what sort of strange characters I needed to type to prove that I am not a spambot, I found the image below:

Now I am not a particularly superstitious person, nor do I spend much time thinking about entrails, and I realize that it is possible to code in a small set of possible anti-spam choices...but I must say that on the heels of reading about the Hindenburg Omen, my first thought was that surely the Anti-Spam Omen must be a signal worth heeding.

Back to our regularly scheduled market correction…

Portfolio123.com: The Engine Behind Portfolio A1

A reader asked which tool I used to develop and manage Portfolio A1.

I talked a little about Portfolio123.com’s functionality when I introduced Portfolio A1 back in February, but I probably should have said more about this excellent web site. In a nutshell, Portfolio123.com is a web site that provides a comprehensive set of tools to help an investor develop stock ranking systems (not filters, but systems that rank all stocks based upon user-selected and weighted fundamental and/or technical criteria), backtest those ranking systems, and evaluate ranking systems based upon buying and selling rules established by the user. While many tools and features are available, one of most important features Portfolio123.com offers is high quality portfolio-level backtesting for stock ranking engines in combination with any associated portfolio management rules that users choose wrap around these ranking engines. In addition to backtesting, Portfolio123.com makes it easy for investors to manage and evaluate portfolios in real-time once they have been launched. Portfolio A1 is one such example; I have included a snapshot of one of my earliest efforts below. The more senior portfolio carries the unwieldy name of Bal4d 98S T10, but has been up and running for over three years with excellent results to date.

There are many other tools available in addition to the graphic I have included below; in the future I will highlight some of these tools in the context of Portfolio A1.

I encourage anyone who is interested to investigate Portfolio123.com's functionality, read some reviews, watch some product tours, check out the FAQs and other documentation, and test drive the site with their 14 day free trial.

For the record, I have no relationship with Portfolio123.com other than that of a satisfied customer.

Correlation Ideation

Let’s say, for the sake of argument, that you are intrigued by the 71% gains that MOS has logged in the past eight weeks in Portfolio A1, but for whatever reason do not want to own that particular stock. Perhaps you have an opinion that the fertilizer stocks are overbought or that a supercycle is just beginning in this sector. Which stocks should you be looking at? I recommend visits to three free web sites that can help you answer this and other related questions: Market Topology; Sector SPDR Correlation Tracker; and DeepMarket.com’s correlation tool. Each of these sites has some particular strengths that I discuss below.

My first stop to evaluate correlation data is usually at MarketTopology.com. Once there, you need to click on the Equities Markets: USA link to arrive at their “i-work” page. From here, just enter the ticker and either click on the ‘Calculate’ button to return data in a table (usually the better choice) or try ‘Map’ to see a graphical representation of the securities with the highest correlation. There are several other boxes you can use to filter the results; these should be self-explanatory and ripe for experimentation. In the case of MOS, the four highest correlations returned are POT, CF, AGU, and TRA – all companies in the fertilizer sector. The next two most correlated securities are both materials ETFs: VAW, the Vanguard Materials ETF; and IYM, the iShares Dow Jones Basic Materials Sector Index Fund. It is these types of discoveries that make tangential company and sector research more fun and interesting. Note also that the table also has a column for ‘Average Daily Volatility’ for those interested in identifying highly correlated stocks or ETF that are significantly more or less volatile than the baseline security.

Among the three sites discussed here, the ease of use award would probably go to the Sector SPDR Correlation Tracker, which simply asks for a ticker and generates three lists: highest correlation sector SPDRs; highest correlation stocks/ETFs; and lowest correlation stocks/ETFs. As an added bonus, you can generate java comparison charts for any four securities on these lists for additional analysis. Let’s say you are interested in the FXI, but prefer to take a position in an individual stock instead of the ETF. Using the Sector SPDR correlation tracker, you would be pointed in the direction of CHL, CEO, LFC, and BIDU.

At the bottom of the list is DeepMarket.com, which scores high for content, but low for aesthetics. Their correlation tracking tool lists the top 5 highest positive correlations and (lowest) negative correlations for the past 10, 30, 100, and 200 day trading periods. The site provides the correlation coefficient and a rudimentary line chart, but little else. What I do like is the ability to slice and dice correlations over four different time periods (the longer time periods probably provide the most value,) but apart from that feature, the other two sites are to be preferred.

I should mention that while I have focused on positive correlations here, each site provides a list of the most extreme negative correlations as well. While these generally are not as strong correlations as the positive correlations, they do provide and excellent jumping off point for someone looking to add securities to a portfolio that may be inversely correlated to some of the portfolio’s riskier holdings. This type of approach is admittedly more art than science at the individual security level, but for those unable to evaluate portfolio level correlation data, it is a substitute worth exploring.

Portfolio A1 Gains 9.8% in Week

The highly volatile Portfolio A1 roared past the benchmark S&P 500 index last week, with a stunning gain of 9.8% on the week. The gains bring Portfolio A1’s cumulative return since the February 16, 2007 inception to 12.6%, which is also 5.3% greater than that of the SPX during the same period.

Two stocks were responsible for most of the weeks gains: DryShips (DRYS) was up 23.1%; and The Mosaic Company (MOS) added 17.7%. The gain in MOS brings the fertilizer producer’s cumulative return to an eye-opening 71.4% in the eight weeks it has been in the portfolio – far and away the best performer in the portfolio to date.

It has been a dramatic roller coaster ride for this portfolio over the past three months, which makes this a good time to reiterate that the purpose of this portfolio is to aggressively maximize capitalize gains in the context of a concentrated, high risk strategy. One glance at the equity curve tells the story.

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Back to Zero. Was That the Bump?

In a week where Goldman Sachs hit a new all-time high while BIDU had a range of 58 points in one session, you could make the case that volatility is winding down or just warming up for the next act. Despite Thursday’s 13.3% jump in the VIX, the volatility index ended the week up only 4.8% or 0.92 points to 17.73. Still, this small bump was enough to send the VWSI back to neutral, following an unprecedented run of three consecutive high readings in the indicator.

The coming week is bound to provide considerable ammunition for both bulls and bears, as there are many important earnings reports in the technology and finance sectors. Barry Ritholtz at The Big Picture breaks things down in another excellent “Week in Preview” with details on earnings and upcoming government data, as well as the usual high quality set of links to some of the top commentary and analysis in the investment world. Even if you don’t click all the way through, be sure to check out Barry’s summaries.

For what little it is worth, I am more bearish than the VWSI, but the bears are going to have to do a lot better than a one day pullback to make me a believer. Perhaps earnings and options expiration will help to sort out the believers and the non-believers.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For a VWSI of zero, I recommend an inexpensive Rhone blend. Inexpensive is a relative term, but with yesterday I finally got around to tasting a $13 wine that from D’Arenberg that managed to secure a 90 rating from Robert Parker: The Hermit Crab. The 2005 version is 70% viognier and 30% marsanne. To my palate, the marsanne sets the tone here, keeping the viognier component in check and delivering a subtle complexity that astonished me. Frankly, I can’t think of any white blend in this price range that I have enjoyed more in recent years. Seek this one out.

For other inexpensive Rhone blends, I continue to also recommend: Oakley Five Reds; Robert Hall’s Rhone de Robles and Tablas Creek’s Cote de Tablas Blanc; Wrongo Dongo, the contrarian favorite from Spain; and The Stump Jump (I prefer the white over the red) from Australia. If you are looking for additional ideas, I encourage you check out the Rhone Rangers.

From Overripe to Vulnerable?

I recently published a list of ten of my “Overripe High Fliers” in a post with the intriguing name of “BIDU: Hogs (Eventually) Get Slaughtered.” Ironically, BIDU was trading at 301 at the time of that post (September 25^th), not too far from where it is as I type this, but I’ll save a more detailed discussion of BIDU for another day.

As of yesterday, my Overripe High Fliers list (yes, I actually call it an OHFdex) was up to 17 components. In the graphic below, I have sorted the OHFdex components by daily percentage change. Clearly the Macau gaming high fliers LVS and WYNN bucked the trend yesterday. Interestingly, those two stocks are down today while the tech stocks are rallying. The OHFdex group of 17 includes many of the market leaders and top performers from the past few months. If these continue to bounce back, then the bull market should remain strong. On the other hand, if this group falters, then the market will have to find new leadership or else succumb to the same gravity.

For quick visual reference, I have also included the CandleGlance charts from StockCharts.com for the 14 highest fliers (yes FSLR, LDK and ICE have been demoted.) For the record, these charts include a 20 day SMA in blue and a 50 day SMA in red:

More on VIX Futures and Volatility Expectations

Don’t tell anyone, but I call these my “More on…” posts because I can be headline-challenged at times...

Moving right along, thanks to an anonymous poster who reminded me that FutureSource.com has excellent free futures data, including intra-day quotes. Since I last checked out their site, they have considerably expanded the information available on the VIX and the newer volatility futures. For easy reference, I have added a link the FutureSource.com volatility futures quotes in the upper right hand corner of the blog.

Yesterday I posted a CBOE chart of the VIX futures data out through August 2008 that showed VIX futures pricing in increased volatility over the next ten months, with most of that priced in as short-term mean reversion anticipated during the November options/futures expiration cycle.

Expanding on that theme somewhat, today’s chart compares the life of June 2008 VIX futures (VX-M8 CF) to the cash VIX for the past year. While you would expect the cash VIX to be considerably more volatile than a futures contract 8-12 months out (recall the February 26-27 cash vs. futures VIX action) this was not the case during the July through August VIX spike and only began to become apparent by the higher readings that persisted in the June 2008 futures after the cash VIX began to subside. What I find particularly interesting about the current situation is that once the cash VIX dropped below 21.00 and kept dropping all the way down to the 16.08 reading earlier today, the June 2008 futures refused to follow. The two different Y-axes somewhat obscures the absolute numbers involved here, but the key takeaway – that of an increasing divergence over the past month – is hard to miss.

It should come as no surprise that the futures and the VWSI are saying the same thing. Once again, the big questions are how long it will take for the spread between the cash VIX and futures VIX to narrow and whether it will be more of a rising cash VIX or a declining futures VIX that will be responsible for a narrowing spread.

VIX Futures and Volatility Expectations

Periodically, I get a question about where to find VIX futures data. A few brokers (optionsXpress is one) have this information available via their web site and/or trading platform. The CBOE also provides VIX futures data at no charge through the CBOE Futures Exchange (CFE). Follow the link provided and click on the “Price and Volume Detail” tab to get information on all the VIX futures contracts for the previous trading day. The CFE also has a Historical Market Data page for those who are interested in detailed historical statistics.

I have clipped a snapshot of yesterday’s closing data to give a sense of what information is available. Note that most of the action is in the front three months, yesterdays futures were pricing in an 0.94 gain (a 17.06 futures settlement price vs. a 16.12 close in the VIX cash price) in the VIX over the next five days (October contracts expire a week from today), and volatility expectations from November 2007 to August 2008 are fairly uniform and muted.

If we do see volatility return to the markets soon, as I anticipate, I will compare a snapshot of VIX futures then with the current picture.

When to Short China?

Eventually, there will come a time when you will look back and say to yourself, “Why wasn’t I short China? It was such a no-brainer…” The answer to that question has a lot to do with the dictum that the markets can stay irrational much longer than many of us can stay solvent. Ask anyone who was short tech stocks in 1999 and knew it was just a matter of time before they were proven right.

There are a number of ways to approach this problem, but ultimately you want to be short when the majority stops buying on the dips and starts selling into the rallies. When does this happen? Generally, when the short-term moving averages (such as the 10 day SMA) start to roll over and slip below the intermediate-term moving averages (i.e. the 65 day SMA) distribution is occurring.

In that same vein, ratio charts can be helpful to spot speculative trends as well. Keep your eye on the relative performance of the FXI versus the NASDAQ and remember that it is better to catch the easy middle part of the move than to call the turning points. Traders should aim for the easy money; let the so-called gurus (and bloggers) shoot for bragging rights and the easy headlines…

Goldman Sachs (GS) Hits New All-Time High

In case anyone was wondering, this means the looming financial crisis has officially been canceled.

As much as various sentiment indicators suggest that there is too much froth in the markets, that doesn't mean it is a good time to be short. Said another way, never try to anticipate when a fast moving locomotive will make a U-turn, but be nimble enough to grab onto the caboose as it goes by, regardless of the direction...

ISEE Highlights Froth

Just in case it is not already obvious to anyone who may be an occasional reader, the VIX and the ISEE are my two favorite measures of market sentiment.

Right now the VIX is suggesting that the current market environment is overheated. This is evident in measures such as the distance the VIX is below various moving averages, the VWSI, and the VIX:SDS ratio.

Until recently, the ISEE was a little more prone to fence-sitting, but that changed with yesterday’s 187 reading, the highest single day reading since August 2006. On the heels of that large number comes a wave of call buying this morning that has the ISEE at 270 as of 11:10 EDT. Now it is not unusual to see extreme readings in the ISEE early in the day, when the denominator is low, but what is unusual is to see those extreme readings get even more extreme as the day wears on, such as the ISEE actually jumping up from 257 to 270 during the last 40 minutes. This development bears watching…

Schaeffer Thinks VIX May Be Signaling ‘All Clear’

In today’s Monday Morning Outlook: Small Cap Sentiment and a Significant VIX Move, Bernie Schaeffer opines that last week’s VIX close below the 32-week simple moving average could signal the same sort of “all clear” message that a similar VIX close did in August 2006.

On the SPX-VIX correlation front, Schaeffer also looked at Friday’s action and noted that “the SPX rallying more than 0.85% while the VIX drops less than 10% - has had historically bullish implications dating back to 1990. Specifically, after 20 days the market is higher 69% of the time; the average gain in the SPX over this period is 1.65%.”

As an aside, readers may be interested to know that I have provided links on the right hand column of the blog to several important voices who frequently talk about the VIX and market sentiment. The links to “Other Important Voices” can be found just below “Blogs I Frequent” section and currently includes the likes of Bernie Schaeffer, Larry Connors, Fred Ruffy, Jay Kaeppel, and Mark Hulbert.

Top 10 Forecasts from ‘The Futurist’ Magazine

I have highlighted the top ten forecasts from The Futurist magazine below. More details, references, and additional information are available from Outlook 2008, an annual collection of “the most thought-provoking ideas and forecasts” appearing in the magazine.

While I generally measure my investment time horizon in days, it always pays to be thinking several years ahead.

1. The world will have a billion millionaires by 2025. Globalization and technological innovation are driving this increased prosperity. But challenges to prosperity will also become more acute, such as water shortages that will affect two-thirds of world population by 2025.
   
   
2. Fashion will go wired as technologies and tastes converge to revolutionize the textile industry. Researchers in smart fabrics and intelligent textiles (SFIT) are working with the fashion industry to bring us color-changing or perfume-emitting jeans, wristwatches that work as digital wallets, and running shoes like the Nike +iPod that watch where you're going (possibly allowing others to do the same). Powering these gizmos remains a key obstacle. But industry watchers estimate that a $400 million market for SFIT is already in place and predict that smart fabrics could revitalize the U.S. and European textile industry.
   
   
3. The threat of another cold war with China, Russia, or both could replace terrorism as the chief foreign-policy concern of the United States. Scenarios for what a war with China or Russia would look like make the clashes and wars in which the United States is now involved seem insignificant. The power of radical jihadists is trivial compared with Soviet missile capabilities, for instance. The focus of U.S. foreign policy should thus be on preventing an engagement among Great Powers.
   
   
4. Counterfeiting of currency will proliferate, driving the move toward a cashless society. Sophisticated new optical scanning technologies could, in the next five years, be a boon for currency counterfeiters, so societies are increasingly putting aside their privacy fears about going cashless. Meanwhile, cashless technologies are improving, making them far easier and safer to use.
   
   
5. The earth is on the verge of a significant extinction event. The twenty-first century could witness a biodiversity collapse 100 to 1,000 times greater than any previous extinction since the dawn of humanity, according to the World Resources Institute. Protecting biodiversity in a time of increased resource consumption, overpopulation, and environmental degradation will require continued sacrifice on the part of local, often impoverished communities. Experts contend that incorporating local communities' economic interests into conservation plans will be essential to species protection in the next century.
   
   
6. Water will be in the twenty-first century what oil was in the twentieth century. Global fresh water shortages and drought conditions are spreading in both the developed and developing world. In response, the dry state of California is building 13 desalination plants that could provide 10%-20% of the state's water in the next two decades. Desalination will become more mainstream by 2020.
   
   
7. World population by 2050 may grow larger than previously expected, due in part to healthier, longer-living people. Slower than expected declines of fertility in developing countries and increasing longevity in richer countries are contributing to a higher rate of population growth. As a result, the UN has increased its forecast for global population from 9.1 billion people by 2050 to 9.2 billion.
   
   
8. The number of Africans imperiled by floods will grow 70-fold by 2080. The rapid urbanization taking place throughout much of Africa makes flooding particularly dangerous, altering the natural flow of water and cutting off escape routes. If global sea levels rise by the predicted 38 cm by 2080, the number of Africans affected by floods will grow from 1 million to 70 million.
   
   
9. Rising prices for natural resources could lead to a full-scale rush to develop the Arctic. Not just oil and natural gas, but also the Arctic's supplies of nickel, copper, zinc, coal, freshwater, forests, and of course fish are highly coveted by the global economy. Whether the Arctic states tighten control over these commodities or find equitable and sustainable ways to share them will be a major political challenge in the decades ahead.
   
   
10. More decisions will be made by nonhuman entities. Electronically enabled teams in networks, robots with artificial intelligence, and other noncarbon life-forms will make financial, health, educational, and even political decisions for us. Reason: Technologies are increasing the complexity of our lives and human workers' competency is not keeping pace well enough to avoid disasters due to human error.

Portfolio A1 Reconsiders DryShips (DRYS)

Last week I expressed my surprise that the portfolio had decided to sell out its position in DryShips (DRYS) after the stock registered a 27% gain in just four weeks in the portfolio. In retrospect, my skepticism looks warranted, as DRYS logged an 8.9% gain last week, while the stock it was replaced with, Shanda Interactive (SNDA), was only able to add 0.3% during the week. That differential, which meant a net of about 1.7% to Portfolio A1 last week, accounts for all of the 1.4% lost relative to the benchmark S&P 500 index last week.

Ironically, Portfolio A1’s stock ranking system has reconsidered this week and decided to add DryShips (DRYS) once again, while dropping the one other stock that has had two round trips in the portfolio: Terex (TEX).

While Portfolio A1 continues to try to run down the S&P 500, I am refining the next iteration of my public portfolio in the background and am readying for a January 1, 2008 launch. One of the most important changes is that this portfolio will not be a 100% mechanical system. It will be partly discretionary, so that I will be able to make decisions along the lines of overriding a sell signal in DRYS, if I don’t think it is appropriate.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Slips to +3; Pressure Builds for Correction

The word ‘correction’ implies that something is wrong that needs to be corrected. Even though I spent a good portion of last week on the wrong side of the markets, that doesn’t make the markets wrong, it merely makes me wrong.

Still, the persistent high positive numbers registered in the VWSI over the past three weeks is unprecedented, which is part of why I have been wrong side of the market. While the VWSI and VIX are excellent short-term indicators, they are far from omniscient.

Strictly by the numbers, the VIX registered its fourth consecutive substantial weekly drop last week, losing 1.09 or 6.1% to end the week at 16.91. This is the lowest end of week reading in three months and raises the question of where the VIX will ultimately find a bottom. I recently attempted to answer this question; and Adam Warner at Daily Options Report had some similar thoughts on the subject.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For previous VWSI readings of +3, I highlighted sauvignon blancs from Cloudy Bay and the Marlborough region of New Zealand, as well as some excellent California producers whose sauvignon blanc can be had locally for $10 or less: Bogle; Chateau St. Jean (where it goes under the fumé blanc moniker); Concannon; Kenwood; and Sterling. This time around, I recommend an elegant, complex sauvignon blanc, with a little bit of oak, from Gary Farrell Vineyards. Their 2005 effort can be had for about $25; for my money, it knocks the socks off almost all of the chardonnays in that price range.

Finally, for an entertaining (think the mannerisms of Joe Pesci and Woody Allen blended with the enthusiasm of Jim Cramer) and informative look at sauvignon blanc, I encourage the reader to sample Gary Vaynerchuk's "Sauvignon Blanc Taste-Off" on wine library tv.

Where Will the VIX Find a Bottom?

Let me start out by stating for the record that I have no idea whether it is appropriate to use traditional charting and other technical analysis techniques to attempt to determine support and resistance levels for the VIX. After all, the VIX is a multi-generational derivative that is a good distance removed from reality. For purposes of simplification, think of the VIX as a shadow puppet (more accurately, the composite shadow puppet from 500 simultaneous light sources); if we want to learn more about it, should we study the shadows or consider the hands from which the shadows are cast? I have a tendency to talk about the shadows, but for charting purposes I am inclined to believe that they are still just shadows.

So…with that backhanded disclaimer out of the way, let me turn my attention to a VIX that just made an intra-day low of 16.63. Whether that number sounds high or low depends upon where you have been anchoring a ‘normal’ price in your mind. At 16.63, the VIX is 68% above the year’s low (9.87), 56% below the year’s high (37.50), and about 7% above the VIX’s lifetime mean, which stands at 18.93.

I recently made a guesstimate that the VIX would bottom in the 16-17 range in October and I have no reason to depart from that thinking. I will, however, offer the weekly chart of the VIX below as one way to think about that 16-17 support range. Instead of the long-term moving averages (which may look interesting, but are of dubious value), focus instead on the Williams %R number. When the %R crosses below -80, it has a tendency to signal a bottoming out in the VIX – to the extent that you can tell when a shadow puppet is bottoming out…

SPX-VIX Correlation Nugget

I’ve been banging the SPX-VIX correlation drum fairly hard lately, so it’s time I moved on to other things.

Before I do, however, I will point the reader to a previous post in which I laid out some of my thinking on the significance of the correlation. I think the title says it all: “High Positive Correlation Between VIX and SPX Often Signals Market Weakness.”

There is also the issue of recent correlation data. For the past week and a half or so, the SPX and VIX have had an unusually high positive correlation, at least relative to historical data. In fact, the last time the SPX and VIX showed correlation levels this high for several days running it was…February 22, 2007, just three days before the largest VIX spike since the CBOE began tracking the VIX in 1990. Now before anyone jumps to conclusions, none of the eight previous correlation ‘spikes’ of comparable magnitude from the current decade resulted in a significant move in the SPX, so the historical record has to be considered ambiguous at best in the current environment.

SPX-VIX Daily Correlation

Yesterday I offered up some numbers to help describe the relationship between daily moves in the SPX and the VIX. I hear quite a few observers comment along the lines of “the SPX was up(down) X% and yet the VIX was only down(up) Y%.” Typically, the next action is to wonder aloud whether the corresponding VIX movement is ‘normal’ and whether any divergences might provide clues about the future direction of the markets.

Naturally, I’ll take the easy part of that equation first and offer the reader two ways to look at this. The graph below plots daily percentage changes in the VIX against daily percentage changes in the SPX. From the graphic, you can see that the relationship between the two is fairly linear for a SPX moving +/- 1.5% in a day. Once the SPX moves outside of those bounds, however, the equations get a little messier. Part of this, of course, is the accelerating fear factor that comes with extreme market moves.

The next graph ignores the absolute numbers and focuses on the magnitude of the typical VIX movement versus the SPX movement. Readers are encouraged to ignore the valley around the zero (where strange things happen when you try to divide by zero) and focus instead on the fairly predictable ratio of the VIX to SPX that varies from about -2.5x to about -5.0x, depending upon the daily change in the SPX.

As for the remaining question about whether divergences from the normal relationship provide reliable clues about the future direction of the market, I am going to address this more difficult question over the course of the lifetime of this blog. I will offer this though: if I think I can simplify the answer in one concise post, I will do the best I can to communicate my thinking here.

More Thoughts and Numbers on the SPX-VIX Correlation

I have used this space to talk about the correlation between the VIX and SPX, the SPX:VIX ratio and an bunch of other related subjects. Some may be ready to scream “Enough already!” but now it’s time we really got serious about the subject.

Let’s start with yesterday. There was a lot of talk (if you travel in certain blogging circles, at least) about how unusual it was for the SPX to jump 1.33% while the VIX moved down only 0.89%. The contention that the move on the part of the VIX was rather tepid seems to make sense in theory, because it is ‘common knowledge’ that the VIX typically moves in the opposite direction of the SPX and at a much faster rate. Where are the numbers to support this belief? Well, I’m going to start trotting them out in this space, but not all at once, so that I everyone has a chance to move to higher ground before the flood hits.

Some numbers to contemplate, using data from 1990:

• The VIX and the SPX move in the opposite direction on 76% of all trading days
• On those days the VIX and SPX move in the same direction, the move is more likely to be up than down
• In percentage terms, the median daily move in the VIX is -4.2x the daily move in the SPX

Getting back to yesterday, the SPX has risen 1.33% on seven previous instances. On all seven occasions when the SPX has risen 1.33%, the VIX has dropped, with a mean drop of 6.3%, a maximum of 10.1% and a minimum of 1.4%. Of those seven previous instances, the SPX recorded the largest subsequent gains (10, 20 and 50 days out) when the VIX dropped the farthest (10.1%); the SPX had the worst subsequent performance (10, 20 and 50 days out) when the VIX dropped the least (1.4%.) I know this is just seven data points, but history is not looking favorably on yesterday’s VIX performance.

I’ll have a lot more to say about this subject, with a lot more statistical significance, in the near future.

Quiet Before the Storm?

Though the most recent installment was published last Friday, I would be remiss in not highlighting the work done by Fred Ruffy at Optionetics.com. Fred authors a weekly Sentiment Journal that covers many of the issues I touch on here, with a mixture of charts, tables and text in an effort to summarize the week that was and provide some insights into the coming week.

Ruffy's most recent entry bears the title Quiet Before the Storm? He looks at much of the same data that interests me and we reach many of the same conclusions, mostly cautionary, about the current state of the markets. For the record, even with today's continued market strength, I find myself net short the markets (and long volatility) for the first time in 2007.

Finally, for those who may be interested, Fred also fields questions at Optionetics on their Ask Fred Ruffy discussion board.

Portfolio A1 Jumps 5% in Week

As the equity curve below shows, the August plunge has largely been eradicated in September, thanks in part to an impressive 5% gain in the portfolio last week. The strong week puts Portfolio A1’s cumulative return back into the plus column, with gains since the February 16^th inception now at 1.8%. While this performance continues to trail the 4.9% gain registered by the benchmark S&P 500 index during the same period, an optimist might venture a small smile for the first time in about two months.

One unusual aspect to last week’s gains is the decision by the stock ranking system to drop DryShips (DRYS) after a stunning 27% gain in just four weeks in the portfolio. This is the first time the portfolio has dropped a double digit gainer and it is a little bit of a head scratcher, but perhaps the stock ranker has turned HAL on me taken up to reading Investor’s Business Daily, specifically a Friday article titled Smiling Dry-Bulk Shippers See The Boom Times Lasting For Years.

To replace DryShips, the portfolio has decided to dive headlong into China by picking up Shanda Interactive (SNDA), the Shanghai-based interactive entertainment company. In my discretionary trading I am short China stocks at the moment, so this portfolio may provide yet another interesting competition between man and machine.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows: