Thursday, January 31, 2008

Bulkowski on Bottoms

I was surprised to see that while I am in my second year of blogging, I have yet to make a reference to Thomas Bulkowski’s excellent Encyclopedia of Chart Patterns. As the title suggests, this is more of a reference book than a page turner, yet it is an invaluable tool for anyone who is interested in stock charts, whether they would classify themselves as a novice or an expert.

I mention Bulkowski because many people will undoubtedly be trying to determine whether the recent lows are likely to result in a bottom, and what to expect going forward if this bottom holds or if it fails. Bulkowski’s work is an excellent place to start, where you can brush up on a wide range of bottoms he has classified and analyzed from a trading perspective, including the classic Head-and-Shoulders Bottoms, as well as some of the more esoteric Bulkowski favorites, such as Horn Bottoms, Pipe Bottoms, Bump-and-Run Reversal Bottoms, and a variety of double bottom chart patterns.

Whether you agree with all of Bulkowski’s conclusions is not important. Just looking at his work and thinking about how one might go about challenging some of his thinking will more than compensate most traders for the expense of the book. In the end, I find that there is a fair amount that can be swallowed whole and I cannot help but marvel at the meticulous rigor of Bulkowski’s approach, a process that hearkens back to my discussion earlier this week about what makes an expert trader.

In addition to the three books he has written (a fourth, Encyclopedia of Candlestick Charts is due out in the first week of March), Bulkowski maintains a web site, The Pattern Site, that offers a high level view of his thinking, at no charge.

Finally, regarding my own perspective on the recent market action, I am not ready to call a bottom, but the events of the last 48 hours have me thinking that the likelihood we are forming a bottom is much higher than most pundits think.

Wednesday, January 30, 2008

Strength in Financials

I am of the opinion that there is a fine line between bravery and stupidity – and when it comes to front running any FOMC announcements, stupidity often rules the day.

With that in mind, consider the action in the financial sector over the past week or so. Looking at the XLF SPDR, we have an impressive two day bottom put in last Tuesday and Wednesday, with a pop of 20% from a bottom of 24.11 and a potential cross of the 50 day SMA less than 1% away from current levels. The volume at the bottom was impressive and has held up fairly well on the way up. Certainly a cross of the 50 day SMA and a turning up of the 20 day counterpart must bode well for that sector and increase the likelihood that this month’s plunge will ultimately turn out to be the bottom.

All of this is predicated, of course, on the markets having confidence that the Fed is doing the right things to shore up our financial systems, provide appropriate liquidity, and keep the dominoes from getting any wobblier. Presumably, the markets have priced in a 50 basis point move by the Fed today and have valued the financial sector on the assumption that solutions to the current situation – though they may be slow to take root and turn out to be expensive – are going to ultimately resolve the current credit crisis.

I won’t be front running the Fed today, but if the financial sector turnaround means anything – and it usually does – it could mean that there is still a lot of easy money to be made cherry picking some of the stronger names that have beaten down with the rest of the sector.

Tuesday, January 29, 2008

Expert Traders

Brett Steenbarger’s TraderFeed blog is a superb resource for data-driven market analysis as well as a review of many of the important psychological aspects of trading.

I found two recent posts and a promised next installment on trader performance to be particularly insightful. In How Common Is Elite Talent Among Day Traders? Brett cited a study which determined that 80% of day traders lose money. In today’s follow-up, What Makes an Expert? Three Surprising Research Conclusions, Brett concludes that repeatable success can best be attributed to those traders who essentially develop what I would call a closed-loop feedback system and strive for continuous improvement.

The bottom line is that superior trading is not the result of intelligence, tools or a holy grail setup. Instead, top performance is the result of the efforts of those who do the best job of developing and applying a process that takes maximum advantage of experience and learning opportunities to develop and refine one’s edge. In Brett’s words, it’s all about a “structured learning process.” Brett has promised that he will offer up his thinking on what sort of structured learning process would be ideal for traders and when he does, I will be quick to weigh in with my thoughts.

Monday, January 28, 2008

Crossroads Options

Raise your hand if you think the market is at a crossroads where it is more likely to make a big move in one direction or the other rather than just drift sideways from current levels.

I see a lot of hands going up, which doesn’t surprise me, as I also think the markets are at one of those crossroads that precedes a big move. The problem, of course, is getting the direction right.

The most popular way to play a large anticipated move of undetermined direction is with a long straddle or a long strangle. If you get a big move – and particularly if you get is shortly after initiating the position – you will likely be able to lock in a substantial profit. Losses are limited to the cost of opening the position, but if volatility is widely expected, the position can be expensive to open and time decay can be painful.

For what it’s worth, I am often partial to a different approach: call backspreads and put backspreads. There a couple of important distinctions between a straddle/strangle approach and a backspread approach. First of all, straddles and strangles can entail a significant initial outlay. With backspreads, on the other hand, you can essentially finance the excess out of the money calls or puts by selling some at the money or slightly out of the money options and end up with a net credit or zero cost transaction. Second, if the options sold are at the money or out of the money, you will make money if the underlying does not move. Finally, as the graphic below (of a call backspread) demonstrates, the big windfall with a back spread is unidirectional. So unlike the straddle or strangle, large profits only accrue when you can call the direction of the move.

If you are interested in learning more about backspreads, check out John Summa’s Backspreads: Good News for Breakout Traders article in

Portfolio A1 Bounces Back

While it was not a big bounce, the fact that Portfolio A1 bounced 1% more than the benchmark S&P 500 index did last week has to be considered a good sign. After 49 weeks, the portfolio’s 6.4% gain still compares quite favorably to the 8.6% loss in the SPX over the same period.

New addition Terra Industries (TRA) led the way with an 8.6% gain for the week, after taking the fertilizer baton from previous portfolio anchor, The Mosaic Company (MOS).

The 2008 year to date numbers (through Friday) show that Portfolio A1 has fallen faster than the SPX – -12.8% vs. -8.7% – with the superior cumulative performance numbers for the portfolio largely a reflection of a superb fourth quarter in 2007. Some may see this as a possible anomaly, but this portfolio is set up to ‘fish for whales,’ a theme I will expound upon in the future.

There no changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

VWSI at Zero After VIX Hits 5 ½ Year High

You know it’s an interesting market when the VIX hits a 5 ½ year high (37.57) on Tuesday, while the VWSI actually manages to end the week down a point at zero.

Part of the reason for these statistical oddities is that the VIX fell 23% from Tuesday’s high to Friday’s close, resulting in a weekly gain of ‘only’ 1.9 (7%.) The 29.08 close is the second highest end of week close since March 2003, behind only the 29.99 close in the middle of August 2007.

With a 23% move already accounted for, the VWSI has a neutral volatility outlook going into the week, apparently viewing last week’s volatility snap back move as already having fully discounted future mean reversion opportunities.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the crazy week that was and the week that lies ahead in his End of January Linkfest.

As we wait for the Fed to announce their next move(s), this might be a good time to cut back on trading an brush up on some reading. In case you missed it, I would start with Roger Lowenstein’s [author of When Genius Failed: The Rise and Fall of Long-Term Capital Management] The Education of Ben Bernanke from last Sunday’s New York Times. Three books I have recently enjoyed that are particularly pertinent to current markets are:

Also, for links to Fed speeches, charts of market action on Fed Days, etc., don’t forget my collection of Fed Links.

(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 began 2007 by recommending some Rhone blends and later expanded the category to include any expensive blend. Over the course of the year, my two favorite inexpensive blends turned out to be the $8 Oakley Five Reds (the 2003 vintage is a blend of 41% syrah, 27% zinfandel, 22% petite sirah, 10% alicante bouschet, and 1% mourvedre from Cline Cellars); and the 2005 vintage of The Hermit Crab from D’Arenberg, a delicious $13 blend of 70% viognier and 30% marsanne.

Friday, January 25, 2008

The Game Is Afoot

Today’s bearish reversal is the first minor skirmish following the recent selloff and attempt at a bottom.

In looking at a chart of NASDAQ composite, the obvious ultimate support level is the 2202 bottom that was put in on Wednesday. Almost as important, however, is the green line at about 2320-2325 that I have added to the 30 minute chart below. For the moment at least, 2320 is the critical line in the sand. This line highlights important gaps on Wednesday and Thursday that served as resistance on both days, as the bottom was forming. Now the 2320-2325 area appears to have flipped from resistance to support in the face of today’s downturn.

It is way too early to draw any conclusions about the bottom earlier in the week, but there is a possibility that we are seeing the first higher low, which would move the battlefield to the 2220-2410 arena – the full extent of today’s range. About the only thing I can say with confidence at this point is that the game is afoot. How well the bulls defend 2320 should go a long way to determining whether this week’s action will turn out to be an important bottom. If 2320 falls, I suspect it will be very difficult to rally sufficient support to make 2202 hold.

Thursday, January 24, 2008

Reversal Bar Analysis at Quantifiable Edges

I have been impressed by the breadth of top notch analytical thinking across the investment blog world in the past few weeks and have found many insights of note from some of the stalwarts on my blogroll. For the moment, however, I want to highlight one new blog, Quantifiable Edges, authored by Rob Hanna, that has particularly impressed me with some timely and thought provoking analysis.

Rob just happens to be in the midst of publishing some excellent work he has been doing on reversal bars – a subject that should be top of mind for all traders, given the recent market action. I encourage readers to click through and have a look: Quantifiable Edges on reversal bars

MBI, Bond Insurers, and Volatility

One of the more interesting – and important – subplots to keep an eye on during the current market difficulties is that of the bond insurers. The two most prominent of these bond insurers, MBIA (MBI) and Ambac (ABK), are in the news today with reports that the New York Insurance Superintendent is trying to arrange a capital infusion from the likes of Goldman Sachs (GS), Merrill Lynch (MER), JPMorgan (JPM), Citigroup (C), and Wachovia (WB). Presumably, the Fed is doing some arm twisting and offering some financial incentives behind the scenes, as a failure to resolve the problems with the bond insurers would likely trigger systemic havoc and involve a long and expensive list of dominoes in the process.

Eric Dinallo, the New York Insurance Superintendent, was quoted earlier today as saying that while a rapid resolution is essential, ironing out the details of a bailout may take awhile. “It is important to resolve issues related to the bond insurers as soon as possible,” Dinallo noted, while cautioning “these are complicated issues involving a number of parties and any effective plan will take some time to finalize.”

While most investors should be thinking about the bond insurer issue in terms of its impact on the broader markets, there are some interesting plays on bond issuers themselves. As reported in 24/7 Wall Street, Goldman Sachs laid out some potential valuations under three different scenarios, ranging from the bond insurers’ being unable to raise enough capital to mollify the rating agencies to a situation where the capital raised enables the bond insurers to continue to operate as they had in a pre-crisis mode. Looking just at MBI, the valuation spread ranges from $6 to $48.

Investments don’t get much more speculative than this, as the chart from optionsXpress above shows. For the record, all February puts now carry an implied volatility of more than 200. While I am not going to recommend a specific trade here, there are some fascinating options spreads and ratio spreads to look at for those who believe that the Goldman scenarios and numbers are in the ballpark.

Wednesday, January 23, 2008

NDX Fails Briefly, Other Indices Hold Bottoms

Bottoms are an interesting species. They are almost impossible to call in advance and surprisingly difficult to identify with a little hindsight. Typically, by the time you have enough hindsight to say, “Hey that was a bottom back there!” you have already missed a good portion of the move up from that point.

A number of indicators can help raise the probability of calling a bottom, the VIX among them, but we are still in the meteorological realm in terms of accuracy – and very much in the pre-Doppler era at that.

Most students of market bottoms agree that evidence of widespread capitulation is the best way to identify a market bottom. The reasoning is essentially that it is ‘better’ to have one day of extreme investor panic than a number of days in which the cumulative losses add up to one big drop while the psyche of the investor is able to digest the grief on the installment.

According to the reasoning above, yesterday had some elements of extreme investor panic at the open, but the ease with which the markets rallied from that point suggest that there may not have been enough panic or pain to account for a traditional capitulation bottom. This morning’s open was also relatively low in terms of panic and pain – at least on the capitulation scale – so there will be many who will wait for another strong retest of yesterday’s lows (and of investor fortitude) before committing to new bullish positions.

It is worth noting that one major index had yesterday’s low breached this morning: the NASDAQ-100 (NDX). Thanks to AAPL’s weak guidance yesterday after the bell, the stock opened dramatically lower and pulled the NDX down with it. The NDX has since recovered, but it and AAPL should be watched closely, as their support levels will likely be tested before those of the other more widely followed indices.

Tuesday, January 22, 2008

Brunhilde Day Today?

Today could turn out to be one of those days that imprints the value of the VIX deeply into the psyche of many traders.

While I have gone out of my way to suggest that the markets do not have to see a VIX spike in order to put in a bottom, it appears that following this morning’s surge in the VIX to 37.57 (the highest reading since October 2002) many buyers felt comfortable starting to nibble. Now with the markets inching back toward even for the day, the likelihood of a high volume reversal day signaling a market bottom is increasing dramatically.

While I have done some nibbling of my own, I would not be surprised to see at least one test of the lows of the morning and would hold off on calling a bottom until we see more evidence of higher lows and higher highs.

On the other hand, if today turns out to be a bottom, you can bet that that next time we have a major selloff, traders will be watching the VIX even more intently to determine when it signals that bottom. If the VIX was important before today, it is about to become even more important going forward, when traders eagerly watch to see when Brunhilde is going to sing.

Portfolio A1 Falls as Mosaic’s Run Comes to an End

It was fun while it lasted, but it had to come to an end eventually. The Mosaic Company (MOS), which had run up an eye opening 176% in the first five months it was in Portfolio A1, is now gone from stable, victim of a rule that automatically culls any stock that falls 20% from the high recorded during the holding period. Also shown the door as a result of a 20% drop is Brazil Telecom Participacoes (BRP).

Replacing MOS and BRP are LG Philips LCD Co. (LPL) and Terra Industries (TRA). LG Philips LCD Co. is a Seoul-based $16 billion joint venture in the display business between two global giants, LG Electronics and Royal Philips Electronics. TRA, a nitrogen fertilizer company, demonstrates how some portfolio ‘rules’ can backfire, as this company is a direct competitor of Mosaic in the fertilizer business and at only 10% of Mosaic’s market capitalization is actually a much riskier play in this sector. Nevertheless, the stock ranker has spoken and TRA should do well if this week turns out to be a bottom. As far as the wisdom of holding an LCD manufacturer at a point where consumer demand appears to be drying up, I am skeptical, but this remains a 100% mechanical portfolio, where my perspective does not matter.

After falling 11.4% last week, Portfolio A1 is still sporting a 5% gain since the February 16, 2007 inception, considerably better than the 9% loss in the benchmark S&P 500 index during the same period.

There no other changes to the portfolio this week.

A snapshot of the Portfolio A1 is as follows:

VWSI at +1 as Historic Meltdown Approaches

In light of the oncoming freight train that is today’s session, it seems somewhat academic to recount the action in the VIX last week. For the record, last week the VIX gained 3.50 points (14.8%) to close out the week at 27.18. The VWSI rose one tick to +1.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and takes a stab at what will likely be a historic trading week in his 3 Day Weekend Linkfest: Review/Preview (authored Sunday evening, so it doesn’t include the thinking coming out of yesterday’s carnage.)

I am estimating that the VIX will open between 35 and 36, then move higher from that level as the rush to the exits precludes the need for anyone to yell “Fire!” A VIX north of 40 would not surprise me, nor would a short-term bottom forming sometime later in the week.

(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 +1, I recommend a guwurztraminer. For the record, my favorite American version of this wine is the dry gewurztraminer from Londer Vineyards of Anderson Valley. I have not yet sampled the 2006 vintage, but the 2005 was an unforgettable wine that I would love to see in a blind tasting against some of the top Alsatian competition.

In my previous roundup of California gewurztraminer, I suggested Navarro and Harvest Moon. For some of my top selections from Alsace, check out Trimbach; Hugel; and Domaine Weinbach. You can also check out the top-rated gewurztraminers in the 2007 San Francisco Chronicle Wine Competition.

Friday, January 18, 2008

Will a 29.30 VIX Placate the Crowd?

Until the past few days, I did not realize how many investors – or at least pundits – are of the opinion that the market cannot put in a bottom until the VIX spikes. True, the classic market bottom includes a dramatic drop, a spike in volume, and a spike in investor fear to purge even the most stubborn investors of their losing long positions. As I have stated previously, however, I am comfortable in my belief that a VIX spike strongly increases the likelihood of a bottom, but should not be considered a requirement, per se.

Consider, for a moment, that a VIX spike capitulation bottom may be one of those investment phenomena in which one’s individual assessment doesn’t matter. If enough people believe that A is a precondition for B and trade accordingly, just about any A can become a self-fulfilling prophecy.

Back to the VIX spike, we just hit 29.30 on the VIX a moment ago. While some were calling for the VIX to cross 30 to signal a market bottom, it is possible that the current level may be considered close enough to draw in those looking to play the oversold bounce card.

I have chosen to include a weekly chart of the VIX as a framework for evaluating the current VIX spike. It shows that a 20% deviation from the 10 week SMA has proven to be a fairly reliable timing device in the past. It remains to be seen whether that is the case today, but I am not anticipating a VIX spike over 30 between now and the next Fed meeting.

Thursday, January 17, 2008

Bernanke Prepared Remarks Sink ISEE to Historic Lows

The ISEE is at historic lows with Ben Bernanke 1 1/2 hours into his testimony before the House Budget Committee.

Between 9:50 and 10:10 a.m. EST, approximately 290,000 new put positions were opened in individual equities on the ISEE. This is in sharp contrast to the meager 34,000 or so new call positions that were initiated during the same period.

Given that a copy of Bernanke's prepared remarks we distributed at approximately 10:00, the mostly likely conclusion is that some of the larger players are voting with their feet that the Fed's too little too late approach continues to offer a significant downside opportunity for those who are short the market.

At 11:30 a.m., the ISEE has climbed to 37, but with such a large number of puts already up on the scoreboard, there is a good chance that today will see a new single day closing low for the ISEE.

Wednesday, January 16, 2008

Volatility RIP?

I have talked rather extensively about the surprising lack of volatility in the markets during the past month or so, particularly given the sharpness of the current downturn and the preponderance of gloom and doom news out there. For a little while, at least, it was possible to ignore this phenomenon and chalk it up to “calendar reversion.” Now that the holiday season is behind us, this explanation no long holds water and it seems everyone wants to know why the VIX just sits there in the low to mid-20s.

For those interested in the evolution of my thinking on this subject, I encourage your to consider reading Not a Lot of Fear or Volatility Lately (11/27/07); No Fear (12/19/07); The Incredible Shrinking VIX (12/21/07); VIX Shrinkage Continues… (12/24/07); The Low Fear Selloff (1/4/08); and VWSI at Zero as VIX Meanders (1/14/08).

The bottom line is that I cannot explain why the volatility indices appear to be relatively indifferent to what many think is the beginning of a nasty bear market. Of course, this relative complacency would be possible only if investors as a whole were not worried about a bear market – and when was the last time that investors failed to panic when the markets turned down sharply?

While I have no answers, per se, I do have a few working hypotheses that I tweak from time to time, in no particular order:

  1. increased use of inverse and double inverse ETFs (i.e., QID) for hedging/speculation

  2. the expectation of a forthcoming emergency rate cut limiting upside potential for puts

  3. the possibility that there has been so much advance warning about a potential market meltdown that those who have wanted to protect their portfolio and/or speculate on a downside move have had ample time to do so, at their leisure

  4. a vicious cycle in which the less the VIX moves, the less valuable (reliable) it is as a hedge (or highly leveraged hedge)

If and when I can come up with a better answer to this question, I will cut in with a live feed from Volatility Central…

Tuesday, January 15, 2008

When Volatility and Put to Call Activity Diverges

A reader asked whether I think tracking the ratio of the VIX to the ISEE has any value in terms of market timing.

I track indicators that sum relative volatility and put to call activity as well as a couple that examine the ratio of volatility to put to call action. For the most part, these two categories of sentiment indicators tend to confirm each other. Further, when volatility and put to call numbers signal the same extreme sentiment across both dimensions at the same time – as is usually the case – this dramatically increases the expected value of a number of contrarian setups.

Strong divergences between volatility and put to call activity are relatively rare. I did blog about this type of divergence at the end of May 2007, just before the VIX started upward on a path that would see it triple in less than three months. For the record, my conclusion at that time, which continues to be supported by the data I collect, is that “high readings of volatility relative to put to call data are generally bullish for the broad markets while high readings of put to call data relative to volatility are generally bearish for the broad markets.”

In looking at the ISEE numbers, keep in mind that this is a call to put ratio, so that if one wishes to compare the VIX to the ISEE, it is best to invert one of the numbers before putting them under a microscope and studying their Brownian motion

Monday, January 14, 2008

Checking for Atheists

One of the things I like to do when I see the markets bounce is what I call my “atheist check.” Essentially, I take a look at the current and recent numbers for the ISEE to see if there are many believers who are flocking to buy call options. The lower the number, the more atheists there are that are still out there (or ‘undecideds’ if you prefer the political metaphor to the religious one), and therefore the larger number of potential converts available. Contrarians love potential converts, as they are the future fuel for subsequent bull legs. Generally, when I see an ISEE number (they use a call to put ratio, not a put to call ratio like the CBOE does) of 120 or below, I consider this to be a bullish signal. An ISEE of under 100, which signifies more people opening new put positions than call positions, is very bullish.

As a rule, an ISEE of under 100 is relatively rare, particularly over extended periods. What I find noteworthy about the current market is that the ISEE has closed below 100 for five of the past six days and at 92 as of 12:50 EST today, is on target to make that six of seven. The only other time that the ISEE has registered six of seven sub-100 closes since the exchange began keeping records in October 2002 is in August 2007, at the very bottom of the selloff caused by the first iteration of a subprime panic.

As far as I am concerned, the current ISEE data is almost as compelling as the 37.50 VIX spike we had in August. While the VIX demonstrates how fearful the atheists are, the ISEE reveals how many of them are out there and reminds me of one of my favorite quotes, which comes from John Bender and appears in Jack Schwager’s Stock Market Wizards, “It's not the current opinion of the stock that matters, but rather the potential change in the opinion.”

Portfolio A1 Makes Big Bet on Brazilian Telecoms to Start Year

For the first time in awhile, Portfolio A1 gave back some ground to the benchmark S&P 500 index last week. Even with last week’s sub-par performance, since the February 16, 2007 inception, Portfolio A1 now has a cumulative gain of 20.7%, compared to a 3.7% loss for the SPX.

After falling 7% last week, Sinopec, a.k.a. China Petroleum & Chemical Corp (SNP) has been dropped from the portfolio, victim of a rule whereby a position is automatically closed once it falls 20% from its high during the ownership period. Also dropped were Norwegian energy and aluminum giant Norsk Hydro (NHYDY), but in this instance as a result of a declining rank from the stock ranking system. The ranking system partly reflects several technical factors and picked up on the fact that NHYDY’s stock has also struggled and is down about 17% for the first two weeks of 2008.

Replacing SNP and NHYDY in the portfolio are returnee Fresh Del Monte Produce (FDP) and a second Brazilian telecom company: Tele Norte Leste Participacoes (TNE), an integrated fixed line and mobile telecom provider with a $9.5 billion market cap. TNE joins long-time favorite BRP to give Portfolio A1 an unusual mix of 2/5 Brazilian telecoms in this five-legged portfolio. By design a focused five stock portfolio is intended to make significant bets in specific sectors and regions, but it is unusual to find this type of concentration in the portfolio, which uses a maximum sector weighting of 30% to place sector limits on all new purchases. The reason there are currently two telecom companies in the portfolio is that Mosaic (MOS) has had such a strong run (up 175.7%) that it now comprises 42% of the portfolio, so that it is possible for the other four holdings to split the remaining 58% with two companies in one sector that do not total to 30%.

Note that the portfolio has no provision for limiting the concentration of holdings by country or region.

There no other changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

VWSI at Zero as VIX Meanders

There is probably a better word out there to describe the recent lack of action in the VIX, but I’m going to stick with ‘meander’ for now. After weekly changes of 9% or more in one direction or the other for 11 out of the past 12 weeks, the VIX dropped a mere 0.26 (1.1%) last week to end the week at 23.68. Perhaps more important, in spite of those 12 relatively volatile weeks, last week’s close leaves the VIX just 0.10 above the 50 day SMA, indicating that this has been a lot of running hard simply to stay in the same place.

The VIX Weekly Sentiment Indicator (VWSI) is as unimpressed by the recent market downturn as the VIX, currently registering a zero, which indicates no bias toward increasing volatility.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be in his Mid January Linkfest: Review / Preview.

Looking forward, I am still puzzling over the implications of the recent lackluster VIX. Three possible conclusions immediately jump out at me:

  1. the markets have a lot longer to fall and won’t bottom until we have a meaningful VIX spike (I consider this possible, but certainly not a fait accompli, as I spelled out in Can the Markets Bottom Without a VIX Spike?);

  2. investors are not particularly fearful at the moment because after six months of hearing about an upcoming disaster have bought all the puts they want and/or are getting desensitized to additional bad news;

  3. the VIX no longer has the predictive value it once had, due in part to the flourishing of double inverse ETFs like the QID and other increasingly popular instruments for the bearishly inclined.

I will be evaluating all three possibilities going forward and will update my thinking here as it evolves.

(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 began 2007 by recommending some Rhone blends and later expanded the category to include any expensive blend. Over the course of the year, my two favorite inexpensive blends turned out to be the $8 Oakley Five Reds (the 2003 vintage is a blend of 41% syrah, 27% zinfandel, 22% petite sirah, 10% alicante bouschet, and 1% mourvedre from Cline Cellars); and the 2005 vintage of The Hermit Crab from D’Arenberg, a delicious $13 blend of 70% viognier and 30% marsanne.

Friday, January 11, 2008

Scrolling Back…

I have had several requests to revive last year’s practice of periodically publishing links to some of my favorite recent posts from other blogs.

With the caveat that I have not been rigorous about bookmarking all of my favorites, here are some recent posts that I think may have some archival significance well beyond the day they were posted:

Thursday, January 10, 2008

Chart Porn

If I had tried a little harder, I’m sure I could have come up with a better title for this post, but something like “Strange and Unusual Charts You are Guaranteed Not to Find Anywhere Else” and their ilk seemed like too much work.

So let me summarize the current market situation, if I can. Essentially, almost all the momentum and support/resistance charts say that a bear curtain has descended upon the markets. On the other hand, Panglossian types are still able to find solace in the fact that some oscillators suggest that the recent moves down have been excessive. Additionally, they can always change the moving averages on their charts from days and weeks to months in order to support their contention that the markets are in the midst of pulling back to support. At this stage, deciding which camp has the most like-minded souls has as much to do with one’s philosophy and outlook as it does the result of rigorous analysis.

In the end, it’s quite possible that none of this matters. As one commenter from yesterday suggested, perhaps the only things that do matter are what the bearded man sings and how mellifluously it falls on our ears (that and perhaps whether he is a baritone or a castrato.) Hint: if it’s Das Lied von der Erde, I’m buying gold.

But enough silliness for now. Getting back to some chart porn, I am including the chart below not so much because the conclusions are fresh (“things are bad” or “things are about to turn,” depending upon your perspective), but because I’m fairly sure you cannot find this chart anywhere else. The chart tracks the ratio of up volume to down volume for the NYSE and uses a 21 day EMA to smooth the data. The NASDAQ version of the data looks similar, but this NYSE chart shows the potential for volume data to help call both tops and bottoms in advance. So dial up some Mahler and watch the volume.

Wednesday, January 9, 2008

Can the Markets Bottom Without a VIX Spike?

Back in November, in Not a Lot of Fear or Volatility Lately, I cautioned, “despite what you read elsewhere, not all market bottoms require a high volume capitulation session, with an accompanying VIX spike.”

Of course, that claim immediately triggered a request for me to back up my claim with some data: Could you describe or show an example of a major bottom without a volume and or VIX spike?

For the benefit of those who do not always read the comments section, I am reprinting my response in full, as it may shed some light on current market conditions.

I knew I should have had the answer handy before the inevitable question showed up -- and the ink wasn't even dry on my post yet...

OK, since only has SPX weekly volume going back to 10/98 and since I'm more interested (generally) in the VIX than in SPX volume, I looked at the VIX and SPX on a weekly basis going back to 1990, which is as far back as VIX data goes, and here is my thinking:

A) Classic capitulation (VIX spikes at least 2x above previous levels and volume surges) bottoms appear in Aug-Dec 1991, Mar 1994, Aug 1998, Sept 2001, and July 2002. More recent instances include May-Jul 2006, Feb-Mar 2007, and Aug 2007.

B) Bottoms that lack a significant VIX spike (in the area of 2x above previous levels) include Jul-Sept 1996, Mar 1997, Mar 2001, and Sept-Oct 2002. More recent examples include Mar-Aug 2004 (one bottom or three mini-bottoms), Aug 2005, and October 2005. I am not ruling out the current [November 27, 2007] environment as another one of these 'uneventful bottoms.'

Note that "major bottoms" may mean one thing to one person and other to someone else. I'd be tempted to argue that the only major bottoms we've had since the VIX data begins are 1990 and 2002 -- so the bottoms above are necessarily more of the intermediate and long-term variety.

So the answer to the question posed in the title is a hearty, “Of course they can!” As a matter of fact, I expect the current downtrend will likely end without the VIX spiking even close to twice the recent levels.

Tuesday, January 8, 2008

Arrow Up For Tomorrow

I generally shy away from making stock market predictions and prefer the Stuart Walton jellyfish approach to investing, but sometimes the markets get so egregiously out of whack that I feel obliged to state the obvious. In this case the obvious is that the probability of a short-term rally beginning tomorrow is extremely high.

Many of the overbought/oversold indicators that I study closely (ISEE, TRIN, VXN, etc.) suggest that the markets are ready for a bounce tomorrow. In short, tomorrow is setting up to be a mean reversion, oscillator lover's shooting gallery. Keep in mind, however, that if the markets do not make a U-turn into oncoming traffic, it is often more instructive to observe what the markets fail to do than what they actually end up doing.

In the jellyfish tradition, when a bounce arrives, I have no intention of trying to guess how long it will last. The important question is whether large investors will be selling into any rally to unload inventory before the bear market grip tightens – or if this may be the beginning of another periodic pullback in the continuing 5 ½ year bull trend.

As always, caveat emptor!

The Fallacy of the Bearish First Five Days

I will be the first to admit that one of my favorite trading books to browse through is the Stock Trader’s Almanac, complied by Jeffrey Hirsch and Yale Hirsch. The current version of this annual classic, Stock Trader’s Almanac 2008, has already been sitting on my desk for three months.

I mention this book because the authors have been instrumental in widely disseminating the idea of the ‘January Baromenter,’ which posits that “as goes January, so goes the market.” While the idea of the January Barometer dates back to at least 1972, the corollary, which should be on the mind of many investors today, is that the first five days of January provide an effective ‘early warning system’ about the trend for the balance of the year.

Before I critique these two ideas, let me point out that the data for the general premise of January as a microcosm of a full trading year is compelling. Using the S&P 500 index, the January Barometer includes only five major errors in the past 58 years; and 31 of the last 36 times the first five days were up, the year ended up as well.

But before you load up on more QID in anticipation of the market being sucked into a black hole, it is important to recognize that the data obscures what happens when the year gets off to a particularly ugly start, as it has in the first four trading days of year (through yesterday), where the SPX has been down 3.6%.

As it turns out, since 1950 the SPX has only had a five day start that was worse than 2008 on two occasions: 1978 and 1991. In both cases, however, the year managed to turn around and finish in the green. In 1978, the SPX shook off a -4.7% first five days and was up 6.0% the rest of the year. The turnaround in 1991 was even more dramatic, as anyone who owned NASDAQ stocks (up 56.8% that year) will surely recall. After falling 4.6% the first five days of 1991, the SPX was up 32.5% for the remainder of the year.

If one wants to expand the analysis to the worst full month starts since 1950, the four worst of these starts also turned around by the end of the year as well. In 1970, January was down 7.6%, but the balance of the year was up 8.4%. In 1960, it was -7.1% followed by +4.5%; in 1990 it was -6.9% and +0.3%; and in 1978 it was -6.2%, with a +7.7% turnaround from February through December.

As always, be careful with what you take away from this analysis. Of the 21 Januarys that the SPX has been down, the balance of the year was down 10 times and up 11 times. The bottom line? If there is any message worth remembering from the data above, it is that good starts tend to persist, ugly ones tend to reverse, and slightly down beginnings run the greatest risk of turning into a rout.

Monday, January 7, 2008

One Year Blogiversary!

Today marks exactly one year since I decided to launch VIX and More as a place to archive some of my thinking on volatility and the markets.

There have been times when I would have been better served to spend additional time and energy to do more research, analysis, system development, etc., but on balance, having a blog has been more fun than work and the exchange of ideas via comments and e-mail has had a positive impact on my trading.

Thanks to all who have contributed to this site by reading, commenting, and linking to some of what I have had to say. Particular thanks to those blogs who have sent the most traffic my way:

What have readers found most compelling on this site over the course of the past year? Of the 422 posts that 117,000+ unique visitors have had a chance to review during my first year, here are the top 25 most read posts:

  1. A Sentiment Primer (Long)
  2. Correlation Ideation
  3. How to Find the Spiker Before the Earnings Announcement
  4. BuyWrite Index as a Timing Tool?
  5. Commercials Get Long the VIX in a Big Way
  6. High Positive Correlation Between VIX and SPX Often Signals Market Weakness
  7. When to Short China?
  8. A Baker’s Dozen of Favorite Indicators
  9. Waiting for Godot
  10. A Dozen Things My Trading Accounts Are Thankful For This Year
  11. What My Dog Can Tell Us About Volatility
  12. Implied Volatility and Earnings Spikers
  13. Drilling Down on Sector Performance
  14. Brian Overby on Trading VIX Options
  15. First Annual VIX and More Blog Disclaimer Awards
  16. The McClellan Summation Index
  17. Thinking About the VXV
  18. The Incredible Shrinking VIX
  19. Using the VIX as a Timing Tool for the SPY
  20. VIX Price Movement Around FOMC Meetings
  21. A Challenge to Two Things You Think You Know About the VIX
  22. VIX March OTM Calls
  23. What’s in the FXI?
  24. The Promethian Trader
  25. Greenspan and the China Bubble

Portfolio A1 Begins 2008 By Increasing Gap on SPX

While the first three trading days of 2008 knocked 0.8% off of the value of Portfolio A1, this was much better than the 3.9% loss in the benchmark S&P 500 index. Since the February 16, 2007 inception, Portfolio A1 now stands with a gain of 21%, in contrast to a 3% loss for the SPX.

Brasil Telecom Participacoes S.A. (BRP) was the only stock in the portfolio that advanced during the week, bucking the downtrend in US-based technology stocks.

There no changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

Sunday, January 6, 2008

Muted Reaction from VWSI as Markets Drop

The US markets sold off in dramatic fashion last week, with critical technical support levels failing to hold in a number of key indices, including the tech heavy NASDAQ Composite and NASDAQ 100, as well as the small cap Russell 2000. For a change, the damage in tech stocks was greater than it was in the SPX, where financials continue to be the most highly weighted sector.

As I chronicled on Friday, this has been a “low fear selloff” even when one focuses on the volatility index of the hard hit NASDAQ 100, the VXN. In terms of the VIX, the reaction has also been comparatively mild. Last week the VIX rose 3.20 points (15.4%) to 23.94. While this is the highest end of week close in six weeks, an SPX drop of 4.5% typically triggers a rise of about 19% in the VIX, so a 15.4% rise has to be considered a lackluster move relative to market conditions.

Consistent with a lackluster VIX in the face of considerable selling, the VWSI dropped only to -3, suggest a slight mean reverting bias going forward.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be in his Linkfest 2008 Review/Preview.

Looking ahead, it is worth noting that the two consecutive weekly jumps of 10% or more in the VIX has only happened six time since 9/11 – and the last five of those have seen the VIX fall in the subsequent week. After two weeks of 12.3% and 15.4% gains, I would not be surprised to see the VIX pull back a little in the coming week.

(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 -3, I continue to recommend a barbera. While Italy produces the best know barberas, Barbera d’Asti and Barbera d’Alba, it is fruity, highly drinkable version of this wine from the Sierra Foothills that recently tickled my fancy: the 2005 Renwood Sierra Series barbera. If you are looking for a different varietal to add to your list of everyday reds, seek this one out. For only $9 at my local wine store, it’s a bargain and a great change of pace.

If you are interested in an entertaining and informative look at Italian barbera, I encourage you to check out Gary Vaynerchuk at Wine Library TV, with The Barbera Episode.

Friday, January 4, 2008

The Low Fear Selloff

Now that most of the holiday-related “calendar reversion” (nicely coined by Adam at the Daily Options Report) is behind us, we have the opportunity to get a fresh look at unadorned volatility. You know what? There is not that much of it out there, particularly given the current market conditions.

Since the NASDAQ is suffering the brunt of the damage today, I have chosen to include a graph of the VXN, or NASDAQ-100 volatility index. Given the market conditions, you would expect the see the most ugliness here, yet volatility looks surprisingly tame, particularly since the NASDAQ Composite was down 78 points when this snapshot was taken.

I’m having a big storm here in Northern California, with high winds and frequent loss of power, so don’t be surprised if VIX and More ends up offline for awhile, as I am not particularly well hedged against meteorological volatility.

[Note that the image above is from Port Orford, Oregon, a current capture of the spectacular webcam from Home by the Sea, a B&B situated on a bluff overlooking Battle Rock Beach]

Thursday, January 3, 2008

Yes, I’m Frequenting More Blogs These Days

I’m sure nobody bothers to pay attention to this, but I periodically tweak the “Blogs I Frequent” section of VIX and More whenever a particular whim hits me. Since I’ve had that set of links up for almost a year, I thought I should clarify what it is and why certain blogs are there.

First, when I began blogging I had no idea what a feed was and I was under the mistaken impression that a blog would be the best way for me to keep track of links to all of my favorite blogs. That approach worked for awhile, until my news appetite expanded to the point where I needed to scroll down to access all my information source links and the ‘simplicity’ of the approach became too cumbersome for my liking. Fortunately, necessity birthed not just invention, but some technology test drives as well, and I settled on Bloglines as my favorite tool for managing feeds, as I detailed back in April.

I mention all of this because Bloglines is my primary news aggregation source 99.9% of the time, delivering 242 feeds on a relatively timely basis. Every once in awhile, Bloglines has technical difficulties and I resort to a backup system. Usually that backup takes the form of Google Reader, but there are some occasions where I prefer to fall back on the blog.

Now I trade primarily as a result of charts, technical analysis, market sentiment indicators and the like, but I don’t particularly enjoy looking at everyone else’s charts, which is why the list of the blogs I frequent has a disproportionately fundamental and macroeconomic focus and why the sequence (and invisible grouping) might appear chaotic. Ultimately, my blogroll is a somewhat arbitrary subset of my Bloglines feeds, with preference given to sites that I rarely if ever see on other blogrolls.

For all these reasons, I have recently added three important voices to my blogroll:

Finally, thanks to all who have made VIX and More a part of their blogroll or personal reading list during the past year.

Wednesday, January 2, 2008

McMillan on Interest Rate Moves Preceding Volatility

Interesting fodder for further contemplation, from options guru Larry McMillan in Barron's: Volatility Likely to Remain High in 2008.

The article is much more interesting that the title might suggest and discusses a 'theory' that short-term interest rates precede volatility by 2 1/2 years. While this sounds like a stretch to me, if you believe the theory, then the VIX should be topping in early 2009 -- which just happens to be about the time suggested by some of my VIX macro cycle work. Certainly worth a click through for the curious...

Selloff Overdone Prior to FOMC Minutes Release?

In the hour and 40 or minutes or so before the FOMC releases the minutes from their December meeting, I am using the market weakness to make some buys. I have a number of reasons for doing this, not all of which I am going to detail here. Instead, I will post a chart of the NASDAQ TRIN, the counterpart to the NYSE TRIN that I discussed a couple of days ago. TRIN numbers can be calculated for each exchange. I watch the NASDAQ closely because the NASDAQ often leads the NYSE in terms of determining speculative sentiment.

In the chart below, I use 5 minute bars over a 10 day range. My thinking, in a nutshell, is not that I can guess what the FOMC minutes will reveal, nor even how the market will react to it, but I suspect that if the news is considered bullish by traders, the market will move much more decisively than if the news is considered to be bearish.

I consider this a contrarian sentiment play, with an asymmetrical news reaction magnitude potential. From a probability perspective, it’s about a 50% play; from an expectation perspective, I think the numbers are solidly in my favor.

Sector Clues in First Hour of 2008?

It’s never too early to try to discern what some of the new investing themes for 2008 might be, which is why I have included the sector snapshot for the first hour of trading.

Given the low ISM numbers this morning, I am not surprised to see weakness across the equity spectrum. A couple of commodity sectors – gold and natural gas among them – are continuing their strong end of 2007 momentum into the beginning of the new year. One pocket of bullishness in the first hour that surprised me and is worth watching going forward is biotech.

On the downside, banks continue to get hammered, while REITs are currently in the middle of the pack.

Tuesday, January 1, 2008

2007 Performance: Portfolio A1 +21.95% (from 2/16/07)

I am official closing the books on 2007 for Portfolio A1 with a 21.95% gain since the portfolio’s February 16th inception. This performance is 21.07% better than that of the SPX during the same period.

In addition to the usual portfolio summary statistics and equity curve, I have included some additional graphics that should be largely self-explanatory.

[For more information on the technology used to create and maintain this portfolio, check out an earlier post, The Engine Behind Portfolio A1]

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