Friday, February 29, 2008

McClellan Summation Index Turns Positive

It may seem like the height of folly to be talking about an upturn in the market on a day when the DJIA is down 230 points, but I’m not going to let that stop me.

Apart from the recent bump in the markets, I see several factors that lead me to believe that the markets are poised to continue to go up from current levels. The first of these, as highlighted by J.J. McGrath on his MackTheKnife blog, is that money formerly on the sidelines is starting to flow back into mutual funds. It may not be a flood yet, but it is a toe in the water. The second factor is the persistent extreme readings in put to call ratios that are evident in the ISEE and the CBOE equity only numbers. These numbers indicate that while some institutional money is coming back into the market, many retail investors are still sitting on the sidelines or have a short bias.

A third way to think about pent-up demand is to look at the McClellan Summation Index, a chart of which I have appended below. As can be seen in the chart, the index just turned positive for the first time since late October. While this is by no means a guarantee that the markets are moving up, this signal has historically been a bullish one. Perhaps more importantly, one way to think about the size of the red areas under the zero line is that these represent bearish periods in which pent-up demand continued to accumulate under the surface, roughly proportionate to the duration and magnitude of the red spike.

To summarize my thinking here, two bullish signals are mutual funds moving cash into the market and advance decline data turning positive, suggesting that the tide has turned. At this stage, only options sentiment data needs to normalize to indicate that the retail investor is once again comfortable going long and helping to push the market out of the recent trading range.


Thursday, February 28, 2008

optionsXpress Trading Patterns and the VIX

One of the trading tools that satisfies my inner investment voyeur is the Trading Patterns feature at optionsXpress. If the “Trading Patterns” name doesn’t ring a bell, you might also know this feature as “People Trading ___ Also Traded…” in the spirit of Amazon’s recommendation technology and predecessor technology that dates back to internet pioneer Firefly Network Inc.

In the past, I have used the Trading Patterns data to see which companies were being most actively traded by those who are seeking high risk speculative momentum plays. I somewhat arbitrarily made BIDU the poster child for these momentum chasers and have twice looked at what those who were playing with BIDU were also trading.

With all the discussion around potential substitutes for the VIX at least as a hedging tool, I thought it might be interesting to get a broader picture of those who trade VIX options. Thanks to Trading Patterns, I have captured just such a snapshot below. Not surprisingly, VIX traders are aggressive risk takers. In aggregate, they appear to be hoarding gold (GLD) and going short with the double inverse ETFs for real estate (SRS) and the NASDAQ-100 index (QID). It’s just a guess about the direction of some holdings, but the other positions appear to fall squarely in the short finance and technology camp: SPY, WB, AAPL, YHOO, and NVDA. The one finding that I see as somewhat surprising is the presence of the ProShares Ultrashort Oil & Gas ETF (DUG). Given the list of trading vehicles, I am concluding that the VIX players see oil and gas as overbought instead of a safe haven like gold. In any event, it is clear that the pessimism of VIX traders continues to be grounded in an expansion of the real estate and financial woes, the expectation that this will drag technology down with it, and the opinion that gold is the most sensible long position at the moment.

Wednesday, February 27, 2008

The VIX and Going Short

A reader asked about the feasibility of the declining VIX providing an entry signal for new short positions. Specifically, he noted that his weekly chart of the VIX, which utilizes a 43 week simple moving average, has contained all the action in the VIX over the past year or so, with that 43 week SMA acting as support. Ultimately, his question concerns whether I believe that the 43 week SMA is likely to hold.

Before I get to the details of that question, let me reiterate my general thinking about using traditional technical analysis on the VIX. In a nutshell, I believe that because the VIX is a derivative (more accurately a derivative of a derivative), traditional technical analysis has only limited validity. This is particularly noteworthy when it comes to support and resistance. If the VIX hits 20, for instance, nobody can rush in and buy the VIX to support it at that level, because one cannot buy and sell the cash VIX. Sure, some may use a VIX of 20 as a rationale for starting to buy VIX options or futures, but the impact of these transactions on the cash VIX is indirect and weak. The impact becomes a little stronger if traders use VIX signals to buy SPX options, but I still prefer to think of the VIX as more of a thermometer than an actual weather phenomenon. Even a major deity would have trouble adjusting the sunshine, clouds and other factors to make the temperature read exactly 60 °F on your back porch.

So my bias is generally against moving averages as providing meaningful support and resistance for the VIX, given that I believe an arithmetic mean of a derivative of a derivative is not a meaningful number. I do believe, however, that previous intermediate and long-term highs and lows in the VIX (e.g., January’s 37.57), round numbers (20, 25, 30, etc.), and deviations of significant magnitude from various moving average (% of 10 day SMA, etc.) can signal (or perhaps even trigger) important psychological milestones and provide high probability entries.

My conclusion, therefore, is that the 43 week SMA is more likely to hold if coincides with a previous low, round number or distance from certain critical SMAs. Given the current numbers, I would say that strong support in the VIX is mostly likely to be found in the 19-20 range.

Just for fun, I have included three charts that provide three very different perspectives on the VIX. The top chart is a basic chart of the VIX going back about a year. As with the major indices, consolidation in the form of a triangle pattern is obvious, but with the VIX, the pattern reaches back to August. The VIX:VXV ratio chart shows the volatility expectations for the next 30 days (VIX) vs. the next 93 days (VXV) – and these are middling at best. The final chart shows a lifetime of the VIX graphed against the SPX, with a horizontal line showing the lifetime mean of the VIX (19.03) thrown in for good measure. There are a number of potential conclusions to draw from these charts, but when I add them all together I come out neutral on the VIX, at least for the short to medium term time frame.

As an aside, when it comes to initiating new short positions, I don't like getting short until at least the third trading day of a new month, particularly with so much worried money sitting on the sidelines. Finally, in terms of support and resistance, I prefer to use the broad equity indices instead of the VIX to time entries and would watch SPX 1410 and NDX 1900 more closely than the VIX, but keep a weather eye on a VIX of 19.

Tuesday, February 26, 2008

Brazil Rallies While China Struggles

As the chart below shows, speculative money has been cautious about China since late October, but still bullish on Brazil, as indicated by the strong performance in EWZ, the iShares MSCI Brazil Index ETF. Not only is EWZ showing a gain for the year, but in an impressive display of strength, it has rallied more than 30% off of the January low. This performance puts EWZ not only well ahead of the most popular Chinese ETF, FXI, but also considerably ahead of the broad market emerging market ETF, EEM, known formally as the iShares MSCI Emerging Markets Index.

While EWZ is a great way to play the Brazilian market, there are several ADRs that are worth singling out as well. My Portfolio A1 holds Tele Norte Leste Participacoes SA (TNE) and has also been long Brasil Telecom Participacoes SA (BRP) in recent months, but there are even better plays. In fact, of the handful of long-term global holdings that I believe you could almost buy and forget about, two of my favorites are Brazilian giants. At the top of the list is Petroleo Brasileiro SA (PBR), a.k.a. Petrobras, the superbly managed national oil company that is pushing the envelope in the ultra-deep recovery space with their massive Tupi oilfield. Close behind is Vale (RIO), formerly know as Companhia Vale do Rio Doce, the metals and mining giant that recently extracted a 65% price increase in iron ore prices from Baosteel, the largest steel company in China.

In a healthy global economy, PBR and RIO are two of the best blue chip oil and iron plays out there. For those wishing a broader, more diversified play, EWZ is hard to beat, especially as Brazil continues to outpace China.

Monday, February 25, 2008

The XLF and the SPX

After I penned (keyboarded?) The Rising Popularity of XLF Options on Friday, I was please to see that a number of other bloggers picked up on the XLF theme and weighed in with some interesting commentary. One post I found particularly noteworthy was from Bob Barnes at bzbtrader. In his aptly titled, Deconstructing the XLF, Bob breaks down the top holdings of the XLF, dissects the open interest, and discusses trends in short interest as well. (If you click through, don’t stop with the XLF post, as Bob does an excellent job with a broad range of charting and TA issues and should be required reading for anyone who follows the QQQQs.)

Another thing to think about vis-à-vis the XLF is the relative performance of this sector to the broader indices, like the SPX. In the chart below, I have graphed a ratio of the XLF to the SPX, with a blue area chart of the SPX added for context. As financials are still the largest sector component of the SPX, it is not surprising to see these two indices move in the same direction. When the XLF and the SPX diverge, however, investors should pay close attention. The divergence from May to October is notable, for instance, with the decline in the XLF perhaps providing a warning that the market was topping during this period. Another interesting period is in early February, when the SPX rose in spite of a falling XLF. Now it appears that both the SPX and XLF are moving sideways in unison. For what it’s worth, I don’t expect the SPX to be able to stage a significant rally without dragging the XLF along for the ride or perhaps even following the financials back up.

So watch the XLF in absolute terms, but also keep an eye on the performance of the XLF relative to the SPX.

WTI Continues to Lift Portfolio A1

In just three weeks in the portfolio, W&T Offshore (WTI) has demonstrated the beginnings of star power, logging weekly returns of 9.2%, 5.6% and, most recently, 9.6%. Also helping to increase Portfolio A1’s performance delta over the SPX was a strong performance this week from Tele Norte Leste Participacoes (TNE) (+8.6% for the week) and fertilizer high flier Terra Industries (TRA) (+3.0 for the week).

With the boost from WTI, Portfolio A1’s performance since the 2/16/07 inception now stands at of +12.3% vs. -7.0% in the benchmark S&P 500 index over the same period.

There no changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

Amidst Symmetrical Triangles, VIX and VWSI Slide

With market indices in a symmetrical triangle consolidation pattern, trading ranges have been shrinking as of late. The VIX has reflected this lack of action by dropping to its lowest levels relative to its 20, 50 and 100 day simple moving averages since the beginning of the year. After touching 26.95 on Wednesday, the VIX fell back to end the four day week at 24.06, down 0.96 (3.8%) from the previous week.

A symmetrical triangle pattern is often resolved by a dramatic move one way or the other. In the current market environment, the direction of that move is anyone’s guess, but for now, I am positioned for a move to the upside.

The VWSI is a little more cautious and is showing a +1 reading at the moment, down from a +3 last week and, essentially neutral about market volatility in the near-term, suggesting that a sideways to slightly more volatile market is the most likely course of events for the coming week.

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 is on tap in his Oscar Night Linkfest.

I am toying with introducing a multi-faceted sentiment indicator in this weekly VWSI space, but for now I am sticking with the VWSI:

(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. 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, February 22, 2008

The Rising Popularity of XLF Options

Earlier in the week, I looked at the decreasing volume in VIX options in Interest in VIX Waning? Over the course of my analysis, I attributed some of the decline in VIX options to the launch of QID (and SDS) options back in November.

While the QID and SDS are undoubtedly stealing some market share from the VIX for those looking at leveraged hedging opportunities, a much bigger factor has been the meteoric rise in interest in options for XLF, the financial sector SPDR.

As the graphic below demonstrates, XLF options were not actively traded until July 2007. After a surge in interest in mid-summer, volume dropped off until November, at which time implied volatility and options volume both rose dramatically. By means of comparison, back in June 2007, XLF and VIX options traded in roughly equal numbers, but so far in 2008, XLF options volume has been outpacing VIX options volume by about five to one. Additionally, I find it noteworthy that a there has been a sustained increase in XLF options volume since the beginning of November – the same time that VIX options volume peaked and started to decline.

There are several other features of the XLF implied volatility chart that are worth pointing out. One of which is that implied volatility and options volume have moved in almost perfect lockstep over the past six months. Another point of interest is that XLF implied volatility peaked just as the major indices bottomed in January. A break below the current 35 support level might signal a lessening of put activity in the financial sector and perhaps indicate that the January bottoms are a good bet to hold.

Thursday, February 21, 2008

Intrade Prediction Markets as a Sentiment Indicator is a fascinating place to park your brain from time to time. At this prediction market site, users can buy and sell binary options contracts that allow them to place bets on whether a future event will happen. Intrade has a broad range of contracts that cover everything from whether Osama Bin Laden will be captured by a particular month, which country will host the 2016 Olympics, what the year’s snowfall will be in New York City, and a wide variety of bets about the US election.

Prediction markets have received considerable press and academic attention for their purported ability to provide a better predictive view of the future than that of individual experts. Evaluating the arguments on both sides of this issue is beyond today’s scope, but those who are interested in reading about these claims may wish to start with Prediction Markets: Does Money Matter? by Servan-Schreiber, Wolfers, Pennock and Galebach and move on to prediction markets as a proxy for probabilities in Interpreting Prediction Market Prices as Probabilities by Wolfers and Zitzewitz. For an excellent broad introduction to prediction markets, I recommend Prediction Markets, also by Wolfers and Zitzewitz.

Unfortunately, the volume of trading activity for the financial and economic prediction markets contracts are not as popular as those for politics and entertainment. I do think, however, that there is considerable potential value not only in establishing probabilities for future events, but also gauging investor sentiment. At the moment, the most heavily traded financial contract at Intrade is whether the US will go into a recession in 2008. I have included a chart of that contract, which goes back to August 2007, in the graphic below, which compares estimates of the probability of a recession with the SPX during the same period. While there is a very high negative correlation here (i.e., we have yet another contrarian sentiment indicator working), I find it particularly interesting that the expectations for a 2008 recession peaked just as the SPX was making its January bottom.

If only there were a little more volume in the financial contracts, I suspect there would be quite a few more gems to pluck from the prediction markets. Until then, they are still a great place to get a sense of what the odds are that Barack Obama wins the Democratic nomination or Barry Bonds will be found guilty of one or more of the perjury and obstruction charges he is facing.

Wednesday, February 20, 2008

Speculation in Commodities vs. Technology

During the course of the five year bull market that appears to have ended last October, the technology and commodities sectors have been two areas where a considerable amount of speculative money has flowed in search of extraordinary returns.

Since October, money has flowed out of technology, as indicated by the action in IGM, a popular technology ETF. Conversely, speculative money has been flowing in large quantities into commodities, as the action in gold, agriculture, oil, natural gas and other commodities can attest to. While there are a number of commodities indices and ETFs out there, many of them (notably the CRB Index, but also the GSCI) have such a heavy weighting in oil and gas as to make them de facto energy indices and not a good proxy for a broader representation of industrial metals, precious metals, agricultural commodities and the like. For this reason, I have chosen to highlight the iPath Dow Jones AIG Commmodity Index (DJP) as my broad-based commodities benchmark (the Rogers International Commodity Index, ticker RJI, is also broadly diversified, but is only it its fifth month of operation.)

Looking at a ratio of the IGM and DJP ETFs or stacking them on top of each other, as I have done below, you can see the flow of speculative money out of technology and in to commodities. For those seeking a strong upward trend in the current downturn, commodities represent an excellent opportunity. Conversely, when speculative money starts flowing out of commodities and back in to technology, expect to see the NASDAQ and other broad indices stage a more sustained move to the upside.

New ETFs?

So I'm thinking about a couple of new ETFs that are in the can't miss category:

  1. FadeTheOpenETF -- fades any opening gap of 1% or more, with a PSAR trailing stop

  2. ShortTheFedSpeechETF -- goes short the major indices (or at least the financials) 10 minutes before any Fed member speaks and doesn't close out the position until the markets have a session in the green

Perhaps in a couple of years, you can have a full ETF trading strategy menu, so that just before the open each day, you can absorb all the news and click on a couple of strategy boxes, then watch the ETFs do all the work for you.

Which obvious ETF winners am I missing?

Tuesday, February 19, 2008

Interest in VIX Waning?

A number of readers have wondered whether the recent lack of volatility in the VIX in the face of a strong market downturn indicates that the VIX is losing some of its relevance. This is a fair question.

As the graphic to the right indicates, not only is the implied volatility and historical volatility of the VIX currently hovering near 52 week lows – when clearly investor fear is not similarly lax – but since about mid-November or thereabouts, the volume of VIX options traded has dropped dramatically as well. In fact, with the benefit of hindsight, it appears that the popularity of VIX options surged from May through November of 2007, only to have recently returned to the levels that preceded the anxiety over the subprime problems and all the dominoes since uncovered that appear to have been within tipping range.

Of course, if the VIX’s beta starts dropping below historical levels, it is possible that we may have a situation in which, as I described previously, the less the VIX moves, the less valuable (reliable) it becomes as a highly leveraged hedge against long market positions.

One of the theories about the lack of action in the VIX is that those who are looking for another way to have a highly leveraged hedge have flocked to the inverse and double inverse ETFs. Did anything happen in November that might support that theory? Well, lo and behold, it turns out that the most popular of the double inverse ETFs, the QID, just happened to start trading options in November. Coincidence? I suspect not. While the volume of QID options relative to VIX options is rather small, clearly the game has changed.

This observation is not going to persuade me to change the name of the blog, but don’t be surprised if you see me posting about the QID more often. After all, as the chart on the bottom shows, QID volume (and on balance volume) has demonstrated considerable predictive potential over the past year.

Portfolio A1 Beats SPX by 15.5% in First Year, Helped by Commodity Theme

With two of the five focus positions in agriculture and energy, the commodities theme has been good to Portfolio A1. W&T Offshore (WTI), the oil and gas exploration and production company, is now up 15.4% in the two weeks it has been in the portfolio. Last week’s biggest winner was Terra Industries (TRA), which posted a 10% gain for the week, moving up with the red-hot nitrogen fertilizer space.

After one full year of performance (since the February 16, 2007 inception), Portfolio A1 officially goes in the books with a return of +8.23%, compared to a -7.25% move in the benchmark S&P 500 index over the same period, a net performance gain of 15.48% by the portfolio over the benchmark.

In terms of risk-adjusted return, the graphic to the right shows that Portfolio A1 has had an average beta of 1.48 and an impressive annualized alpha of 23.58% during the first year that the portfolio has been up and running.

In many respects, this portfolio was established to provided focused approach to "fishing for whales." That approach has been largely successful if a little inconsistent during the first year, landing such strong momentum stocks as of MOS, DRYS, TEX, PBR, RIO and others. Part of what makes finding so many big winners possible is a very high annual turnover. At 674%, this is clearly a trading portfolio, not a buy and hold approach. Losses are generally cut quickly and a new hook goes over the transom almost every week. I look forward to seeing how the portfolio fares in the second year, as we begin that year with what looks to be an extremely challenging investment environment.

More Sideways VIX and VWSI Action While ISEE Plummets

From a volatility perspective, 2008 continues to unfold in a curious manner. The markets are decidedly bearish – and even when they briefly recover or drift sideways, the doom and gloom headlines continue to cast a long shadow over investors’ expectations about the markets going forward. The VIX, on the other hand, hardly seems to care, registering an increase of 1.08 over the last seven weeks. The same is true for the VWSI, which has treaded water in the +3 to -3 range during this period.

Last week was more of the same. The VIX dropped 2.99 (10.7%) to 25.02. The VWSI moved more significantly, from 0 to +3, but the +3 reading from the end of the week is still consistent with a neutral outlook.

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 is on tap in his 3-Day-Weekend Linkfest!

In the realm of interesting market sentiment data, I continue to be most interested in the ISEE, which ended the week with several record low readings. This is normally a bullish contrarian indicator, but as I have noted here on several occasions, the divergence with the volatility indices is a bearish signal.

(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. More recently, I was impressed by a 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.

Friday, February 15, 2008

More Record Lows in the ISEE

I haven't bothered posting about the ISEE lately not because nothing of interest is happening with that index, but because the story hasn't changed. In fact, the ISEE has set new record lows in the 20 day simple moving average for the past two days and the 50 day SMA for the past three days.

The VIX may look placid, but be careful not to conclude too much from that one data point. Options buyers may not be panic-buying puts and driving up volatility readings, but their relative interest in buying calls vs. puts is much lower than it ever has been during the six years for which the ISE has published ISEE sentiment data.

As I mentioned a month ago, history suggests that the markets usually struggle after we have a lackluster VIX combined with investors who are reluctant to buy calls.

Thursday, February 14, 2008

BIDU, Calls and Time Decay

I am generally not a fan of being long any options during options expiration week, as the effort required to ‘salmon’ upstream against the relentless current of time decay (theta) makes these trades extremely challenging. Not only do you have to get the direction right, but you have to do it in a big way and in a hurry. Of course, if there is another volatility event that you have to overcome during options expiration week, that makes the task even more difficult.

Baidu (BIDU) is a perfect case in point. Earnings came out after the close last night and while the most recent quarter comfortably exceeded expectations, the company’s tepid guidance had some analysts wondering what the future revenue stream looks like.

With the conflicting numbers and multiple interpretations available, the market action has been interesting to watch. After closing at 261.09 yesterday, BIDU traded up almost 30 points in the after hours session last night, before settling back to an after hours gain of about 18 points. In pre-market the stock gradually slid down to 274, up about 13 points over Wednesday’s close. When the regular session opened, the stock fell quickly to 263, recovered sharply to trade briefly above 280, and has been in a downtrend ever since, currently trading back down to about 267.

The first graphic, which comes from optionsXpress, shows how the options were behaving after about a half hour of trading, when BIDU was up 16.97 at 278.06. If you happened to be long BIDU calls at a strike of 270 or above, you were losing money, even with the stock up 6.5%.

Normally, one would expect a post-earnings volatility crush, where IV contracts and all options lose their value, but as the iVolatility chart on the bottom shows, IV was not particularly high (relative to recent historical BIDU levels) coming into earnings, nor did it drop dramatically after earnings were out (see the IV numbers in the optionsXpress table.)

BIDU’s action today is an excellent illustration of what happens toward the end of the options expiration cycle, when time decay accelerates. While it is still possible to make money being long options, the percentages are with those who are on the side of time decay. If you are looking at a stock with high IV and an earnings report or other volatility event, consider that at the money options can still be losers even if you get the direction correct and have a 6.5% move in the underlying on your side.

Wednesday, February 13, 2008

VIX February Options Calendar Anomaly

Just a quick note to remind anyone who is trading VIX options that the February options expirations calendar [which is pinned at the bottom of the "VIX & Sentiment Links" in the upper right hand corner of the blog] has some unusual features that are the result of the timing of Good Friday, which falls on expiration week in March this year.

Without getting into all the details, the bottom line is that the expiration day for February's VIX options is Tuesday, February 19th, instead of the usual Wednesday. With the President’s Day holiday falling on Monday the 18th, this moves the last trading day in VIX options up to Friday, February 15th – the day after tomorrow. Note that the same expiration and last trading dates also apply to VXN and RVX options.

Anyone who wishes to dive into the details of the VIX options calendar and other related information is encouraged to brush up on the VIX options contract specifications.

NASDAQ 2315-2320

If you have been watching the NASDAQ Composite Index for the last few weeks, it is likely that you have paid close attention the area around 2315-2320.

I usually don’t talk about basic support and resistance levels in the major indices, largely because guys like TraderMike and a host of others cover those bases nicely. Given all the interest associated with whether the market has bottomed or will bottom soon, I chose to focus on 2320 in The Game Is Afoot back on January 25th. With three weeks of hindsight, this has turned out to be an even more critical level than I had expected it would be.

In the chart below, which shows 60 minute bars over the course of the past month, the 2315-2320 area has defined two important gaps and repeated instances of critical support and resistance. If today’s rally continues, it is possible that this level will not be tested going forward; however, if it does get tested again, expect the battle for 2315 to be one of the most important skirmishes that will determine whether the lows of January 22nd and 23rd turn out to be a bottom.

Tuesday, February 12, 2008

The VIX, VXV and Volatility Expectations

I am frequently asked to provide more commentary on VIX futures and the extent to which expectations for future volatility as indicated by VIX futures contrasts sharply with the cash or spot VIX. While I think this is a worthwhile exercise, I am not a big fan of the various charts that I can easily put my hands on, including this one from (which can be easily edited) that compares the August 2008 VIX futures with the cash VIX. The chart in the link above, for instance, uses different Y-axis values for the futures and the cash market, making comparisons a little too murky for my taste.

It is for these reasons that I was so excited when the CBOE announced the VXV, which is analogous to the VIX except that it uses a 93 day time horizon in lieu of the 30 day time frame of the VIX. Better yet, the VXV is supported by my favorite chart service,, which makes it easy to provide a wide range of customizable comparisons of the VIX and the VXV.

Launched three months ago, the VXV chart finally has a critical mass of data that makes it easier to identify trends. My interest, however, is not so much the VXV in a vacuum as it is compared to the VIX. Hence the VIX:VXV ratio, which is what the chart below captures. While it is still relatively early to have high confidence trading rules for this ratio, my working hypothesis continues to be that this ratio will be mean reverting around 1.00, with the best long entries (for the SPX or other long instruments) when the ratio drops below 0.90 and the best short entries when the ratio rises above 1.10.

In addition to the extreme values that the VIX:VXV ratio generates as trading signals, some of the middling values may also have interpretive value. As I type this, for instance, the ratio sits at 0.997, suggesting that there is no discernable difference between volatility expectations over the next 30 days and over a 93 day period. Said another way, today’s rally does not seem to have put the VIX in an ‘oversold’ mode, at least relative to future volatility expectations.

Monday, February 11, 2008

NASDAQ Summation Index

When it comes to market breadth indicators, I have particular fondness for the McClellan Summation Index, which I have discussed in this space several times in the past year. While the McClellan Summation Index draws upon NYSE advance decline data, I am actually a little bit partial to the NASDAQ variant. For those who use, the ticker for the NASDAQ summation index is NASI and the NYSE/McClellan version is the NYSI.

So here is the big question: is the historically low NASI advance decline data a buying opportunity or a warning sign?

In order to best answer that question, I have included a chart below that plots NASI data going back ten years. It clearly shows that buying on any significant NASI dip (say -900 or lower) since the October 2002 bottom has been an excellent investment tactic, as was the run up to the 2000 market top. The graph also shows, however, that during the 2000-2002 bear market, this was a risky strategy that tried to capture short bounces which were brief countertrends against a falling tide. It was possible to be successful, but tight stops and/or a narrow time horizon were needed to control risk.

When all is said and done, we are back to a discussion about whether it makes sense to buy on the dips. In a well defined uptrend, there is not doubt that this is a winning strategy. In a bear market, one can still make money on the bullish countertrend, but these need to be surgical strikes. There isn’t much in the way of sideways action evident in this long-term chart, but it is safe to conclude that buying on the dips in a non-trending market – classic oscillator-based trading – is less profitable than trading with the trend, but offers more substantially opportunity than trying to trade against it.

My current reading of the NASI is that we are more likely than not to get a bounce off of current levels; if it turns out we are in a bear market, these gains will be short-lived, but if we are putting in a bottom of at least intermediate-term length, there is considerable opportunity to the upside.

WTI Boosts Portfolio A1

After a challenging start to the new year that resulted in a major reshuffling of the portfolio, it looks as if Portfolio A1 is now back on track with an interesting cross-section of holdings. Part of the credit for the performance turnaround should go to W&T Offshore (WTI), the oil and gas exploration and production company that gained 9.2% in the first week it was in the portfolio. A five stock portfolio is always a crap shoot of sorts, but given the current market environment and opportunities it presents, I am pleased with the current makeup of the portfolio.

After 51 weeks (since the February 16, 2007 inception), Portfolio A1 sports a cumulative performance of +4.8% vs. a -8.5% performance in the benchmark S&P 500 index over the same period.

Gone after just one week in the portfolio is Chattem (CHTT), which is being replaced by Invitrogen (IVGN), a lab testing and diagnostic company that just last week reported solid earnings and resolved some patent disputes. For those looking for more information on IVGN, a good place to start is with the conference call transcript from the February 5, 2008 conference call.

There no additional changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

VWSI at Zero Even though VIX Jumps 16.6%

It is very unusual to see the VIX make a significant move and the VWSI to register a zero reading, particularly given the mean-reverting bias built in to the VWSI calculations. As a result, last weeks 16.6% jump in the VIX has me suspecting that the VIX may be a better barometer of market volatility in the coming week or two.

Officially, the VIX ended the week at 28.01, up 3.99 or 16.6%. While the VIX has been mostly going sideways the past three weeks, the current level is still 66% higher than the 18.47 close just seven weeks ago.

Normally, when I see the VIX jump 15% or more in one week, I start to think about selling some VIX options. With the VWSI at zero, however, there doesn’t seem to be a tradeable edge in the current situation. Furthermore, a quick glance at the VIX COT report chart shows the commercials continuing to add to long positions even as the VIX trends higher (the orange line is the ‘net commercials’ and dark line is the ‘net large traders’) – a very unusual posture for a group that generally prefers to fade the big moves. Perhaps something wicked this way comes

(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, February 8, 2008


It’s Friday, which means that if you have long positions, you are likely to be calculating the risks of holding those positions over the weekend and imagining what sort of headlines might greet you and your portfolio on Monday morning.

There is so much headline risk – or at least perceived headline risk – out there right now that I suspect it will be very difficult for the bulls to put together a sustained rally today. That being said, each Friday going forward is going to be a litmus test of sorts for the bulls, particularly next Friday, which falls just before a three day weekend in the US.

Though this is only the sixth Friday of 2008 and far from enough data points to begin talking about statistical significance and confidence intervals, the first five Fridays of the year have a mean loss of 1.30%, while Mondays through Thursdays have only seen an average drop of 0.37% over the first 21 non-Friday sessions of the year.

In simplistic terms, I do not think that the bulls can make a credible case for a market turnaround as long as they are unwilling to bid prices up in advance of the weekend. When Fridays start looking up and weekend risks start looking palatable, this may be one of the signs that we have put in a bottom.

Index Volatility and Component Correlation

While I was sleeping soundly this morning, Adam at Daily Options Report was already up and deconstructing the volatility of the S&P 500 index. Drawing upon some data compiled by Bespoke Investment Group that show increasing correlation across the S&P 500 sectors during the course of the past six months, Adam concludes that the current high levels of index volatility (VIX, VXN, RVX, VXO, VXD) are due in part to this recent increase in correlation among the components of the S&P 500.

In Correlation Station (no relation to Terrapin Station), Adam breaks it down as follows:

“You can boil index volatility down to two basic factors. One is the volatility of the component stocks, the other is the correlation between those very stocks. And they can very much offset each other. Imagine a world where half the stocks were moving violently and basically trending in one direction, and the other half was moving violently the other way. Index volatility would be very low as the moves would pretty much offset each other.

What we have now is the opposite. Stocks aren't that cosmically volatile, but they are all moving in relative unison. Ergo index volatility is theoretically *high* relative to individual stock volatility.”

There is not much I can do to improve upon that explanation.

While an understanding of the correlation phenomenon is important, I’m sure many are wondering if the current situation is tradeable. For what little it is worth, I am not going to be taking trades that should be winners if correlations start unwinding, but I encourage those who are interested in this subject (yet another type of mean reversion play) to check out Adam’s thinking about some possible trades along these lines.

Thursday, February 7, 2008

Sentiment Failures

I am of the opinion that failures usually provide more important signals than confirmations. For instance, if a company reports good news and sells off, then that action speaks louder than if the stock had bounced on the news (not withstanding all the “buy on the rumor, sell on the news” lore.) The same is true for broad market data and the broader indices. To my mind, these are fundamental failures.

There is an analogous situation with technical analysis. A failure in this context could be a stock or index that has consistently bounced off of a particular support level that now violates that support and continues lower. I believe that these TA failures speak volumes more in terms of informational content than if support had held for the n+1th time.

Which brings us to yesterday. Two measures in particular suggested that market sentiment was so strongly negative as to make a bounce a high probability event: the ISEE had just hit a new low in its 20 day SMA and the NASDAQ TRIN (30 day EMA) had spiked to levels not seen since 2002. The bottom line is that it a bounce should have been like shooting fish in a barrel for the bulls. Since the bulls could neither hold onto their gains, nor put a dent in the selloff that ensued, I am forced to conclude that in the course of this substantial sentiment failure, they didn’t even graze any of the fish. I am also changing my bias to bearish until the bulls can demonstrate a modicum of marksmanship…

Wednesday, February 6, 2008

Mean Reversion After Big Drops

Eddy Elfenbein at Crossing Wall Street has a nice little graphic and commentary up today: How the Market Behaves on Big Down Days.

After researching the 37 instances in which the S&P 500 index dropped 3.2% or more (as it did yesterday), Elfenbein draws the following conclusions:

“The average loss for the sell-off is 5.01%. After that, nearly every day is an up day. By the ninth day, the S&P 500 is down 3.48%, which is indeed, a retracement of about one-third. The market still trends higher to the 17th day where it's down just 3.01%, or about a 40% retracement. At that point, the linger effects of the sell-off seem to dissolve.”

Elfenbein’s findings should come as no surprise to those who pay attention to the TRIN and ISEE, as well as the VIX, various market breadth indicators, etc. While volatility has been on the tame side lately, the TRIN, ISEE, and McClellan Summation Index have all been suggesting a strong oversold situation and a high probability mean reversion bullish entry.

The duration of the retracement pattern identified by Elfenbein is also worth noting, as it hearkens back to some work on VIX spike retracements I published last April in Lessons from the Post-2/27 VIX Price Action, where the optimal retracement window was determined to be about eight days.

Tuesday, February 5, 2008

Massive Put Buying on ISEE Toward the Close

About 230,000 equities only puts (vs. about 22,000 calls) between 15:10 to 15:30

Bullish NASDAQ TRIN Signal

One of my favorite contrarian sentiment indicators is the (NYSE) TRIN and it’s NASDAQ counterpart, which (responsible for the chart below) codes as the $TRINQ.

The chart I have chosen for today [Edit: updated EOD chart is first chart below; 2nd chart provides longer historical context] uses 60 minute bars over the past two months to demonstrate that in spite of the recent bounce, today’s action sets up another bullish contrarian buy signal – at least in the NDX. This signal looks stronger if you consider the possibility of some support in the 1780 area. Take this with a grain of salt, but consider that the TRINQ’s track record has been very strong as of late.

Also consider that more generally, it may pay to fade any strong move that develops in the current environment of uncertainty – and perhaps to sell premium just beyond important support and resistance levels.


Volcker Endorses Obama

I do my best to keep politics out of this blog, but I thought it was particularly interesting that several days ago, former Federal Reserve Chairman Paul Volcker announced that he was endorsing Barack Obama. What baffles me and is the main reason I even bother to mention it in this space is how little news play this item has received.

Here we have probably the most important presidential election in a generation or more, with a semi-incumbent running whose husband just happens to be the only President to balance the budget in the past 35 years. Further, despite the war in Iraq, the economy is shaping up as a the key issue in the race and suddenly we have the most famous and revered Fed Chairman coming out in support of...the fresh face whose lack of experience is derided by critics.

I found the following quote from Volcker to be particularly telling:

"It is only Barack Obama, in his person, in his ideas, in his ability to understand and to articulate both our needs and our hopes that provide the potential for strong and fresh leadership."

Monday, February 4, 2008

Divergence Between Put to Call and Volatility Data

Several weeks ago in Checking for Atheists, I talked about how bullish moves can be fueled by a large supply of non-believers who prefer to cling to a wall of worry in times of great uncertainty. These investors often prefer to wait until a bullish move is well established before they cautiously and reluctantly begin to resume long positions.

Volatility indicators, such as the VIX, usually provide an insight into just how worried these investors are, but put to call ratios do us one better: they give us a sense of their numbers. Right now, the numbers are compelling. As I noted in my weekly VIX recap, the ISEE data reflect all-time record lows of new call positions initiated relative to new put positions on the International Securities Exchange (ISE) over the past 20 days – a trend that has carried over to today’s session.

The other important put to call ratio that I follow closely is the CBOE’s equity put to call ratio ($CPCE on, a chart of which I have included below. Like the ISEE, the CPCE is showing historically high level of puts to calls – in numbers not seen since early 2005. In the chart below, note that P/C readings of 0.70 or higher have consistently been good buying opportunities and today’s 10 day EMA of 0.73 has not been surpassed since May 2005.

Several readers have asked about the significance of a divergence between volatility and put to call readings. As I discussed last May in More Thoughts on the PCVXO, divergences in which volatility readings are much higher than put to call numbers are usually bullish, while the current situation, with put to call numbers much higher than volatility data, tend to resolve in a bearish move going forward.

PBG Dampens Relief Rally at Portfolio A1

Last week provided a relief rally for most equities, but Portfolio A1 was barely able to eke out a gain, largely due to a poor earnings report from Pepsi Bottling Group (PBG). Tuesday’s report of flat case growth, increasing costs and guidance well below analysts’ expectations led to widespread dumping of the shares. Despite a rally in the markets, the bottler lost 9.1% for the full week.

In spite of PBG’s woes, Portfolio A1 is still up 6.8% for the 50 weeks since inception, as compared to a 4.1% loss in the SPX over the same period.

Not surprisingly, PBG has been dropped from the portfolio, along with LG Philips LCD Co. (LPL), a pick I was scratching my head about two weeks ago.

An interesting new addition to the portfolio is Chattem (CHTT), a consumer products company whose brands include many products advertised on late night TV (Dexatrim, Garlique, Gold Bond, Selsun Blue, pHisoderm, Kaopectate, etc.) The brands may not be sexy, but the stock has been on a tear. Back in 2000 the stock traded as low as 2.37; Friday it closed at 79.73. The other new addition is W&T Offshore (WTI), a Houston-based oil and gas exploration and production company, with geographical focus on the Gulf of Mexico.

There are no other changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

VWSI at +1 as Put to Call Numbers Raise Eyebrows

It may sound strange given all the market drama that has played out so far this year, but 2008 has been a relatively uneventful year so far for those who follow the VIX. Sure there was that two day blip where the VIX traded in the mid-30s during January 22-23, but even then the action in the VIX paled in comparison to everything else that was hitting the fan across the investment universe.

Last week was more of the same. The markets bounced, albeit weakly, and the VIX dropped 5.06 points (17.4%) to end the week at 24.02. While the VIX move looks impressive on paper, it merely brought the volatility index right back to the 50 day simple moving average. The VWSI is also largely discounting last week’s drop in the VIX, as it ticked up from zero +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 the week that is on tap in his Superbowl Linkfest.

Getting back to the VIX and the VWSI, while these numbers are unremarkable, the action in the ISEE suggests that tectonic forces are indeed at work just under the surface, with the ISEE’s 20 day SMA just missing an all-time low on Friday.

(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. 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, February 1, 2008

What Fell and What’s Bouncing

The chart below shows two different performance sorts of sector ETFs. On the left are the top ETF sector performers during the past month; on the right are the top ETF sector performers during the past five days. For the record, these graphics were generated by and can be sorted by any time frame specified in the columns.

Not surprisingly, the big winners for the month were the ultrashort ETFs, particularly in technology and energy sectors. On the long side, real estate and finance-related ETFs showed well during the month, an indication that these sectors may be attracting a fair amount of bottom feeding activity.

Switching to performance data for the last five days, one can clearly see the strong buying action in the real estate and financial sectors, with retail and basic materials ETFs also supporting the recent bounce. So far, the bullish action following last week’s bottom has been driven largely by sectors sensitive to interest rates and cyclical growth. The technology sector, which had a nice bounce pre-FOMC, has been largely absent from the party during the past few days.

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