Yield Curve Looks Just Like May 2003

There are several places on the web where you can watch a short time-lapse video that shows the recent history of the yield curve. One of those places is Fidelity’s Historical Yield Curve page.

In reviewing the history of the yield curve on the Fidelity site, I was surprised to see that the current yield curve is almost identical to the yield curve as it stood on May 2003. This may just be a historical coincidence, but May 2003 also represents the beginning of the five year bull market that followed the 2002-2003 bottom. In the graphic below, I have added a blue arrow to mark May 2003, which just happens to be the time that the SPX started making higher highs and confirming that a bullish move was underway.

Recall that the inverted yield curve which began in 2006 and caused considerable consternation among investors, turned out to be an excellent – if somewhat early – predictor of the coming stock market top and subsequent economic malaise. Historically a steep yield curve, such as the one we have at present and saw in May 2003, has generally been a harbinger of better times ahead and is often found at the beginning of economic expansions.

Ten Things Everyone Should Know About the VIX

I have had quite a few requests to present some introductory material on the VIX, so with that in mind I offer up the following in question and answer format:

Q: What is the VIX?
A: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.

Q: How is the VIX calculated?
A: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.

Q: Why should I care about the VIX?
A: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.

Q: What is the history of the VIX?
A: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The ‘original VIX’ (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at the money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.

Q: Why is the VIX sometimes called the “fear index”?
A: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, “since volatility often signifies financial turmoil, [the] VIX is often referred to as the ‘investor fear gauge’”. The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.

Q: How does the VIX differ from other measures of volatility?
A: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.

Q: What are normal, high and low readings for the VIX?
A: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.

Q: Can I trade the VIX?
A: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: VXX, which targets VIX futures with 1 month to maturity; and VXZ, which targets 5 months to maturity. An inverse VIX futures ETN, XXV, was launched on 7/19/10. This product targets VIX futures with 1 month to maturity. As of May 2010, options have been available on the VXX and VXZ ETNs.

Q: How can the VIX be used as a hedge?
A: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.

Q: How do investors use the VIX to time the market?
A: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.

[Last updated on 7/22/2010]

Complacency Up Pre-FOMC

For anyone who follows the VIX, the headline above should not come as a surprise, but here the indicator adds a little color to the story.

The VIX:SDS ratio is something I introduced last August. In essence, it plots the VIX against the 2x inverse ETF of the SPX to help determine to what extent the VIX is just moving in the opposite direction of the SPX and to what extent there is an emotional component – either fear or complacency – in addition to the normal negative correlation.

As seen in the chart below, the VIX:SDS ratio has been largely moving sideways since September, but has been drifting steadily lower since the markets bottomed in March. More importantly, the current VIX:SDS ratio is also approaching levels not sustained since July, when the credit crisis had not yet begun to unfold. Also of interest is the 0.05 differential between the 10 day and 100 day simple moving averages, reflecting that current levels of complacency are the highest in relative terms since the launch of the SDS ETF in July 2006.

As always, where there is excessive complacency, bulls should exercise extra caution.

Odometer Turns Over

I never intended for VIX and More to cover more than a small niche of the blogging universe, so when I saw the unique visitor counter hit another small milestone yesterday, I thought it would be an appropriate time to acknowledge those blogs who have referred the most visitors to this site.

Ranked in order of the number of referrals, I offer a heartfelt thanks to the following:

1. Daily Options Report
   
   
2. Abnormal Returns
   
   
3. The Kirk Report
   
   
4. Headline Charts
   
   
5. Chris Perruna
   
   
6. The Buttonwood Speculator (formerly The Kingsland Report – and it is active again)
   
   
7. Trader Feed
   
   
8. Slope of Hope
   
   
9. The dk Report (currently on a blogging sabbatical)
   
   
10. Afraid to Trade
    
    
11. A Dash of Insight
    
    
12. Trading Goddess
    
    
13. Condor Options
    
    
14. The Big Picture
    
    
15. The Global Liquidity Blog
    
    
16. Quantifiable Edges
    
    
17. The Shark Report
    
    
18. 1Option
    
    
19. Option Pundit
    
    
20. Random Roger

Thanks also to all the readers – no matter how you found your way here from all 145 countries – for all you have contributed to the VIX and More dialogue.

What Is High Implied Volatility?

Readers generally ask much better questions than my rhetorical ones. For that reason, I will see if I can set aside more of my time in this space to answer reader questions.

Recently I received several questions about how to determine whether implied volatility is high and when someone declares IV to be high, what exactly the basis for comparison is.

Ultimately, the assessment of what is high implied volatility is a subjective one, but typically the person attaching the label is making a comparison between current implied volatility levels and a historical range of either implied volatility or historical volatility levels.

To my thinking high implied volatility is best determined according to the following criteria:

1. relative to a lookback period (1 year, 6 months, 3 months or whatever – but be careful with shorter time frames) for previous implied volatility levels
   
   
2. relative to historical volatility (one could argue that the time frames are less important here)
   
   
3. relative to the current implied volatility of peers or a broader group of similar stocks (you hardly ever hear about this, but I think the comparison is relevant)

The most important piece of information to remember is that implied volatility is inherently forward looking and historical volatility is, by definition, backward looking. This is important because traders know when potential market moving events are coming and implied volatility moves accordingly. With historical volatility, on the other hand, it is much too easy to drive a car right into an unseen wall while trying to navigate by looking out the rear view mirror.

When I think about implied volatility levels, I am usually looking at ‘relative volatility’ or implied volatility as a % of the most recent 52 week range. The recent volatility trend, if any, is also worth investigating. I always check the current IV-HV spread, but to switch metaphors, it is generally better to know about the hurricane headed your way than the one that has just passed through. Finally, it is critical to know if important events are just around the corner, such as earnings, an FDA decision, the resolution of important litigation, etc. When evaluating implied volatility for ETFs or indices (and data sensitive stocks, such as financials), upcoming events to focus on would likely be more along the lines of impending government data, proximity to Fed meetings, etc.

For the record, I went back and coded some of the more important archived posts on implied volatility with the implied volatility label. In the future, I will offer up some thoughts on how to interpret implied volatility levels and use some real-time examples.

Implied Volatility Suggests Risk in Financials at Six Month Low

Just yesterday, in Financials Struggle to Establish Momentum, I expressed some concern that the recent relatively weak performance of the financial sector (XLF) did not bode well for any sustainable bull moves. Perhaps the sector overheard me, as today the XLF is up 2% in an otherwise flat market as I type this.

While the price action is ultimately what matters most, there is more to the story than just the prices of the financial stocks. In particular, I am watching the implied volatility of XLF, the financial sector’s bellwether ETF. As depicted in the chart below, the implied volatility (which has a significant fear and anxiety component in it) for XLF is approaching levels not seen since the first week in November.

I consider option traders to be a fairly savvy bunch; if they think that the risk premium in the financial sector is lower than any time in the past six months, I am going to listen – and watch to see what happens to the price.

Financials Struggle to Establish Momentum

Further to my recent comments in The Energy and Materials Rally, I thought it might be interesting to show the relative performance of the financial sector (XLF) versus the SPX. The chart below shows that while the financials helped to drag down the SPX over the past six months or so, it also reveals that any gains that the SPX has been able to make over the past 2-3 weeks have been without the participation of the financial sector.

I am of the opinion that while the technology (XLK) and industrial (XLI) sectors can provide leadership in any bull move up from current levels, such a move will be severely hampered and likely short-lived without the participation of the financial (XLF) and consumer discretionary (XLY) stocks.

BIDU Speculators

When I first looked at the optionsXpress trading patterns (“People Trading ___ Also Traded ___”) function back in September, I certainly did not expect that it would become a recurring feature on the blog.

I did, however, have the good fortune of selecting Baidu (BIDU) as my example stock and came up with a good list of speculative companies – all of which were taken to the woodshed at the end of October and sold aggressively over the past six months or so.

Here we are in April and the market has put in a provisional bottom and lo and behold, BIDU is up over 70% in the past month. So, I asked that same rhetorical question once again and optionsXpress was kind enough to oblige me with a list of companies that BIDU speculators have been pushing up over the past month. [All optionsXpress customers can do the same for any security by going to the Quotes tab, clicking on Quote Detail, then clicking on the People Trading… link under the chart on the right.]

There are no real surprises on my end this time around, save perhaps the inclusion of two financial plays, MER and XLF, though it is interesting to see how the list has changed since the last time I did this, which just happened to be on October 30, 2007, at the time the markets were peaking.

The Energy and Materials Rally

While Google (GOOG), Caterpillar (CAT), and other big technology and industrial names have recently helped push stocks to their best levels in three months, the rally off of the March 20^th bottom may not have the kind of sector composition behind it that is conducive to an extended move. In fact, so far the bull run has been largely the result of strong performance in the energy and materials sector – a good portion of which can be attributed to the search for a hedge against inflation.

The chart below shows the performance of the nine AMEX Select Sector SPDRs relative to the S&P 500 index since the March 20^th bottom. The sectors normally associated with an economic turnaround – technology (XLK), industrials (XLI), and consumer discretionary (XLY) – have heretofore not been leading the charge. On the other hand, the leading sectors over the past month – energy (XLE) and materials (XLB) – are not the sectors that typically are able to lead a sustainable rally. In the next week or two, look for other sectors to start outperforming the energy and materials group. If this fails to happen, there will probably not be sufficient market breadth to keep the current rally alive.

VIX Numbers and Overbought Signals

From the looks of some of the Google searches that have been attracting readers to the blog today, it appears that a sub-20 VIX that is more than 10% below the VIX’s 10 day simple moving average has a lot of people wondering about overbought signals.

I have talked about various rules (MarketSci rule, Trading Markets 5% rule, etc.) which utilize the VIX to signal overbought and oversold conditions and I can summarize my thinking briefly here:

• Focus on the relative values of the VIX (i.e., with respect to a recent trading range) instead of absolute values
• Consider the cash VIX in the context of expectations for future volatility
• The more extreme readings give more reliable signals
• History favors mean reversion for the VIX
• Mean reversion does not always happen quickly, so scale in to a position
• If you follow good risk control, VIX signals are one of the few ones for which it is acceptable to add to losing positions (assuming the mean reversion signal is still valid)
• Be sure to start taking profits in no more than 1-2 weeks
  

So…that is my thinking. A sub-20 VIX? Not really relevant. A VIX more than 10% below the 10 day SMA? Generally tradeable. A better signal? While it is still too early ‘cling tightly’ to the VXV (an index that calculates the 93 day implied volatility for the SPX options), I am bullish on the VIX:VXV ratio – and the chart of that ratio suggests that the market is approaching an overbought condition.

Citigroup and Implied Volatility

Consider for a moment that much beleaguered Citigroup (C) is going to report earnings tomorrow morning on options expiration day.

Shouldn’t implied volatility tell us something about how anxious investors should be? Well, that is indeed the case, but the story is not perhaps what one might expect. If implied volatility is to believed, anxiety about Citigroup’s plight peaked about a month ago (when the stock market bottomed) and has been declining ever since. At current levels, Citigroup’s implied volatility is at the lowest level it has been in the past six weeks.

I have included Citigroup’s three month implied volatility chart below, as it is too interesting to let this one go and should make nice fodder for the archives.

Zooming Out on Consumer Spending

By now the news that the University of Michigan Consumer Sentiment Report for April was at the lowest level since March 1982 has been almost fully digested. A number of bloggers have done an excellent job pointing out that lows in this index often coincide with lows in the stock market. Babak at Trader’s Narrative , for instance, has an excellent graph of sentiment and stocks in Consumer Sentiment Always Darkest Before the Dawn. Don Fishback’s Market Update has a similar chart up today.

The upcoming Pennsylvania primary notwithstanding, I am going to set aside poll data for the moment and focus on one of my favorite consumer sentiment indicators: a comparison of consumer discretionary stocks to consumer staples stocks. This can easily be done with two sector ETFs, XLY (Consumer Discretionary Select Sector SPDR Fund) and XLP (Consumer Staples Select Sector SPDR Fund.) Keeping in mind that stocks are supposed to lead the economy by 6-9 months, the XLY:XLP ratio should tell us something about how stocks are pricing in expected consumer spending patterns over the next 2-3 quarters.

The XLY:XLP chart below is a weekly chart, which provides a sense of the recent ebbs and flows of consumer spending patterns. The chart demonstrates that when the ratio trends down and/or makes a significant low, these events usually coincide with market bottoms. It remains to be seen whether this pattern will hold in the current economic environment, but there are signs that the consumer discretionary ratio, like equities, is starting to move off of the recent bottom. This is an important ratio, not just for what it suggests about future consumer spending patterns, but also for flagging the extent to which investors feel compelled to favor the more defensive consumer staples stocks or the more speculative consumer discretionary ones.

Measuring Stress in the System

Historically, the VIX has been an excellent proxy for measuring the level of anxiety and stress in the financial markets…but not always the best one.

Back in early March 2007, I suggested credit default swaps – and particularly the Markit indices – as a way to monitor how the markets are pricing in the risk of defaults. Another common way to monitor default risk is to look at the yield spread between corporate bonds of various rating categories versus the (presumably) riskless US Treasury debt of comparable maturity.

Let me nominate a third alternative: LIBOR rates. LIBOR (formally the London Interbank Offered Rate) is essentially the established rate at which banks lend to each other. Normally LIBOR rates track the Fed Funds rates fairly closely, but lately the LIBOR rates have remained elevated even as the Fed has acted to cut rates and attempted to inject liquidity into the system. If you want to get a sense of how effective the Fed has been in easing tight credit, LIBOR rates (and the "TED spread," which is the difference between LIBOR and the Fed Funds rate) are a good place to start. As the chart below shows, even though LIBOR rates may have topped a month ago, they remain quite elevated when compared to the August-December period.

For more detailed discussion of LIBOR, the Fed, and the current credit crisis, a good place to start is Michael Shedlock’s Failures of the Term Auction Facility – which is decidedly not for the faint of heart.

Financials Testing Critical Support Level

This morning, State Street (STT) reported a $3.2 billion loss on its investment portfolio and an additional $2.5 billion loss on conduits, then was placed on Ratings Watch Negative by Fitch Ratings, signaling that Fitch will review the company’s credit rating for a possible downgrade.

While the State Street news put a damper on financial stocks, XLF, the most widely followed ETF for the financial sector, is trading up as a write this. Earlier in the session, XLF tested an important March 31^st low of 24.40 (see chart below) and has since bounced back. The 24.40 level is an important support level for the XLF and one to watch closely, particularly as tomorrow brings additional earnings reports from J.P. Morgan Chase (JPM) and Wells Fargo (WFC), as well as several smaller banks.

Three Top Bloggers Look at the VIX

Since what little ‘analysis’ there is of the VIX is usually of the quick and dirty variety, I was delighted to see that three bloggers who I have a great deal of respect for just happen to be featuring articles on the VIX this morning.

The first piece, from Condor Options, asks a basic question that I often grapple with when it comes to volatility indices: Is the VIX Impervious to Technical Analysis. I have to say that I am largely in agreement on the three main points made in the post:

• Support and resistance don’t matter
• Long term moving averages don’t matter
• Correlation does not imply causation

That being said, in my opinion there are quite a few ways in which technical analysis can be applied to the VIX, but the universe of valid approach is much smaller for the VIX than it is for other indices. Part of the problem, as I have stated here on several occasions, due in part arises from the fact that in the case of the VIX, one cannot trade the underlying directly.

Ian Woodward is clearly of the camp that one can apply technical analysis tools to the VIX. In Whither Goes the Volatility Index – VIX, Ian lays out a detailed TA approach for looking at the VIX and interprets the implications for the markets based on various trading ranges for the VIX this week. I think there is some validity to Ian’s approach, but this is not how I generally use the VIX.

Last but not least, Tom Drake has an indicator that he calls the 2CS, which combines the VXO (the original VIX, prior to the 2003 modifications) and the CBOE combined put to call ratio to get a two dimensional view of options sentiment. In The 2CS Revisited, Tom discusses how he uses the 2CS to help identify market bottoms. His approach appears to be similar to mine in many respects. Also, the 2CS is clearly a relative of the OSI (Options Sentiment Indicator) that I publish and discuss in my subscriber newsletter.

I suspect the increased interest in the VIX is a by-product of the ongoing discussion in many circles that the VIX has not spiked enough to signal a textbook capitulation bottom, particularly given the magnitude of the macroeconomic concerns. I continue to think that while a VIX spike of 40 or more would placate many of those who are waiting for a more obvious sign of capitulation, this is not necessary to confirm a bottom, particularly given the current trading range of the VIX in the low to mid-20s.

VIX Back Above 10 Day SMA; VWSI at Zero

Last week's bearish action in the equity markets moved the VIX back over its 10 day simple moving average for the first time in three weeks. As the markets enter a pivotal earnings week, it will be interesting to watch the VIX to see how damaging any earnings surprises turn out to be -- or how much bad news has already been discounted.

The VIX Weekly Sentiment Index (VWSI) is back at zero, down from +3 the previous week, meaning that the volatility forecast for the next 1-2 weeks is neutral, with a roughly equal probability of a spike in volatility or a continuation of the move down.

Avoid Subscriber Newsletter Delivery Issues

First, a quick thanks to all who have signed up for the subscriber newsletter. I have been quite pleased by the response to date.

Unfortunately, at least one subscriber has had trouble receiving the newsletter. If any other subscriber has failed to receive an issue on any Wednesday or Sunday evening Pacific Time, please drop me a note.

To be on the safe side, all subscribers are encouraged to add bill.luby@gmail.com to their email program's "approved senders list" to ensure that future issues do not end up in a spam or bulk mail folder.

NASDAQ 2315 Again

Two months ago I noted that the 2315 level for the NASDAQ Composite Index had figured prominently in several important gaps and served as a critical support and resistance level for the index going back to mid-January.

In range-bound markets – which is what we are in for now until we get a decisive move up or down – these important support and resistance levels end up being revisited on a quite a few occasions and ultimately prove to be an important measuring stick for the strength of subsequent market action.

Looking at the three month chart (with 60 minute bars) below, in the past two months the 2315 level has played an important role in two new gaps, one from the end of February and another at the beginning of April. The end of February gap down served as a ceiling for price action for almost a month, while the April 1^st gap up has been the floor for price movements over the course of the past two weeks. Today’s sharp drop tested the gap and the corresponding 2315 level. So far, that test of support has held. As long as 2315 continues to hold, the markets should continue to consolidate and move up from current levels, but should 2315 be breached – and the gap down to 2290 be closed – expect emboldened shorts and panicky longs to put the 2155 low back in to play.

Persistent High Put to Call Ratio

The last time I mentioned the CBOE Equity Put to Call Ratio, one month ago today, it was at such elevated levels that I titled the post Put to Call Everest and limited my commentary to a brief question, “What number comes after infinity?” The extreme put to call data even inspired me to make my first major bottom call since trying to catch the bottom in the NASDAQ in 2002 (I was also a little early then, but close enough.)

Fast forward one month and the put to call data continue to show a preponderance of non-believers, with put buying dominating the options activity. Given the headlines of the past few days, this widespread pessimism is easy to understand. The more important question is how long it will endure.

Critical market bottoms are almost always marked by a spike in put to call ratios. For aggressive investors, the current levels probably offer an attractive risk-reward profile. More conservative investors may wish to wait for a confirmation signal, such as the 10 day exponential moving average of the CBOE Equity Put to Call Ratio dropping below 0.80 (the blue horizontal line in the chart below.) More market shocks certainly lie ahead, but history suggests that the current environment has a high probability of producing above average returns – perhaps even considerably higher than that – over the next month or two.

Volatility Spikes Above 10 Day Moving Average

After three weeks of down trending volatility, the bearish action of the past three days has caused the VXN (volatility index for the NASDAQ-100) to reverse course and spike back above the 10 day simple moving average. As the NASDAQ-100 (NDX) has fallen more dramatically than the S&P 500 has this morning, the corresponding spike in the VIX, while similar, has not quite moved that volatility index up to the 10 day SMA.

As best as I can determine anecdotally, the use of volatility indices – particularly the VIX – to measure the ebb and flow of market sentiment has been on the rise in recent months. One of the most common ways to use the VIX is to measure the deviation from the 10 day SMA and bet that the larger the deviation, the more likely the index will rapidly move in mean reversion fashion in the direction of the 10 day SMA.

In trending markets, the mean reversion plays are excellent opportunities to add to a trend trade. When the markets are moving sideways, as they appear to be doing now, the VIX is better used as an oscillator for timing swing trades from one sentiment extreme to another.

In the chart below, I have added 10% and 20% moving average envelopes to the VXN to help define the most likely parameters of a volatility swing. While some resistance is usually evident as volatility swings back over the 10 day SMA, the opposite side of the 10% moving average envelope – a VXN of 30.09 in this case (26.09 for the VIX) – is where the volatility swing is most likely to run out of steam as it encounters stronger resistance. On the chart, the 10% moving average envelopes are represented by the dotted green lines. The solid green lines are 20% moving average envelopes; these usually signal the end of an extreme volatility swing and are more reliable mean reversion trading signals.

Sticky Sentiment

Back in February I received a lot of positive feedback for a post titled Intrade Prediction Markets as a Sentiment Indicator which discussed the usefulness of prediction markets as a gauge of investor sentiment. This is a theme I will come back to in due course, but for now I wanted to highlight some excellent complementary work in this area.

Expanding on prediction markets as sentiment indicator theme and drawing an interesting parallel in the sports world, Jeff Miller at A Dash of Insight has a superb post up today in which he looks at the ebb and flow of the North Carolina vs. Kansas game as a case study in investor sentiment. In Sentiment Is Slow to Change: A Basketball Lesson, Part One, Jeff uses a real-time chart of the price of the futures contract for the game from Intrade’s sister site, TradeSports.com and provides a thought-provoking analysis of the changing fortunes during the game and the betting response in the futures contract. I highly recommend that readers click over for the full story, but I have taken the liberty of posting Jeff's conclusion below:

“The lesson here is that market sentiment is very ‘sticky.’ Those investing in UNC futures were not just fans. Most were regular players of many sporting events, seeking a profit on this one. They began with an opinion, and the opinion was slow to shift.

The value of looking at an example like this is that the entire picture of sentiment and reality can be captured in the space of a few hours.

In the stock market, a similar process may take many months or even years. We shall explore this further.”

I am certainly looking forward to the next installment in this series.

M3 Expanding at Rate of Almost 20%

There are many excellent web sites out there that specialize in a small slice of the economic universe, as VIX and More does, and in due time I’d like to think that I will be able to shine some light on most of the better ones.

When it comes to the money supply, one of the best ones is NowAndFutures.com, run by a self-described “small group of middle aged and older investors who got fed up with the lack of straight and relatively simple data on investing and economics, and put up a web site to address our various concerns.”

One of the subjects in which NowAndFutures excels is the money supply. Specifically, when the Fed decided back in March 2006 to stop publishing M3 data, NowAndFutures stepped up with their own M3 model and started publishing what they are calling M3b – a very close approximation to the discontinued M3 number.

I mention all of this because the recent moves by the Fed to inject liquidity in the system are starting to show up in the money supply data, including the M3b calculation, which is depicted in the NowAndFutures graph below. In some respects, volatility is the opposite of liquidity, so those who are wondering why the VIX has a 21 handle and is trading below the 200 day SMA for the first time in months can look to the recent dramatic expansion of the money supply for a large part of the explanation.

VWSI at +3 as VIX Keeps Falling

The VIX fell 3.26 (12.7%) to end the week at 22.45, the lowest end of the week close for 2008 so far. Last week's move brings the drop in the VIX to 8.71 points or 28% over the past three weeks and brings the index to a level about 8.9% the 10 day SMA and 15.3% below the 20 day SMA.

While these may sound like fairly extreme readings, the VWSI has only ticked up from +1 to +3 in the past week (but up from -4 three weeks ago), suggesting a most likely scenario of only a mild increase in volatility over the next week or two.

With all the recent attention being given to the VIX and the 200 day SMA (currently at 22.90), I thought I should weigh in by expanding upon some comments I have made previously. Specifically, it is my opinion that technical analysis does not work well with a derivative in which one cannot trade the underlying. Part of my thinking is that there is no such thing as support for the VIX at the 200d SMA (or any moving average) because one cannot trade the VIX directly when it hits a support (or resistance) point. In a more general sense, many TA techniques are on shaky ground with derivatives in which the underlying is not traded, so I am skeptical about the value of technical analysis of the VIX.

That being said, if enough people use the VIX as a market timing tool, some of the market's response to important TA VIX signals can filter down to the VIX itself and have somewhat of a reinforcing effect. I suspect that the effect, if any, is quite small.

Those who want to eyeball the significance of the 200d SMA are encouraged to look at a chart of the VIX with the 200d SMA going back 5 years or more. The only time that the 200d SMA appears to have served as even minor support or resistance was in July 2006 -- and that looks more like a small coincidence on the long-term chart than solid technical support. For the most part, the 200d SMA has been irrelevant throughout the history of the VIX -- and there is no reason to think that fact should change in the present environment.

Chinese Solar Stocks on the Rise

Two areas that have been rife with speculative frenzy – both bullish and bearish – over the past year or so have been China and solar stocks. Not surprisingly, the space where the two intersect, Chinese solar stocks, has been one of the most volatile segments of the market.

I have elected not to show the long-term chart of these stocks, which looks a lot like a higher beta version of the chart of the FXI. Instead, the chart below compares the year-to-date performance of the most significant players in the Chinese solar space that are traded on US exchanges: JASO; STP; LDK; YGE; TSL; SOLF; and CSUN. I left JASO as the anchor and show the volume in this stock at the bottom of the chart because JASO is the biggest gainer of the year so far and the chart shows that after the March 10^th bottom, strong volume flowed into the stock over the next three days, marking the beginning of the current leg up.

Given their high profile and speculative history, Chinese solar stocks can be an excellent speculative barometer, not only for China and the solar sector, but for the markets as a whole. More importantly, where there is strong speculative activity, particularly coming off of a sharp bear move, there is increased confidence in the markets and a high degree of perceived opportunity.

Equities or Commodities?

Ever since the bear market of 2000-2003 found a bottom and started up, equities and commodities have largely been moving up together. That relationship came to an end when the equity markets topped in mid-October. Since then, as the first chart below indicates, the SPX has been falling while the Reuters/Jefferies CRB Index of commodities has been on the rise. While the direction of these indices has recently changed, the inverse relationship appears to be holding up. The SPX and CRB chart below shows that commodities turned down about two weeks ago, just before the equity market bottomed.

A quick and dirty explanation for this change might be that speculative money started getting out of equities last August and September as the market topped, concerns were raised about the credit markets, and the Fed started cutting rates. The Fed’s actions clearly caused many investors to be more concerned about inflation and pushed them in the direction of assets – such as commodities – that have historically performed well in an inflationary environment.

In addition to the StockCharts.com SPX and CRB chart, I have also included a six month heat map, courtesy of FINVIZ.com, which shows in dramatic fashion, that commodities have been one of the few areas of strong performance during the past six months.

As financial firms de-leverage, it is possible that speculative bets will be limited to equities or commodities, but not both, so it is important to watch which asset class is soaking up most of the money currently on the sidelines. I will update this story as it unfolds.

[graphic: StockCharts]

[graphic: FINVIZ.com]

Portfolio A1 Performance Through 3/31/08

After I decided to stop posting an update to Portfolio A1 each weekend, I was surprised and pleased to hear that several readers were using the portfolio’s selections to augment their own holdings.

With that in mind, I thought it might be interesting to update Portfolio A1’s performance through the first quarter of 2008 – and thereafter on a quarterly basis.

As the graphics below show, the Portfolio suffered its worst month to date in January, breaking a string from September through December in which the portfolio annihilated the benchmark S&P 500 index. Despite the relatively disappointing performance in the first quarter of 2008, from a cumulative return perspective, Portfolio A1’s 5.3% return since the February 16, 2007 inception is still 14.4% better than the 9.1% loss suffered by the SPX during that period.

I should note that the new VIX and More Subscriber Newsletter has three model portfolios that are updated weekly: Aggressive Trader; Growth; and Foreign Growth. These were publicly launched in the newsletter on Sunday, but for the record, each of the three model portfolios have been up and running for the past 3-4 years and have significantly outperformed both the SPX and Portfolio A1 during comparable measurement periods. Finally, there is also a Stock of the Week ‘Portfolio’ whose performance I will be tracking partly for posterity and partly for entertainment value. For more details on the subscriber newsletter, click on the link in the upper right hand corner of the blog.

Turning to the VXN…

Yesterday, I presented a chart of the ratio of the VIX to the VXV and offered the interpretation that this indicator was suggesting little more than a mild overbought condition.

Now that we have a 400 point rally in the DJIA in the books, it seems that quite a few pundits are pointing to the VIX and calling the market overbought. Yesterday I barely stopped short of saying that the study of the percentage deviation of the VIX from the 10 day SMA is the “lazy man’s way to interpret the VIX,” but truth be told, that is about where I come down on the subject (with apologies to all the women who fall into the same trap.)

Yes, it is important for traders to keep their stable of indicators simple and easy to manage, but in doing so there is always the risk of oversimplification.

Getting back to the VIX, it is down another 0.18 (0.8%) as I type this, while the SPX is up 0.44%. I’m sure that makes the 10%ers even more convinced that the market is about to pull back, but I am not prepared to accept that interpretation. The VIX:VXV ratio continues to move sideways today and other volatility measures – which I vow to give more space to going forward – show more of a range-bound pattern than anything resembling the plummeting volatility that the 10%ers are undoubtedly seeing in the VIX.

Recall that financials are the largest component of the SPX, which means they also have the heaviest weighting in the VIX (the same is true for the S&P 100 index, a.k.a. the OEX, and its volatility counterpart, the VXO.) That being said, now that the Bear Stearns (BSC) situation has been resolved, the Fed has expanded its role to enhance the liquidity of the investment banks, and Lehman Brothers (LEH) appears to be out of the woods after experiencing strong demand for its $4 billion convertible preferred offering, it should come as no surprise that volatility which is closely tied to the financial sector is showing the steepest drop. As an example, the most closely watched financial sector ETF, XLF, has seen volatility drop 36% since the March 17^th high. By the same token, falling volatility has taken the VIX and VXO down below their 200 day simple moving averages. Move over to the VXN (the volatility index for the NASDAQ-100 or NDX), however, and the picture is much less dramatic. Instead of falling volatility, the chart shows range-bound volatility going back to August 2007 and current readings still comfortably above the 200 day SMA, albeit with a pattern of higher lows. Given the relative weightings of the financial sector in the various volatility indices, from my perspective a strong break in the VXN below 25 would be a better broad-based sign of falling volatility than most of what we can discern from the VIX and the moment.

VIX:VXV Not Signaling Overbought Market

With the VIX trading at its lowest level (23ish) since late February, there are a number of investors who are trying to determine whether a falling VIX signals an overbought situation in the market.

There are many ways to use the VIX as a market sentiment indicator to assist in calling tops and bottoms. The most widely used is probably to determine the distance the VIX is from the 10 day simple moving average and get long if the VIX is 10% above the 10 day SMA and short if the VIX is 10% below the 10 day SMA. A simple plot of the VIX and the appropriate moving average envelopes will do the trick here – and also indicate that the markets are currently in an overbought condition.

Another way to use the VIX – and one which I continue to have high hopes for as the historical record evolves – is to use the ratio of the VIX (30 day implied volatility for SPX options) to the VXV (93 day IV for the SPX options) to determine the extent to which current volatility readings deviate from future volatility expectations. I have discussed this VIX:VXV ratio on a number of occasions and have continued to observe the predictive value of extreme readings. Now that I have the benefit of 4 ½ months of VXV data, I can say that the ratio continues to generate useful readings – and suggests that the current market is not particularly overbought (see chart below.)

I will continue to monitor instances in which the SMA +/- 10% rule and the VIX:VIX ratio rule(s) diverge and provide periodic updates in this space.