Thursday, July 31, 2008

Biotech Breakout Confirmed

Further to my Biotech on a Tear post earlier this week, today’s action confirms that biotechnology stocks are officially breaking out. The chart below is a weekly chart of IBB, the most active of the biotechnology ETFs. It shows the ferocity of the biotech move over the course of the past month, even in the face of recent disappointing news on the Alzheimer’s front that battered Elan (ELN) and Wyeth (WYE).

Factoring in today’s 3% gain, IBB is set to close at a level not seen since the end of 2001. Note also that the candlestick patterns for the previous highs made in 2004, 2006, and 2007 all show a significant reversal pattern during the week in which those highs were made. With one more day in the week and a large buffer, the current chart pattern is likely to print a bullish pattern for the full week, in addition to the new high.

If you want to see what is hot in the biotech world, the sortable biomedical sector list at is a good place to start.

Wednesday, July 30, 2008

Implied Volatility and Magnitude vs. Direction

Awhile back, a reader posed what sounded like a basic question:

Isn't implied volatility a function of the size of the move, rather than direction? So why is VIX more commonly referred to as a fear index if high VIX can imply movements in both directions? I mean- HOW and exactly where does the direction get factored into VIX?

This question sounds as if it if might have an easy answer. The problem is that when you scratch the surface of implied volatility, a bunch of other questions have a tendency to pop up and all the tangents make it easy for the questioner’s eyes to glaze over. So, to make a long story a little shorter, I have decided that it is time to draft some detailed posts that look under the hood at both implied volatility and historical/statistical volatility. Not to worry, this won’t happen today; more likely I will tackle these subjects over the course of the next two or three weeks in a series of posts.

Getting back to the questions posed above, to set the context, historical volatility (also known as statistical volatility) looks backward at actual historical price movements and calculates volatility in terms of standard deviations over a given period of time. The result is expressed as an annualized volatility number (the percentage of one standard deviation), just like the VIX. Historical volatility does not care about the direction of the volatility, only the magnitude.

In theory, implied volatility should also be directionally agnostic. Investor psychology and the mechanics of the options marketplace, however, mean that reality diverges from theory as options are transacted. Recall that implied volatility is derived from actual options prices. When the other options pricing variables (strike price; price of the underlying; time to expiration; dividends; and risk free interests rate) of an option are frozen, this leaves implied volatility as the only remaining variable in the options pricing equation. This is how implied volatility is derived.

In the very short term, options prices are largely a function of the price of the underlying and implied volatility, as the other variables tend to change at a slow and/or predictable rate. When the price of the underlying is relatively stable, implied volatility has a tendency to drift down and bring options prices with them. When the price of the underlying (whether it be a stock, ETF, index or whatever) moves sharply, this is when things get interesting. If the underlying moves up quickly, it has a tendency to attract new buyers and sellers. Implied volatility usually rises with the move and so do most options prices. Ultimately, implied volatility becomes a function of supply and demand for options at specific strikes and expirations. If new transactions keep hitting the ask price, then options prices will move quickly and implied volatility will adjust upward to accommodate the new prices. Sellers will also be inclined to keep raising their asking price to account for this demand – again stretching prices and pulling implied volatility along for the ride. Generally, this will not result in a “panic buying” situation, particularly if the underlying is an index or an ETF. Greed is not instantaneous; it tends to build over time. There might be a concern with an individual stock that an acquisition is in the works, a legal matter has been settled, word of an FDA decision has leaked out, etc., but other than these scenarios (which do not apply to an index or an ETF), sharp upward moves tend to be orderly and have a relatively limited short-term psychological impact on the investor.

If you turn this scenario around and think of the move as a sharp selloff, some different dynamics come into play. First consider the maxim that stocks tend to fall faster than they rise. Second, when it comes to portfolio protection, the rush to buy puts to protect an existing position is much more dramatic than any sort of call purchases during a bull spike. Third, the worst case scenario for a bear move includes not only the scenarios noted in the paragraph above, but incorporates any number of potential disasters from a CEO/CFO resignation to accounting irregularities, lowered earnings guidance, new legal challenges, etc. Fourth, as the downward move gathers momentum, investors have a tendency to buy whatever puts they can, at the market, for whatever prices are available. It is this insensitivity to prices during a panic selling situation that tends to overwhelm the ask price and cause market makers to raise the prices of puts dramatically; this, in turn, triggers a sharp jump in implied volatility.

Ultimately, the same aspects of investor psychology and behavioral finance (i.e., loss aversion) that translate into more panic selling than panic buying also mean that the supply and demand imbalance for options is typically greater in sharp bear moves than in sharp bull moves. The result is that implied volatility tends to spike more with an X% drop than as a result of an X% rise. Statistically, these moves are identical, but psychologically and from a transaction perspective, spikes down will generally move implied volatility more than comparably sized spikes up. Since the VIX is essentially the implied volatility of the SPX, this is one of the reasons why the magnitude and direction of a market move determine the impact the move will have on the VIX.

Tuesday, July 29, 2008

Biotech on a Tear

While most sectors have been faltering for the past month or two, biotechnology has been an exceptional performer, with the top biotech ETF, IBB, now more than 15% above its June low, as the chart below shows.

I last profiled biotech on May 1st in Time for Biotech to Turn Around? In retrospect, May and June were excellent months to get long biotech, even as the broad markets headed south.

Of IBBs top ten holdings, five of the ten are currently at or just below their 52 week highs, including:

  • Amgen (AMGN) – making another new 52 week high today
  • Illumina (ILMN) – made a new 52 week high yesterday
  • Celgene (CELG) – just 1.6% below its 52 week high
  • Gilead Sciences (GILD) – 5.7% below its 52 week high, but up about 40% for the year
  • Genzyme (GENZ) – 7.1% below the 52 week high, set back in January

Of course, there are many more success stories among some of the smaller cap biotechnology companies. So while the markets drift sideways and we wait to see if traditional technology stocks can provide leadership, this might be a good time to stock up on one of the few strong sectors: biotechnology.

Monday, July 28, 2008

Bullish Case Losing Traction

As this week is somewhat of a vacation for me, I had a rare day where I missed about 95% of the trading action and am only now checking the patient’s vital signs. On a down day like today, I expect to see some more bullish bias creep into some of my contrarian sentiment indicators; much to my surprise, today things actually look worse for the bulls in that regard.

Now that it has been more than two months since I posted the chart below, I thought this evening might be a good time to update the three sectors I have been watching most closely since the March bottom. These 'indicator species' sectors are the financials (XLF), homebuilders (XHB), and consumer discretionary (XLY) stocks. As the chart shows, the financials and homebuilders recently moved above their 50 day simple moving average, only to fall sharply below that important technical level over the course of the past three days.

Until the XLF, XHB, and XLY can all close above their 50 day simple moving averages, I am likely to be skeptical of anything that has the appearance of a rally.

Friday, July 25, 2008

Sector Performance in the Last Two Bull Moves

I have been fielding a bunch of questions about sectors, particularly oil and energy, over the past few days. Included in most of my responses has been a comparison of the March to May bull move and the most recent move that came off of the July 15th bottom. Since I rarely repost content from my subscriber newsletter, I thought it might be a good excuse to cut and a paste a section from Wednesday’s newsletter on sectors:

Let me reflect on the nature of the March to May rally from SPX 1256 to SPX 1440, a gain of 184 points. As shown in the sector breakdown (top graph), there was strong sector participation across the board. Interestingly enough, energy was the top performing sector, followed by technology and materials. Financials fell in the middle of the pack.

Fast forward to the past six trading days and we have the SPX now 82 points above the low. This is not quite half the move of the March to May rally, but an impressive showing for a little more than one week of work. Note how the sector breakdown looks quite different in the current rally (middle graph). The extent to which financials have powered the recent move is impressive, if a little lopsided. Note that only financials are the only sector to have made larger percentage gains in the current rally than in the March to May move. In fact, besides financials, only the industrial and consumer discretionary sectors have made at least half of the gains from the earlier rally in the more recent rally. All the other sectors have made gains of 3% or less, with energy and utilities showing losses.

The bottom chart uses the same data as the middle chart, except that percentage gains and losses are net of the performance of the S&P 500 index. This confirms that the financials are the only sector really responsible for moving the SPX. The consumer discretionary sector has provided a small lift and the industrials are just narrowly beating the SPX, but without participation from financials, this rally would have a much different look and feel.

Thursday, July 24, 2008

Headwinds Again?

I was traveling today and missed all of the market action. It certainly looks like it was an interesting day, as the headwinds index showed a turn back toward the old long energy and short financials trade. True the energy sector did not rise today (all nine of the AMEX sector SPDRs were down), but it did show some signs of stabilizing.

When I need to get caught up on the best of blogland, the first place I visit is Abnormal Returns, which has a knack for consistently cherry picking the best of what is out there.

For those who need a VIX fix, look no further than Adam of Daily Options Report in That Old VIX Magic, and long-time favorite Michael Stokes of, whose The VIX Isn’t Magical is a can’t miss article today.

Note that Michael Stokes is one of many to weigh in on the question I posed on Monday: Does the VIX Have Market Timing Value? Check out the comments section for some interesting give and take from a wide variety of ably articulated perspectives, including a recent take from the highly skewed Kurt Osis…

I should be back at it tomorrow, same time, same channel, probably long natural gas and short the banks, maybe even nibbling on a few more VIX calls.

Wednesday, July 23, 2008

Headwinds Index: How Long Can Financials Outperform Energy?

Two weeks ago, I introduced something I called the headwinds index, a simple ratio of financials (XLF) to oil (USO). It took another week for that index to bottom and the markets to rally, but since that bottom, financials have jumped 37% while crude oil has fallen 14% from its peak. The headwinds have turned into a strong tailwind, at least for the past six days.

The question, of course, is how long financials can continue to gain ground before a new long oil, short financials trade becomes too attractive to pass up. Several of my indicators suggest that the tailwinds are about to dissipate in the next day or two; after a strong opening, today’s developing gravestone doji also calls into question the staying power of the recent trend reversal.

At a minimum, I suspect the new tailwinds have gotten ahead of themselves. When they start to move back in the wrong direction, there is little reason to remain in the long financials, short oil trade past its useful life. As sailors are fond of saying, “tack on a header!”

Tuesday, July 22, 2008

Natural Gas Implied Volatility Spiking

Perhaps it is just a coincidence that the “Oil VIX” appeared on the scene just as the implied volatility in oil futures (or at least as captured by USO) was hitting an eight month high. The “Oil VIX” (formally known as the CBOE Crude Oil Volatility Index; ticker OVX) and crude oil may get the lion’s share of the energy headlines, but lately it has been natural gas that has been making the more dramatic moves.

A look at the three month chart of UNG (the natural gas ETF that is the counterpart to USO), courtesy of the ISE, shows implied volatility steadily increasing over the past five weeks, with the gap between implied volatility and historical volatility continuing to widen – all while natural gas has pulled back about 27%.

Natural gas implied volatility levels are higher than oil implied volatility levels at the moment, and the pullback in natural gas presents some interesting trading opportunities. Some momentum players are already short here and some value hunters are buying on weakness, particularly if they believe in the long-term commodity bull and other supply and demand issues that are specific to natural gas.

The case for natural gas trading sideways from current levels is hard to make. Directional bets are expensive, due to high IV. Two trades I am looking hard at, with a bullish directional bias, are bull put spreads and call backspreads. The former limits upside and downside; the latter is more aggressive and more risky.

Monday, July 21, 2008

First; Now

First there was, a nice little site to practice your technical analysis skills with what is essentially a chart trading simulation program, where you start with $100,000 and use charts, moving averages, and volume to make long or short bets on the stock charts that are presented at random. This is a fun site that is both educational and addictive.

Upping the ante a little, now we have While Chartgame lacks the shorting option (even if you can "pre-borrow" the shares) of Inspected, it adds some all-important customizable indocators: RSI; MACD; and Bollinger. One other feature I like most at Chartgame is the ability to let time pass and optimize entries and exits rather be forced into the more limited buy/sell/skip now options that are available with the Inspected version of the game. This is a good way to sharpen discipline for entries and exits alike.

Technical analysis practitioners and aspiring TA students can learn a lot about chart pattern recognition from these two sites. I recommend giving them a test drive.

Time for Reader Input: Does the VIX Have Market Timing Value?

I am going to try something different today: I’ll frame an issue in the context of an article from a highly regarded pundit, skip my own commentary, and ask for readers to weigh in with their thoughts. We’ll see how this works, if it works at all…

First, a quick summary of the pundit and the issue. Mark Hulbert, who I happen to think highly of, is out today with an interesting point of view in Putting on the VIX over at MarketWatch. The subtitle, “Commendary: Not necessarily bullish that VIX briefly rose above 30 last week” summarizes Hulbert’s position nicely, but I want to highlight several quotes from the article.

First, let me start with Hulbert’s conclusion:

“Even in those situations in which the VIX does appear to have statistically significant ability to forecast market movements, it turns out that those abilities largely derive from no special insights on the part of the VIX itself, but instead because of the stock market's tendency to rebound after steep corrections.

I owe this latter insight to Samuel Eisenstadt, research director at Value Line, Inc. Eisenstadt several years ago designed an econometric test to see if high VIX readings contain any unusual market-timing information after market declines, above and beyond the already-apparent fact that the market has just fallen. He came away empty-handed. High VIX readings tell us nothing more than we would already know from casually reading the news headlines.

The bottom line? The stock market may indeed continue to rally over the next several weeks. But if it does so, it won't be because the VIX momentarily rose above 30 last week.”

Early on in the article, Hulbert makes the case for the attractiveness of the VIX as follows:

“…consider first how the stock market performed over the subsequent month following a VIX close above 30: On average over the past 18 years, it gained 3.8% (as measured by the Dow Jones Wilshire 5000 index). In contrast, the stock market gained just 0.7% over the subsequent month following VIX closes below 30… Furthermore, similar contrasts existed at the quarter, six-month and 12-month horizons.”

Hulbert then goes on to refute the data for VIX closes above 30:

“…there's no way of knowing how high the VIX will rise when it first crosses the 30 threshold. Sometimes, like last week, the stock market immediately rises when that ceiling is broken, leading in most instances to the VIX falling back below 30. On other occasions, however, the stock market continues declining despite the VIX rising above 30, causing the VIX in most cases to continue rising. The all-time high for the VIX is 45.74.

So even though, other things being equal, higher VIX readings are more bullish than lower ones, there's nothing particularly magical about the 30 level.

To correct for this sleight of hand, I focused on just those occasions in which the VIX initially broke the 30 ceiling, after having been below 30 for at least three months previously. The data now painted an entirely different picture: Following those occasions, the stock market on average performed no better than it did the rest of the time.”

Readers, what do you think? Do you find Hulbert’s arguments convincing? Why or why not? What other important perspective and/or data do you think Hulbert is overlooking here? I would be interested in hearing some reader opinions in the comments below.

Friday, July 18, 2008

Are Commodities Reversing or Consolidating?

It has been a dramatic week in the markets, with the long oil and short financials trade reversing hard and a number of the relationships that have been intact for the past nine months being thrown into disarray.

As I have been maintaining since early in the year, speculative money is likely to be flowing into either commodities or equities, but not both. That basic premise has not changed, but what has been called into question is whether the second half of 2008 will be more friendly to commodities or equities.

I believe the answer to the commodities or equities conundrum is that it is still too early to tell, but commodities still have to be considered the preferred asset class. Two charts below tell a good deal of the story. The first graphic is a weekly chart of the Reuters/Jefferies CRB index, which is heavily weighted toward energy. It shows that the recent pullback in commodities is consistent with previous pullbacks and consolidation periods. Neither the magnitude nor the duration of the recent reversal in the bullish commodities trend suggests that the bull market in commodities is winding down.

The second chart last appeared on this blog two months ago. It reflects the ratio of the commodities basket in the Rogers International Commodity Total Return Index (RJI) to the SPX. [RJI is an ETF linked to the Rogers International Commodities Index that has a broad weighting, with less emphasis on energy than most commodity indices] The ratio chart also shows much more of a consolidation ongoing in the present market environment than a reversal.

Of course, one more week of soaring financials and plummeting oil prices will dramatically change the tone of the chart, but for now at least, consider the commodities trend to still be intact (and susceptible to buying on the dips), which means the case for a reversal in equities is still a weak one at this stage of the game.

Thursday, July 17, 2008

First Impressions of MSI Wind

I have had a new MSI Wind ultra mobile laptop in the house for 24 hours now. This laptop has a 10” screen, 80 GB hard drive, Atom processor running at 1.6GHz, and is pre-loaded with Windows XP. All this comes with a footprint of only 10.2” x 7.1” and tips the scales at only 2.3 lbs. [full specs are available from the MSI site]

In the interest of full disclosure, I am such a laptop aficionado that in my two decades plus of computing, I have never owned a desktop. Back in the day, I toted around a Toshiba T1000 for two years on an airplane before I saw anyone else attempting to carry on another laptop; since then I have gone through literally dozens of laptops, including a 3.4 lb. Fujitsu LifeBook P7010 when those 10.6” screen models were first released several years ago.

So…when I saw the MSI Wind coming, I jumped.

My experience so far has been mixed. MSI has managed to stretch the keyboard out so that it takes up the entire 10.2” width of the machine (see photo). This is still almost two inches smaller than a standard laptop keyboard space, but the results are workable, given a little time to adapt. As is usually the case with non-standard keyboards, the problem is not so much getting used to a new configuration as it is alternating between that configuration and another keyboard.

So far the screen is the biggest limitation I have had to contend with. The 1024 x 600 resolution is certainly acceptable, but the issue for me is that there is not much in the way of real estate beyond what is required for email. It is possible to use a browser, but that experience is a little too much like walking around the house with a pair of binoculars strapped to your eyes. I can manage quite nicely with a 14” inch screen and find that a screen in the 13” range is workable, but at 12” and below I feel as if I have a mobile communications device rather than a laptop. Ultimately it all comes back to form factor.

So I am left to wonder if the proliferation of Asus Eee-inspired mini-laptops will find their niche. In all fairness, my wife loves the machine, but she uses it mostly for email and light browsing. You can always hook it up to a big LCD display, but then the other compromises seem more annoying: the undersized keyboard; the middling processor; etc.

I may have to wait for a foldable display and keyboard…

How 'Bout Them Earnings?

Bespoke Investment Group has a surprising statistic out this morning: with 11% of the S&P 500 companies reporting, Bespoke has calculated the current quarter's EPS beat rate to be 72%. There are a lot of earnings reports still to come, but if it holds, the 72% beat rate will be the second highest in the past decade.

Even more impressive is the additional statistic that 34% of the companies that have already reported are in the financial sector, which has to be considered among the most earnings challenged in the current environment.

The beat rate will be an important trend to watch.

Wednesday, July 16, 2008

XLF Volume Spikes 3.3 Standard Deviations Above Mean Yesterday

If I could pick only one ticker to watch in order to gauge the market’s health in the current environment, it would probably be XLF, the most popular of the financial sector ETFs. You could make an argument for RKH, the regional bank ETF, XBD, the broker dealer ETF, or any number of others, but XLF covers the entire financial sector, from Allstate (ALL) to Zions Bancorp (ZION).

With all the talk about the degree of a VIX spike needed to signal a bottom and other measures of capitulation, I am surprised I have not heard anyone else mention the volume in XLF yesterday. As shown in the graphic below, XLF traded over 469 million shares yesterday, eclipsing the previous volume record (set just last Friday), by over 150 million shares. The 469 million share turnover also represents 3.3 standard deviations above the mean, which translates into an extremely unlikely event. [Note that in the chart below, the Bollinger band settings for volume are for 3 standard deviations instead of the default 2 setting] This is capitulation-level volume in the sector that is most important to the stock market at the moment. If XLF can weather all the financial sector earnings due out tomorrow, I suspect that a bottom will be in for the financial sector.

Tuesday, July 15, 2008

CBOE Launches "Oil VIX" (OVX)

Today the CBOE launched an "Oil VIX" (OVX) based on options on the USO crude oil ETF.

According to the CBOE press release, the exchange is in the process of expanding their volatility index product line into commodities and foreign currencies.

I think this is an exciting development that just happens to fit nicely with several chapters in my upcoming book.

I'll have a lot more to say about the OVX and other CBOE volatility products going forward.

Bernanke and Moody's May Have Accelerated Formation of Bottom

As I type this, the Dow Jones Industrial Average is down about 200 and the VIX has spiked to 30.79, largely as a result of prepared remarks by Ben Bernanke and a downgrade by Moody's of Fannie Mae (FNM) and Freddie Mac (FRE).

As a result of these two developments, some capitulation activity has been accelerated and the likelihood of an intermediate bottom forming today, tomorrow or Thursday is now over 95%.

Monday, July 14, 2008

Volatility and Sentiment Tidbits…and Today Doesn’t Matter

Some semi-random thoughts inspired by today’s market action:

  • The VIX:VXV ratio spiked up to 1.12 at 1:12 p.m. EDT (I’m not superstitious, but that’s an interesting bullish signal)

  • The underappreciated VXN (volatility index for the NDX or NASDAQ-100) spiked over 34 on Friday and made it as high as 33.76 earlier today. That’s not enough to satisfy the “VIX must spike over 30!” purists, but it is an interesting data point, particularly because the VXN and NDX excludes financials

  • My VIX algebra says that two medium to large VIX spikes on Friday and today do not equal one large capitulation-friendly VIX spike

  • The CBOE equity put to call ratio – an excellent market timing indicator – is looking bullish

When all is said and done, I don’t think we can have a serious market rally until the tone of the news flow changes, regardless of market technicals and sentiment data. There must be several bullish macroeconomic and/or fundamental data points which collectively give the bulls a reason not to be so skittish. At a minimum, the markets need to navigate the PPI, CPI, industrial production and capacity utilization data due out tomorrow and Wednesday, then weather the flood of earnings reports (with strong representation from some key financial institutions) on Thursday. Even then, there is the Citigroup (C) earnings story on Friday morning.

Whatever happens to the rest of today’s session, the balance of the week will tell the story.

Friday, July 11, 2008

VIX:VXV Ratio Now at 1.10

The VIX:VXV ratio has just hit the 1.10 level, which I consider to be a strong buy signal.

For the record, the 1.10 reading was reached at 12:28 p.m. EDT, with the VIX at a level of 28.97 (+13.21%)

Implied Volatility at Fannie Mae (FNM) Tops 400

Not that this should surprise anyone who has been following this story, but it is an impressive number nonetheless and deserves to be captured here for archival purposes at the very least.

VIX:VXV Ratio Tops 1.08, Signals a Buy

For those out there who have become fans of the VIX:VXV ratio, just a quick heads up that it just moved over 1.08 to generate the first buy signal since mid-March.

For more on the VIX:VXV ratio, click on the link above or the label below.

Thursday, July 10, 2008

Implied Volatility of Top Three SPX Sectors

Yesterday, in The Impact of Financial and Energy Stocks on the VIX, I talked about the low (and sometimes negative) correlation between the SPX and some of the sectors represented in the index.

Today I am posting a graphic of the top three sectors (per the Sector SPDR breakdown) in the SPX: technology (XLK: 19.7%); energy (XLE: 15.3%); and financials (XLF: 14.2%). The graph shows a strong correlation between the implied volatility of the SPDR sectors. This should come as no surprise.

Some readers have expressed confusion about correlations between prices and implied volatility. The key takeaway is that SPX implied volatility is not cumulative. The net implied volatility of the SPX is a function of not just the implied volatility of the components or sectors, but also of the directional pull. Let’s take a simplified example. Consider a hypothetical situation in which XLK and XLE are both 18% of the total SPX and both have an implied volatility of 40. If both are perfectly correlated, then 36% of the SPX should have an implied volatility of 40. If, on the other hand, XLK has a correlation of +1.0 (100% positive correlation) and XLE has a correlation of -1.0 (100% negative correlation), then the two sectors cancel each other out and the ‘net implied volatility’ for this 36% slice of the SPX is an even zero.

As a general rule, the higher the correlation among the sectors and individual stocks, the higher the net implied volatility. High implied volatility combined with low or negative correlations generally translates into lower net implied volatility.

For some more detailed individual research into this topic, I recommend Don Fishback’s Index Implied Volatility Is Based on Correlation and Time – It’s Not Just Magnitude!

Wednesday, July 9, 2008

The Impact of Financials and Energy Stocks on the VIX

The rapidly changing fortunes of financial institutions and energy stocks have been widely chronicled – so much so that there is no need to repeat the details here.

The implications of the shift away from financials and toward energy touch upon several issues that I have not yet seen addressed in the media. One of the obvious ones is the composition of various stock indices. In the S&P 500 index (SPX), for instance, just from 2007 to the present, financials have dropped from 22% of the index to 14% of the index, while energy stocks have surged from 10% to 16% of the index. The change is particularly important when one considers that financials (XLF) have historically been highly correlated to the SPX (0.91 over the course of the past year), while the energy sector (XLE) has typically had the lowest correlation to the SPX (-0.28 for the past year).

Consider that in the past year, the index has been tilting away from financials and toward energy stocks, essentially swapping a positive 0.91 correlation for a negative 0.28 correlation. Given that the VIX is based on SPX options, there can be little wonder why the VIX has been moving more lethargically as of late: an increasingly dominant sector – the energy group – is pulling in the opposite direction of the other sectors. The result? Sector gridlock is dampening the movements of the SPX and of SPX derivatives, like the VIX.

[Hat tip to Adam at Daily Options Report and Don at Don Fishback's Market Update for jump starting some of my thinking on this subject.]

Tuesday, July 8, 2008

Headwinds Index: Financials (XLF) vs. Oil (USO)

Two numbers have been moving consistently in the wrong direction for the US economy during the past few months: oil prices and bank loan portfolio quality.

The chart below, which reflects a ratio of the valuation of financials (XLF) to crude oil prices (per the USO ETF), neatly captures the recent double threat posed by trends in these two sectors.

You can make an excellent argument that a bottom will not be in until at least one of the two trends, probably both, have reversed. My thinking is that the XLF:USO ratio chart is an excellent tool to monitor those two trends and pinpoint the turnaround. At the very least, I consider the XLF:USO ratio to be a reasonable proxy for two of the major headwinds that the markets are grappling with.

Monday, July 7, 2008

VIX:VXV Ratio Approaches Bullish Territory

One of the better indicators over the past 7 ½ months has been the VIX:VXV ratio, which, as the chart below shows, has been quite accurate in calling tops and bottoms in the market following the VXV launch back in November 2007 and I whose application I pioneered soon thereafter. I mention this because the last time the VIX:VXV ratio gave a clear bullish signal was at the mid-March bottom; and the ratio is coming close to another VIX:VXV bullish signal today.

For more information on the VIX:VXV ratio, try The VIX, VXV and Volatility Expectations. For more information about the VXV, try Thinking About the VXV.

Thursday, July 3, 2008

On Measuring Volatility

Mike at has a good post up today with the title of Measuring Volatility. He touches a lot of bases, but it all starts with the following statement:

“When it comes to measuring or sensing stock market volatility, I do not follow the VIX.”

Now I may have invented that silly tagline, “Your one stop VIX-centric view of the universe,” but I am the first to argue that a defaultist mind set is the wrong way to approach the investment landscape. If you follow the same indicators with the same default settings as everyone else, you are setting yourself up not just to follow the crowd, but to be a half step behind it. In order beat the crowd, what is needed is a variant perception.

Back to HEDGEfolios for a moment:

“The key element of volatility using traditional methods like the VIX rests on the reversal at extremes in a contrarian indication such as buying when the VIX exceeds 30. This is a very dangerous concept and I do not advocate for its use… I never liked that approach so I do my own thing and look at each stock, the turnover in each and how the composite of all signal changes indicates the market volatility.”

Volatility is a wide-ranging concept. It can be defined, measured and applied to over 10,000 stocks and ETFs in many different ways. To think that best way to harness information about volatility is to buy when the VIX hits X is ludicrous.

Consider that the concept of volatility can be applied not just to price, but to volume, options prices, market breadth data, etc. Volatility is a characteristic of every slice of the almost infinite flow of data that is associated with the markets.

It’s not just what you measure, it’s how you measure it. Volatility can look forward when it is in the form of a forecast or a derivation, such as implied volatility. When volatility looks backward, the opportunities to get creative are even richer. There is historical volatility, average true range, Bollinger bands, Chaikin volatility, relative volatility, and a variety of ways in which to index volatility.

Go ahead and watch the VIX, but don’t think for a moment that you are going to have an advantage over the thousands of other people who are watching the same indicator. Sure, you might come up with the next great VIX permutation, but you are far more likely to get a leg up on the competition by revisiting some basic questions:
  • Is volatility worth following?
  • How can more knowledge about volatility make me a better investor?
  • Which aspects of volatility should I pay attention to?
  • How should I measure that type of volatility?
  • How do I interpret those measurements for maximum ROI?
One of my favorite measures of volatility is the number of buy and sell signals my various systems generate each evening. It’s simple, but effective. And I can be sure that nobody is not going to show up on CNBC tomorrow touting the same approach.

Wednesday, July 2, 2008

Getting Tougher to Push Financials Lower from Here?

Halfway through today’s session, my screen is once again filled with red, as the indices look as if they are poised to take a run at yesterday’s lows.

From a sector perspective, the picture is considerably muddier, as two recent laggards, financials (XLF) and consumer discretionary (XLY), are clinging to positive territory as I type this. As I see it, one or the other of these sectors will have to continue to deteriorate if the markets are going to continue lower from current levels.

Given that the financials are already down 53% from their May 2007 highs (see chart below), it is important to keep in mind that the easy money has already been made on the short side. A wide variety of financial sub-sectors (mortgage companies, bond insurers, money center banks, regional banks, investment banks/brokers, etc.) have already made multiple trips to the woodshed – and while some individual issues may still be quite vulnerable going forward, there is a limit to the amount of blood that can be squeezed from a broad-based ETF or index.

Going forward, I suspect the risk/return profile of the financial sector may actually favor the bulls. If the next couple of broad market moves down fail to pull the financials with them, the path of least resistance for the likes of XLF may indeed be up. Keep an eye on this development, because if (and admittedly this is a very large “if”) the financials are done falling, then the markets are likely to be ready to put in a bottom too.

Tuesday, July 1, 2008

Fearogram Maps Recent VIX Complacency

There has been so much talk about complacency in the VIX that I thought I should dust off the old fearogram and see just how complacent the VIX has been as of late.

For those who are new to the concept of the fearogram (a term I hatched last October), it is essentially a chart of the daily change in the VIX vs. the daily change in the SPX. (For more background on the fearogram concept, try previous posts with the fearogram label.)

The chart below plots a best fit diagonal black line which represents a ratio of the daily percentage change in the VIX to the daily percentage change in the SPX for every trading day going back to 1990. Essentially, the larger the distance between individual data points and the fearogram best fit line, the more extreme the level of fear or complacency. For data points above and to the right of the best fit line, the VIX is increasing out of proportion to the drop in the SPX, indicating more fear. For data points below and to the left of the best fit line, the relatively muted reaction of the VIX suggests more complacency. Data points that hug the best fit line are indicative of a VIX that is consistent with typical historical relationships between the VIX and the SPX.

In the chart below, the blue diamonds are plots of individual daily ratios of VIX and SPX percentage changes for each day during the past two weeks. In studying the chart, note that during the past two weeks, the VIX has never once shown more fear than is reflected in the average daily ratio.

Of course, today is looking like it could be the day the tide finally turns.

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