VWSI at Zero Pre-FOMC

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

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

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

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

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

NASDAQ 100 Taking NASDAQ Composite for a Ride

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

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

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

Two Thoughts on the McClellan Summation Index

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

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

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

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

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

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

Four Generals Will Tell the Story

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

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

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

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

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

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

Fibonacci Retracements and Trading Ranges

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

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

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

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

How Fearful Were We Last Week?

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

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

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

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

Portfolio A1 Pulls Away from SPX

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

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

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

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

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

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

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

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

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

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

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

A Small Pimple

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

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

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

Random ‘Crash’ Generator

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

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

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

Back to our regularly scheduled market correction…

Portfolio123.com: The Engine Behind Portfolio A1

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

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

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

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

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

Correlation Ideation

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

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

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

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

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

Portfolio A1 Gains 9.8% in Week

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

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

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

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Back to Zero. Was That the Bump?

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

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

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

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

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

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

From Overripe to Vulnerable?

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

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

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