VXN Reversal Signal

The attached chart shows the VXN (volatility index for the NASDAQ-100 or NDX) over the past five years, with a 10 day simple moving average, flanked by dotted lines representing 20% above and below the 10 day SMA.

Anybody who has been paying attention knows that the last several days have been highly unusual. As the chart shows, the VXN, which rarely closes outside of those 20% bands, is currently 38.2% above the 10 day SMA. This is about as extreme as it gets for volatility outliers and suggests a high probability of a sharp reversion to the mean in the VXN, coincident with a bounce back in the NDX.

For the record, the same market bottom signal is coming from the VIX and SPX, but without the extreme reading that is characterized by the VXN and NDX. By contrast, the signal from the RXV and RUT is substantially weaker and only marginally tradeable.

Volatility signals with this level of confidence are extremely rare, so if you are looking for an excuse to get long in a big way for the short term, or to trade VIX along the lines recently suggested by Brian Overby, today is an excellent opportunity to try to time the markets.

NASDAQ Chart with Hourly Bars

On Friday I posted a weekly chart of the NASDAQ going back six years. Today I am swapping the wide angle lens for a telephoto one and focusing on hourly bars for the past month. I am emphasizing the NASDAQ Composite (and the NDX) because that is where a good deal of the speculative activity has been as of late and where the correction was most severe last week.

The graph below shows four semi-arbitrary simple moving averages for the NASDAQ Composite Index: 13 bars; 20 bars (the faint dotted gray line in the middle of the Bollinger Bands); 30 bars (the same as the Williams %R time frame); and 100 bars. All this spans roughly a period of 1 ½ days to about 3 weeks. With the aforementioned Bollinger Bands and Williams %R data, as well as the Fibonacci retracement lines, there are many ways to keep score. As much as anything, however, I will be looking at the intensity and duration of the bull rallies off of the bottom. Given that many indicators point to the current situation as significantly oversold, the absence of a compelling bull rally may provide as much information as what is actually happening. In other words, a draw should favor the bears.

Finally, I still haven’t seen much in the way of fear yet…

Portfolio A1 Increases Lead Over SPX as Markets Drop

After the disastrous mid-August performance, it was heartening to see Portfolio A1 outperform the benchmark S&P 500 index during last week’s market turbulence. While the margin of outperformance was small, this now means that the portfolio is up 9.6% since the February 16, 2007 inception – a period in which the SPX is down 0.1%.

Some of the portfolio’s individual holdings did not fare particularly well during the week, with the result that the stock ranking system has elected to drop DryShips (DRYS) and StatoilHydro (STO). These stocks are being replaced by China Petroleum & Chemical Corp., more commonly known as Sinopec (SNP), as well as Perini (PCR), the large Boston-based construction company. In spite of the very strong year it has had, I am not sure I would be chasing Perini at this point, but, this being a mechanical portfolio, all I can do is raise an eyebrow and be prepared to eat some crow.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Hits -9 as VIX Spikes

In a week where technology stocks were hit harder than financials for the first time in a long time, the VXN rose 30.1% while the VIX rose 23.9% or 5.49 points. Coming on the heels of last week’s 17.6% jump in the VIX, this marks only the third time this decade that the VIX has risen 15% or more in two consecutive weeks, with the two previous instances being two weeks in the middle of May 2006 and the two weeks spanning 9/11.

Even with the VIX printing a rare -9 reading (the third -9 in four months, but only the fifth in the past six years) and the NASDAQ registering the biggest weekly drop in five years, the selloff had a relatively orderly feel to it – at least so far. The fact that the VIX is still ten points below its mid-August high suggests a lack of panic, as does the below average fearogram readings for the SPX:VIX ratio on both Thursday and Friday.

In addition to the extra spice of options expiration, next week’s government data includes a hearty broth of October retail sales data (Wednesday), October consumer prices (Thursday), and October’s industrial production and capacity utilization figures. Earnings season continues, with a healthy does of retail and technology earnings on tap as well.

For a comprehensive look back on last week and a glance at what the coming week may have to offer, I recommend the following links from Barry Ritholtz at The Big Picture:

• Week in Review
  
  
• Week in Preview

While the -9 VWSI reading suggests a likely bounce in the coming week, my Where’s Waldo analysis tells me that long red candles in the NASDAQ rarely trigger bounces in the following week. Given that history, the relative lack of fear in the SPX:VIX ratio, the failure of the ISEE to drop below 100 last week, and several other factors, I enter the week by carrying over my bearish bias. I will be watching closely to see what sort of enthusiasm the bulls put into efforts to establish a bottom and threaten yet another quick retracement. This time around I expect it to be at least as difficult as it was in the summer of 2006 for the bulls to push the markets back to new highs, but…this selloff is still early.

(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 -9, I continue to recommend carmenere as an ideal pairing. The last time around, I sugested a Concha y Toro 2003 Terrunyo Carmenere, some favorite carmeneres listed at Cellar Tracker, and an American effort at Dover Canyon. For ideas about varietals I do not have a lot of experience with, I often check out what is selling at one of San Francisco’s best wine stores, K&L Wine Merchants. A quick search on their site yields a good number of carmenere blends, as well as several selections where carmenere is the dominant varietal.

Where’s Waldo?

The markets have not been a lot of fun and games for the past couple of days, so I thought this might be a good time to play ‘Where’s Waldo?’

For the sake of argument, instead of that trademark red and white sweater and cap that often gives him away, imagine that Waldo is a long red candlestick followed by anything that looks like a strong bounce back week immediately thereafter. Can you find a Waldo that looks like this? While there are many long red candlesticks, I can’t find one Waldo – at least looking at the NASDAQ weekly chart going back six years. Don’t forget that almost the entire period covered in this chart is a raging bull market, so the bias should be bullish and there should be a bunch of Waldos.

How many longs will be brave enough to hold over the weekend? My sense of the current market is that the ugliness continues at least into the first half of Monday’s session, at which point the bulls will have their first chance to show what sort of firepower they still have left.

Disclaimer: I am short Waldo as this goes to press.

The Week in Fear

Since I’m going to have to give a name to this concoction, I’m going to call it my weekly fearogram. Why not? "Fear plot" sounds a little too Halloween for my taste.

In any event, in the chart below, just like its October 22^nd and October 3^rd predecessors, I attempt to show how the daily SPX:VIX ratio compares to the median ratio for 18 years of data. Interestingly, the chart shows a surprising amount of fear on Monday, followed by middling sentiment on Tuesday, before an atypical amount of fear kicked in yesterday. Perhaps because the market opened in a relatively benign fashion today compared to some early futures projections, fear is actually below normal for the trading day so far.

In between bouts of intensive trading, I am back-testing this fearogram data and hoping to provide an appropriate interpretive framework soon. My initial hypothesis is that the absence of fear will make it easier for the current pullback to continue.

FXP Is Here

Talk about a timely launch!

As I mentioned last week, FXP, the double inverse of the iShares FTSE/Xinhua China 25 Index (FXI), has begun trading today. FXP is already showing up in Yahoo Finance, but has yet to appear in Google Finance.

Already showing some liquidity, FXP has traded 70,000 shares in the first 50 minutes. Watch the price and the volume on this one.

BIDU Fibonacci Targets

In measuring back to the mid-August low, I calculate BIDU's Fibonacci retracement targets to the downside to be 326 (38.2%), 295 (50%), and 263 (61.8%). This could get interesting.

Brian Overby on Trading VIX Options

Steven Smith of TheStreet.com has a video interview up in which he asks Brian Overby for his thoughts on how to trade VIX options.

Overby, who is Director of Education at TradeKing and authors an informative options blog, Options Guy, tackles some of the idiosyncrasies of the VIX and has some excellent suggestions for those who insist on trading the volatility index. Frankly, there is close to 100% overlap between what he says and what I believe about the VIX.

I recommend clicking through to the video, but in a nutshell, Overby’s thinking boils down to the following:

1. VIX options do not follow the (cash) VIX index
   
   
2. To understand the price action in VIX options, look at VIX futures
   
   
3. When trading VIX options, trade the front month (closest contracts to expiration)
   
   
4. Trade VIX options when the VIX is at the extremes of its trading range
   
   
5. Utilize a mean reversion trading strategy
   
   
6. Look to sell vertical spreads (sell puts when the VIX is low; sell calls when the VIX is high)

SPDR Check: Technology and Financials

Back in August, I posted about some interesting divergences in implied volatility in the technology and financial sectors. Fast forward two and a half months and with Citigroup (C), Merrill Lynch (MER) and their brethren in the dog house while Google (GOOG), Research in Motion (RIMM) and the most of the other large cap tech stocks on a tear, the story has morphed from diverging implied volatility to diverging performance and future expectations.

So this seems like a good time to look at my favorite AMEX Select Sector SPDRs again to see what has happened. In the chart below, I compare the plight of XLF, the financial sector SPDR (XLF top holdings), to XLK, the technology sector SPDR (XLK top holdings.) Where I see the big divergence in performance is following the second week in October, from which point the financials have been beaten down almost as badly as they were during the dramatic July-August drop. The interesting part this time around is technology stocks, which fell in sympathy with financials during the summer, yet have been almost unassailable during the past three weeks.

I am skeptical that the market can continue to remain in a bullish mode without the participation of the financials, yet, on the other hand, the fundamentals of technology stocks do not seem to warrant that they join financials on the bear side of the ledger. For now at least, the bears will have to be content with claiming victory in the financial, consumer discretionary and real estate sectors, while the bulls control the majority of the remaining sectors. Eventually, I expect all the bulls or all the bears to capitulate in a dramatic major move. I’m not sure whether the move will be up or down, but each sector skirmish will provide some additional clues.

BIDU and FXI Going Separate Ways Today

Last week I detailed the components of the iShares FTSE/Xinhua China 25 Index (FXI), the ETF that began the day with a gain of 87% for 2007.

With year to date gains of 263% for the same calendar year, Baidu (BIDU), the internet search juggernaut occasionally referred to as ‘the Chinese Google’ appears to be playing a different game altogether – and in some respects it is. BIDU is not part of the FXI, but it has garnered considerable attention in the western press for its dominance in the Chinese search market. BIDU has also seemed to be impervious to the recent tech selloffs as well. This morning the stock even shook off the biggest drop in Hong Kong stocks since 9/11 as well as some negative commentary in Barrons (a preference for GOOG over BIDU) to turn a 9 point loss into a 12 point gain. While this is indeed an impressive performance, what is most impressive of all is that today’s price action in BIDU has come while the FXI has been struggling with a loss in the area of 7-10%.

All of which leads to the chart below. I have been speculating that many of the 240 points BIDU has tacked on since mid-August are at risk before the end of the year and now wonder whether the separation from FXI on the chart may not just be a visual jumping of the shark, but a metaphorical one as well. BIDU has printed several bull flags in the past few months that have proved to be pauses on the way up. If the stock continues up while the FXI heads back to earth, I will be looking to buy BIDU puts on the first sign of weakness.

Portfolio A1 Stretches Margin Over SPX to 9.6%

Continuing the strong bounce off of the mid-August lows, Portfolio A1 exited the week with fewer scars than that of the benchmark S&P 500 index. Now up 13.3% since the February 16, 2007 inception, the portfolio’s performance compares favorably to a 3.7% gain in the SPX. In spite of the recent performance, as I have discussed previously, I will retire the 100% mechanical Portfolio A1 at the end of the calendar year and replace it with a more complex portfolio that incorporates some discretionary thinking and more active management on my part.

This week one marginal performer, Shanda Interactive (SNDA), the Chinese internet company, is being dropped from the portfolio and will be replaced by StatoilHydro (STO), the state-owned Norwegian oil giant.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

Selloff in Financials Jolts VIX; VWSI at -3

The Fed gave the markets a 0.25% rate cut, but in the 2 ½ days that followed, investors did more selling than buying, pushing the VIX up 3.45 points (17.6%) to 23.01 by the end of the week and marking the highest close in the VIX in seven weeks.

Commercial banks and other financials helped to increase investor anxiety, with Citigroup (C) and Merrill Lynch (MER) causing most of the consternation. For a superb summary of the week that was and the week that might lie ahead, I highly recommend reading up on what Barry Ritholtz at The Big Picture has assembled (I think I’ll make these links a regular feature of my weekly VWSI update):

• Daylight Savings Linkfest: Week in Review
  
  
• Daylight Savings Linkfest: Week in Preview

Turning to the VWSI, the increased volatility helped to push the dial to a VWSI of -3 by the end of the week. The last time the VWSI closed the week at -3 was back in the first week of 2007, when the ‘spike’ to 12.14 initially looked like an aberration, as the next seven weeks saw the VIX close in the 10s and low 11s. Of course, everything hit the fan on February 27^th and it has been a different investing environment ever since. I have no reason to predict that the current -3 reading may come at a similar juncture, but it is always instructive to look back at recent history and try to imagine how the current market lens differs from the already outdated one.

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

Wine pairing: For a VWSI of -3, I suggest a versatile light red wine. No, not a Beaujolais (even though another Beaujolais nouveau release date is soon approaching) or the gamay grape behind the wine. No, not a pinot noir either. Instead, I recommend something old and something new: a barbera. This grape is widely planted in Italy and is used frequently as a blending grape, both in Italy and in the United States.

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

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

Odds and Sods

Friday is always a good time to do some housekeeping, so here are some updates to recent themes in the blog:

In terms of fear, yesterday showed a fair amount of it, as the 25.3% increase in the VIX is about twice the median for a 2.6% drop in the SPX. While today’s markets seem to have settled down a little after an exciting opening, the elevated fear persists. For those who may be interested, you can always eyeball today’s VIX and SPX percentage changes on my fear-complacency graph to make your own assessment.

Now that the Fed may be done cutting rates for the moment (see Mike Shedlock, “Is it Two and Done?”), the good-news-is-good-news-and-bad-news-is-good-news cycle may be coming to an end as well. This means we are likely entering a Rorschach cycle, where interpretations of government data start to be largely driven by your view of the investing landscape, in addition to any psychotic disorders that may be lurking just below the surface.

In the four generals, four horsemen, etc. category, the large cap tech leaders continue to do well, while Southern Copper (PCU) has struggled a bit. The big story in the group, however, is MasterCard (MA), which saw its stock surge 20% after a blowout earnings report. Much of MasterCard’s success can be attributed to increased acceptance of plastic across the globe, rather than in the US, where growth is slowing. In fact, given the doldrums that the Retail HOLDRS (RTH) ETF has been in since July, I will be focusing closely on the many retailers who report earnings just before Thanksgiving. For some related perspectives, Toro’s Running of the Bulls argues convincingly that the four horsemen have a lot of room still to run, while Chris Perruna is following MasterCard closely.

Some quick takes for the VIXophile crowd:

• Ian Woodward notes a fifth Hindenburg Omen signal
• Brett Steenbarger at TraderFeed has some of interesting thoughts about volatility: how VIX spikes can help market timing; and what it means for position sizing
• Mike at HEDGEfolios.com has some compelling thoughts about the Fed and commercial banks in a post-Glass-Steagall world
• Doug Kass predicts that the worst is yet to come in terms of write downs at financial institutions; meanwhile, per Greg Newton at Naked Shorts, Merrill Lynch has tried to park some of its liabilities off the balance sheet for a year
• Bespoke has a great visual comparison of the China bubble to previous NASDAQ and homebuilder bubbles
• Finally, PC Magazine has a very positive review of the new $400 ASUS Eee PC 4G laptop

What’s in the FXI?

Now that the iShares FTSE/Xinhua China 25 Index (ticker FXI) is regularly trading 5 million or so shares per day, it would be fairly easy for a trader to make a living trading just this one basket of China stocks. It has volatility, it has options (check out the new Morningstar options data if you haven’t already), and it will soon have a 2x inverse ETF (ticker FXP) if you want to play the other side at twice the speed.

But what is in this index? Note that the China internet stocks (BIDU, FMCN, SOHU, SINA, etc.) and the China solar stocks (LDK, JASO, TSL, YGE, etc.), both recent market darlings, are conspicuously absent from the list. I have included an October 31, 2007 snapshot of the components of the FXI, with all quotes from the Hong Kong Stock Exchange:

Ten companies included in the FXI are also traded on the NYSE with ADRs. For easy reference I offer links to a Yahoo Finance version of that list in an intra-day format and also in the more detailed summary format. At the moment, all ten companies on this list are trading down 2-6% for the day, while the FXI is down 3.4% after hitting a new high of 219.56 during yesterday’s trading session.

When the FXP arrives, I will probably give it a test drive, but not until there is more convincing evidence that the FXI has put in at least a short-term top. At that point, the volume in the FXP may also provide some interesting clues about investor sentiment, specifically the breadth and depth of concern about a bubble in the Chinese stock market. For now at least, there is no reason to believe that the China trend is going to end soon and the best place continues to be on the long side.