McClellan Summation Index Looking Bullish

A lot has been written about weakness in market breadth in the past week or so. With storm clouds looming over advances and declines, new highs and new lows, volume, etc., one might conclude that the breadth story is uniformly negative. Part of that interpretation depends upon whether you look at the ‘bad news’ in market breadth as confirmation of the breakdown in the broad market indices or whether you consider market breadth extremes to be contrarian indicators – at least in the short-term.

I fall into the contrarian indicator camp, but tend to focus on the intermediate term when it comes to highs and lows. Short-termers may be partial to the McClellan Oscillator; I am more interested in the McClellan Summation Index.

When I last posted about the McClellan Summation Index, it was October 25^th and I was concerned about two technical aspects of the index that I interpreted as bearish. It certainly has been a bearish month since then, but now the index suggests that we are coming out of an extreme oversold condition that should provide a bullish foundation for at least the next few weeks…so I’m back on the bull side of the fence for now.

Not a Lot of Fear or Volatility Lately

Given all the gloom and doom headlines across the mainstream media and blogging world (the lines are already blurring, it seems…) I am a bit surprised to see how little journalistic panic (embellishment?) has translated into market panic.

Starting with the graphic to the left, which depicts the frequency that the term “VIX” has appeared in blog posts with a certain minimum Technorati authority level over the past 180 days (see original tool), it almost appears as if the VIX is an idea whose time has come and gone. Lately, the talk is all about subprime, CDOs, SIVs, with interest rate spreads as the scorecard de jour. The markets may be down 10%, but with the VIX at 26 and change as I type this, the VIX is not part of the story.

In my ongoing effort to attempt to differentiate between fear and volatility, I turn to the VIX:SDS ratio at moments like these to see how fear has waxed and waned while the markets have fallen rather dramatically. The one year chart of this ratio is below. Previous incarnations of the VIX:SDS ratio chart have all been of the 6 month variety, but I think it is important to look at the current market environment and be able to compare it to the February-March and July-August VIX spikes (the SDS inverse ETF only launched on 6/13/06, so it is not possible to capture the ratio during VIX spike from 5/12/06 to 6/13/06.)

There are many ways to think about this chart (keeping in mind, of course, that it compares an oscillating number with a beta of about -4.2 to a trending number with a target beta of -2.0), but what I keep coming back to is the distance between the current reading or 10 day SMA and the longer-term 100 day SMA. In some respects, this isolates the magnitude of the fear component of the VIX and in the chart below, it underscores how little fear there has been relative to the recent drop in the SPX, especially when compared to similar values in February-March and July-August. I am not sure exactly how to interpret this, but I suspect that either the market will recover to a level that is commensurate with the fear, or perhaps we will see a significant VIX spike well into the 30s that will likely signal a near-term bottom. And despite what you read elsewhere, not all market bottoms require a high volume capitulation session, with an accompanying VIX spike.

Smart Money and the VIX

Bernie Schaeffer’s “Monday Morning Outlook” is generally an excellent perspective for any trader to contemplate going into the trading week. This week’s commentary is one of the better ones, as Schaeffer looks at a variety of data points to consider whether or not the markets may be putting in a bottom.

One of the themes that Schaeffer takes up is a sense of concern starting to overtake the recent investor complacency. Schaeffer cites the VIX as an example of continuing complacency in his remarks and in so doing goes on to make a potentially more interesting claim that he and his colleagues believe the VIX action represents the maneuverings of the smart money:

“One dissenter to this growing crack in the complacent armor was the VIX, which was little changed even while the market moved defiantly into losing territory. In fact, the supposed ‘fear barometer’ has shown little signs of alarm for a few weeks now, preferring instead to shuffle sideways. It has yet to make a significant move above the 30 level or come within sniffing distance of its mid-August peak.

However, the VIX action presents some very interesting possibilities. Its continued inability to move below the 32-week trendline is bearish, as we've pointed out before. But I wonder whether the fact that the November spike has fallen short of the August spike might actually be bullish in its implications, in the sense of a ‘non-confirmation’ of the pullback, rather than the conventional view that this is a bearish indicator of complacency. This interpretation would only make sense if you felt the VIX represented smart money, an evolving conclusion that we at Schaeffer's have reached over the course of this year [emphasis added]. Note that you could consider the VIX spike in the first quarter to be a non-confirmation relative to the spike in the second quarter of 2006, as it fell shy of the 2006 peak. The spike to higher VIX highs in August then ‘confirms’ the bearish trend, and by that reasoning (assuming the VIX has, in fact, peaked) the current spike is another non-confirmation with bullish implications.”

Setting aside the caution-complacency issue for the moment, I find it interesting that Schaeffer believes the VIX is the footprints of the smart money. I am slowly coming to the same conclusion myself and will attempt to address this issue a little more scientifically in this space in the future.

Portfolio A1 Dragged Down By Perini (PCR)

With a little over a month to go in the trading year, Portfolio A1’s 1.5% gain provides only a slim margin over the 1.0% loss in the benchmark S&P 500 index. That margin shrank substantially last week, on the heels of continued weakness in Perini (PCR).

When stories start circulating with headlines like Stop the Blank Checks to Iraq Contractors, it is no surprise to see the stocks Perini and other top contractors in Iraq and Afghanistan suffer in the wake of a swirl of bad publicity. After losing 11.5% in two weeks, Perini (PCR) is now down 32% from its July high and is being dropped from the portfolio as a result.

Replacing Perini in the portfolio is the first stock to be bought on three separate instances: DryShips (DRYS). Portfolio A1 rode DryShips up earlier in the year and had less success with an early October buy. If the global commodity boom continues, this may look in retrospect to be an excellent buy on weakness; on the other hand, if the anxieties and slowing economic growth in the US start to be felt around the globe, then it may be a long time before DryShips’ stock approaches the October highs once again.

With the addition of DryShips, the portfolio looks to be positioned aggressively for the final five weeks of the year. If it turns out that we are in a bear market, that 2.5% cushion over the SPX will likely be long gone by the end of December.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Holds at Zero in Advance of Black Friday Data

It was a quiet week in Lake VIXbegone. Very quiet. So quiet, in fact, that the VWSI remained stuck on a zero reading for the second week in a row and the VIX gained only 0.47 points or 1.8%, the fourth lowest weekly change all year.

As is my new custom, I look to Barry Ritholtz at The Big Picture to sum up the week that was and the week that will be:

• Thanksgiving Day Weekend Linkfest: Review/Preview

Consumers were apparently keen on snapping up bargains on Black Friday, where sales were up 8.3% over last year and followed through on Saturday, with sales up 5.4% versus the previous post-Thanksgiving Saturday. The combined Friday-Saturday statistics show a 7.2% increase in sales over 2006, with a 4.8% increase in traffic more than making up for a 3.5% decline in purchases per person.

Whether the surprising strength in consumer spending will take some of the momentum away from the bears remains to be seen, but my personal bias is slightly bullish going into the week, despite the weakness in a number of technical indicators.

(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 have heretofore been recommending a variety of inexpensive blends. Just this week I enjoyed the 2005 Trentadue Old Patch Red. This berry explosion is an unusual blend of 70% zinfandel, 20% petite sirah, 5.5% carignane and 4.5% syrah. Surprisingly, the petite sirah comes through as dominant, with the zinfandel playing a rare secondary role, with the exception of what I thought was a touch of residual sugar in the finish. This is a fun wine to drink and at $12 at my local wine store, worth seeking out.

Previous recommendations for a VWSI of zero have included Brassfield Serenity, as well as a wide variety of Rhone blends.

A Dozen Things My Trading Accounts Are Thankful For This Year

I am a strong proponent of taking stock of what is working and what is not working on a regular basis.

That being said, if my trading accounts could speak, these are some things they would be thankful for so far in 2007:

1. More active use of trailing stops (probably the #1 reason for increased trading success in the past few years)
2. Increased use of the VIX (and VWSI) to aid in timing the market
3. Emphasis on put to call ratios (especially the ISEE) to evaluate market sentiment
4. Lack of hesitation in initiating short selling positions (the end of a long bias approach)
5. Blogging – and all the cross-pollination of ideas that it has engendered
6. ETFs – to diversify, go short, apply leverage, etc.
7. More time stops (including hybrid price/time stops such as a Parabolic SAR)
   
8. Better strategies for taking partial profits in options positions
   
9. Following the China trend, whichever direction it takes me
10. Iron condors and other strategies to capture premium associated with high volatility and/or non-trending securities
11. Numerous enhancements to a detailed and continuously evolving spreadsheet I use to track and analyze all my trades
12. Standardization on a single momentum indicator for my charts: Williams %R

OHFdex Update

Since several readers expressed some interest – or at least some amusement – in the OHFdex (Overripe High Fliers Index) I unveiled back on October 12^th, I though it might be interesting to see how these high fliers have fared during the recent market turmoil.

Given that most major indices peaked at the end of October, I did not expect the changes from October 12 to November 20 to be particularly dramatic, but as can be seen below, the devastation over the past 5 ½ weeks has been widespread and substantial, even though it is only a small portion of most of the peak to trough losses over the past three weeks.

The companies that have fared the best during the period in question have done so partly with a stronger post-October 12 runup, but also by doing a better job of weathering the current downturn. These are the tech stalwarts, AAPL and RIMM (GOOG was also up 11 points during this span), as well as the two Chinese tech plays, BIDU and CHL.

I have been short five stocks on this list at one time or another during the past three weeks: AAPL; BIDU; GRMN; DRYS; and CROX. I suspect that most of the easy money on the short side has already been made, but if the NDX fails to hold 2000 and if the NASDAQ composite cannot stay above the 200 day SMA (currently 2584), I’ll flip from neutral to bearish and look to this list to find where the momentum money is most nervous.

Three Noteworthy Posts from Afar

In the blogosphere it’s hard to really say what ‘afar’ is – or even if there is such a thing – but I wanted to use this space to highlight three VIX-related posts that have recently caught my attention.

Earlier this morning, Macro Man (whose intellectual domain spans well beyond the macro) was ruminating on what a convergence of thinking about the VIX, the credit markets, and the US consumer might mean in terms of the future direction of the markets in a post aptly titled Fear and Greed. For the record, I have commented on the correlation between the SPX and the VIX on a number of occasions and have pointed out that a high positive correlation is more likely to foretell a bearish move than a high negative correlation.

Adam at Daily Options Report (as much as he posts, when does he have time to trade?) anticipated some of this yesterday in VIX Going Forward, in which he discusses the Holiday Effect and the tendency of traders to lower bids in order to better match the short trading week to the seven day calendar week used to price options. His Holiday Effect forecast: “volatility numbers on the board this week may be misleadingly low.” Bingo!

Getting a little farther afield, over the weekend, Brett Steenbarger at TraderFeed posted some very interesting research and analysis in Herding Behavior in the Stock Market: A Look at Volume Concentration. Frankly, this may be the most interesting stock market post I have read all year; rather than attempt to summarize his thinking, I am going to recommend that you click over and read his post in the original, as well as a related subsequent post, Herding Sentiment in the Stock Market and Prospective Index Returns. In between turkey (ham?) sandwiches, I will certainly be thinking about market sentiment, volatility, and herding over the next few days.

Happy holidays to all.

Very Low ISEE on Friday

The ISEE’s close of 68 on Friday was the seventh lowest end of day reading in the index during the five years for which data is available.

As a rule, one day’s worth of data in the ISEE means very little in the long run, while a week or two of extreme readings is generally needed to provide high probability trading setups. With the ISEE currently at 107 as I type this, today is on schedule to be the ninth trading day in a row in which the ISEE has closed at least 15% below its lifetime mean of 151. In fact, looking back to the correction of the summer of 2006, the ISEE has consistently been bullish since that time period.

With the DJIA down another 150 points today, the ISEE data may not be much consolation for longs, but for those who put stock in market sentiment, it looks like the current downturn is more likely to be a short-term correction than an enduring bear market.

MOS and PCR Slow Down Portfolio A1

The run in Mosaic (MOS) certainly was not going to continue indefinitely, but last week’s correction was rather dramatic, as the MOS chart shows. Compounding an already difficult week, Perini (PCR), whose addition to the portfolio caused me to raise an eyebrow at last week, did nothing to assuage my concerns, losing 7.5% in the first week.

The result is that Portfolio A1 now sits with a gain of 5.7% since the February 16, 2007 inception, still comfortably ahead of the 0.2% gain in the benchmark S&P 500 index. As is evident from the bottom two graphics, this enhanced performance has come with considerably more risk than the SPX in the form of a much higher variability of returns. The next iteration of this portfolio (to be launched at the beginning of 2008), will aim to minimize risk somewhat more than the current portfolio, while continuing to seek out stocks like Mosaic that can supercharge returns. The ride will no doubt be just as interesting – and hopefully more profitable and instructive.

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Swings From -10 to Zero in Wild Week

When you are playing the VIX mean reversion game, it doesn’t get any better than last week.

We entered the week with the VIX Weekly Sentiment Indicator (VWSI) at an unusually low -9 reading, but by the time the bull carnage had been tallied on Monday evening, the VWSI was maxed out at -10 and the VXN was looking even more ‘overbought’ than the VIX. These extreme readings triggered a rare market call on my part, which I titled a VXN Reversal Signal, but which also applied to the VIX. On Tuesday, the markets responded on cue, with the NASDAQ composite rallying 89.52 points in an impressive show of strength…and pushing the VWSI all the way back to zero.

Given the fireworks on Monday, the rest of the week was relatively uneventful, with the major market indicies largely meandering and the VIX ending the week at 25.49, down 3.01 (10.6%) from the previous week. In a nutshell, Waldo was nowhere to be found.

As is my new custom, I look to Barry Ritholtz at The Big Picture to sum up the week that was and the week that will be:

• Pre-Thanksgiving Linkfest: Week in Review
  
  
• Pre-Thanksgiving Linkfest: Week in Preview

The VWSI has no bias going into the shortened week (3 ½ trading days, with the half day on Friday) and I find myself in the unusual position of sitting mostly in cash while I look for the currents to tell this jellyfish where to go next.

(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 have heretofore been recommending a variety of inexpensive Rhone blends. The time has come to loosen the reins a bit and broaden the category to include everyday white and red blends from all varietals and regions, as long as they are reasonably priced. With this expanded criteria, I am please to recommend an usual blend of sauvignon blanc, pinot grigio, gewurztraminer, and semillon that goes into the Brassfield Serenity. This is an $11 white blend that is not just a fascinating change of pace, but an excellent food accompaniment and ultimately a wine that is quite impressive as a solo act as well. Finally, if you want to stump your favorite wine snob in a blind tasting, this is almost guaranteed to do the trick…

Nassim Nicholas Taleb on Charlie Rose

I highly recommend that every investor read Nassim Nicholas Taleb’s two books on uncertainty, luck, risk, and revisionist history: Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets; and The Black Swan: The Impact of the Highly Improbable.

For those who are interested in a video Cliffs Notes version of Taleb’s thinking, Charlie Rose has a 15 minute interview with Taleb that aired back in August (hat tip to Eddy Elfenbein at Crossing Wall Street.)

The Other Bubble

I have visited 47 states (all except North Dakota, Arkansas and Oklahoma) and seen a lot more of this country than most will ever see, so when I look at the various foreclosure and subprime maps that have been making the rounds lately, it is easy for me to picture many of these places and the residents I have met there along the way.

On the other hand, I live just north of San Francisco in Marin County, which in many ways, is like living in a completely different kind of bubble in terms of real estate values, disposable income, attitudes, politics, etc. When it comes to real estate in the area, starter homes in the $3 million range are not uncommon. For some additional context, a couple of years ago my wife and I looked at a local $8.5 million house that lacked a private master bedroom and was in need of a fair amount in the way of repairs.

In spite of the projections by the Marin Real Estate Bubble blog, local real estate has been surprisingly resilient. The Marin Real Estate Report tracks a variety of real estate data and is the source of the graphic below, which shows that for the past seven years, real estate has climbed fairly steadily, at least when adjusted for seasonal trends. The story is different in other parts of California, as comparable San Diego data show, but for now at least, the full extent of the Marin bubble seems to be intact.

Catching Up On Reader Mail

Thanks to all who have commented and e-mailed me in the ten months the blog has been up and running. Readers have been a great source of ideas for my research and have helped to sharpen my thinking about the markets and ultimately my ability to trade them successfully.

Some interesting comments and mail have been coming over the transom lately and I thought I’d address a couple of these in public.

There have been a couple of questions about VIX futures. I have not traded them to date, but it is something that I will definitely play with in the coming year. Even though I do not trade them, I certainly watch VIX futures closely, particularly the spread between the front month and the six month futures. Anyone interested in getting a sense of my emerging thinking in this area should check out posts with a VIX futures label. Also, note that the fifth and sixth links from the top in the “VIX and Sentiment Links” in the upper right hand corner of the blog both concern VIX futures.

Straying only a little from VIX futures, someone mentioned VXV, a new product from the CBOE which was launched on Monday and calculates the three month implied volatility in the SPX. The VXV may provide an interesting contrast to the one month IV in the SPX that is reflected in the VIX. I will certainly be taking a close look at the VXV and post my thoughts about it in short order.

Another reader asked if there is any way to invest in the cash or spot VIX directly. Unfortunately, the answer is no, though it is possible that a VIX ETF may be on the horizon. Some technical aspects of creating a VIX ETF (or ETN) are fairly daunting, but given the demand for volatility products, I would expect that it is only a matter of time before we see the launch of at least one volatility ETF.

Finally, one question concerned whether it is possible to replicate the spot VIX by buying a basket of delta-hedged SPX options to essentially re-create how the VIX is calculated. This is certainly possible, if a little complicated. A simpler approach would be to use SPX or SPY options, where you could go long or short volatility with straddles and strangles. If you prefer to hedge your short volatility positions, as I do, you might want to stick to butterflies and condors.

Quote for the Day, From Stuart Walton

"My philosophy is to float like a jellyfish and let the market push me where it wants to go."

- Stuart Walton, as quoted in Stock Market Wizards by Jack Schwager