The Fallacy of the Bearish First Five Days

I will be the first to admit that one of my favorite trading books to browse through is the Stock Trader’s Almanac, complied by Jeffrey Hirsch and Yale Hirsch. The current version of this annual classic, Stock Trader’s Almanac 2008, has already been sitting on my desk for three months.

I mention this book because the authors have been instrumental in widely disseminating the idea of the ‘January Baromenter,’ which posits that “as goes January, so goes the market.” While the idea of the January Barometer dates back to at least 1972, the corollary, which should be on the mind of many investors today, is that the first five days of January provide an effective ‘early warning system’ about the trend for the balance of the year.

Before I critique these two ideas, let me point out that the data for the general premise of January as a microcosm of a full trading year is compelling. Using the S&P 500 index, the January Barometer includes only five major errors in the past 58 years; and 31 of the last 36 times the first five days were up, the year ended up as well.

But before you load up on more QID in anticipation of the market being sucked into a black hole, it is important to recognize that the data obscures what happens when the year gets off to a particularly ugly start, as it has in the first four trading days of year (through yesterday), where the SPX has been down 3.6%.

As it turns out, since 1950 the SPX has only had a five day start that was worse than 2008 on two occasions: 1978 and 1991. In both cases, however, the year managed to turn around and finish in the green. In 1978, the SPX shook off a -4.7% first five days and was up 6.0% the rest of the year. The turnaround in 1991 was even more dramatic, as anyone who owned NASDAQ stocks (up 56.8% that year) will surely recall. After falling 4.6% the first five days of 1991, the SPX was up 32.5% for the remainder of the year.

If one wants to expand the analysis to the worst full month starts since 1950, the four worst of these starts also turned around by the end of the year as well. In 1970, January was down 7.6%, but the balance of the year was up 8.4%. In 1960, it was -7.1% followed by +4.5%; in 1990 it was -6.9% and +0.3%; and in 1978 it was -6.2%, with a +7.7% turnaround from February through December.

As always, be careful with what you take away from this analysis. Of the 21 Januarys that the SPX has been down, the balance of the year was down 10 times and up 11 times. The bottom line? If there is any message worth remembering from the data above, it is that good starts tend to persist, ugly ones tend to reverse, and slightly down beginnings run the greatest risk of turning into a rout.

One Year Blogiversary!

Today marks exactly one year since I decided to launch VIX and More as a place to archive some of my thinking on volatility and the markets.

There have been times when I would have been better served to spend additional time and energy to do more research, analysis, system development, etc., but on balance, having a blog has been more fun than work and the exchange of ideas via comments and e-mail has had a positive impact on my trading.

Thanks to all who have contributed to this site by reading, commenting, and linking to some of what I have had to say. Particular thanks to those blogs who have sent the most traffic my way:

• Daily Options Report
• Abnormal Returns
• The dk Report
• Headline Charts
• Trading Goddess
• Chris Perruna
• The Kirk Report
• The Global Liquidity Blog
• TraderFeed
• The Big Picture

What have readers found most compelling on this site over the course of the past year? Of the 422 posts that 117,000+ unique visitors have had a chance to review during my first year, here are the top 25 most read posts:

1. A Sentiment Primer (Long)
2. Correlation Ideation
3. How to Find the Spiker Before the Earnings Announcement
4. BuyWrite Index as a Timing Tool?
5. Commercials Get Long the VIX in a Big Way
6. High Positive Correlation Between VIX and SPX Often Signals Market Weakness
7. When to Short China?
8. A Baker’s Dozen of Favorite Indicators
9. Waiting for Godot
10. A Dozen Things My Trading Accounts Are Thankful For This Year
11. What My Dog Can Tell Us About Volatility
12. Implied Volatility and Earnings Spikers
13. Drilling Down on Sector Performance
14. Brian Overby on Trading VIX Options
15. First Annual VIX and More Blog Disclaimer Awards
16. The McClellan Summation Index
17. Thinking About the VXV
18. The Incredible Shrinking VIX
19. Using the VIX as a Timing Tool for the SPY
20. VIX Price Movement Around FOMC Meetings
21. A Challenge to Two Things You Think You Know About the VIX
22. VIX March OTM Calls
23. What’s in the FXI?
24. The Promethian Trader
25. Greenspan and the China Bubble

Portfolio A1 Begins 2008 By Increasing Gap on SPX

While the first three trading days of 2008 knocked 0.8% off of the value of Portfolio A1, this was much better than the 3.9% loss in the benchmark S&P 500 index. Since the February 16, 2007 inception, Portfolio A1 now stands with a gain of 21%, in contrast to a 3% loss for the SPX.

Brasil Telecom Participacoes S.A. (BRP) was the only stock in the portfolio that advanced during the week, bucking the downtrend in US-based technology stocks.

There no changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

Muted Reaction from VWSI as Markets Drop

The US markets sold off in dramatic fashion last week, with critical technical support levels failing to hold in a number of key indices, including the tech heavy NASDAQ Composite and NASDAQ 100, as well as the small cap Russell 2000. For a change, the damage in tech stocks was greater than it was in the SPX, where financials continue to be the most highly weighted sector.

As I chronicled on Friday, this has been a “low fear selloff” even when one focuses on the volatility index of the hard hit NASDAQ 100, the VXN. In terms of the VIX, the reaction has also been comparatively mild. Last week the VIX rose 3.20 points (15.4%) to 23.94. While this is the highest end of week close in six weeks, an SPX drop of 4.5% typically triggers a rise of about 19% in the VIX, so a 15.4% rise has to be considered a lackluster move relative to market conditions.

Consistent with a lackluster VIX in the face of considerable selling, the VWSI dropped only to -3, suggest a slight mean reverting bias going forward.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be in his Linkfest 2008 Review/Preview.

Looking ahead, it is worth noting that the two consecutive weekly jumps of 10% or more in the VIX has only happened six time since 9/11 – and the last five of those have seen the VIX fall in the subsequent week. After two weeks of 12.3% and 15.4% gains, I would not be surprised to see the VIX pull back a little in the coming week.

(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 continue to recommend a barbera. While Italy 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.

The Low Fear Selloff

Now that most of the holiday-related “calendar reversion” (nicely coined by Adam at the Daily Options Report) is behind us, we have the opportunity to get a fresh look at unadorned volatility. You know what? There is not that much of it out there, particularly given the current market conditions.

Since the NASDAQ is suffering the brunt of the damage today, I have chosen to include a graph of the VXN, or NASDAQ-100 volatility index. Given the market conditions, you would expect the see the most ugliness here, yet volatility looks surprisingly tame, particularly since the NASDAQ Composite was down 78 points when this snapshot was taken.

I’m having a big storm here in Northern California, with high winds and frequent loss of power, so don’t be surprised if VIX and More ends up offline for awhile, as I am not particularly well hedged against meteorological volatility.

[Note that the image above is from Port Orford, Oregon, a current capture of the spectacular webcam from Home by the Sea, a B&B situated on a bluff overlooking Battle Rock Beach]

Yes, I’m Frequenting More Blogs These Days

I’m sure nobody bothers to pay attention to this, but I periodically tweak the “Blogs I Frequent” section of VIX and More whenever a particular whim hits me. Since I’ve had that set of links up for almost a year, I thought I should clarify what it is and why certain blogs are there.

First, when I began blogging I had no idea what a feed was and I was under the mistaken impression that a blog would be the best way for me to keep track of links to all of my favorite blogs. That approach worked for awhile, until my news appetite expanded to the point where I needed to scroll down to access all my information source links and the ‘simplicity’ of the approach became too cumbersome for my liking. Fortunately, necessity birthed not just invention, but some technology test drives as well, and I settled on Bloglines as my favorite tool for managing feeds, as I detailed back in April.

I mention all of this because Bloglines is my primary news aggregation source 99.9% of the time, delivering 242 feeds on a relatively timely basis. Every once in awhile, Bloglines has technical difficulties and I resort to a backup system. Usually that backup takes the form of Google Reader, but there are some occasions where I prefer to fall back on the blog.

Now I trade primarily as a result of charts, technical analysis, market sentiment indicators and the like, but I don’t particularly enjoy looking at everyone else’s charts, which is why the list of the blogs I frequent has a disproportionately fundamental and macroeconomic focus and why the sequence (and invisible grouping) might appear chaotic. Ultimately, my blogroll is a somewhat arbitrary subset of my Bloglines feeds, with preference given to sites that I rarely if ever see on other blogrolls.

For all these reasons, I have recently added three important voices to my blogroll:

• Teresa Lo - InVivoAnalytics.com
  
  
• Eric Roseman - Roseman Eruptions
  
  
• Tom Drake - Putting the Pieces Together

Finally, thanks to all who have made VIX and More a part of their blogroll or personal reading list during the past year.

McMillan on Interest Rate Moves Preceding Volatility

Interesting fodder for further contemplation, from options guru Larry McMillan in Barron's: Volatility Likely to Remain High in 2008.

The article is much more interesting that the title might suggest and discusses a 'theory' that short-term interest rates precede volatility by 2 1/2 years. While this sounds like a stretch to me, if you believe the theory, then the VIX should be topping in early 2009 -- which just happens to be about the time suggested by some of my VIX macro cycle work. Certainly worth a click through for the curious...

Selloff Overdone Prior to FOMC Minutes Release?

In the hour and 40 or minutes or so before the FOMC releases the minutes from their December meeting, I am using the market weakness to make some buys. I have a number of reasons for doing this, not all of which I am going to detail here. Instead, I will post a chart of the NASDAQ TRIN, the counterpart to the NYSE TRIN that I discussed a couple of days ago. TRIN numbers can be calculated for each exchange. I watch the NASDAQ closely because the NASDAQ often leads the NYSE in terms of determining speculative sentiment.

In the chart below, I use 5 minute bars over a 10 day range. My thinking, in a nutshell, is not that I can guess what the FOMC minutes will reveal, nor even how the market will react to it, but I suspect that if the news is considered bullish by traders, the market will move much more decisively than if the news is considered to be bearish.

I consider this a contrarian sentiment play, with an asymmetrical news reaction magnitude potential. From a probability perspective, it’s about a 50% play; from an expectation perspective, I think the numbers are solidly in my favor.

Sector Clues in First Hour of 2008?

It’s never too early to try to discern what some of the new investing themes for 2008 might be, which is why I have included the StockCharts.com sector snapshot for the first hour of trading.

Given the low ISM numbers this morning, I am not surprised to see weakness across the equity spectrum. A couple of commodity sectors – gold and natural gas among them – are continuing their strong end of 2007 momentum into the beginning of the new year. One pocket of bullishness in the first hour that surprised me and is worth watching going forward is biotech.

On the downside, banks continue to get hammered, while REITs are currently in the middle of the pack.

2007 Performance: Portfolio A1 +21.95% (from 2/16/07)

I am official closing the books on 2007 for Portfolio A1 with a 21.95% gain since the portfolio’s February 16^th inception. This performance is 21.07% better than that of the SPX during the same period.

In addition to the usual portfolio summary statistics and equity curve, I have included some additional graphics that should be largely self-explanatory.

[For more information on the technology used to create and maintain this portfolio, check out an earlier post, Portfolio123.com: The Engine Behind Portfolio A1]

SPX Daily Volatility Below 80 Year Average in 2007

Kudos to Bespoke Investment Group for coming up with yet another interesting graphic, which I have reproduced below.

The graphic shows that the average daily volatility of the SPX was 0.72% in 2007, higher than the low volatility years of 2004-2006, but below the 80 year average of 0.75%.

For more information, try the original Volatility? What Volatility? post at Bespoke.

Bullish TRIN as Year Winds Down

One indicator that I have yet to comment on in 2007 is the TRIN, also known as the Arms Index, after its inventor, Dick Arms.

The TRIN is calculated by first dividing the number of stocks that advanced in price by the number of stocks that declined in price to determine the Advance/Decline Ratio. Next, the volume of advancing stocks is divided by the volume of declining stocks to determine the Upside/Downside Ratio. Finally, the Advance/Decline Ratio is divided by the Upside/Downside Ratio. In mathematical terms, the TRIN looks like:

(Advancing Issues / Declining Issues)

────────────────────────────

(Advancing Volume / Declining Volume)

Like the VIX and put to call ratios, the TRIN is a contrarian sentiment indicator. Generally, a rising TRIN indicates increasing bearish sentiment and a falling TRIN reflects increasing bullish sentiment. I have included the traditional 1.2 and 0.8 thresholds as indicative of sentiment extremes. These are levels at which the probability of a market reversal increases.

Depending on their trading time frame, practitioners use different bars for the TRIN. In the chart below, I chose to use 60 minute bars over the course of a two month period to generate swing signals of the short to intermediate-term variety. For comparison purposes, day traders frequently use 5 or 10 minute bars. It is important to note that different length bars give very different signals and also usually require a rethinking of where one should place the threshold levels for market turns.

At the moment, the TRIN is generating a fairly bullish signal – certainly the most bullish signal since Thanksgiving, when the markets began a strong rally that surprised many who were not watching the TRIN closely.

I will have more on the TRIN in 2008.

Portfolio A1 to Best SPX By 20% in 2007

On the heels of a strong fourth quarter, it looks as if Portfolio A1 will finish 2007 with at least a 20% advantage over the benchmark S&P 500 index since the portfolio’s February 16^th inception. With one trading day left in the year, Portfolio A1 has a 23.4% gain, a full 21.8% better than the 1.6% gain in the SPX during this period.

I will publish some additional statistics once 2007 is in the books, but suffice it to say with the likes of MOS, DRYS, TEX, PBR, RIO and others in the portfolio over the past 10 ½ months, we have been fishing in very rich waters.

In addition to the usual equity curve and summary information, I have added a list of positions that were closed out during the year.

There no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI at Zero as Year Coasts to a Close

A year ago, the VIX stood at 11.56. Last week it ended the week at 20.74, up 79%. Of course, in the absence of a VIX ETF (or ETN), it was almost impossible for volatility aficionados to capture that 79% gain.

For the moment, at least, things seem to be quiet on the volatility front. Last week the VIX gained 2.27 points (12.3%) to bring the index to a level just 0.17 below the 10 day simple moving average and 0.93 below the 20 day SMA. Partly because of this, the VWSI is back at zero and indicating no directional bias for the beginning of 2008.

As is my weekly custom, for a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be in his New Year’s Linkfest.

Finally, as volatility tends to run in 2-4 year cycles, it is appropriate to ask whether the 79% gain in the VIX in 2007 marks the beginning of a new volatility macro cycle. In spite of the historical precedent, I am on the record as saying that the most likely volatility scenario for 2008 is a VIX in the low to mid-20s.

(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 began the year recommending some Rhone blends and later expanded the category to include any expensive blend. For 2007, I will close out the year with my two favorite inexpensive blends: the $8 Oakley Five Reds (the 2003 vintage is a blend of 41% syrah, 27% zinfandel, 22% petite sirah, 10% alicante bouschet, and 1% mourvedre from Cline Cellars); and the 2005 vintage of The Hermit Crab from D’Arenberg, a delicious $13 blend of 70% viognier and 30% marsanne.

Technology, Energy and Bulls

Conventional wisdom – which usually strikes me as something like 95% convention and 5% ‘wisdom’ – holds that returns on technology stocks and energy stocks are largely a function of the business cycle. The theory is that technology stocks generally outperform in the early stages of a bull market, while energy stocks deliver their best returns at about the time that the broad markets peak

I should note that while I have chosen to focus on technology and energy for the moment, the full sector rotation/business cycle theory spans all sectors. For those interested in further reading, the CXO Advisory Group has an excellent discussion of a comprehensive business cycle approach to sector rotation (they are skeptical about trading on the theory) and a variety of sources, including Fidelity and Optionetics, have good summary articles.

Getting back to energy and technology, I have included below a ratio chart of the AMEX Select SPDRs for the energy (XLE) and technology (XLK) sectors going back to their 1998 launch. The graph shows an almost perfect negative correlation between the ratio of energy to technology sector performance and the SPX from 1998 through the end of 2003. This time frame is reasonably representative as well, as it includes two bull periods of about 1 ½ years each, as well as a bear market of a little more than two years.

From the beginning of 2004 to the present, however, the correlation between the energy to technology ratio and the SPX flips from negative to positive, as energy starts to outperform technology at the same time the markets begin a long bull run. For the past four years, up to and including the current month, energy has generally had the upper hand or at least been the equal of the more ballyhooed technology sector.

I find it interesting that the last time the XLE:XLK ratio was this high was July 2006, when the markets were selling off over uncertainty about whether Bernanke would continue to raise the Fed discount rate. Now I won’t go as far as to say that the bull market is officially over if the XLE:XLK ratio gets over 3.0, but keep an eye on this ratio. As US consumers get accustomed to $100/barrel oil and $3.50/gallon gas, any number of things are possible, but I don’t believe the broader markets will continue to rise if energy outperforms technology going forward.