NDX Fails Briefly, Other Indices Hold Bottoms

Bottoms are an interesting species. They are almost impossible to call in advance and surprisingly difficult to identify with a little hindsight. Typically, by the time you have enough hindsight to say, “Hey that was a bottom back there!” you have already missed a good portion of the move up from that point.

A number of indicators can help raise the probability of calling a bottom, the VIX among them, but we are still in the meteorological realm in terms of accuracy – and very much in the pre-Doppler era at that.

Most students of market bottoms agree that evidence of widespread capitulation is the best way to identify a market bottom. The reasoning is essentially that it is ‘better’ to have one day of extreme investor panic than a number of days in which the cumulative losses add up to one big drop while the psyche of the investor is able to digest the grief on the installment.

According to the reasoning above, yesterday had some elements of extreme investor panic at the open, but the ease with which the markets rallied from that point suggest that there may not have been enough panic or pain to account for a traditional capitulation bottom. This morning’s open was also relatively low in terms of panic and pain – at least on the capitulation scale – so there will be many who will wait for another strong retest of yesterday’s lows (and of investor fortitude) before committing to new bullish positions.

It is worth noting that one major index had yesterday’s low breached this morning: the NASDAQ-100 (NDX). Thanks to AAPL’s weak guidance yesterday after the bell, the stock opened dramatically lower and pulled the NDX down with it. The NDX has since recovered, but it and AAPL should be watched closely, as their support levels will likely be tested before those of the other more widely followed indices.

Brunhilde Day Today?

Today could turn out to be one of those days that imprints the value of the VIX deeply into the psyche of many traders.

While I have gone out of my way to suggest that the markets do not have to see a VIX spike in order to put in a bottom, it appears that following this morning’s surge in the VIX to 37.57 (the highest reading since October 2002) many buyers felt comfortable starting to nibble. Now with the markets inching back toward even for the day, the likelihood of a high volume reversal day signaling a market bottom is increasing dramatically.

While I have done some nibbling of my own, I would not be surprised to see at least one test of the lows of the morning and would hold off on calling a bottom until we see more evidence of higher lows and higher highs.

On the other hand, if today turns out to be a bottom, you can bet that that next time we have a major selloff, traders will be watching the VIX even more intently to determine when it signals that bottom. If the VIX was important before today, it is about to become even more important going forward, when traders eagerly watch to see when Brunhilde is going to sing.

Portfolio A1 Falls as Mosaic’s Run Comes to an End

It was fun while it lasted, but it had to come to an end eventually. The Mosaic Company (MOS), which had run up an eye opening 176% in the first five months it was in Portfolio A1, is now gone from stable, victim of a rule that automatically culls any stock that falls 20% from the high recorded during the holding period. Also shown the door as a result of a 20% drop is Brazil Telecom Participacoes (BRP).

Replacing MOS and BRP are LG Philips LCD Co. (LPL) and Terra Industries (TRA). LG Philips LCD Co. is a Seoul-based $16 billion joint venture in the display business between two global giants, LG Electronics and Royal Philips Electronics. TRA, a nitrogen fertilizer company, demonstrates how some portfolio ‘rules’ can backfire, as this company is a direct competitor of Mosaic in the fertilizer business and at only 10% of Mosaic’s market capitalization is actually a much riskier play in this sector. Nevertheless, the stock ranker has spoken and TRA should do well if this week turns out to be a bottom. As far as the wisdom of holding an LCD manufacturer at a point where consumer demand appears to be drying up, I am skeptical, but this remains a 100% mechanical portfolio, where my perspective does not matter.

After falling 11.4% last week, Portfolio A1 is still sporting a 5% gain since the February 16, 2007 inception, considerably better than the 9% loss in the benchmark S&P 500 index during the same period.

There no other changes to the portfolio this week.

A snapshot of the Portfolio A1 is as follows:

VWSI at +1 as Historic Meltdown Approaches

In light of the oncoming freight train that is today’s session, it seems somewhat academic to recount the action in the VIX last week. For the record, last week the VIX gained 3.50 points (14.8%) to close out the week at 27.18. The VWSI rose one tick to +1.

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 takes a stab at what will likely be a historic trading week in his 3 Day Weekend Linkfest: Review/Preview (authored Sunday evening, so it doesn’t include the thinking coming out of yesterday’s carnage.)

I am estimating that the VIX will open between 35 and 36, then move higher from that level as the rush to the exits precludes the need for anyone to yell “Fire!” A VIX north of 40 would not surprise me, nor would a short-term bottom forming sometime later in the 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 +1, I recommend a guwurztraminer. For the record, my favorite American version of this wine is the dry gewurztraminer from Londer Vineyards of Anderson Valley. I have not yet sampled the 2006 vintage, but the 2005 was an unforgettable wine that I would love to see in a blind tasting against some of the top Alsatian competition.

In my previous roundup of California gewurztraminer, I suggested Navarro and Harvest Moon. For some of my top selections from Alsace, check out Trimbach; Hugel; and Domaine Weinbach. You can also check out the top-rated gewurztraminers in the 2007 San Francisco Chronicle Wine Competition.

Will a 29.30 VIX Placate the Crowd?

Until the past few days, I did not realize how many investors – or at least pundits – are of the opinion that the market cannot put in a bottom until the VIX spikes. True, the classic market bottom includes a dramatic drop, a spike in volume, and a spike in investor fear to purge even the most stubborn investors of their losing long positions. As I have stated previously, however, I am comfortable in my belief that a VIX spike strongly increases the likelihood of a bottom, but should not be considered a requirement, per se.

Consider, for a moment, that a VIX spike capitulation bottom may be one of those investment phenomena in which one’s individual assessment doesn’t matter. If enough people believe that A is a precondition for B and trade accordingly, just about any A can become a self-fulfilling prophecy.

Back to the VIX spike, we just hit 29.30 on the VIX a moment ago. While some were calling for the VIX to cross 30 to signal a market bottom, it is possible that the current level may be considered close enough to draw in those looking to play the oversold bounce card.

I have chosen to include a weekly chart of the VIX as a framework for evaluating the current VIX spike. It shows that a 20% deviation from the 10 week SMA has proven to be a fairly reliable timing device in the past. It remains to be seen whether that is the case today, but I am not anticipating a VIX spike over 30 between now and the next Fed meeting.

Bernanke Prepared Remarks Sink ISEE to Historic Lows

The ISEE is at historic lows with Ben Bernanke 1 1/2 hours into his testimony before the House Budget Committee.

Between 9:50 and 10:10 a.m. EST, approximately 290,000 new put positions were opened in individual equities on the ISEE. This is in sharp contrast to the meager 34,000 or so new call positions that were initiated during the same period.

Given that a copy of Bernanke's prepared remarks we distributed at approximately 10:00, the mostly likely conclusion is that some of the larger players are voting with their feet that the Fed's too little too late approach continues to offer a significant downside opportunity for those who are short the market.

At 11:30 a.m., the ISEE has climbed to 37, but with such a large number of puts already up on the scoreboard, there is a good chance that today will see a new single day closing low for the ISEE.

Volatility RIP?

I have talked rather extensively about the surprising lack of volatility in the markets during the past month or so, particularly given the sharpness of the current downturn and the preponderance of gloom and doom news out there. For a little while, at least, it was possible to ignore this phenomenon and chalk it up to “calendar reversion.” Now that the holiday season is behind us, this explanation no long holds water and it seems everyone wants to know why the VIX just sits there in the low to mid-20s.

For those interested in the evolution of my thinking on this subject, I encourage your to consider reading Not a Lot of Fear or Volatility Lately (11/27/07); No Fear (12/19/07); The Incredible Shrinking VIX (12/21/07); VIX Shrinkage Continues… (12/24/07); The Low Fear Selloff (1/4/08); and VWSI at Zero as VIX Meanders (1/14/08).

The bottom line is that I cannot explain why the volatility indices appear to be relatively indifferent to what many think is the beginning of a nasty bear market. Of course, this relative complacency would be possible only if investors as a whole were not worried about a bear market – and when was the last time that investors failed to panic when the markets turned down sharply?

While I have no answers, per se, I do have a few working hypotheses that I tweak from time to time, in no particular order:

1. increased use of inverse and double inverse ETFs (i.e., QID) for hedging/speculation
   
   
2. the expectation of a forthcoming emergency rate cut limiting upside potential for puts
   
   
3. the possibility that there has been so much advance warning about a potential market meltdown that those who have wanted to protect their portfolio and/or speculate on a downside move have had ample time to do so, at their leisure
   
   
4. a vicious cycle in which the less the VIX moves, the less valuable (reliable) it is as a hedge (or highly leveraged hedge)

If and when I can come up with a better answer to this question, I will cut in with a live feed from Volatility Central…

When Volatility and Put to Call Activity Diverges

A reader asked whether I think tracking the ratio of the VIX to the ISEE has any value in terms of market timing.

I track indicators that sum relative volatility and put to call activity as well as a couple that examine the ratio of volatility to put to call action. For the most part, these two categories of sentiment indicators tend to confirm each other. Further, when volatility and put to call numbers signal the same extreme sentiment across both dimensions at the same time – as is usually the case – this dramatically increases the expected value of a number of contrarian setups.

Strong divergences between volatility and put to call activity are relatively rare. I did blog about this type of divergence at the end of May 2007, just before the VIX started upward on a path that would see it triple in less than three months. For the record, my conclusion at that time, which continues to be supported by the data I collect, is that “high readings of volatility relative to put to call data are generally bullish for the broad markets while high readings of put to call data relative to volatility are generally bearish for the broad markets.”

In looking at the ISEE numbers, keep in mind that this is a call to put ratio, so that if one wishes to compare the VIX to the ISEE, it is best to invert one of the numbers before putting them under a microscope and studying their Brownian motion…

Checking for Atheists

One of the things I like to do when I see the markets bounce is what I call my “atheist check.” Essentially, I take a look at the current and recent numbers for the ISEE to see if there are many believers who are flocking to buy call options. The lower the number, the more atheists there are that are still out there (or ‘undecideds’ if you prefer the political metaphor to the religious one), and therefore the larger number of potential converts available. Contrarians love potential converts, as they are the future fuel for subsequent bull legs. Generally, when I see an ISEE number (they use a call to put ratio, not a put to call ratio like the CBOE does) of 120 or below, I consider this to be a bullish signal. An ISEE of under 100, which signifies more people opening new put positions than call positions, is very bullish.

As a rule, an ISEE of under 100 is relatively rare, particularly over extended periods. What I find noteworthy about the current market is that the ISEE has closed below 100 for five of the past six days and at 92 as of 12:50 EST today, is on target to make that six of seven. The only other time that the ISEE has registered six of seven sub-100 closes since the exchange began keeping records in October 2002 is in August 2007, at the very bottom of the selloff caused by the first iteration of a subprime panic.

As far as I am concerned, the current ISEE data is almost as compelling as the 37.50 VIX spike we had in August. While the VIX demonstrates how fearful the atheists are, the ISEE reveals how many of them are out there and reminds me of one of my favorite quotes, which comes from John Bender and appears in Jack Schwager’s Stock Market Wizards, “It's not the current opinion of the stock that matters, but rather the potential change in the opinion.”

Portfolio A1 Makes Big Bet on Brazilian Telecoms to Start Year

For the first time in awhile, Portfolio A1 gave back some ground to the benchmark S&P 500 index last week. Even with last week’s sub-par performance, since the February 16, 2007 inception, Portfolio A1 now has a cumulative gain of 20.7%, compared to a 3.7% loss for the SPX.

After falling 7% last week, Sinopec, a.k.a. China Petroleum & Chemical Corp (SNP) has been dropped from the portfolio, victim of a rule whereby a position is automatically closed once it falls 20% from its high during the ownership period. Also dropped were Norwegian energy and aluminum giant Norsk Hydro (NHYDY), but in this instance as a result of a declining rank from the stock ranking system. The ranking system partly reflects several technical factors and picked up on the fact that NHYDY’s stock has also struggled and is down about 17% for the first two weeks of 2008.

Replacing SNP and NHYDY in the portfolio are returnee Fresh Del Monte Produce (FDP) and a second Brazilian telecom company: Tele Norte Leste Participacoes (TNE), an integrated fixed line and mobile telecom provider with a $9.5 billion market cap. TNE joins long-time favorite BRP to give Portfolio A1 an unusual mix of 2/5 Brazilian telecoms in this five-legged portfolio. By design a focused five stock portfolio is intended to make significant bets in specific sectors and regions, but it is unusual to find this type of concentration in the portfolio, which uses a maximum sector weighting of 30% to place sector limits on all new purchases. The reason there are currently two telecom companies in the portfolio is that Mosaic (MOS) has had such a strong run (up 175.7%) that it now comprises 42% of the portfolio, so that it is possible for the other four holdings to split the remaining 58% with two companies in one sector that do not total to 30%.

Note that the portfolio has no provision for limiting the concentration of holdings by country or region.

There no other changes to the portfolio this week.

A snapshot of Portfolio A1 is as follows:

VWSI at Zero as VIX Meanders

There is probably a better word out there to describe the recent lack of action in the VIX, but I’m going to stick with ‘meander’ for now. After weekly changes of 9% or more in one direction or the other for 11 out of the past 12 weeks, the VIX dropped a mere 0.26 (1.1%) last week to end the week at 23.68. Perhaps more important, in spite of those 12 relatively volatile weeks, last week’s close leaves the VIX just 0.10 above the 50 day SMA, indicating that this has been a lot of running hard simply to stay in the same place.

The VIX Weekly Sentiment Indicator (VWSI) is as unimpressed by the recent market downturn as the VIX, currently registering a zero, which indicates no bias toward increasing volatility.

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 Mid January Linkfest: Review / Preview.

Looking forward, I am still puzzling over the implications of the recent lackluster VIX. Three possible conclusions immediately jump out at me:

1. the markets have a lot longer to fall and won’t bottom until we have a meaningful VIX spike (I consider this possible, but certainly not a fait accompli, as I spelled out in Can the Markets Bottom Without a VIX Spike?);
   
   
2. investors are not particularly fearful at the moment because after six months of hearing about an upcoming disaster have bought all the puts they want and/or are getting desensitized to additional bad news;
   
   
3. the VIX no longer has the predictive value it once had, due in part to the flourishing of double inverse ETFs like the QID and other increasingly popular instruments for the bearishly inclined.

I will be evaluating all three possibilities going forward and will update my thinking here as it evolves.

(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 2007 by recommending some Rhone blends and later expanded the category to include any expensive blend. Over the course of the year, my two favorite inexpensive blends turned out to be 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.

Scrolling Back…

I have had several requests to revive last year’s practice of periodically publishing links to some of my favorite recent posts from other blogs.

With the caveat that I have not been rigorous about bookmarking all of my favorites, here are some recent posts that I think may have some archival significance well beyond the day they were posted:

• Felix Salmon has convincing proof that an astonishing number of investors trade first and think later (if at all)
• Babak at Trader’s Narrative examines the IBES Valuation model, which shows stocks are extremely undervalued, and offers two interesting hypotheses
• Eddy Elfenbein of Crossing Wall Street show how it is easier to make money while sleeping than while trading
• Michael Shedlock of Mish’s Global Economic Trend Analysis lays out his thinking for how to invest for inflation and deflation
• Maoxian (who I just got around to adding to my blogroll) has one of the best 2007 sector performance graphics, covering 30 sectors
• Eddy Elfenbein of Crossing Wall Street has the 2007 sector performance of the ten S&P industry groups in one illuminating graph
• Brett Steenbarger of TraderFeed has an interesting look on market performance following down days
• Ian Woodward offers a retrospective play-by-play account of the Bernanke speech and the market’s reaction
• Eddy Elfenbein (hat trick!) also has a great graphic comparing SPX performance by VIX level
• Barry Ritholtz of The Big Picture captured another excellent volatility graphic for the DJIA, NASDAQ and Shanghai Composite, this time from the New York Times
• Nadeem Walayat of The Market Oracle drills down on the impact of sovereign wealth funds and the implications for investors
• Did you know that iVolatility.com has a blog? Their most recent entry talks about trading VIX call ratio backspreads
• Just four days after publishing a list of my top 25 most read posts from my first year of blogging, The Fallacy of the Bearish First Five Days has rocketed into the top five most read list in less than 72 hours and seems destined to top that list soon
  
• Finally, Charles Kirk of The Kirk Report recently posted a thought provoking assessment of his excellent blog and the challenges of weaving trading and blogging together in a balanced life portfolio

Chart Porn

If I had tried a little harder, I’m sure I could have come up with a better title for this post, but something like “Strange and Unusual Charts You are Guaranteed Not to Find Anywhere Else” and their ilk seemed like too much work.

So let me summarize the current market situation, if I can. Essentially, almost all the momentum and support/resistance charts say that a bear curtain has descended upon the markets. On the other hand, Panglossian types are still able to find solace in the fact that some oscillators suggest that the recent moves down have been excessive. Additionally, they can always change the moving averages on their charts from days and weeks to months in order to support their contention that the markets are in the midst of pulling back to support. At this stage, deciding which camp has the most like-minded souls has as much to do with one’s philosophy and outlook as it does the result of rigorous analysis.

In the end, it’s quite possible that none of this matters. As one commenter from yesterday suggested, perhaps the only things that do matter are what the bearded man sings and how mellifluously it falls on our ears (that and perhaps whether he is a baritone or a castrato.) Hint: if it’s Das Lied von der Erde, I’m buying gold.

But enough silliness for now. Getting back to some chart porn, I am including the chart below not so much because the conclusions are fresh (“things are bad” or “things are about to turn,” depending upon your perspective), but because I’m fairly sure you cannot find this chart anywhere else. The chart tracks the ratio of up volume to down volume for the NYSE and uses a 21 day EMA to smooth the data. The NASDAQ version of the data looks similar, but this NYSE chart shows the potential for volume data to help call both tops and bottoms in advance. So dial up some Mahler and watch the volume.

Can the Markets Bottom Without a VIX Spike?

Back in November, in Not a Lot of Fear or Volatility Lately, I cautioned, “despite what you read elsewhere, not all market bottoms require a high volume capitulation session, with an accompanying VIX spike.”

Of course, that claim immediately triggered a request for me to back up my claim with some data: Could you describe or show an example of a major bottom without a volume and or VIX spike?

For the benefit of those who do not always read the comments section, I am reprinting my response in full, as it may shed some light on current market conditions.

I knew I should have had the answer handy before the inevitable question showed up -- and the ink wasn't even dry on my post yet...

OK, since StockCharts.com only has SPX weekly volume going back to 10/98 and since I'm more interested (generally) in the VIX than in SPX volume, I looked at the VIX and SPX on a weekly basis going back to 1990, which is as far back as VIX data goes, and here is my thinking:

A) Classic capitulation (VIX spikes at least 2x above previous levels and volume surges) bottoms appear in Aug-Dec 1991, Mar 1994, Aug 1998, Sept 2001, and July 2002. More recent instances include May-Jul 2006, Feb-Mar 2007, and Aug 2007.

B) Bottoms that lack a significant VIX spike (in the area of 2x above previous levels) include Jul-Sept 1996, Mar 1997, Mar 2001, and Sept-Oct 2002. More recent examples include Mar-Aug 2004 (one bottom or three mini-bottoms), Aug 2005, and October 2005. I am not ruling out the current [November 27, 2007] environment as another one of these 'uneventful bottoms.'

Note that "major bottoms" may mean one thing to one person and other to someone else. I'd be tempted to argue that the only major bottoms we've had since the VIX data begins are 1990 and 2002 -- so the bottoms above are necessarily more of the intermediate and long-term variety.

So the answer to the question posed in the title is a hearty, “Of course they can!” As a matter of fact, I expect the current downtrend will likely end without the VIX spiking even close to twice the recent levels.

Arrow Up For Tomorrow

I generally shy away from making stock market predictions and prefer the Stuart Walton jellyfish approach to investing, but sometimes the markets get so egregiously out of whack that I feel obliged to state the obvious. In this case the obvious is that the probability of a short-term rally beginning tomorrow is extremely high.

Many of the overbought/oversold indicators that I study closely (ISEE, TRIN, VXN, etc.) suggest that the markets are ready for a bounce tomorrow. In short, tomorrow is setting up to be a mean reversion, oscillator lover's shooting gallery. Keep in mind, however, that if the markets do not make a U-turn into oncoming traffic, it is often more instructive to observe what the markets fail to do than what they actually end up doing.

In the jellyfish tradition, when a bounce arrives, I have no intention of trying to guess how long it will last. The important question is whether large investors will be selling into any rally to unload inventory before the bear market grip tightens – or if this may be the beginning of another periodic pullback in the continuing 5 ½ year bull trend.

As always, caveat emptor!