Three Pivotal Sectors: Financials; Homebuilders; and Consumer Discretionary

Throughout the recent market turmoil, there have been three sectors that I have watched most closely in order to help determine the extent of the challenges the US economy is currently facing and will face in the near future. There should be no surprises here, but for the record, those sectors are financials (XLF), homebuilders (XHB), and consumer discretionary (XLY).

The financials are the foundation of these three sectors and provide a sense of the strength of the institutions involved in credit markets and other related financial businesses. The homebuilders offer some insight into changes in value of existing real estate assets, as well as consumer confidence and willingness to undertake large financial commitments in the coming months. Finally, consumer discretionary firms reflect the size of the pool of disposable income and the level of comfort consumers have in letting go of or holding on to that money.

The chart below shows all three sectors over the past six months. Financials and homebuilders are clearly struggling and have both fallen below their 50 day simple moving averages as of late. The consumer discretionary sector has been the strongest of the three over the past month, but may have peaked last week after getting extended.

Ultimately, my belief is that a healthy economy and a healthy stock market require a strong performance in all three of these pivotal sectors, which is why I call them my 'indicator species' sectors. That may still happen down the road, but at the moment, at least two of the three pivotal sectors are showing a fair amount of weakness.

Inverted VIX: The US Tour

I have mentioned the inverted VIX on two previous occasions, most recently about 5 ½ months ago in Inverted VIX Still Bullish.

In the chart below, I continue my practice of displaying the inverted VIX in a weekly chart and looking at longer term patterns. A lot has changed on the volatility front in 5 ½ months, as evidenced by the fact that the current inverted VIX is farther above its 50 week moving average than it has been at any time since the record 64% one day spike in the VIX on February 27, 2007.

Perhaps even more interesting is that in this five year lookback period covered by the chart, current VIX levels look positively middling and unremarkable on an absolute basis, even though the VIX has come a long way in a short time on a relative basis. A new VIX floor in the 15-16 range is not unreasonable. It is higher than the new VIX floor of 13-15 I was calling for on August 1, 2007, but given all that has transpired in the markets over the past ten months, the fact that these numbers are even in the same ballpark is something to ponder.

[For more on why it is sometimes useful to turn charts upside down while analyzing them, readers may wish to check out A Different Way to Look at the VIX: 1999-2007.]

The Shift from Roads to Rails

The Dow Jones Transportation Average (DJTA) has a long and storied history, but has been frequently overlooked in recent years. Despite this secondary billing, the index is up over 30% since bottoming in January and is close to challenging last summer’s all-time high.

The transports are often thought of as a barometer of the cyclical economy, frequently rising as an economy transitions from recession to recovery. As such, the rise in this index has been noted by many observers as a sign of better economic times ahead.

The reality is that the transportation index aggregates several related industries, including commercial airlines, shipping companies, railroads, truckers, and air freight firms. These firms have had widely varying fortunes lately and the outlook is different from segment to segment. One important distinction between these companies is their exposure to rising fuel costs. Not surprisingly, airlines and truckers have been hit hard by rising energy prices. Shippers and railroads, however, have suffered less of an impact. The distinction is dramatic when drawn between railroads and airlines. In the chart below, I have included not only the DJTA, but the Dow Jones US Railroad Index ($DJUSRR) and the Dow Jones US Airlines Index ($DJUSAR). The chart shows what most of us already know: the rails are booming and the airlines are struggling.

Energy costs are tilting the balance of power away from airlines and truckers back toward the traditional bulk carriers: railroads and shipping companies. In an era of rapidly expanding global trade, not only will the winners be the ones with a significant cost advantage, but their growing market share and growing markets should make for some enticing investment opportunities.

One Reason Why Volatility May Have Bottomed

The graphic below says it all – and the official beginning of hurricane season is two weeks from Sunday.

Given the supply issues with oil and natural gas, even the threat of a hurricane in the Gulf of Mexico is sure to cause considerable consternation. Of course, with all the global warming, this year’s prediction from the folks at Colorado State University is not particularly soothing:

"Based on our latest forecast, the probability of a major hurricane making landfall along the U.S. coastline is 69 percent compared with the last-century average of 52 percent," said Phil Klotzbach of the Colorado State hurricane forecast team. "We are calling for a very active hurricane season this year, but not as active as the 2004 and 2005 seasons."

I’ll have more to say on weather and volatility as we get deeper into the hurricane season.

VIX Options in Current Declining Volatility Environment

Kudos to Adam at Daily Options Report for today’s A Quick Trading VIX Primer, which provides a succinct explanation of the basis for VIX options prices – some of which have left casual options traders scratching their heads in recent days.

In Adam’s words:

“The VIX estimates volatility on the SPX itself for the next 30 days.

VIX futures are a bet on where that estimate will be on the day the future expires. In other words, it is a snapshot of what the market expects for volatility 30 days AFTER the future expires. If it is a September future for example, you are guessing how the market prices volatility 30 days forward from September expiration. You are not betting on SPX volatility between now and September; that is a common misconception.”

Two graphics might help to illustrate this point. The first graphic initially appeared on VIX and More one year ago in VIX Futures: The One Picture to Remember and shows what happened to the VIX futures on the day before and the day of the record 64% spike on the VIX on February 27^th 2007. The bottom line is that the long-term outlook for volatility did not change appreciably, but the VIX futures moved from contango (upward sloping over time) to backwardation (downward sloping over time). So the future still looked the same, but the VIX was expected to take a different path to arrive at essentially the same place.

The second graphic is a snapshot of the VIX options as of this morning. Note that with the (cash/spot) VIX at 17.24, the bid on the May 17.00 puts (0.15) is almost the same as the bid on the May 22.50 calls (0.10). The reason? Mean reversion is priced into the VIX futures – and the options reflect the consensus opinion that a 5 point VIX spike is just about as likely as a 0.25 point drop in the VIX over the next week (recall that VIX options expire on Wednesdays; this month it is one week from today.)

Revert to What?

If there is one thing that most VIX-watchers can agree upon, it is that the VIX is ultimately a mean reverting animal. If you accept that postulate, then the next set of questions that spring to mind generally concern which mean the VIX reverts to and over what time period mean reversion takes place.

Since much of the discussion of the VIX centers around 10 day moving averages, I thought I would zoom out a bit, pull up a VIX weekly chart, and look at some long-term numbers: the 40 and 200 week simple moving averages.

Logically, one might assume that most of the activity in the VIX would fall neatly in between the 40 and 200 week SMAs. Interestingly enough, that has rarely been the case historically. During the past five years, for instance, the VIX has traded in the range between the 40 and 200 week SMA less than 20% of the time, as the VIX has trended down, then back up.

At current levels, the VIX is near the halfway point between the 40 and 200 week SMA, perhaps partly due to some of the gravitational effect of mean reversion. While current levels of volatility appear to resonate as too low for some, a continuation of the bullish bounce off of the March lows should send the VIX back to the 200 week SMA – or even lower.

In sum, while long-term VIX mean reversion does have some analytical use, it is less reliable than the short-term mean reversion patterns that are more commonly utilized for trading.

Strong Bear Signal from VIX:VXV Ratio

I consider the VIX:VXV ratio to be an indicator in the making. Since the VXV is only six months old it is still too early to give it the robust indicator seal of approval, but that doesn’t mean you shouldn’t pay attention to it.

Looking at the chart below, the only previous time the VIX:VXV ratio gave a bearish signal comparable to the current one was just as the markets were about to move down in dramatic fashion from late December to late January.

At the very least, the bulls should consider some downside protection in the current market environment. I suspect the bears are preparing to pounce very soon…

Subscriber Newsletter Update

I have received a number of questions about the subscriber newsletter and I thought this might be a good time to address them.

First, thanks to all who have subscribed. I have been extremely pleased by the response to date. I appreciate all the support and am particularly encouraged by the fact that so far the renewal rate has been 100%.

In terms of content, the Sunday format has already been standardized. The typical Sunday issue is six pages long and has the following sections:

• The Week in Review – my thoughts on what constituted the important macroeconomic, fundamental, and technical news for the past week
• The Week Ahead: What to Look For – includes suggestions on earnings to watch, important government data releases, critical technical support/resistance levels, etc.
• Market Sentiment Update – a discussion of the readings and related implications from two of my proprietary sentiment indicators, the Options Sentiment Indicator (OSI) and the Aggregate Market Sentiment Indicator (AMSI). In some respects these two indicators are descendants of the VIX Weekly Sentiment Indicator (VWSI)
• Asset Class Outlook – where I update my outlook over the short-term (1-3 weeks), intermediate-term (1-3 months), and long-term (6-12 months) time frames for ten important asset classes that cover US equities, foreign equities, bonds, currencies, and commodities
• Current Investment Thesis – my take on what is driving the markets, in which direction, and why
• VIX and More Focus Model Portfolios – three different model portfolios (Aggressive Trader, Growth, and Foreign Growth) consisting of 5-7 stocks each that have returns of +18.0%, -2.7%, and +2.1% since the March 30, 2008 inception
• Stock of the Week – a single weekly stock selection that has a cumulative return of +48.5% since the initial March 30^th selection

The Wednesday issue is much more like the blog, but with a more detailed analysis and a place where I offer more in terms of conclusions and takeaways. It generally runs 4-6 pages and has three standard sections:

• Market Commentary – updates my thinking as laid out on Sunday
• Market Sentiment Update – similar to the Sunday section, but may drill down more on specific issues, such as volatility, put to call data, market breadth, volume, etc.
• Volatility-Based Sector Rotation Model – one of my current research interests is using volatility to time trades on a variety of ETFs, including sectors, geographies, commodities, and currencies. This is not a model portfolio, per se, but I have been providing commentary on what the model is suggesting in terms of sector rotation strategies, what geographies to be long or short in, as well as plays in commodities and currencies

In addition to the three standard sections, Wednesday usually includes several feature sections where the subject matter varies from week to week. Some of the features from the past three issues include:

• The VIX:VXV Ratio Continues to Perform Well
• NYSE Total Volume Suggests Rally May Have Run Out of Steam
• ‘Stock of the Week’ Averages Up 5% in One Day
• CBOE Equity Put to Call Ratio Remains Bullish (a shorter, updated version of this post went up on the blog a week later)
• A Long-Term Look at the VIX and the VXN
• Yield Curve Déjà Vu and Other Musings (a much shorter version of this post went up on the blog later)
• Is the Fed Done Cutting Rates?
• Market Breadth and Sustaining a Rally
• Highs and Lows in the S&P 500 Index

If anyone has any additional questions or comments about the subscriber newsletter, please feel free to email me at bill.luby@gmail.com or check out the subscriber newsletter blog.

The Return of the Links

There was a time where the most popular feature on the blog was my (mostly) weekly set of links to posts on other blogs that had given me something important to chew on. I never intended for that feature to die – and starting today I will do my best to resurrect it.

So without further ado, here is some of what I have been reading and thinking about in the past few days:

• Barry Ritholtz at The Big Picture reveals alternative methods for measuring GDP and inflation (neither of which are good news for the bulls)
• Felix Salmon of Portfolio.com provides the counterpoint for Ritholtz and leverages an interesting article by David Leonhardt in the New York Times to make the case for why inflation is lower than we think
• The Bonddad Blog is skeptical of an upturn in consumer spending or housing in the second half of 2008 (BTW, congrats on the upcoming nuptials!)
• Sudden Debt reflects on three decades of sentiment and consumer spending data
• Michael Shedlock at Mish’s Global Economic Trend Analysis, summarizes Bernanke’s proposals to slow foreclosures, with some excellent housing and mortgage maps
• Jesse at Jesse’s Café Américain has an update on credit default swaps, with some noteworthy banking chart porn
• Asbury Research has an intriguing analysis of the spread between US Treasuries and the Euro Bund
• Random Roger’s Big Picture has a link to a table of world interest rates
• Bespoke Investment Group’s analysis shows that previous winners led Wednesday’s decline
• James Hamilton at Econbrowser looks at changing driving habits and lower gasoline demand in the US
• Paul Kedrosky at Infectious Greed puts the ‘oil bubble’ in historical perspective…twice
• Jason at The Tasgall Group tracks down an interesting peak oil chart
• Brett Steenbarger at TraderFeed highlights sector rotation money flows into technology and financials
• Marc Andreessen at blog.pmarca.com speaks out in favor of dual-class stock structures for public companies
• Babak at Trader’s Narrative has an enlightening piece on cumulative market breadth
• Andrew Clavell of Financial Crookery analyzes Warren Buffet’s approach to selling long-dated index puts
• Don Fishback’s Market Update cautions against buying straddles before earnings announcements
• Adam at Daily Options Report is underwhelmed by the AMEX’s new fixed rate options (I had a similar reaction)
• Condor Options is wary of the internationalization of the VIX
• …and in the event you missed it, my Ten Things Everyone Should Know About the VIX has become my third most read post ever only 1 ½ weeks after it was published
• Finally, Scientific American weighs in on how you can pay off your sleep debt (do it quickly, before the interest rates reset!)

CBOE Equity Put to Call Ratio No Longer Bullish

The CBOE equity put to call ratio, which Stockcharts.com and I refer to as CPCE, has been generating consistently bullish readings since the beginning of 2008. Those bullish readings came to an end about a week or so ago, as the chart below reflects. That does not necessarily mean that options sentiment is turning bearish, only that the ‘free lunch’ portion of the bounce off of the March low is over. Now the likelihood of getting whipsawed – either on the long side or the short side – increases considerably. I suspect that a couple more days like yesterday will push options sentiment back into the bullish contrarian camp, but that remains to be seen. Until the market generates a stronger directional signal, priority should be given to conservative strategies.

VIX Surfing Down the Moving Average Channel

I have seen a number of typing heads out there proclaiming that the VIX is “too low” and therefore the recent rally is about to run out of steam. I have my own reasons (yesterday’s VIX:VXV ratio warning sign, for instance) for thinking that the current move is overextended, but labeling the VIX as “too low” is not one of those reasons.

As best as I can determine, most people who use the VIX to time the market focus on the distance between the current VIX value and 10 day simple moving average, with the expectation that the greater the distance between the two, the more likely that the VIX will snap back in the direction of the SMA. With that in mind, consider the chart below, which shows the VIX in the context of the 10 day SMA and two moving average envelopes that show the 10% (dotted green) and 20% (solid green) distance from the SMA. For the last 6 ½ weeks or so, the VIX has been dropping steadily, but in such a fashion that its movements have largely been constrained to a channel between the 10 day SMA and the -10% moving average envelope. At current levels, the VIX is barely 3% below the very same 10 day SMA, hardly what most would consider to be in the “too low” category.

The Commodities vs. Equities Battle Continues…

If the markets seem a more than little indecisive at the moment, one of the reasons is that ongoing sector rotation has muddied the waters with respect to what is hot and what is not. A lot of the sector rotation churning, on the other hand, is merely asset class trickle down, as investors try to decide at a much higher level whether they want to make a substantial commitment to equities and the possibility of a resumption in the recent bull market – or whether the hard assets of commodities are a more attractive option in light of natural resource shortages and concerns about inflation.

The commodities vs. equities battle has been tilting in the direction of commodities in recent months, but since the March lows the consensus has unraveled. In the chart below, the ratio is of the Rogers International Commodity Total Return Index (RJI) to the SPX. [RJI is an ETF linked to the Rogers International Commodities Index that has a broad weighting, with less emphasis on energy than most commodity indices] The ratio chart shows indecision over the past six weeks, with the symmetrical triangle pattern awaiting resolution. I am not sure which side will win the commodities vs. equities skirmish, but when we can declare a victor in this battle, we should know a great deal about the future of the markets over the next few months.

For a longer term perspective on this subject, see my Equities or Commodities? post of a month ago.

Relative Highs and Lows in the SPX

There are a wide variety of ways to measure market breadth, a number of which I have blogged about in the past in some detail. I have not, however, spent much time discussing new highs versus new lows in the S&P 500 index – and given that this blog spends an inordinate amount of time talking about the VIX, it makes sense that much of the analysis here eventually gets tied back in to the SPX.

Of course there is a chart for this – and in this case I have elected to go back through six months of bearish market movement to make my points. The relative high and low chart is best used for two purposes: to identify oversold levels; and to help flag a change in trend. In the chart below, the 20 day EMA dips below the 20 level in both January and February of 2008 for the first time since October 2002, signaling an oversold condition. The change in trend is harder to spot on this chart, but historically a bullish leg is usually underway once the high low index is back over the 65-70 level. Note that the chart ends with Friday end of day data; this week will bring a better sense of the strength of the current rally.

Limited Upside for Consumer Discretionary Sector?

As Corey at Afraid to Trade pointed out in Some Surprising Trend Day Action, one of the more interesting sub-plots in yesterday’s breakout was the strength in the consumer discretionary sector, which rallied 5.8%.

I am firmly of the opinion that the current stock market rally cannot be sustained unless consumer confidence, consumer purchasing power and consumer activity all rally in concert with the markets.

My concern with the consumer discretionary sector extends to a chart of the sector ETF, XLY. In the weekly chart below, the current level of the XLY (33.55 as I type this) is now back to the 32-34 area bounded by the symmetrical triangle formation of 2005-2006 and is also rapidly approaching the 34.08 50% Fibonacci retracement level. Both of these indicators suggest that the XLY should find considerable resistance in the 34-35 area; if this is the case, the market will have to rely on other sectors to continue the current bull rally.

Time for Biotech to Turn Around?

I have been experimenting with a new volatility-centric sector rotation model that I may start talking about in more detail in this space in the coming weeks.

I mention this because the system generated a buy signal in BBH, the HOLDRS biotechnology ETF. While the system does not require a confirmation signal from today’s trading, BBH is trading up with the broader markets today, albeit with a smaller percentage rise. The chart below shows that biotech actually bottomed in January and has not participated in the rally off of the March lows. Generally a healthy biotech sector is an indication of bullish speculative activity. As such, this is one of my ‘indicator species’ charts to watch.

[Note to readers: I have heretofore avoided any disclosure statements when writing about stocks and ETFs. As my content is currently being picked up by Seeking Alpha and other aggregator sites, I will now make it a practice of disclosing positions in any securities mentioned in my posts. If there is no disclosure, this means I do not have a position in any of the securities I reference, as is the case with BBH today.]