The Impact of Financials and Energy Stocks on the VIX

The rapidly changing fortunes of financial institutions and energy stocks have been widely chronicled – so much so that there is no need to repeat the details here.

The implications of the shift away from financials and toward energy touch upon several issues that I have not yet seen addressed in the media. One of the obvious ones is the composition of various stock indices. In the S&P 500 index (SPX), for instance, just from 2007 to the present, financials have dropped from 22% of the index to 14% of the index, while energy stocks have surged from 10% to 16% of the index. The change is particularly important when one considers that financials (XLF) have historically been highly correlated to the SPX (0.91 over the course of the past year), while the energy sector (XLE) has typically had the lowest correlation to the SPX (-0.28 for the past year).

Consider that in the past year, the index has been tilting away from financials and toward energy stocks, essentially swapping a positive 0.91 correlation for a negative 0.28 correlation. Given that the VIX is based on SPX options, there can be little wonder why the VIX has been moving more lethargically as of late: an increasingly dominant sector – the energy group – is pulling in the opposite direction of the other sectors. The result? Sector gridlock is dampening the movements of the SPX and of SPX derivatives, like the VIX.

[Hat tip to Adam at Daily Options Report and Don at Don Fishback's Market Update for jump starting some of my thinking on this subject.]

Headwinds Index: Financials (XLF) vs. Oil (USO)

Two numbers have been moving consistently in the wrong direction for the US economy during the past few months: oil prices and bank loan portfolio quality.

The chart below, which reflects a ratio of the valuation of financials (XLF) to crude oil prices (per the USO ETF), neatly captures the recent double threat posed by trends in these two sectors.

You can make an excellent argument that a bottom will not be in until at least one of the two trends, probably both, have reversed. My thinking is that the XLF:USO ratio chart is an excellent tool to monitor those two trends and pinpoint the turnaround. At the very least, I consider the XLF:USO ratio to be a reasonable proxy for two of the major headwinds that the markets are grappling with.

VIX:VXV Ratio Approaches Bullish Territory

One of the better indicators over the past 7 ½ months has been the VIX:VXV ratio, which, as the chart below shows, has been quite accurate in calling tops and bottoms in the market following the VXV launch back in November 2007 and I whose application I pioneered soon thereafter. I mention this because the last time the VIX:VXV ratio gave a clear bullish signal was at the mid-March bottom; and the ratio is coming close to another VIX:VXV bullish signal today.

For more information on the VIX:VXV ratio, try The VIX, VXV and Volatility Expectations. For more information about the VXV, try Thinking About the VXV.

Most Read Posts of 2008 (as of 6/30/08)

I recently received a request to supplement my Most Read Posts of 2007 compilation with something more up to date.

My original intention was to wait until the end of the year to highlight the top posts of 2008, but since this year has already been a historic roller coaster ride of sorts, I see no reason not to take a snapshot at the halfway mark.

So, without further ado, the top 25 most read posts of 2008 (through June 30^th):

1. Ten Things Everyone Should Know About the VIX
2. The Fallacy of the Bearish First Five Days
3. Fear and the Flight to Safety
4. Strong Bear Signal from VIX:VXV Ratio
5. VIX Numbers and Overbought Signals
6. Volatility RIP
7. Equities or Commodities?
8. A Long-Term View of the Put to Call Ratio
9. Implied Volatility Suggests Risks in Financials at Six Month Low
10. SPY Put Volume Study
11. Short Interest Screens
12. Lehman Teetering Again
13. What Is High Implied Volatility
14. Brunhilde Day Today?
15. Persistent High Put to Call Ratio
16. Chart Porn
17. Can Markets Bottom Without a VIX Spike?
18. The Rising Popularity of XLF Options
19. What Fell and What’s Bouncing
20. VIX Macro Cycle Update
21. The VIX, VXV and Volatility Expectations
22. ISE Implied Volatility Charts
23. BIDU Speculators
24. SPX to VIX Ratio Turns Up
25. Volatility History Lesson: 1987

On Measuring Volatility

Mike at HEDGEfolios.com has a good post up today with the title of Measuring Volatility. He touches a lot of bases, but it all starts with the following statement:

“When it comes to measuring or sensing stock market volatility, I do not follow the VIX.”

Now I may have invented that silly tagline, “Your one stop VIX-centric view of the universe,” but I am the first to argue that a defaultist mind set is the wrong way to approach the investment landscape. If you follow the same indicators with the same default settings as everyone else, you are setting yourself up not just to follow the crowd, but to be a half step behind it. In order beat the crowd, what is needed is a variant perception.

Back to HEDGEfolios for a moment:

“The key element of volatility using traditional methods like the VIX rests on the reversal at extremes in a contrarian indication such as buying when the VIX exceeds 30. This is a very dangerous concept and I do not advocate for its use… I never liked that approach so I do my own thing and look at each stock, the turnover in each and how the composite of all signal changes indicates the market volatility.”

Volatility is a wide-ranging concept. It can be defined, measured and applied to over 10,000 stocks and ETFs in many different ways. To think that best way to harness information about volatility is to buy when the VIX hits X is ludicrous.

Consider that the concept of volatility can be applied not just to price, but to volume, options prices, market breadth data, etc. Volatility is a characteristic of every slice of the almost infinite flow of data that is associated with the markets.


It’s not just what you measure, it’s how you measure it. Volatility can look forward when it is in the form of a forecast or a derivation, such as implied volatility. When volatility looks backward, the opportunities to get creative are even richer. There is historical volatility, average true range, Bollinger bands, Chaikin volatility, relative volatility, and a variety of ways in which to index volatility.

Go ahead and watch the VIX, but don’t think for a moment that you are going to have an advantage over the thousands of other people who are watching the same indicator. Sure, you might come up with the next great VIX permutation, but you are far more likely to get a leg up on the competition by revisiting some basic questions:

• Is volatility worth following?
• How can more knowledge about volatility make me a better investor?
• Which aspects of volatility should I pay attention to?
• How should I measure that type of volatility?
• How do I interpret those measurements for maximum ROI?

One of my favorite measures of volatility is the number of buy and sell signals my various systems generate each evening. It’s simple, but effective. And I can be sure that nobody is not going to show up on CNBC tomorrow touting the same approach.

Getting Tougher to Push Financials Lower from Here?

Halfway through today’s session, my screen is once again filled with red, as the indices look as if they are poised to take a run at yesterday’s lows.

From a sector perspective, the picture is considerably muddier, as two recent laggards, financials (XLF) and consumer discretionary (XLY), are clinging to positive territory as I type this. As I see it, one or the other of these sectors will have to continue to deteriorate if the markets are going to continue lower from current levels.

Given that the financials are already down 53% from their May 2007 highs (see chart below), it is important to keep in mind that the easy money has already been made on the short side. A wide variety of financial sub-sectors (mortgage companies, bond insurers, money center banks, regional banks, investment banks/brokers, etc.) have already made multiple trips to the woodshed – and while some individual issues may still be quite vulnerable going forward, there is a limit to the amount of blood that can be squeezed from a broad-based ETF or index.

Going forward, I suspect the risk/return profile of the financial sector may actually favor the bulls. If the next couple of broad market moves down fail to pull the financials with them, the path of least resistance for the likes of XLF may indeed be up. Keep an eye on this development, because if (and admittedly this is a very large “if”) the financials are done falling, then the markets are likely to be ready to put in a bottom too.

Fearogram Maps Recent VIX Complacency

There has been so much talk about complacency in the VIX that I thought I should dust off the old fearogram and see just how complacent the VIX has been as of late.

For those who are new to the concept of the fearogram (a term I hatched last October), it is essentially a chart of the daily change in the VIX vs. the daily change in the SPX. (For more background on the fearogram concept, try previous posts with the fearogram label.)

The chart below plots a best fit diagonal black line which represents a ratio of the daily percentage change in the VIX to the daily percentage change in the SPX for every trading day going back to 1990. Essentially, the larger the distance between individual data points and the fearogram best fit line, the more extreme the level of fear or complacency. For data points above and to the right of the best fit line, the VIX is increasing out of proportion to the drop in the SPX, indicating more fear. For data points below and to the left of the best fit line, the relatively muted reaction of the VIX suggests more complacency. Data points that hug the best fit line are indicative of a VIX that is consistent with typical historical relationships between the VIX and the SPX.

In the chart below, the blue diamonds are plots of individual daily ratios of VIX and SPX percentage changes for each day during the past two weeks. In studying the chart, note that during the past two weeks, the VIX has never once shown more fear than is reflected in the average daily ratio.

Of course, today is looking like it could be the day the tide finally turns.

Portfolio A1 Performance Update: 6/30/08

Per reader request, what follows is a snapshot of Portfolio A1 for the month ended June 2008.

The chart below shows the equity curve and some summary performance statistics for Portfolio A1 since the equities only (no ETFs or options), long only portfolio was created on February 16, 2007. During the 16 ½ months since inception, Portfolio A1 has posted a cumulative return (exclusive of dividends) of 23.9%, while the benchmark S&P 500 index has declined 12.1%. This adds up to a net performance of +36.0% for the portfolio vs. the benchmark.

The graphic to the right provides some additional performance details for Portfolio A1 vs. the S&P 500 index over a variety of time frames. For the second quarter of 2008, for instance, Portfolio A1 returned 17.6%, while the S&P 500 was down 3.2%

For the record, Portfolio A1’s current holdings include: Mosaic (MOS); TBS International (TBSI); PetroQuest (PQ); DreamWorks Animation (DWA); and Homex Development Corp (HXM). Portfolio A1 also shares some common ancestry and has a stock ranking system that is similar to the VIX and More Focus Aggressive Trader model portfolio – one of the four model portfolios that I update transaction by transaction for the VIX and More subscriber newsletter.

Finally, I would be remiss in not reiterating that Portfolio A1 was created with tools developed by Portfolio123.com and is managed via Portfolio123.com’s tool set. For more information on Portfolio123.com, please refer to an earlier post on the subject, Portfolio123.com: The Engine Behind Portfolio A1.

Don Fishback on Complacency in the VIX/VXO During Selloffs

When someone follows the VXO more closely than the VIX, it is usually because they have been doing it for a decade or more and found no reason to switch when the CBOE changed how the VIX was calculated back in 2003. For all practical purposes, the differences between the VIX and the VXO are not meaningful enough for most investors to warrant monitoring both volatility indices.

With that preamble out of the way, I am pleased to report on some interesting research on the VXO by Don Fishback, who is indeed an experienced hand when it comes to options and volatility. Looking at instances going back to 1986 in which the OEX (the S&P 100 index, which is the underlying for the VXO) declined 10% and the VXO remained under 30, Fishback concludes:

“Bottom line is that when the market falls 10% off of a recent high, and VXO stays below 30%, what was bad gets worse. In every prior instance where VXO failed to climb to above 30%, the market continued lower. The MINIMUM additional downside is another 10%.”

Granted, these conclusions cover only six data points that fit the statistical profile noted above, but the correlation between the level of the VXO when the 10% OEX decline is met and the extent of the subsequent decline over all 14 data points in the study is also worth pondering. Read the full article at 10% Declines and VXO Less than 30% and consider checking out another take on Don’s work by my blogging alter ego at Daily Options Report.

When it comes to VIX spikes a signs of a market bottom, my thinking is remains that while we don’t need a Brunhilde Day to signal capitulation, the higher the VIX spike, the higher the odds that a bottom will hold. See January’s Can the Markets Bottom Without a VIX Spike? for a more detailed discussion of VIX spikes and market bottoms.

NDX Drops 4% and IBD Bag Indicator Is Yellow…

Earlier this month I talked a little bit about the mean reverting bounce associated with a 3% one day drop in the SPX in VIX Spikes and SPX Drops Are Not Necessarily Two Sides of the Same Coin.

Yesterday, we had a 4% drop in the NASDAQ-100 (NDX) and, not surprisingly, the 33 year historical record of 4% drops in the NDX suggests that a bounce is again likely to follow yesterday’s pain. What I found particularly interesting is that the bounce following a 4% NDX drop has a lifespan of only a month or so before any incremental gains revert back to the historical norm. In fact, the maximum post-bounce advantage peaks at about ten trading days, then slowly starts to erode. Looking at data from all 108 of those 4% drops, average performance begins to drop after the tenth day and is decidedly bearish during the period of 2-6 months after that 4% drop.

Part of the reason for this statistical bull trap is the relatively high number of 4% drops in the NDX that occurred during the 2000-2003 period (accounting for 75% of all 4% drops during the 33 year period under study), which lends a bearish cast to the data.

So what about the IBD bag? Well…someone decided to start me on a trial subscription to Investor’s Business Daily about a week or two ago. I scanned the paper for the first few days and noted with a smile that it came wrapped in a green plastic bag. Yesterday the paper arrived in a yellow bag and I wondered if this was some sort of signal from Bill O’Neil or God or perhaps both. Of course, the markets proceeded to plummet on that yellow bag day. So today I look outside in eager anticipation to see what color the bag is and it’s yellow again. This time the markets are only down about 0.7%, but the day is young. I wonder what it means when the paper arrives in a red bag?

New 2008 Low in the DJIA, Yet VIX Shows Complacency

I have received a number of questions and comments in which readers have expressed surprise about the relative complacency in the VIX (currently at 23.51 as I type this) while the DJIA is in the process of making a new low for the year.

One important and often overlooked element of a VIX spike is surprise. Similar to Nassim Taleb’s idea that a black swan cannot be anticipated, if all of the Bob Janjuah’s of the world predict an impending market crash, the media runs with the story, and investors rush out to snap up portfolio protection…then it becomes much less likely that people will panic and the market will crash if stocks start to turn down. Put another way, where there is a safety net, there is a lot less fear.

Another point worth noting is that the DJIA is not representative of the broader markets, as reiterated by Adam at Daily Options Report today in Lookout Below? The Russell 2000 and NASDAQ-100 indices, for instance, are showing considerably more resiliency in the recent downtrend.

Turning to the VIX:SDS ratio, which I unveiled last August in Fear vs. Volatility (follow the links for some background and explanatory notes), I use this indicator to evaluate the amount of fear and complacency in the market relative to market movements. The size and direction of the gap between the current ratio and the 100 day SMA or the 10 day SMA and the 100 day SMA provide some useful information about the incremental sentiment involved in market moves.

At the moment, it looks as if the VIX:SDS ratio is showing a small amount of complacency, which I find a little unusual for the current market environment, but not particularly noteworthy. Of course, if investors see the monster approaching and prepare themselves accordingly, it is a good bet that the monster will never quite make it close enough to terrify the markets.

The Three-Legged Stool

The issue of whether to rely primarily on fundamental or technical analysis is one that each investor has to struggle with, usually a number of times over the course of his or her investing lifetime.

While the relative merits of the two approaches will appeal to different types of investors, I find it hard to believe that the high court of investment strategy will ever rule in favor of one approach at the expense of the other.

None of this stopped Felix Salmon of Portfolio.com from launching an attack on technical analysis in Monday’s Adventures in Technical Analysis, Jim Cramer Edition. After giving Cramer a well-deserved lambasting, Salmon makes the jump from the particular to the general case:

“…Stock traders don't know anything.

It's not just Cramer, is the point. They all do it: even much smarter and much more analytical traders like Barry Ritholtz do it too. Do what? Resort to ‘technical analysis’, which is the art of drawing lines on charts and extrapolating from them what the market is going to do next.

Whenever you hear words like ‘overbought’ or ‘oversold’ or ‘momentum’ or ‘support’ or ‘resistance’, it means that whatever you're hearing is garbage. But it also means that the person you're listening to has no idea what's about to happen, and is therefore resorting to the financial equivalent of astrology.”

For starters, I would consider Cramer to be more of a fundamental guy than a technical analyst, but that is not the important point. Interestingly, to my thinking, Barry Ritholtz spends as much time as anyone writing about macroeconomic and fundamental issues, but this apparently escaped Salmon’s notice as well.

Ritholtz’s succinct response, which can be found in its entirety in Let’s Get Technical, includes a reframing of the question and a quick summary of some of the merits of technical analysis:

A better question to ask is "What information do charts and related data provide, and how can this be used by investors and traders?"

I posit that, when used appropriately, charts and data can provide tremendous insight:

- Provides a statistical approach to investing, one that describes the probabilities of various outcomes (versus making predictions)
- Charts show you if we are in a bull or bear market, allowing you to manage risk appropriately;
- Trends can keep you away from the wrong sectors (Housing, Autos, and Finance are obvious examples) or keep you in the right sectors (eg., Energy and Ag)
- Developing good risk/reward analyses;
- Tracking what the institutions are doing;
- Identifying specific stocks that might be appealing;

The bottom line is that TA is merely a tool, albeit one used more skillfully by some than others.

Finally, consider this question: If you could look at one and only one source before buying your next stock or fund, which would you choose: a fundamental analyst's report (with no charts in it), or any chart of your choosing? While I like having access to both, I cannot ever imagine buying something without first looking at the chart …”

There are many examples of investors who have been very successful investing exclusively with a fundamental approach – and I’m sure there are at least as many investors who have prospered mightily using only technical analysis. Part of the reason investors gravitate to one approach or the other is that it fits their personality and provides a certain level of comfort.

To my thinking, the most important determinant of whether to focus on fundamentals or technical analysis is one’s investment time horizon. In a nutshell, the shorter the time horizon, the more important technical analysis becomes. Find me a day trader, for instance, that invests primarily based on fundamental factors. One the flip side, find me a chartist who is looking at monthly charts covering more than a decade who does not think it is important to be educated on some of the relevant fundamentals that are driving the long-term price action.

Personally, I like to think of my trading style as marrying roughly equal parts of technical analysis and analysis of market sentiment (which I consider to be tangential to TA), informed by a broad view of stock and industry fundamentals, in the context of a larger macroeconomic environment and interrelated global markets. Ultimately, it’s a three-legged stool, with TA, market sentiment, and fundamental analysis providing a balanced perspective.

Finally, I have received a number of comments in which readers have expressed surprise that my subscriber newsletter covers a much broader range of topics than is generally touched upon in the blog. The reasons for this are simple. All the talking heads talk about macroeconomics and fundamentals all day long. There are also a number of blogs and other web sites that spend a lot of time analyzing charts and other TA data. I choose to focus on market sentiment on the blog because I don’t believe this subject gets nearly the attention it deserves. Those who understand volatility, put to call ratios, market breadth data, and other related subjects and who can combine that information with a fundamental + technical approach have a much greater chance of success than those who ignore market sentiment.

In the subscriber newsletter, I utilize a holistic approach to the markets and incorporate a broad range of themes, because I believe it is important to see the whole playing field and not to have any investing blind spots. The approach seems to be working, as I have a 98% renewal rate and am in the process of writing a book on the subject, slated to be published by Wiley Trading in the first half of 2009.

SPY Put Volume Study

For those who were underwhelmed by yesterday’s monthly charts of the call volume and put to call ratios for the VIX, I am going to try to whelm you a little more by switching over to weekly charts of SPY (the ETF for the S&P 500 index) puts.

The logic here is that those who may not want to be short the market (or hedge long positions) with the additional leverage of VIX calls may prefer the increased liquidity, dollar strike price increments, and penny pricing benefits of SPY puts.

Looking at the chart below, the SPY put volume correlates nicely with intermediate bottoms in the SPX/SPY. Note the current spike in put volume. It is something to think about, anyway, as you contemplate what the Fed could possibly say that might put a stop to the slide in the equities market.

VIX Put to Call Ratios and Call Option Volume

I have not yet posted much about VIX call options volume on the blog, but the subject of VIX option volume and put to call ratios is an interesting one that I will return to periodically.

First, I should set some context by pointing out that two years ago, it was rare for VIX options volume to hit one million contracts in a single month. Following the record 64% one day spike in the VIX on February 27, 2007, VIX options suddenly surged in popularity, with their monthly volume rising steadily and peaking in August 2007 at 7.15 million. Interestingly, since last August, VIX options volume has been fairly steady month to month and has been averaging about 4 million contracts per month.

Given the general increase in activity in VIX options volume, it should come as no surprise that the call volume has surged with the overall options activity. For this reason I have included two VIX options charts, each with the monthly close in the SPX for reference. The top chart shows two years of the VIX monthly put to call ratio. From a quick visual study, it is difficult to conclude that this data provides much in the way of meaningful clues about future trends in the SPX. The bottom chart is a two year history the VIX monthly call volume (with projected end of month volume for June based on data through 6/20/08) and shows a moderate negative correlation between the VIX put to call ratio and movements in the SPX, particularly during 2007. I mention this because VIX call volume for the month of June is on track to be at its highest level in at least 7 months, with the spike in VIX calls increasing the likelihood of a market bottom in the near term.

Consider this an appetite whetter; I will delve more into VIX options and various interpretations of VIX options data in this space going forward.

Volatility at RKH Regional Banking ETF

I just mentioned RKH, the HOLDRS regional banking ETF, on Wednesday in Regional Banking Woes Worsen, where I also posted a graph of RKH’s six month stock price and 30 day implied volatility.

I am revisiting RKH today with a slightly different chart, also courtesy of the ISE, that compares RKH’s implied volatility and historical volatility over the past six months. In the chart below, notice that the implied volatility in this ETF has been more of an uptrend than the spike from mid-March. Notice also that implied volatility appears to have hit a plateau and is still far below the mid-March peak.

Also of interest, the gap between implied and historical volatility is at a six month high right now, as historical volatility has been trending down over the past three weeks at the same time implied volatility has been trending up.

Finally, note that in those instances where historical volatility has been elevated, it usually preceded a drop in implied volatility; conversely, where historical volatility has been depressed, this has a tendency to precede an uptick in volatility. Volatility extremes often signal turning points. Whether the current high implied volatility and low historical volatility means that the regional banks are finally bottoming remains to be seen, but I have to believe that the probability of a bottom is increasing with each volatile session.