Snapshot Notes - May 12, 2008


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MONDAY, MAY 12, 2008

Volatility in Free-fall

05/12/08 3:30 PM EST

As of:

SPX 1375

HELP ARCHIVE

Earlier this morning, we went over a few reasons to expect some upside early this week. There were a few different aspects of the current market that pointed upward, but none of them were particularly strong and none of them targeted today specifically for the rally.

But rally we have, and handily so. In the process, we're already starting to see a couple of reasons that are turning the screws back to mildly bearish from mildly bullish just this morning. Among them are the Price Oscillator that we track intraday, and the giant sucking sound that is implied volatility.

The Price Oscillator tracks how the indices close with each half-hour's bar. The more persistent the trend, the more extreme the Oscillator gets. A rising Oscillator is a good sign of demand, but when it gets over 60% (which it did during the past half-hour), then that is when the trouble usually starts.

If you take a peek at the intraday charts, you'll see that over the past couple of weeks the Oscillator for both the S&P 500 and Nasdaq 100 peaked over that 60% area four other times, and each time it coincided with a spot where further gains couldn't be sustained.

The other concern today is implied volatility, most widely-reflected in the VIX index. The VIX is down more than 8% today and is trading at a six-month low.

I checked for any other time since 1990 that the VIX hit a six-month low, while the S&P 500, on which the VIX is based, was still at least 1% below its own three-month high. That would show us times when traders were assuming a low-volatility environment despite prices that might not justify that assumption.

Returns in the S&P 500 going forward were substandard (and negative) going out as far as two months. From one to ten days out, the S&P was positive less than 45% of the time, and showed an average return that varied between -0.1% and -0.8%. Not a huge negative edge, but certainly less than random. Since the last bear market ended, there were five occurrences, and all led to pretty poor short-term returns going forward (7/25/03, 4/23/04, 7/14/04, 9/10/04 and 2/4/05).

In the last bear market from 2000 - 2002, there were two pockets of concentrated readings like this, and both led to very poor performance going forward, which is no surprise. Those were in early and late June 2001, and again in mid-March 2002.

A common refrain over the past couple of weeks has been that the studies we've gone over have shown mild biases at best. It's been difficult to find anything among the sentiment-, breadth- and price-based studies we follow that would suggest it's wise to really push on either longs or shorts. The ones noted above are no different, but they're once again starting to tilt to the negative side.

I mentioned earlier that the Wednesday of option expiration weeks has been exceptionally strong over the past couple of years. I checked to see if it made any difference if Monday showed a large gain, but there were only two instances. One led to a market that flat-lined for the rest of the week, the other one led to a fairly stiff loss over the next few days. There isn't much we can read into that, and going back further than the past couple of years was equally inconclusive.

The two major indices that have the largest speculative following, the Nasdaq 100 and Russell 2000, are leading today, but both remain under the levels we've touched on a few times over the past couple of weeks (2000 on the NDX and 740 on the Russell). With the negatives we'd gone over heading into last week, and the fresh ones this afternoon, I'm still leery of our upside prospects in the short- to intermediate-term, particularly as long as those indices are under those resistance areas. I'll be looking for a good spot to sell short the broader market as the week wears on.

Intermarket Relationships Not Helping Much

05/12/08 9:25 AM EST

As of:

SPX 1375

HELP ARCHIVE

Good Monday morning...We begin the new week with a very slight positive bias to the pre-market futures. News flow has been relatively quiet, and the only real economic releases of note this week should be retail sales (tomorrow) and the CPI figures (Wednesday).

To start the week, we have a couple of potentially bullish implications. Like the negative factors we'd outlined heading into last week, most of what I could find was what I would consider minor.

The indices have pulled back over the past week, setting five straight days of lower lows in the S&P 500. That comes after the index had hit a three-month high a week ago, and while it is in an intermediate-term uptrend (an upward-sloping 50-day moving average).

This kind of setup has occurred 39 times in the S&P since 1950. The largest edge was for three days out, which showed a positive return 62% of the time and an average of +0.2%. The last five instances, going back to 2001, were all positive.

We also have option expiration this week, which has had a fairly positive bias over the past couple of years. Since the beginning of 2006, 74% of the option expiration weeks have been positive (20 out of 27), but the average return was only +0.5%. Wednesdays have by far been the strongest day of the bunch, being up 78% of the time by an average of +0.5% - accounting for all of the points gained during expiration week.

In addition, there was a notable divergence between the large-cap DJIA and small-cap Russell 2000 indices on Friday. While the Dow losses were in large part due to AIG, it's still been unusual to see that index down nearly 1% while there was risk-taking evident in the small-cap indices.

Over the past 20 years, when the Dow has fallen by that much on a day when the Russell 2000 managed to stay positive, the Dow was up over the next few days 62% of the time (21 out of 34) by an average of 0.5%. The Russell 2000 was up over the next few days 63% of the time by an average of +0.7%.

One of the factors that has been making the past couple of weeks difficult is that we've gotten quite a few conflicting signals among different markets. Since the October high, there have been some solid intermarket relationships that have helped us to forge better edges in stocks. But recently some of the correlations between stocks, bonds, commodities and currencies haven't been holding up as well.

One of those correlations is between stocks in the U.S. and the Euro/Yen currency cross. I went over this on May 1st, when we were seeing a divergence between stocks (which were rallying strongly), while the Euro/Yen was falling hard. That was an odd divergence, and it's one of the reasons I became suspect of the stock rally being sustainable.

Earlier this month, I posted a Data Brief that suggested that the Dollar rally had perhaps become a bit "too much, too fast" and was due for at least a short-term breather. Part of the reasoning for that was how traders were positioned in the Euro (extremely net short). If the Euro rallied based off too-negative sentiment, then the Dollar Index would likely fall, as the Euro makes up about 60% of U.S. Dollar Index.

Another 12% of the Dollar Index is made up of the British Pound. And the latest Commitments of Traders data for that currency contract now shows an equally interesting setup as you can see from the chart on the site. Just as speculators are net short the Euro to an almost record degree, they are in the Pound as well.

As we discussed in the Data Brief, the traders taking the other side of speculator positions are the "smart money" commercial hedgers. And hedgers in the Pound are now holding 80% of all existing long contracts, up from less than 20% in mid-March (just as the Pound was topping out). We'd have to go all the way back to June 2001 to find another time when commercials were holding a larger percentage of open interest in long Pound contracts.

I'm no currency expert, but a side trade I'll be watching this week is in the CurrencyShares British Pound (FXB). Based on the positioning of traders in the latest CoT report, that "stock" should be able to hold above its recent low of 194.

If it does, then then also creates something of a problem for stocks, potentially. Stocks and the Dollar have been positively correlated, so if the Dollar falls, then it would more than likely coincide with falling stocks. But sentiment on Oil and Gas has gotten way ahead of itself, meaning those markets should be taking a rest - which should help stocks.

Then we have the Treasury Bond market, which is about to enter an exceptionally positive seasonal period. Since the introduction of Bond futures, the 30-year contract has rallied 77% of the time between mid-May and mid-June, by an average of just over 2%. We've also seen sentiment on bonds come down from an optimistic extreme, helping to remove one of the headwinds in that market. And when bonds have rallied over the past six months, then stocks have usually fallen.

It's this kind of mixed picture which has been so confusing, and it's why I'm taking things very slowly and not trading much at all. We went over quite a few edges over the past couple of weeks, all pointing to weak equity prices. We got that last week, which helped to relieve some of those bearish implications, but most of them were longer-term than just one week.

Bottom line, this is a very muddled market to me and I'm not seeing the type of edge I prefer to see - in stocks, bonds, currencies or commodities - that make me interested in taking large positions. My best guess at this point is that we'll see a technical rally early this week as the major indices have come down to test probable support levels. But after that, I think we'll see another leg down that leads to lower lows than we saw last week.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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