After Expiration, Volume (Not Necessarily Volatility) Will Drop

08/14/08 3:35 PM EST

As of: SPX 1251 HELP  ARCHIVE

After the gap down opening caused by a bad mix of higher inflation and higher jobless claims, equities roared back and have spent most of the afternoon trying to cling to those gains.

We've seen some big TICK readings in both directions today, no doubt due in part to tomorrow's option expiration, but it also seems a bit like traders are punching the clock before heading out on vacation.

Volume has been declining for most of the past week, and that is going to continue through the end of August barring some outstanding circumstances.  Tomorrow may be an exception due to option expiration (when volume can be quite high) but other than that we're about to enter the peak of vacation season before the school year begins after Labor Day.

The chart below shows the average weekly composite volume for NYSE stocks over the past decade, compared to its average over the prior year.  Bars rising above zero mean volume is higher than average; bars below zero mean below-average volume.

From the chart, we can see that the first five weeks of the year tend to have exceptionally high volume, averaging about 20% above the yearly average.  After that, we see a gradual move closer to average until about week 21 when we oscillate above and below.

The blue highlight shows weeks 33 through 37, the zone we're now entering.  All of them are below zero, averaging about 7% below average.

Low volume often translates into whippy, narrow-range days, so let's take a look at how the average daily changes in the S&P 500 fare during the upcoming weeks compared to average:

There actually wasn't much of a deviation in late August - two of the weeks showed slightly below-average daily changes, but we didn't see any really extreme contraction in the percentage that the S&P moved on a daily basis, despite the traditionally low volume.

Earlier in the summer, we saw a multitude of bars below the zero line (highlighting times of smaller than average daily changes), and during late September and October most of the bears are well above zero (meaning highly volatile conditions), but the upcoming period didn't show a clear pattern one way or the other.

One of the takeaways from this is that even though we will almost certainly see volume drop off precipitously over the next two weeks, that shouldn't lead us to be complacent - we're still going to see some big moves.  In fact, over the past decade the VIX implied volatility indicator has risen during the last two weeks of August 61% of the time by an average of more than +2%, and with an average maximum gain (+14%) well above its average maximum decline (-9%).

Directionally, there isn't much to go on for the equity indices.  There has been no discernable seasonality pattern that holds over the last weeks of August.  There is a small (but consistent) upside bias coming up over the next few days, but after that it's a 50/50 proposition.

Just taking a peak at something I mentioned this morning with regards to the out-performance of the Russell 2000 versus the DJIA, over the last two weeks of August the small-cap Russell has out-performed the large-cap Dow nearly 70% of the time over the past 20 years, including 8 of the last 9 (last year was the only exception since 1999), so perhaps that index has a bit more to go before we see the usual mean-reversion kick in with a return back to larger-cap stocks.

As far as the broader indices go in the short-term, I don't see much here that's intriguing from either side of the coin.  Our most sensitive guides have cycled back from the oversold conditions they reached yesterday and in fact the Price Oscillators even hit overbought levels earlier today.  At the moment, pretty much everything is neutral.

Other than a new sign of excessive speculation among Rydex traders, understandable given the recent run by technology and small-cap stocks, most of our other guides are either neutral or cancelling out an opposite extreme in a different indicator.  The studies we went over since July 15th gave a good hint at a one- to three-month rally, and we're reaching the lower limit of that general time frame now, but there should be more to go in this recovery and I continue to have a general preference for long-side setups.

With the alleviation of the most recent oversold conditions, I don't see much of an edge here in the short-term.  We usually have some negative seasonality immediately following option expiration, but during August that bias has been neutralized, so I'm pretty much just sitting on some intermediate-term longs and not doing much from a trading perspective.

More Index Divergences Highlight Odd Environment

08/14/08 9:25 AM EST

Good Thursday morning...We begin the day with a modest hit in the pre-market futures as traders did clearly not like the tone of the morning's economic reports.  Higher inflation and jobless claims are not a good combination, and the S&P's sold off 15 points in response.  Commodities are backing off a bit as well, and foreign markets were mixed.

Over the past couple of days, we've looked at the divergence between the S&P 500 and Nasdaq 100, as the former got hit fairly hard while the latter held up very well.  Historically, that has been a positive for the markets on a very, very short-term time frame but other than that there wasn't much to it.

Another standout divergence is the one between the small-cap Russell 2000 and the large-cap Dow Jones Industrial Average.  Once again yesterday, those two indices diverged in a major way, with the Russell performing well while the Dow, not so much.

Looking back over the past 20 years, there were 37 other days when the indices diverged as much as much as they did yesterday.  Going forward, there wasn't much that was consistently positive or negative - the most stand-out results were after one week, when both indices were up nearly 65% of the time with solid, but not outstanding, average returns.

The most consistent relationship was the one between the two indices.  The next day, the Russell out-performed the Dow 60% of the time by an average of +0.4%.  The small-cap index continued to beat its old, wiser cousin up to two weeks later, but then the gap between the two began to narrow and became more in line with random the longer out we looked.  Once again, this kind of divergence was a short-term affair.

When looking at the bigger-picture difference between the two, we see that the Russell is within 3% of its six-month high, while the Dow is still more than 10% below its own six-month high.  We've only seen that once before, which was from mid-February 2000 through mid-March 2000.  The Dow greatly under-performed the Russell during that stretch but when the markets bottomed in mid-March, it was the large-cap indices that roared back while the small-caps got hit.

There isn't much we can read into one instance, but generally when we see these kinds of extreme differences between indices, we get some additional short-term movement in the direction of the divergence, then mean reversion.

We'll see that tested today as we get a gap down opening.  Since the market really began worrying about inflation in the beginning of 2007 and as indices like the CRB Commodities Index were about to take off on a 50% rally, traders have actually responded in muted fashion to the monthly CPI reports - the S&P 500 has gapped up 56% of the time on the morning of the reports since the start of 2007, and it has ended the day higher about the same percentage of the time.

When the S&P has gapped down 0.25% or more, as it is indicated to do this morning, the very short-term performance was mixed, finishing higher than the close 3 out of 6 times.  But three days later, the index was up only 1 of the 6 and showed an average return of -0.9%.  When the S&P gapped up by 0.25%, in contrast, then after a few days it showed an average return of 0.2%, so there was quite a difference there.

This is a very unusual juncture we're dealing with at the moment, with high-beta indices like the Nasdaq 100 and Russell 2000 doing well and hovering at or near overbought territory, while more senior indices like the S&P 500 and DJIA have been hit fairly hard and are closer to oversold than anything.  That conflict is reflected in most of our broad-market sentiment indicators, which remain locked evenly between bullish and bearish extremes.

The out-performance of higher-risk sectors has been noticed by Rydex mutual fund traders, which have once again begun to gravitate towards where the action is - our Rydex Beta Chase Index is back up to a level of 4, meaning that those traders are four times more likely to trade a risky fund than a safer one.  That's approaching "excessive speculation" territory that has caused some trouble for the market in the past.

I mentioned yesterday that given some short-term oversold readings and an approach towards support, the S&P should be able to hold on to the 1280-1285 area.  It broached that intraday but rallied strongly in the afternoon to close above that zone.  Today's gap is taking us right back down towards yesterday's lows, which we should see hold if the recent breakout is going to last.  If we go on to make lower intraday lows today, below yesterday's low, then my guess is we're going to see 1250 before long.  I'm still at least modestly bullish in an intermediate-term time frame so I have a general preference for looking for long-side opportunities, but a failure to hold this breakout wouldn't be especially encouraging.