Octoberphobia Volatlity Reigns

By: Gregory Clay | Mon, Oct 13, 2014
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10/12/2014 8:10:38 PM


Market Summary

Major Wall Street stock indexes fell for the third straight week. On Friday the S&P 500 and Nasdaq posted their largest weekly declines since May 2012 and the Dow Jones Industrial Average turned negative for the year, led down by technology stocks after Microchip Technology company warned of a major pullback in the industry. The S&P closed at its lowest level since late May and right at its 200-day moving average, a key technical indicator it has not breached since late 2012. The moving average also coincides with an intraday low hit early in August. For the week the Dow dropped 2.7 per cent. The S&P and Nasdaq, down 3.1 per cent and 4.5 per cent, respectively.

Previous Weekly Setup commentary is playing out as advertised "We expect volatility to increase over the next two months from the current historical lows including another price pullback.Don't be surprised if September starts strong but the market begins to fade as money managers' start selling off losers and repositioning assets for the end of the third quarter window dressing."

We also said "Last week all the major stock indexes followed the Russell 2000 lower.the Dow Jones Industrial Average is in danger of following the Russell 2000 index into negative territory for the year.mid-September breakout failed rather quickly.The Russell 2000 is having the hardest time, its 50-day moving average has crossed below its 200-day moving average, the dreaded "death cross". Russell 2000 does have a tendency to lead on the way up and the way down.October is the last month of the "Worst Six Months" for DJIA and S&P 500 and the last month of NASDAQ's "Worst Four Months." As confirmed in the updated chart below, the Dow Jones Industrial Average followed through on matching the Russell 2000 index in negative territory for the year. And you can see the other major indexes are moving rapidly towards being underwater for the year with the S&P 500 index next in line to go negative.

In the year-to-date S&P 500 index chart below we highlight the price falling below the long term uptrend line for the first time all year. This is considered a serious breach and the price is right at its 200-day SMA which is the next support level. If the S&P confirms a break below the 200-day SMA look out below as we are heading into correction territory.

Similar to the S&P 500 index above, in the Dow Jones Industrial Average chart below the index is priced right at its 200-day SMA which also serves as the long-term uptrend line. If the Dow index makes a confirm break below its 200-day SMA it will sink further into negative territory for the year.

Investors fled to the safety of government debt, with the 30-year Treasury bond’s yield nearing the 3.0 percent level for the first time since May 2013. The graphic below charts the performance of S&P 500 index compared to Treasury bonds. As we have been saying the past few weeks "It appears that investors are pulling funds out of equities as the market falls and parking the money into treasury securities." in the updated chart below treasuries are at 52-week highs as the S&P 500 is moving toward correction territory along with other equity indexes.


Market Outlook

Market watchers will be keeping an eye on the Fed as it was reported that Federal Reserve officials on Saturday took stock of a slowdown in the global economy and said it could delay an increase in U.S. interest rates if serious enough. Most notably, Fed Vice Chairman Stanley Fischer said the effort to finally normalize U.S. monetary policy after years of extraordinary stimulus may be hampered by the global outlook. The end of the month is the next schedule FMOC meeting and if the Federal Reserve starts hinting that it will remain accommodative to the financial markets this will almost certainly boost stocks higher into year end. The other key issue is how many companies exceed third-quarter revenue and earnings estimates plus fourth-quarter future guidance projections. If the Fed maintains a stimulus program and third-quarter financial results are good this should be sufficient fuel to catapult stocks back toward recent highs.

Stocks in major global markets closed out one of their worst weeks of the year on Friday, with an index of global equities hitting an eight-month low, and oil slumping to a four-year low as worries about slowing global economic growth darkened the investment outlook. Growing risk aversion has boosted buying in safe-haven government debt. Lipper data shows U.S.-based taxable bond funds attracted $12.7 billion in inflows for the week ended Wednesday, a one-week record, while U.S. equity funds saw $6.7 billion in outflows, with most coming from exchange-traded funds. Notice in the chart below how over the past month skittish investors are focusing on investments that benefit from a low interest rate, low inflation environment. The traditional equity sectors are being sold off as investors worry about future global economic growth trends.

Another tool that we use to help confirm the overall market trend is the Bullish Percent Index (BPI). The Bullish Index is a popular market "breadth" indicator used to gauge the internal strength/weakness of the market. It is the number of stocks in an index (or sector) that have point & figure buy signals relative to the total number of stocks that comprise the index (or sector). So essentially it is the percentage of stocks that have buy signals. Like many of the market internal indicators, it is used both to confirm a move in the market and as a non-confirmation and therefore divergence indication. If the market is strong and moving up, the BPI should also be moving up as more and more stocks make the "buy list." When the market moves down, one expects the BPI to also move down to confirm the market's weakness. As seen in the updated chart below, the S&P 500 BPI has been sinking lower and lower as money managers continue selling stocks.

Similar to the S&P 500 index above, the NYSE Bullish Percentage Index below is plunging as large cap stocks are being sold along with small caps.

A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the general stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi charts are similar to the Japanese candlesticks charts you are used to seeing. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend.

Last week we reported "Notice that momentum is in a confirmed downtrend.If there is a break above the downtrend line in the chart, this will confirm the bullish divergence signal." In the updated Momentum Factor ETF (MTUM) chart below, bullish divergence was not confirmed as the downtrend line remains intact. As noted, bearish momentum is getting stronger. However what is really sounding an alarm is bearish distribution shown in the chart. Bearish distribution is defined as falling prices on higher than normal volume. Multiple bearish distribution days occurring within a few weeks of each other is considered a sign of large institutional traders dumping stocks. Until we get a bullish accumulation day (higher price on above average volume) and/or the downtrend line is broken expect prices to continue falling.

In a sign of increased volatility, the CBOE Volatility Index (VIX), the market's favored gauge of Wall Street anxiety closed at 21.24, its highest level since December 2012, as more investors purchased puts for protection against further declines. More than 27 million contracts traded in the U.S. options market Friday, according to Trade Alert data, the busiest day of the year. As circled in the weekly Volatility Index (VIX) chart below the VIX is at a level it has not reached almost two years. Though recent history suggest that volatility is high, prior to the current long-term bullish leg the VIX regularly reached between 30's and 50's. Therefore, don't be surprised if the volatility gets to much higher levels.

In the one-year CBOE Volatility Index (VIX) graph the index has jumped to the same level where stock prices crashed earlier in the year. We recently said "If stocks continue to slide investors will continue pushing the index higher.This indicates that investors are getting a little nervous about the market and are buying more put option contracts to hedge their long stock positions."

The current American Association of Individual Investor Survey (AAII) survey percentages are right at their long-term averages. What is even more surprising considering falling stock prices is that the bullish percentage actually increased substantially last week. Last week we said "If the current AAII sentiment survey trend continues expect individual investors to become even less bullish." We consider AAII survey results to be a very reliable contra-indicator of near term price direction. Individual investors are usually wrong about the market and the fact they have become even more bullish in the face of falling prices suggests there is more downside to be had. It appears individual investors may be holding on to long positions and preparing to ride out the near term bearish move and anticipating a year-end bounce.

Second-quarter National Association of Active Investment Managers (NAAIM) exposure index averaged 81.64%, the third-quarter average dropped to 71.09%. Last week the NAAIM exposure index was 41.03%, and the current week's exposure is 33.14% as the percentage is sinking to extraordinary lower levels. As discussed above, nervous money managers are pulling funds out of equities and parking the money into treasury securities.


Trading Strategy

Last week we introduced the term "Octoberphobia" which is used to describe the phenomenon of major market drops occurring during the month. Market calamities can become a self-fulfilling prophecy, so stay on the lookout and don't get whipsawed if it happens.

Money managers have scrambled to reduce big bets in stocks and other risky assets as expectations for world economic growth have shifted in recent days. Our previous analysis reported "Consumer staples normally strengthen in the fall." In the updated chart below you can see that Consumer Staples and Utilities retained their value compared to other sectors over the past month. But whatever you do it is prudent to avoid energy stocks as this sector continues to be decimated with no letup in sight. Even short positions on energy stocks would be dangerous at this point as most of the downside move may have already been gotten. Keep in mind that 'holding cash' is a viable strategy. Considering current market volatility, maintaining a high cash position is an excellent move because you can take advantage of 'buying the dips' when prices stabilize.

Regards,

 


 

Gregory Clay

Author: Gregory Clay

Gregory Clay
Option Strategist
High Value Option Trader
Weekly Income Credit Spreads
Easy Money Options Income

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