Morning Market Comment - July 7, 2009

Good morning...We begin the day with flat pre-market futures. The economic calendar is light this week, and while Alcoa kicks off earnings season tomorrow, the deluge of 2nd-quarter reports won't begin until the week after next, when 30% of the S&P 500 components are scheduled to announce their performance.

When most folks talk about stock market sentiment, there are usually just one or two indicators they are referencing - the VIX and/or the Investor's Intelligence sentiment survey. For whatever reason, those two indicators have become the de facto standard.

Both have their weaknesses, and it's not a good idea to rely solely on either, but still that's where a lot of people stop their sentiment analysis. The VIX got a huge amount of attention last fall, and rightly so, as it rocketed to multi-decade highs during the financial collapse.

Since then, stock market movements have dampened down, causing both historical and implied future volatility (which is all the VIX measures) to gradually return to more normal ranges.

There was an article on Bloomberg on Monday regarding the VIX, and how it was languishing near multi-month lows. Usually, the interpretation of that is that traders have become relatively complacent, and thus there is little demand for the protection of put options.

In a curious development, despite the fall in the VIX, the implied volatility on put options is considerably higher than that on call options. This so-called "skew" between puts and calls is at a multi-month high.

"The biggest drop in U.S. options prices since 1998 masks growing anxiety over the stock market’s rebound, as traders pay more for bearish contracts than any time since before the failure of Lehman Brothers Holdings Inc."

Bloomberg, July 6, 2009

So this is a very unusual scenario. The VIX has declined substantially over the past few months, which tells us that traders believe future market moves will be less volatile than we've been used to. But under the surface, this is not necessarily a sign of complacency. While the VIX tells us that overall option premiums have declined, traders are still paying a bunch more for put options than call options.

One way we can visualize this is via a relatively new indicator created by Credit Suisse bank. CSFB's analysts wanted a way to measure the relative demand for put and call options, which the VIX doesn't really do a very good job of, so they came up with the CSFB Fear Index.

This Fear Index is pretty straightforward. It shows us how far away from current prices we'd have to go to be able buy a put option with the proceeds from selling a call option that is 10% away from current prices. For example, if the Fear Index was at 10%, then we'd be able to buy a put that was 10% out of the money, which means that calls and puts would be in perfect harmony and there would be no "skew" so to speak.

If the index were at 20%, however, then we'd only be able to afford a put option that is 20% away from current prices - that's the kind of thing that would show up during times of fear. So when the Fear Index is low, there's little fear; when it's high, there's a lot of fear. Makes sense, right?

Interestingly, contrary to what the VIX is suggesting, there's quite a bit of that fear now.

A few days ago, the VIX fell to a six-month low. But like the Bloomberg article tells us, the demand for put options was actually quite high, and indeed the CSFB Fear Index was hitting a six-month high at the same time the VIX was falling to its lows.

The last time this happened was in May 2008. As you can tell by the little red dot on the S&P 500 chart, that wasn't a great time for the market going forward.

CSFB was kind enough to generate data on this index back to 1998, so we have about a decade's worth of history we can compare against the VIX to see if there was any other time as unusual as our current one. Turns out there were a few of them.

The table below highlights other dates when the VIX hit at least a three-month low at the same time the CSFB Fear Index hit at least a three-month high. In other words, we're looking at times the VIX index was masking underlying fear in the market.

There were two instances (December 2003 and October 2006) when this divergence didn't make much difference to the market. Stocks continued to climb steadily for another one to two months before any meaningful correction, and even those subsequent selloffs didn't take the S&P 500 below the level it was trading at prior to the divergence.

The other six instances are a different story, however. The S&P was mixed over the short-term, performing right in line with random. It was the intermediate-term that was more questionable, with an average return well below random. The six losers didn't do well at all over the next three months, losing an average of -7.5% with all but one worse than -5%.

If we look at the other bear market occurrences (01/23/01, 05/24/01, 11/15/02 and 05/14/08), then the results going forward were understandably weak. The three-month return in the S&P averaged -9.2% with all of them losing at least -6.8%. The average maximum gain during the three months was only +2.3% compared to an average maximum loss of -14.3%. Ouch.

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration. Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

During mid-April, the market held up extremely well in spite of some overbought types of indications. This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

While there were - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I was looking for the S&P to run into trouble if it traded into 940-950, which happened early in June. I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

With the most recent surge in the spread between the Dumb Money and Smart Money Confidence, and the tendency for initial breakouts from volatility coils to be "false", I was looking for the first breakout above 950 to be beaten back. Now that that's happened and we're nearing the opposite end of the May - June range, we need to see how the market responds to short-term oversold conditions, especially now that we've seen a "failed" rally above the 200-day average.

The recent 90% down volume readings when coming off of an intermediate-term high aren't necessarily a sign that the trend is changing, but if we can't get meaningful bounces from short-term oversold conditions early this week, and especially if we lose the 880ish area on the S&P which would trigger the Head & Shoulders pattern we discussed on Monday, then the 850ish area will be the next focus.

For the past couple of months, the market has been responding fairly predictably to obvious technical support and resistance levels. Almost every time we first approach an obvious support or resistance level, particularly if we're oversold or overbought respectively, the market turns back.

That happened again yesterday as the S&P near that 880ish area while the STEM.MR Model was oversold. Given the stats we looked at yesterday morning, it was unusual to see a reversal during the day - much more common would have been a weaker close followed by a rally into mid-week - but that temptation to buy into support was apparently too strong for eager beaver buyers.

That leaves us kind of twisting in the wind here. We're not really oversold any longer after the afternoon rally, we're not near any special technical levels of note, and the consistent tendency to rally into mid-week was spoiled a bit by the late recovery yesterday. I don't see any solid short-term edge with this setup.