Wednesday, 8 October 2008
Technical Damage Done
Not only did the S&P 500 Index (SPX) experience a monthly close below its 80-month moving average in September, but it also closed below its 160-month moving average during last Friday’s trading. This long-term trendline marked a bottom for the SPX during the bear market in 2002-2003.
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Technical Damage Done
Joseph Hargett and Todd Salamone
6 October 2008
Not only did the S&P 500 Index (SPX) experience a monthly close below its 80-month moving average in September, but it also closed below its 160-month moving average during last Friday’s trading. This long-term trendline marked a bottom for the SPX during the bear market in 2002-2003.
So what are the implications of this longer-term technical deterioration? And is there “blood in the streets” after the 777-point decline in the Dow last Monday? Some traders and investors came to this conclusion based on the CBOE Market Volatility Index’s (VIX) highest close in six years on Monday. Certainly, one might conclude that with the VIX closing at a level that has been notorious for marking bottoms dating back to 1998, a buying opportunity was at hand.
As such, were those investors who were seeking portfolio protection and speculating on further downside in the market really acting irrationally and overpaying for index put options like they usually do at market bottoms? They were not overpaying for index options as they did on the day of the market’s crash in 1987 and during previous VIX spikes above 40.
Major peaks in the VIX occur when the implied volatility of SPX options trades significantly above the index’s actual, or historical, volatility. I’ll add that when the VIX peaked at 36.47 in August 1990 after Iraq’s invasion of Kuwait, the 20-day historical volatility was at 17.22, implying that index option buyers were once again overpaying for portfolio protection.
We entered this week’s trading with the VIX at 45.14, while the SPX’s 20-day historical volatility is at 57.32. Should the VIX’s pattern of peaking only after trading at a significant premium to the SPX’s historical volatility continue, more selling could be on the horizon.
Despite the SPX’s close below long-term moving averages, our message remains the same: Stick with the stronger financial and homebuilding equities, but hedge your exposure to these sectors by going short a related exchange-traded fund or going long a related ultra-short exchange-traded fund.
Furthermore, avoid large-cap technology stocks, such as Research in Motion, Apple, Qualcomm and Microsoft, which are heavily owned by the hedge-fund community.
To gauge the action in the credit markets, one indicator that we watch is the spread or difference between the five-year swap rate and the five-year Treasury bond yield. The swap spread measures the risk-free borrowing rate (five-year Treasury) and the rate at which the market expects inter-bank borrowing (swap rate) to occur in the future. Simply put, the higher the spread, the more perceived credit risk for banks.
On Sept. 29, the swap-spread reading reached 1.21, the highest reading taken during the past several years (my data go back to 2000). To put this 1.21 reading in perspective, this is higher than the average swap reading for 2008 (0.87) by nearly 40%.
Finally, if options are currently not a part of your trading strategy, consider learning and utilizing them. The leverage that these vehicles provide allows you to put limited dollars at risk in the market, as you can use long-term or deep in-the-money options as a stock substitute. Moreover, you can profit from them in both up and down markets.
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