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Home » Blog » 2012 » 03 » This market is headed higher: Don’t fight the tape, but be careful
By Lawrence G. McMillan

(Marketwatch) - Just a week ago, the market had its worst day of the year. The Standard & Poor’s 500 Index finally touched and even closed below its 20-day moving average, for the first time in 52 trading days.

During that lengthy time, the S&P 500 SPX +0.26%   never even touched that moving average. That is the second longest such streak of all time. The only longer one occurred ended on July 14, 1944! There are other, similar “streaks” that the market had been forging — such as not having even one 1% daily decline until last Tuesday. It was also the first “90% down day” this year. All of these “streaks” were in existence because of the steady, slow-motion rise in the market.

But now that those streaks are over, what can we expect? Most traders think that it means the market is ready to collapse, but history shows us that it really means that the market is about to become more volatile. However, the price direction of that volatility can be in either direction.

Considering that the market has responded strongly to the upside and broken out to new post-2008 highs, we would have to say that the volatility is going to manifest itself on the upside.

Last week’s low on SPX was 1,340 — right at the same support level that still exists from early February. A close below there would be bearish confirmation, so from the viewpoint of the SPX chart, the 1,340 level is once again of major importance. Below there, the long-term trend line of this current bullish phase is at about 1,305 at this time. The 1,340 area has become so well-recognized as a support area that if it is breached in the near future (something we don’t expect will happen), that would be a cause for some major selling. Personally I would not want to see SPX close below its 20-day moving average at 1,360. That would be a failure of this most recent upside breakout.

The equity-only put-call ratios are still on sell signals, as are many other put-call ratio measures. This means that call buying has been so heavy that these ratios are trading down to levels most commonly associated with market tops. So far, the stock market has ignored indicators such as these, as traders continue to pour money in. But it is worth noting.

Market breadth (advances minus declines) hasn’t been nearly as strong as the market itself. This is especially true if one considers only “operating companies,” and not the full array of securities that trade on the NYSE (NYSE breadth reports a lot of ETF’s, Preferreds, and many other things that are more interest-rate related than equities are). So there is a bit of a negative divergence here, too. When breadth weakens, but stocks continue to rise, that is a warning sign — albeit not necessarily an immediate sell signal. Normally, such a divergence would be a problem, but this market doesn’t seem to care much about such things.

Countering the potential negativism of put-call ratios and equities, is what’s going on in volatility — as measured by the CBOE’s Volatility Index VIX -0.59%   and its derivatives. VIX continues to decline rather sharply, as it probed below 14 at one point today. The sharp drop in VIX over the past two days is partly because of the way that VIX is calculated. It is no longer using the prices of SPY March options and is using the prices of May options. That caused a negative factor to be applied to VIX, in comparison with Friday’s calculations. Hence VIX dropped more than it would have on a normal day.

In any case, the VIX futures didn’t drop nearly as much, so VIX futures premiums expanded and the term structure steepened. There is a big premium in March VIX futures of 2.11 points, even though they expire on the 21st. But the premiums really get huge after that. April is 3.10, August is 10.46 (!!) and October is 12.41. These are just crazy numbers. They continue to reflect a retail and, I suspect, institutional appetite to “own volatility” just in case the market collapses. Tons of buyers are pouring into the volatility ETN’s and ETF’s, such as VXX, TVIX, VIXY, etc. For example, the amount of money in the VXX ETN (the largest of the group) has doubled so far this year. That’s a lot of “volatility buying.” The managers of these ETN’s buy the VIX futures, for that is their underlying instrument. That increases the futures’ premium. In turn, they need to roll these futures daily, so that increases the steepness of the term structure.

These buyers of volatility ETN’s, and by inference volatility derivatives, at such inflated prices will lose money — probably lots of it. Only then will these premiums shrink, and probably only then will the market collapse. So this huge demand for protection is a contrarian indicator: as long as “everyone” thinks they need to buy volatility, there is probably little chance of a volatility explosion. Right now, the VIX derivatives continue to be a bullish indicator — whether you consider it to be contrarian evidence of people’s bearishness or whether you go by the traditional interpretation of the construct of the VIX futures.

There are certain strategies that can be used to take advantage of these inflated VIX derivatives, in a hedged, manner, and we utilize them in the Marketwatch Option Letter .

In summary, SPX prices are headed higher it seems. Yes, there are some problems being presented by potentially negative signals from breadth or put-call ratios, but the fact is that traders seem to have an insatiable demand for protection in the form of VIX derivatives. This is one of those markets where price is really the only indicator you need: as long as the SPX chart continues to rise and continues to hold at important support areas (such as 1,340 and 1,360), you can ignore the other indicators.

Source:  Marketwatch - This market is headed higher