Stocks quoted in this article:
The following is a reprint of the market commentary from the May edition of the Option Advisor, published on April 26. Prices and the chart are as of the close on April 26. For more information or to subscribe to the Option Advisor, click here.
In my commentary last month in this space, I discussed what I described as the "feeding frenzy" in the open interest for the two major volatility-based option products -- the CBOE Market Volatility Index (VIX) and the iPath S&P 500 VIX Short-Term Futures ETN (VXX). My conclusion was that the manic trading in these volatility-based instruments -- despite relatively low market volatility and a slow, steady rally in the major stock indices -- was a symptom of fear-based investor behavior, and that, in contrast, market tops occur almost by definition when the sentiment environment is greed-based.
The S&P 500 Index (SPX) was trading at about 1,402 at that time, and it closed today at 1,399, resulting in essentially zero market movement over the past four weeks. In addition, the S&P closed today with a year-to-date gain of 11.3%, and all of the closing price action over this period has been compressed between +8% and +12% on a year-to-date basis.** Yet, despite this snooze-worthy market action, the VIX managed to soar from a low of about 14 at last month's press time to a peak of about 21, before settling at its current level near 16.
From my perspective, there is more than undue bearishness involved in this apparent dissonance between extremely well-contained U.S. stock price behavior and the tendency for option implied volatility levels to surge in hair-trigger fashion on minor pullbacks. Specifically, concerns (serious at times) about the economic situation in Europe as expressed through volatile European stock markets has been exerting a major pull on U.S. stock market volatility. And these European markets are -- right here and now -- at critical levels, the action around which may well determine the course of their behavior for the remainder of the year. And I believe the sentiment backdrop on the U.S. stock market is such that, should these European markets post even modest gains for the remainder of 2012, U.S. stocks could soar.
As of today's close, the Euro Stoxx 50 Index, for all its volatility, has been essentially flat in 2012 -- posting a year-to-date gain of about 0.4%. On the upside this year, with the exception of a 10-day period in mid-March, all Euro Stoxx rallies have been capped at a 10% gain on a closing basis. On the downside, Monday's bottom registered at -3% year-to-date, and prior to Monday's nadir the year-to-date low weighed in at -1.4% on Jan. 9. The punch line here is that the European markets have been very respectful of round-number levels, which renders encouraging (but by no means definitively bullish) the fact that we have now re-taken a positive year-to-date return.
The major reason, from my perspective, that stabilization and, better yet, a rally in the European markets could have such explosive potential for U.S. stocks emanates from the fact that we have been "importing" a level of fear and anxiety far out of line with the price action in our own market, and this in turn has engendered a huge degree of protective behavior by U.S. investors in terms of index put buying, hedged bets on a surge in volatility, and an ongoing flow of funds that strongly favors bonds over equities. To the extent stocks rally in Europe and investor confidence increases to the point that these fear-based activities diminish, the resulting "unwind" of this fear trade, which has created ongoing headwinds for U.S. stocks, could produce tailwinds of immense proportions.
**I consider 1,400 on the S&P, as well as a 10% year-to-date gain (or, for that matter, a 10% year-over-year gain), to be "round-number levels." While it may seem trite and simplistic, it is very important to pay attention to such levels in order to gauge the health of the market (or of a stock), as well as help project where the market is headed. For a discussion of the seriously underappreciated significance of round-number levels and how to bridge this gap in most investors' toolboxes, see my article entitled "Trading on the Level" from the summer 2011 issue of our SENTIMENT magazine.