Monday Morning Outlook

Do Not Disturb Your Bullish Positions

Does the solid start to 2013 have longer-term implications?

by 1/5/2013 9:33:36 AM
Stocks quoted in this article:

The recently inked fiscal-cliff deal -- or the "budget-deal lite," as Todd Salamone says -- pushed stocks significantly higher last week, as Wall Street let out a collective sigh of relief. Against this backdrop, we enter the week in familiar territory, and it wouldn't be shocking to see volatility creep higher, he notes. Meanwhile, Rocky White breaks down two indicators -- one of which could have very bullish implications for the rest of the year.

  • Is portfolio insurance on sale?
  • Which stocks are leading the proverbial pack?
  • Reading the tea leaves after the first week of 2013.

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Is the VIX on 'Repeat'?
By Todd Salamone, Senior V.P. of Research

"VIX option players seem to be suggesting there is a need to replace expired VIX calls, but not at any cost. The 'not any cost' mentality could be smart money at play ... the low VIX call activity might make sense, as the uncertainty (deal or no deal) that has inflated the VIX relative to SPX historical volatility gives way to more clarity with the turn of the calendar year."

"Admittedly, there are many ambiguities as we enter the final hours leading up to the fiscal cliff and the turn of the year ... Overall, we remain bullish, as there has not been significant technical deterioration in the market, despite the frustrating range action ... Bulls could consider turning short-term cautious on a solid VIX move above 21-22.50, as this area is 50% above the calendar-year lows and the most recent low in the 15 area ... We prefer mid-cap stocks, and would not disturb bullish mid-cap holdings unless there is evidence of a technical breakdown."
-Monday Morning Outlook, December 29, 2012

"$GLD it took gold futures 18 months to clear $1,000/oz for good after first touching this level; $MID first touched 1,000 20 months ago"
-@toddsalamone on Twitter, January 2, 2013

"While Wall Street initially cheered the half-baked solution, the delayed spending cuts and the looming debates on extending the debt ceiling will eventually chip away at investor confidence, translating into increased market volatility."
-, January 2, 2013

"... more volatility appears to be in store ... investors should view any potential short-term rally with skepticism.'I certainly think the market can attempt another rally, but at this stage think that is more of a selling opportunity than one that needs to be chased,' Mr. Tchir says."
-The Wall Street Journal, January 2, 2013

"$VIX and $SPX historical vol in line with each other for first time since mid-Nov"
-@toddsalamone on Twitter, January 3, 2013

It happened again! The CBOE Market Volatility Index (VIX - 13.83) ran up to an area 50% above its calendar-year and recent low before peaking. As long-time readers of Monday Morning Outlook can attest, this is an act we have seen numerous times in the past, and it set the stage for an impressive advance on the last trading day of 2012 and the first trading day of 2013. The catalyst was "budget-deal lite," as investors finally got the clarity they were seeking on 2013's tax structure. We used the term "lite" because clarity on spending cuts will have to wait, as Congress and the president effectively executed -- in the spirit of college bowl season and NFL playoffs -- a "two-month punt."

From both a volatility perspective and a technical perspective regarding the S&P 500 Index (SPX - 1,466.47), we enter next week's trading in familiar territory. The VIX, for example, is perched in the 14-15 area -- a region it's been unable to penetrate below since April 2011, despite multiple attempts to do so. Meanwhile, the SPX finds itself back at the September and October highs in the 1,460-1,470 area, where it stalled ahead of a 7.5% pullback into the mid-November low.

 Daily Chart of SPX since May 2012

The typical post-VIX expiration surge, followed by an eventual deflating VIX, is a pattern that played out again in the past few weeks. Another pattern that repeated itself is the tendency of the VIX to rise ahead of "event risk" (the Dec. 31, 2012 fiscal-cliff deadline), even as historical volatility remained muted, followed by a VIX implosion with the event's passing. Finally, with the VIX failing to sustain a move above the 20-21 area on its most recent attempt to do so, and now back in the 14-15 area -- half the 2012 high -- the "sell VIX 20, buy VIX 15" mentality of 2012 is apparently alive and well, with portfolio insurance currently perceived as being "on sale."

This mentality is evident as we analyze VIX option activity since VIX expiration on Dec. 19:

  1. In the two days immediately following VIX expiration, with VIX trading in the 17 area, call open interest increased by 200,000 contracts, as VIX call players looked to replace expired calls -- no major surprise.
  2. In the four trading days after Christmas, with the VIX probing the 20 area, call open interest increased by only 90,000 contracts, implying (correctly) the expectation that the VIX had little room to move higher.
  3. After the New Year, with the VIX sharply plummeting back to the 14-15 area, VIX open interest increased by 250,000 contracts in only three trading days, implying volatility players expect a floor to be in place around current levels.
Monthly Chart of VIX since January 1993

With the SPX trading at a former peak, and portfolio insurance low -- relative to both historical volatility and its range during the past couple of years -- a creep higher in volatility would not be a major shock. Should volatility increase, as measured by the VIX move higher, we wouldn't be surprised if this occurs amid a period of choppiness.

But with the S&P 400 MidCap (MID - 1,056.07) trading at all-time highs, in an apparent breakout above the brick wall at 1,000, this is the kind of leadership that bulls welcome, as the strongest market periods are coincidental with small-cap and mid-cap leadership. Combine this with the big relative short position in the market, amid another round of calls for higher volatility as we enter the new year, it appears the long volatility trade could be destined to be a loser in 2013 like it was in 2012.

As we said last week, do not disturb your bullish positions, and continue to emphasize the mid-cap area.

Daily Chart of MID since March 2011

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