Monday Morning Outlook

Eight Points to Consider as the Market (and the World) Stares Down 2013

Facts and figures from the year that was

by 12/29/2012 9:22:31 AM
Stocks quoted in this article:

Will New Year's revelers be toasting prosperity or drowning their sorrows come Monday evening? The market sold off into Friday's close as a fiscal-cliff resolution continued to seem miles away. As Todd Salamone points out, though, this uncertainty makes the round-number market levels we've been watching even more significant. Meanwhile, Rocky White takes a look back at 2012 from an equities standpoint to uncover the good, the bad, and the ugly.

  • What the latest VIX options activity is telling us.
  • One technical development that could warrant short-term caution.
  • Reviewing the best and worst stocks of 2012.

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: Reviewing the Charts for Potential Support
By Todd Salamone, Senior V.P. of Research

"As we move into an abbreviated trading week, the big question is, 'Will VIX call buying and index/ETF put buying be brisk, now that volatility has popped?' On one hand, we could make the case that it will, as market participants continue to replace VIX call options that expired last Wednesday, while other market participants look to replace index and ETF put options that expired on Friday. But on the other hand, in the very near term, with holiday-related time decay threatening and volatility already popping, some may view portfolio insurance as too 'expensive,' which could be supportive of the market at a time when stocks normally face headwinds."
-Monday Morning Outlook, December 22, 2012

"... the VIX peaked on Friday at a level 50% above the August closing low. Throughout most of calendar year 2012, and with the exception of only the April-May period, the VIX has had a tendency to peak around levels 50% above the prior calendar-year low. Should those that typically seek portfolio insurance decide to wait for a 'better price,' such a mentality could be supportive in the immediate days ahead."
-Monday Morning Outlook, December 22, 2012

"$SPX and $VIX on 11/29/12: 1,415.96 and 15.06, respectively. At present readings: 1,411.76 and 20.19. Surge in IV amid no net movement"
-@toddsalamone on Twitter, December 28, 2012

Some things have changed since last week, but not a lot has changed since last month. A budget deal to address the "fiscal cliff" is still in question and the markets continue to react to hints of no deal being struck, then hints of a deal getting done ... rinse, repeat. The end result has been little net movement in the S&P 500 Index (SPX - 1,402.43) since late last month, when the SPX was trading at 1,415.95 on Nov. 29. At this time the CBOE Market Volatility Index (VIX - 22.72) was trading at 15.06.

We have seen this act before, where volatility -- as measured by the VIX -- advances ahead of a calendar event, and the SPX churns for days. That said, and this has also been the case for most of 2012, the VIX continues to get capped in the area that is 50% above its calendar-year lows (in this case 20-21).

 Daily chart of VIX since December 2011

Generally speaking, since July, VIX option players have been betting on a spike in volatility that has yet to develop. In fact, per the graph below, the VIX's 20-day buy-to-open call/put volume ratio reached a 2012 high of 3.63 on Dec. 21, two days after the expiration of December VIX options.

 VIX 20-day buy-to-open call_put ratio since January 2012

We observed VIX option activity day-by-day since the expiration of December VIX options. Based on the table below, it is clearly evident that:

  • There was indeed a rush to replace expired December VIX call options, as the two days immediately following VIX expiration saw buy (to open) call/put volume ratios of 10.6 and 9.2, which is "off-the-chart" high and most likely exacerbated by the nearing "fiscal cliff doomsday."
  • But, note on Dec. 21, Dec. 26, and Dec. 27, the VIX traded near or just above the 20 zone, and call buying relative to put buying dried up considerably.

For now, 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. However, it if isn't smart money, the short-term consequences of not getting a deal done could be a huge negative, as there is a lot less portfolio protection in place relative to the days immediately preceding December VIX expiration.

VIX option activity since December VIX expiration

After going months, weeks, days before automatic tax hikes and spending cuts kick in without a budget deal, we are literally down to hours before the automated fiscal actions occur in the absence of a last-minute or last-hour deal. On Sunday evening, the House reconvenes, and news related to an agreement or no agreement could determine the direction of the VIX (and the equity market) in the days ahead.

Many market participants are expecting a sell-off if a deal isn't reached, as forecasts for a recession will likely rise and, subsequently, earnings forecasts will likely be reduced. One surprise -- in the context of no deal -- is equities holding firm as "pre-event" volatility (as measured by the VIX) implodes. If such an outcome occurs, it would be the market interpreting recession fears as misplaced. In this light, 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.

Meanwhile, as we approach the New Year, major benchmarks continue to lurk around key round-number levels, with very little in the way of sustained moves above or below these psychological marks. The lack of direction around these round-number speed bumps indicates hesitancy and indecisiveness. For example:

  1. The SPX is back below its 80-day moving average and the 1,420-1,425 area, which marked highs earlier in the year, but the round-number 1,400 has been supportive on pullbacks this month, including on Thursday and Friday.
  2. The S&P 400 MidCap (MID - 1,004.33) remains above 1,000, with this millennium level marking the low in Thursday's pullback.
  3. The Nasdaq Composite (COMP) closed at 2,960.31 on Friday, as it continues to trade in a range that is 50-60 points north and south of the round 3,000 level since late last month.
  4. The Dow Jones Industrial Average (DJI 12,938.11) continues to trade around 13,000 since the breakout above 13,000 in mid-March 2012, there have been 119 closes above 13,000 and 83 closes below 13,000. Since March, there has been a touch of 13,000 in every month with the exception of June, September, and October.

Admittedly, there are many ambiguities as we enter the final hours leading up to the fiscal cliff and the turn of the year:

  1. Choppy price action, with round numbers supporting pullbacks, but buyers disappearing once former highs are challenged.
  2. Fiscal cliff -- deal, or no deal? Even if no deal, is a recession inevitable like talking heads predict?
  3. Big short position in the market is supportive, but then again, active investment managers are extremely bullish and optimism from this group has preceded corrections in the recent past.
  4. VIX call open interest is back to relatively low levels after December expiration. However, the recent surge in volatility to 50% above the 2012 lows has represented buying opportunities, and volatility could implode once we have more clarity on tax hikes and spending cuts.

Overall, we remain bullish, as there has not been significant technical deterioration in the market, despite the frustrating range action mentioned above. 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.

It is possible that technical deterioration could occur in the equity market, even as the VIX fails to surge, given that the VIX is already trading at a healthy premium to SPX historical volatility. Therefore, keep an eye on SPX 1,390, which is the site of the index's 160-day and 200-day moving averages. Another benchmark to watch is the MID, as a break below 980.00 would push it firmly below the key 1,000 mark and its 120-day moving average, which has had importance recently, per the chart below.

We prefer mid-cap stocks, and would not disturb bullish mid-cap holdings unless there is evidence of a technical breakdown as described above.

Daily chart of MID since January 2012 with 120-day moving average

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