Monday Morning Outlook: A VIX Peak and a Market Bottom? Not Quite

              

Today's in-depth look at the week ahead begins with a recap of last week's rising fears of a consumer-led recession despite passage of the $700-billion bailout package. Next, Schaeffer's Senior Vice President of Research Todd Salamone examines the relationship between the CBOE Market Volatility Index (VIX) and the S&P 500 Index's (SPX) historical volatility. Joe Sunderman, Vice President of Financial Market Analytics, examines the 5-year swap rate as it pertains to the 5-year Treasury bond yield. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Fears of a Consumer-Led Recession Trump Passage of Wall Street Bailout
By Joseph Hargett, Senior Equities Analyst

Where to start? The week began with the Dow Jones Industrial Average (DJIA) logging its largest ever single-day drop, as the Dow plunged 777.68 points on Monday. Wachovia (WB) was seized by the U.S. government and the House of Representatives failed to pass a $700-billion bailout of the financial system, prompting a sharp sell-off in the waning hours of the session. However, hopes that the government would pass a revised version of the bill surfaced on Tuesday, leading the Dow to its third-largest, single-day gain, despite a slew of negative economic reports. The focus turned to the Fed and jobs data on Wednesday, as hopes that the Federal Open Market Committee would cut interest rates at its October meeting began to gain traction, while the ADP's employment index showed that employment in the private sector fell by 8,000 in September.

Thursday should have been a banner day for the market, as the Senate passed its version of the bailout bill and the Securities and Exchange Commission extended its short-sale ban. But durable goods orders fell during August, and a "sell on the news" mentality was gaining ground in regards to the bailout of the financial system. By Friday, the belief that a consumer-led recession was strong enough to outweigh the House of Representatives' passage of the $700-billion bailout plan. These fears were reinforced by the biggest monthly decline in U.S. jobs in more than 5 years. Nonfarm payrolls for September plunged by 159,000. News that Wells Fargo (WFC) made a surprise bid for Wachovia (WB) helped buoy equities on the day, but the Dow ultimately dropped 157 points by the close to round out the week with a loss of 7.3%. The S&P 500 Index (SPX) fell below the 1,100 level for the first time since November 2004, shedding 9.4% on the week, while the Nasdaq Composite (COMP) swallowed the steepest weekly loss, plunging 10.8%.

What the Trader is Expecting in the Coming Week: The CBOE Market Volatility Index (VIX) versus the S&P 500 Index's (SPX) Historical Volatility
By Todd Salamone, Senior Vice President of Research

To put last week's market action into perspective, it's probably best to revisit what I said in the prior week's edition of Monday Morning Outlook:

"Beyond the market-moving headlines out of Washington, we'll be keeping a close eye on the SPX's technical backdrop. For example, we've discussed the importance of the 1,200 level in previous commentaries. This round-number region has bent, but it has not broken. Traders have pushed the SPX below 1,200 during the past 2 weeks, only to find the broad-market index closing above this level by the end of the week. This level is the site of a key long-term moving average that has proven to be significant during the past several years. The 1,200 level is also home to a 50% retracement of the bear-market lows in 2002 and 2003, and the peak in late 2007. What happens in the short term could very well determine the market's long-term risk-reward situation."

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 in Friday's trading. This long-term trendline marked a bottom for the SPX during the bear market in 2002-2003. What's disappointing is that the market sold off following both the failure of the House of Representatives to pass a bailout bill and the House's passage of a modified version of that same bill.

So, what are the implications of this longer-term technical deterioration? As Bernie Schaeffer noted in the October issue of The Option Advisor newsletter on September 25:

"So it is certainly conceivable that we can get an end-of-month close early next week below the 80-month that would place us in bear-market mode. And an even more ominous move below the 160-month is within easy striking distance in this volatile environment. There is no doubt that sentiment - both quantitative and anecdotal (just look at the doom-and-gloom covers of the business magazines and the news weeklies) - is bearish and that there is a lot of fear in the air. But it is unfortunately the case that while bearish sentiment in a bull market invariably presents a buying opportunity, in a bear market we are faced with the very difficult problem of attempting to determine whether or not bearish sentiment has reached the "blood in the streets" extreme that can give us an 'all clear' signal."

So, was there "blood on the streets" after the 777-point decline in the Dow on Monday? Some traders and investors came to this conclusion based on the CBOE Market Volatility Index's (VIX) highest close in 6 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? As I alluded to in a recent commentary - and as seen in the table below - those buying puts on Monday 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.

Using the data above, it appears that major peaks in the VIX occur when the implied volatility of SPX options trades is significantly above the index's actual, or historical, volatility. I'll add that when the VIX peaked at 36.47 in August 1990 during the Savings and Loan crisis, the 20-day historical volatility was at 17.22, implying that index option buyers were once again overpaying for portfolio protection. As we enter this week's trading, the VIX is 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. We'll closely follow this relationship between the VIX and the SPX's historical volatility in the coming days and weeks.

Meanwhile, now that President Bush has signed the $700-billion bailout bill, questions remain. Is it the right solution? When will we begin to see the impact of this bill? What's more, it is important to remember that these problems are not contained to the U.S., as France and Germany remain in disagreement about a bailout in Europe. Finally, earnings and elections are around the corner, adding to the uncertainty in the current environment. In the midst of this global storm, the focus will once again return to the Fed, as poor economic data last week amid falling commodity price raised expectations that a rate cut is 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 (RIMM), Apple (AAPL), Qualcomm (QCOM), and Microsoft (MSFT), which are heavily owned by the hedge-fund community.

Finally, if options are currently not a part of your trading strategy, consider learning and utilizing them. The leverage that these vehicles provide allow 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 in both up and down markets. Thank goodness for these trading vehicles in times like this!

Indicator of the Week: The 5-Year Swap Rate Versus The 5-Year Treasury Bond Yield
By Joe Sunderman, Vice President of Financial Market Analytics

Foreword: Despite the turmoil seen in the equities markets this week, the bigger mess remains in the credit markets. According to an article in Bloomberg last week:

"The crisis deepened after the worst month for corporate credit on record. Leveraged loan prices plunged to all-time lows, short-term debt markets seized up and even the safest company bonds suffered the worst losses in at least two decades as investors flocked to Treasuries. Credit markets have frozen and money-market rates keep rising even after central banks pumped an unprecedented $1 trillion into the financial system."

Given this state of the credit markets, we felt it was necessary to address this issue in this week's commentary.

Background: To gauge the action in the credit markets, 1 indicator that we watch is the spread or difference between the 5-year swap rate and the 5-year Treasury bond yield. The swap spread measures the risk-free borrowing rate (5-year Treasury) and the rate at which the market expects inter-bank borrowing (swap rate) to occur in the future. For example, if the 5-year swap rate stood at 3.52% and the 5-year Treasury bond yield was 2.68%, the swap spread would be 0.84, or 84 basis points (3.52% - 2.68%).

How to Interpret the Data: Simply put, the higher the swap spread, the more perceived credit risk for banks. By graphing the data, one can see periods when the credit markets were under stress, as swap spreads expanded and concerns over inter-bank loans heightened.

Current Reading: On September 29, the swap-spread reading reached 1.21 – the highest reading taken during the past several years (my data goes 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%.

Implications: The credit markets are frozen, as indicated by the swap spread's extremely high readings. This impacts not only financial institutions, but also non-financial companies that rely heavily on short-term debt (i.e. Caterpillar, General Electric). Additionally, this credit freeze is not only occurring at our financial institutions and corporations, but is having a trickle down effect to Main Street, as it is becoming more challenging to get loans for home and car purchases. All eyes are on the $700-billion federal bailout, as investors hope that the bill will grease a very dysfunctional credit market. We will continue to monitor this indicator to see what impact the bailout has on the credit markets.

This Week's Key Events:
By Joseph Hargett, Senior Equities Analyst

Here is a brief list of some of the key events for the upcoming week. All earnings dates listed are tentative and subject to change, please check with the company's website for official reporting dates.

Monday

• There are no economic reports scheduled for release on Monday. There are also no major earnings reports scheduled for the day.

Tuesday

• The minutes from the September 16 meeting of the Federal Open Market Committee will be released on Tuesday, followed by August's consumer credit report. Meanwhile, Alcoa (AA) officially kicks off the start of the third-quarter earnings season, followed by YUM! Brands (YUM) and Safeway (SWY).

Wednesday

• August pending home sales and the weekly report on U.S. petroleum supplies are slated for release on Wednesday. On the earnings front, Costco Wholesale (COST), Monsanto (MON), and Helen of Troy (HELE) are on the docket for earnings reports.

Thursday

• Thursday brings weekly initial jobless claims and August's wholesale inventories on the economic front. Earnings reports for the session include Lam Research (LRCX), SLM Corp. (SLM), and International Speedway (ISCA).

Friday

• We round out the weekly economic calendar with import/export prices for September and August's trade balance. On the earnings front, General Electric (GE) headlines the session, followed by Emmis Communications (EMMS) and Host Hotels (HST).

And now a few sectors of note...

Dissecting The Sectors

Sector

Financial Bullish

Outlook: Despite the passage of the $700 billion-bailout plan, it was a turbulent week for the financial sector. Wells Fargo (WFC) proved that it has the mettle to weather the storm by placing a surprise bid for Wachovia (WB) on Friday, despite Citigroup's (C) offer to take over the ailing U.S. banking concern. Overall, it was a rough week for the financial sector, as the Select Sector SPDR Financial Fund (XLF) fell 12.2% on the week. Despite the overall malaise, there are plenty of prime opportunities within the sector. Specifically, PNC Financial Services Group (PNC) has garnered a year-to-date gain of more than 18%, while Wells Fargo Group (WFC) is up more than 16% during the same time frame. Despite these strong performances, investors are still betting against PNC and WFC. The former sports a Schaeffer's put/call open interest ratio (SOIR) that rests at 1.67, just 12% shy of an annual peak, while 9 of the 13 analysts following PNC rate the shares a "hold." Meanwhile, WFC's SOIR of 2.05 indicates that puts more than double calls among near-term options. Furthermore, 12 of the 16 analysts following WFC rate the shares a "hold" or worse. As such, we expect these pockets of opportunity to benefit from a heavily pessimistic sentiment environment.

Sector

Housing Bullish

Outlook: Since bottoming near the 94 level in mid-July, the PHLX Housing Sector Index (HGX) has rallied more than 25%. Furthermore, the index's positive price action has even pulled its 10-week and 20-week trendlines into a bullish cross – a technical formation that often signals additional upside potential for the HGX. Despite this strong technical performance, investors remain heavily bearish on housing stocks. Specifically, Toll Brothers' (TOL) Schaeffer's put/call open interest ratio (SOIR) of 1.34 rests in the 96th percentile of its annual range, while Ryland Group's (RYL) SOIR rests just 6 percentage points shy of an annual high. Additionally, Wall Street is betting against the group, as 4 of the 8 analysts following RYL rate the shares a "hold" or worse, while 5 of the 8 brokerage firms covering TOL have issued "hold" or worse ratings. An unwinding of this negativity could help pressure the housing sector steadily higher.

Sector

Large-Cap Technology Bearish

Outlook: The tech-laden Nasdaq Composite (COMP) maintained its leadership role in last week's broad-market decline, with the COMP dropping more than 10%. Furthermore, the Select Sector Technology SPDR Fund (XLK) breached key long-term support at the 19 level and is now trading at multi-year lows. The exchange-traded fund remains an underperformer, maintaining a year-to-date loss of more than 29%. On the sentiment front, there are still a number of overloved names within the technology sector. Microsoft (MSFT) has garnered 16 "buys," 4 "holds," and no "sells," while Google (GOOG) has acquired 18 "buys," 2 "holds," and no "sells." Even Apple (AAPL), with its year-to-date decline of nearly 50% remains a heavy bullish favorite. Currently, AAPL's SOIR of 0.65 ranks below 98% of all those taken during the past year, while 15 of the 21 analysts following the shares rate them a "buy" or better. With more technology CEOs warning of decreased corporate spending on tech (MSFT's CEO Steve Ballmer issued the latest warning last week), we could see this bullish sentiment unwind in the form of added selling pressure.

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