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Monday Morning Outlook: How to Handle a Spiking VIX

Volatility surged last week as stocks took a turn for the worse

by 2/26/2011 12:32:35 PM
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Indicator of the Week: VIX Spikes
By Rocky White, Senior Quantitative Analyst

Foreword: There was finally some volatility in the market last week. The S&P 500 Index (SPX) was down 2% on Tuesday, and then fell some more on Wednesday. Over those two days, the index fell a total of 2.6% -- which is its biggest short-term loss since last August. The CBOE Market Volatility Index (VIX), which tends to move in the opposite direction as the market, spiked higher as a result, moving up 35% over the two-day period. The chart below shows the VIX and SPX going back to 2010. The yellow circles denote prior instances where the VIX gained at least 30% over a two-day period.



Previous VIX Spikes

VIX Spikes: When the market begins falling, traders scramble to put on hedges to guard against a significant drop in the market. A popular way to hedge is to buy put options on the SPX. The scramble to purchase these options increases option premiums -- and, in turn, the VIX. That's why the VIX is called the "fear index." Below, we'll see how previous VIX spikes have turned out for the market.

Going back to 2000, there have been 11 other times when the VIX gained at least 30% during a two-day period. Below is a table showing how the SPX performed afterwards. All of the signals have occurred since 2005. So, for comparison, I also have a table showing how the SPX has typically performed since then.



SPX Returns after Previous VIX Spikes

Analysis: The returns are pretty bearish for the market during the next two weeks to a month following previous VIX spikes. What caught my eye was that the percent positive two weeks later was 36% -- but one month later, it was 73%. However, the average return is very negative one month out. So, what's going on? Below is a table showing each of the individual results after a signal.



Closer Look at VIX Spikes

There is a pretty clear divide in the table above between the returns before 2008 and the returns after. Before 2008, the big VIX spikes were nothing to worry about. All five signals before 2008 preceded a higher market one month later. Since 2008, it's been a different story. Three of the six returns have not only been negative, but they have been very negative. Two of the signals happened during the 2008 market crash, and the other negative signal happened just before the May 6, 2010 "flash crash."

This Week's Key Events: February Payrolls in Focus
Schaeffer's Editorial Staff

Here is a brief list of some of the key events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.

Monday

  • Economic data comes fast and furious this week. On Monday, the calendar kicks off with December's pending home sales, personal spending and income for January, the Chicago purchasing managers index for February, and the Dallas Fed manufacturing survey for February. On the earnings front, we'll hear from A123 Systems (AONE), Overstock.com (OSTK), Edison (EIX), and Rosetta Stone (RST).

Tuesday

  • Tuesday morning brings us the Institute for Supply Management's (ISM) manufacturing index, as well as auto sales data for February. Meanwhile, Federal Reserve Chairman Ben Bernanke will begin a two-day tour of Capitol Hill with testimony before the Senate Banking Committee. The earnings schedule includes AutoZone (AZO), Domino's Pizza (DPZ), Hovnanian Enterprises (HOV), and ReneSola (SOL).

Wednesday

  • The pace picks up on Wednesday: We'll hear the ADP payroll report for February, Bernanke's testimony before the House Finance Committee, the latest Beige Book from the Fed, and the regularly scheduled update on domestic oil supplies from the government. Also on the day's docket are quarterly reports from Costco (COST), BJ's Wholesale (BJ), Staples (SPLS), and PetSmart (PETM).

Thursday

  • Key economic reports on Thursday include weekly jobless claims and the ISM's nonmanufacturing index for February. Scheduled to report earnings are H.J. Heinz (HNZ), Marvell Technology (MRVL), Novell (NOVL), and Silver Wheaton (SLW).

Friday

  • All eyes will be on the Labor Department's nonfarm payrolls report for February, with a Dow Jones survey revealing expectations for an increase of 192,000 jobs. That key report hits the Street before the open, while January's factory orders will be released mid-morning. Meanwhile, the earnings calendar slows to a crawl, with Bronco Drilling (BRNC) and Madison Square Garden (MSG) among the small handful of companies reporting.

And now a few sectors of note...

Dissecting The Sectors
Sector
Automotive
Bullish

Outlook: Like most of Wall Street, the automotive sector was beaten lower last week due to rising violence and turmoil in the Middle East. However, many key names within the group found support and were in the process of bouncing back by Friday afternoon. American Axle & Manufacturing Holdings Inc. (AXL), for example, rebounded more than 4.5% at the end of the week, after finding support at its 80-day moving average. Toyota Motor Corp. (TM), Goodyear Tire & Rubber Co. (GT), and BorgWarner (BWA), meanwhile, continued higher along their respective 20-day trendlines. Overall, the Fidelity Select Automotive Fund (FSAVX) found support at its rising 80-day moving average, and appears poised to resume its long-term uptrend. As we have noted in this space before, FSAVX fund flows indicate that capital is returning to the sector following several months of outflows. This pattern should provide lift for automotive stocks as a whole. On the sentiment front, there is room for upgrades from brokerage firms, as only 53% of analysts covering automotive stocks rate them a "buy." Short interest is also notable, with BWA sporting a short-to-float ratio of 9.46%, while more than 15% of AXL's float is sold short. Should this negativity begin to unwind, we could see additional buying pressure brought to bear on the sector.
Sector
Leisure
Bullish

Outlook: Proving that last week was one of rebounding from technical support, the Retail HOLDRS Trust (RTH) found a floor at its 80-day moving average and the 105 level amid last week's bedlam. What's more, the SPDR S&P Retail Index (XRT) is sitting on a 52-week gain of roughly 29%, with the index bouncing off short-term support near the 48 level. Oil's spike to its highest price since October 2008 spooked quite a few Wall Street pundits, with most claiming that the jump would put pressure on discretionary spending. Some prominent publications even dusted off the "double dip" talking point. With prices rising out of fear and not demand, oil cooled off heading into the weekend, allowing for a rebound in retail/discretionary stocks. We expect this trend to continue, and view excessive pessimism toward the sector in a bullish light. Within the group, we tend to favor Wynn Resorts (WYNN), Cracker Barrel Old Country Store (CBRL), and Chipotle Mexican Grill (CMG). WYNN is sitting on a 52-week gain of more than 90%, but sports a short-to-float ratio of nearly 5%. Finally, short interest totals 9.5% and 8.4% of the available float for CBRL and CMG, respectively, meaning that there is the potential for additional upside if short sellers are forced to buy back their losing positions.
Sector
Coal
Bullish

Outlook: Growing turmoil in the Middle East created upward pressure for energy stocks last week, helping to provide a boost for members of the coal sector. What's more, the Market Vectors Coal (KOL) exchange-traded fund (ETF) once again rebounded from its 80-day moving average last week, with the fund now challenging a short-term technical hurdle in the 47.50 region. KOL has been quite an outperformer during the past several months, with the ETF soaring more than 50% since late August. During this time frame, KOL has enjoyed the support of its 10-week moving average. On the sentiment front, analysts have grown increasingly wary of the sector throughout this rally. Specifically, the percentage of "buy" ratings on coal stocks has fallen from roughly 60% in August to about 53% at present. KOL's ability to rally in the face of this growing negativity has bullish implications from a contrarian perspective. What's more, the Energy Select Sector SPDR (XLE) ETF's International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) buy-to-open 50-day put/call ratio is currently low relative to its 2008 highs, but has turned higher recently. A rise in this ratio could indicate that investors are in accumulation mode, utilizing puts to hedge long positions.

Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insight about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.

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