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Inflated VIX Premium Could Deter Potential Buyers

Optimism is on the rise, even as stocks approach formidable resistance

by 2/11/2012 9:55:06 AM
Stocks quoted in this article:

Despite a few new multi-year highs for the major equity indexes, stocks ended last week modestly lower. Traders were spooked when euro-zone finance ministers demanded deeper spending cuts from Greece, which raised the prospect that the cash-strapped country could miss a looming deadline to secure bailout funds. With the drop-dead date set for this Wednesday, Feb. 15, it's entirely possible that more choppy trading is on the horizon.

In fact, Todd Salamone notes that a pullback is likely at this point, as the major equity indexes finished last week just below significant resistance levels. Against this backdrop, Todd examines whether the recent crop of bullish headlines is a potential contrarian indicator -- or just a natural reaction to the market's impressive rally. On the technical front, Rocky White takes a look at the cluster of "golden cross" formations to determine whether this indicator is truly a positive sign for stocks. Finally, we wrap up with a preview of the key economic and earnings reports for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: A Pullback Is Possible, but Panic Selling Is Unlikely
By Todd Salamone, Senior VP of Research

"The apparent increase in shorting activity among institutional players could result in a pause or consolidation, as equities were previously enjoying a bid from both short-covering and institutional buying. While evidence of institutional buying remains, a renewed interest in short selling could result in a coincident headwind that might lead to choppiness in the immediate days ahead."

"Since the SPX's breakout above 1,260 in late December, it has been a straight march higher, with only one minor hiccup along the way: a pullback from the intraday highs of 1,330 to 1,300 from Jan. 26 to Jan. 30. The index comes into this week's trading at another potential resistance level, in the 1,340-1,350 area. As you can see on the chart below, the SPX was turned back from these levels on multiple occasions in 2011, suggesting this could be the next speed bump with which the index must contend."
- Monday Morning Outlook, February 4, 2012

Last week, we discussed the growing possibility of a pause in the impressive stock market advance, as some institutional players were showing signs of initiating short positions once again, following a period in which the equity market enjoyed a bid from both short-covering activity and underweight institutions deploying cash into the market. Since the big pop higher on Friday, Feb. 3, the market has done very little. A negative turn in the Greek debt saga last Friday, Feb. 10 sent stocks sharply lower, erasing a choppy grind higher throughout most of last week. The only encouraging technical note is that the SPDR S&P 500 ETF Trust (SPY - 134.36) never retreated beneath the previous Friday's post-gap lows, or its lows earlier in the week.

30-Minute Chart of SPY since Feb. 3, 2012

Hitting our radar last week was fresh evidence of optimism creeping into the market, right as the S&P 500 Index (SPX - 1,342.64) and the S&P 400 MidCap Index (MID - 964.49) approached their 2011 resistance levels in the 1,350 area and the 1,000 millennium mark, respectively. With key equity indexes lingering near resistance, these bullish headlines suggest we could be ripe for a pullback -- or, at the very least, continued choppiness in the days ahead. For example, headlines that caught our eye included:

In addition to the Feb. 9 headline suggesting a bullish technical backdrop, we saw technical research suggesting the CBOE Market Volatility Index's (VIX - 20.79) recent breakout has bullish implications. While we respect those publishing this research and think the studies are indeed valuable, our main takeaway is that the technical crowd seems to be taking a bullish stance -- the same crowd that was voicing concerns in late 2011, and roughly 100 SPX points ago.

Therefore, as contrarians, we are open to the fact that the market may be vulnerable to giving back some of its gains in the near term, as we see optimism coming in as the SPX and MID approach key resistance areas. A short-term pullback would be healthy, and would not jeopardize our overall bullish stance on equities for the intermediate and long term.

That said, it isn't necessarily a "slam dunk" that we retreat in the short term. After all, the positive sentiment isn't exactly misplaced, with the SPX up about 22% in a four-month period. In other words, one should put less weight on the contrarian implications of optimism in the context of strong price action, and more weight on the contrarian implications of optimism that occurs within the context of weak price action.

The good news for bulls is that in the event of a pullback, we would not expect a decline to be exacerbated by panic selling, since those that have recently accumulated stocks have purchased index or exchange-traded fund (ETF) puts, or VIX calls, as insurance against a correction. This was not the case around this time last year, when un-hedged buyers drove equities higher into mid-February, before negative European headlines surprised investors, resulting in a 7% correction in a month's period. Moreover, institutions at present do not have the exposure to equities that they did at the beginning of 2011, which suggests fresh cash on the sidelines that could mute a decline.

Finally, the "VIX Premium" indicator is again on our radar, which is a measure of the VIX relative to the SPX's actual, historical volatility. Given the steady demand for index and ETF put options that have accompanied the rally, put premiums have risen considerably relative to call premiums, driving the VIX to a substantial premium relative to SPX historical volatility.

For example, the VIX closed at 20.79 on Friday, or 146% above the SPX's current historical volatility of 8.44. As you can see on the chart below, the current VIX premium is relatively high. Therefore, a risk to bulls is that hedged players find put premiums too expensive, and thus sharply reduce their equity accumulation due to the expensive portfolio insurance. As you can see on the chart below, when the VIX is at a discount or is trading at a small premium to historical volatility -- implying cheap portfolio insurance -- major short-term buying opportunities have occurred during the past several months.

VIX Premium with SPX since 2011

With portfolio insurance relatively expensive -- and thus unattractive for some hedge fund managers looking to put cash to work -- and the SPX and MID trading just below former resistance, the near-term price action may not be as rosy as the past several weeks. But pullbacks should continue to be viewed as buying opportunities, as considerable cash remains on the sidelines.

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