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Monday Morning Outlook: Uncertainty Is in the Air as Wall Street Prepares for Change

Should there be more fear reflected in the CBOE Market Volatility Index?

by 11/10/2008 6:50:57 AM
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Today's in-depth look at the week ahead begins with a recap of last week's short-lived rally ahead of an historical Presidential election, and the subsequent sell-off heading into the weekend. Next, Schaeffer's Senior Vice President of Research, Todd Salamone, examines technical support and resistance levels for the S&P 500 Index (SPX), as well as several key sentiment indicators for the broad market. Joe Sunderman, Vice President of Financial Market Analytics, drills down on the CBOE Market Volatility Index (VIX) and its relationship with the SPX's 20-day historical volatility. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: An Historic Week Ends on a Sour Note
By Joseph Hargett, Senior Equities Analyst

Despite a strong finish, last week marked a return to the bear market, as all 3 of the major U.S. indices plunged about 4%. The first week of November started off benignly on Monday, as the Dow Jones Industrial Average (DJIA) dropped a mere 5.8 points, despite a report from the Institute for Supply Management (ISM) that its manufacturing index plunged to its lowest level since 1982. Tuesday saw the end of a nearly 2-year campaign for the office of President of the United States, as voters turned out in droves for the chance to make history by voting for the first African-American president, or the first female vice president. The market was in high spirits, as the Dow surged 305 points after lawmakers on Capitol Hill hinted that they may invest in a broader range of financial firms, such as GE Capital.

But Tuesday's election anticipation gave way to a "sell on the news" event on Wednesday, with the Dow falling 486 points following worse-than-expected results from the ADP National Employment jobs report and the ISM's non-manufacturing report. The sell-off extended into Thursday; the DJIA plunged 443 points as traders dealt with another round of negative employment data from the Labor Department, which indicated that continuing jobless claims hit a 25-year high. A poor earnings report from Cisco Systems (CSCO) didn't help matters, either. The maelstrom had blown itself out by Friday, as not even a 14-year high in the unemployment rate and a larger-than-expected drop in nonfarm payrolls could keep the major U.S. indices from rebounding sharply. The Dow added 248 points on Friday, but closed the week with a loss of more than 4%. Meanwhile, the S&P 500 Index (SPX) lost 3.9% last week, while the Nasdaq Composite (COMP) gave back 4.3% on a week-over-week basis.

What the Trader Is Expecting in the Coming Week: Support, Resistance, and Sentiment for the S&P 500 Index
By Todd Salamone, Senior Vice President of Research

On October 27, the S&P 500 Index (SPX) entered the week just above chart support near its mid-October lows and rallied. The index entered last week just below resistance from its October 17 highs and ended the week in the red. This week, the SPX starts out sitting smack in the middle of a month-long trading range between 1,010 and 850, which are levels to pay close attention to this week.

Intraday chart of the S&P 500 Index since October 20, 2008

Meanwhile, the 900 strike is home to heavy put open interest in the November option series, and could also provide an area of potential support. Since the SPX entered its current trading range last month, the index has closed below the 900 strike only twice. This region also marked the SPX's lows last week.

Last week, I discussed the powerful high-volume rally on the S&P Depository Receipts (SPY) on October 28 and the short-term bullish implications for the 2 weeks following the signal. This signal "shuts off" on Tuesday. For those of you keeping track, the SPY closed at 93.76 on October 28, and we'll know tomorrow if this signal preceded another bullish 10-day period.

Last Thursday, however, was somewhat of a mirror image of October 28. In other words, the SPY lost 5.5% on a day in which volume exceeded its previous 10-day average. In each of the previous 37 instances where this has occurred, it has essentially been a coin-flip probability as to whether the SPY finished higher or lower in the 10 days following such an event. However, the signal has bearish implications, since the average loss of 4.2% compares to only a 3.7% average gain.

We are also closely watching the behavior of the CBOE Market Volatility Index (VIX – 56.10) from 2 perspectives. First, the VIX continues to trade at a steep discount to the SPX's 20-day historical volatility, which has begun to level off just above 80% during the past few weeks. Our interpretation of this development is that there is little fear of another major setback in the market. Typically, such fear leads to major market bottoms. If fear and panic were elevated, the VIX would be trading above the actual volatility of the SPX.

Second, we are keeping an eye on the 44-45 area in regard to the VIX. We think this area is important, as it marked last week's low, and represents the VIX's "half-high" achieved on October 24. Moreover, this area is currently home to the VIX's rising 50-day moving average.

Even though we are in a period that has traditionally been strong for the market, investors should be cautious. Specifically, hedge funds remain a dominant force in the market, and are apparently still going through periods of de-leveraging. We saw more evidence of this de-leveraging on Wednesday and Thursday, as "forced selling" emerged with energy and steel stocks leading the market lower.

Along these lines, we've heard of several dates by which hedge fund investors must redeem their holdings. One such date is November 15, while the others lie at the end of November and December. Perhaps hedge-fund managers began raising cash last week in anticipation of the November 15 deadline. These deadlines may continue to plague the market in the weeks ahead, as hedge-fund managers use any signs of market strength to raise cash. Therefore, we recommend that you continue to avoid the sectors that hedge funds are heavily long, namely energy and technology.

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