The following is a reprint of the market commentary from the December edition of the Option Advisor, published on December 18. Prices and the chart are as of the close on December 18. For more information or to subscribe to the Option Advisor, click here.
In my commentary in this space on November 20, I stated that "today's market plunge has sliced through the 788 level on the S&P 500, which represents half of the October 2007 peak at 1,576. There is often significant support at these 'half-high' levels after major declines, and the jury may not yet be out (after today's close at 752) on the 788 level still holding as support. But should it not hold, we are likely to have some very serious additional pain ahead especially in light of the less than compelling sentiment backdrop."
The "half-high" at 788 did in fact hold, and the S&P 500 Index (SPX) proceeded to rally by 24% from its intraday lows on November 20 at 741 to yesterday's peak at 919, thus meeting the 20% gain threshold that many would use to declare "a new bull market." Of course, with the S&P at 885 ensconced more than 10% below any reasonable line of demarcation that could remotely characterize it as being in bull mode (the 195-month moving average, currently at about 1,012), such "bull market" talk is at best premature and at worst nonsense. But what we've seen does illustrate the power of the support that can emerge once an asset sheds 50% of its peak value. The fact that we can rally by an additional 125 S&P points from here and still be in a bear market indicates the huge ground that bear market rallies can cover.
With this "half-high" concept fresh in our minds, let's explore the implications of the recent sharp decline in the CBOE Volatility Index (VIX - 47.34). As my colleague Todd Salamone noted today in an internal email to our traders, the VIX at its intraday low of 44.50 pretty much completed a 50% decline from its peak of 89.53 on October 24. Recognizing that a viable VIX low might now be in place at this "half-high" level, Todd proceeded to ask, "Is this the calm before a new storm (i.e., another leg down in the market that would inevitably be accompanied by a major rally in the VIX), or as a reporter just asked me, is the VIX headed back to the pre-Lehman levels in the 25-30 area?" I think this is a very legitimate question worth further exploring in this space, particularly as we are about to enter a new year.
So with the understanding that the bearish case for the VIX is almost certainly congruent with the bullish case for the market, let's take a closer look at this VIX action for additional directional clues. First, from a technical standpoint the decline in the VIX has taken out some important support levels. Per the accompanying chart, potential support at the round-number 50 level as well as at the rising 80-day moving average was obliterated this week, as was an important up-sloping trendline as recently discussed by Larry McMillan. And the 40-week moving average, which had been a key support and resistance level for the VIX prior to September, is light years away at a shade above 34, so there is plenty of room to the downside.
Another factor that exerts a downward tug on the VIX is correlation among sectors. High sector correlation such as we experienced during the worst of the market decline this year serves to pump up the VIX, as there is little counter-trend movement to dampen market volatility. But we've recently seen more evidence of sector divergences (the commodity names vs. the financials comes to mind). A continuation of this trend will serve to pull the VIX lower, but I'd note that such behavior is more of a byproduct of a healthier market environment than the cause of it.
The biggest risk I see to the case for a lower VIX (and I see it as very formidable) is the fact that the VIX continues to trade substantially below the 20-day historical volatility of the S&P, a trend that only accelerated with today's VIX implosion. With more and more widespread talk of the VIX as a "fear gauge," it is often forgotten that the VIX is at its core a measure of projections for future volatility that are generally based on recent realized volatility. And while a "47 VIX" can be considered "high" relative to the norm for the VIX in recent years, it is actually "low" when compared to the recent volatility of the market, with this "VIX discount" to 20-day historical S&P volatility in the area of 20%. As we've stated in our weekly Monday Morning Outlook e-newsletter, periods in recent months during which the VIX has been trading at such a steep discount to realized volatility have been quite weak for the market. And there is good reason for this phenomenon, as this VIX discount can be viewed as a proxy for investor complacency.
So there you have it - many of the "technicals" argue for a lower VIX, while the VIX discount to historical volatility argues for a higher VIX. Might the "tie breaker" be the 50% decline in the VIX from its peak to support at its "half-high"? That's my belief, and as such this would argue for a continued defensive posture. At the same time, I believe there are sectors - such as the homebuilders and the financials - whose sentiment backdrop and price action are supportive of a bullish posture. But I would hedge any significant long positions in these sectors with shorts in such vulnerable areas as energy and technology.
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