VIX Contango Extreme Could Send the Dow Back to 19K

The extreme VIX contango could have bearish repercussions for the stock market in early 2017

Senior Vice President of Research
Dec 27, 2016 at 8:40 AM
facebook twitter linkedin


If you've been reading my weekly commentaries during the past few weeks, you are fully aware of the emphasis on multiple indexes approaching round numbers simultaneously -- with "round numbers" referring to century marks, millennium levels, and/or round-number year-to-date (YTD) returns.

And if you are a CNBC television viewer, you have been continuously informed that the Dow Jones Industrial Average (DJIA - 19,933.81) has gone from closing in on 20,000 to stalling at making the run at 20,000 by week's end. As the Dow retreated from its high, only 13 points shy of the 20,000 mark, the S&P 500 Index (SPX - 2,263.79) pulled back to its round 10% YTD mark, situated in the 2,250 half-century area. As I pointed out in the Dec. 12 Monday Morning Outlook with respect to the SPX:

"…half-century marks have historically acted as magnets during trading range behavior and/or key pivot areas after a big advance or pullback. The importance of these half-century levels could be due to the heavy open interest that tends to build up on SPX and SPY options at these strike prices that represent half-century levels on the SPX."

The premise behind alerting you to the round numbers was to suggest that a hesitation in the post-election rally was an increasing possibility. In fairness, I first began cautioning about a hesitation occurring when two highly followed benchmarks, the Dow and SPX, were trading around 19,000 and 2,200, respectively. I was premature with this call, but as other round numbers on multiple benchmarks came into play, the message did not change.


"... the S&P MidCap 400 Index (MID - 1,667.73) and NYSE Composite Index (NYA - 11,125.22) stalled at round-number year-to-date percentage gain levels of 20% and 10%, respectively... In fact, MID's month-to-date high so far is at 1,698 -- just a couple points shy of the round 1,700 level. "
    -- Monday Morning Outlook, December 19, 2016

Indeed, during the past two weeks, there has been evidence of the rally stalling as major benchmarks consolidate just below the highs put in earlier in the month. For example, the Dow retreated from 20,000 -- a millennium mark that has garnered a plethora of attention relative to Dow 19,000. By the way, have you seen the Dow 20k hats on the floor of the New York Stock Exchange?  If not, check out the lead image in the Dec. 14 Wall Street Journal article entitled, "It's Almost Dow 20000: Where's the Party? Where Are the Hats?"  

While a few traders on the floor donned the 20k hats prematurely, the good news for longer-term investors concerned about euphoria preceding a market top is that there isn't the "party" atmosphere of 1999 when the Dow hit 10,000 (only to peak just one year later and move into bear mode until 2002-2003). Excerpts from the Journal article linked above offer a good frame of reference between the sentiment backdrop then and now:

"After the Dow Jones Industrial Average reached 10000 for the first time in 1999, New York City Mayor Rudolph Giuliani and New York Stock Exchange Chairman Richard Grasso gaveled the session to a close and tossed Dow 10000 hats, commissioned by the NYSE, to cheering traders on the floor... a NYSE spokesman said there were no festivities or official gear on tap for Dow 20000. On Wednesday morning, the spokesman said the exchange decided in the past day or so to make 'some' hats, but no major celebration was planned and no celebrity guests were lined up."
    -- The Wall Street Journal, December 14, 2016

Returning to the topic of round numbers, the S&P MidCap 400 Index (MID - 1,673.55), after first retreating from the round 1,700 mark, has been meandering in the 20% YTD gain area around 1,675. In fact, this month's choppy MID behavior around 20% YTD is, so far, similar to its behavior around the 10% YTD level in September and October, when it was trading just above the round 1,500 mark.

mid daily 1223

Meanwhile, the SPX made a couple of lows just above the 2,250 half-century level, which is also right above its 10% YTD gain. And the Nasdaq Composite (COMP - 5,462.68) has been leveling off during the past two weeks just below the round 5,500 level, which is 10% above last year's close. For the time being, major equity benchmarks appear to be in neutral as round-number levels and round-number YTD percentage gains come into play.

On the volatility front, there are a few things that warranted attention last week -- including the fact that the CBOE Volatility Index (VIX - 11.44) closed at its lowest level since July 2014. An exchange-traded note (ETN) that we follow, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV - 49.59), which is linked to short-term VIX futures, rallied to an area of major peaks in June and August 2015. As the name indicates, XIV is an inverse ETN -- so if volatility declines, the ETN will advance.  

Add the XIV to the list of benchmarks approaching potential round-number resistance -- in this case, $50, which coincidentally is near the 100% YTD return mark, based on XIV's 2015 close of $25.80. Last week, the $50 level acted as resistance. Similarly, the $50 level provided resistance ahead of two VIX spikes in June and August 2015 -- the first of which coincided with a 5% pullback in the SPX that lasted about a week in late June, and the second of which coincided with a 4% decline over a near two-month period in August-October 2015.

xiv 2-yr daily 1223

Another thing that hit my radar last week is the extreme discount in the VIX reading relative to VIX futures. It's normal for the VIX reading to be below VIX futures prices -- a situation known as contango. But in the past couple of weeks, the contango is much larger than usual. During periods of extreme fear, the VIX reading will move above futures prices, which is known as backwardation. This usually occurs after a steep pullback in equities, such as that which occurred before the election. Backwardation, which is unusual, usually occurs near a bottom during corrective phases.

A VIX-VIX futures contango extreme, much like we are heading towards at present, could be viewed as excessive short-term optimism, as the demand (or perceived demand) for protective SPX puts is low, resulting in lower SPX put prices. We quantify contango by subtracting the VIX reading from the current four-month VIX futures price daily, and then dividing by the VIX reading and making it a percentage. We smooth the calculation with a 10-day moving average. The higher the 10-day moving average of the daily percentages, the greater the contango extreme (see chart immediately below).

vix contango extreme 1223


As you can see in the chart, the 10-day moving average of the (VIX 4-month futures less VIX) divided by the VIX is nearing 60%. During the past seven years, since VIX futures volume became popular, the 10-day moving average has reached 60% only three previous times (March 2012, August 2012, and August 2016). The table below shows how the SPX has behaved after past readings of 60%. It suggests a flat market in the one- to two-week time frame, with resolution to the downside one month from the signal.

If volatility rises from here coincident with an SPX decline similar in magnitude to the two pullbacks that occurred in the summer of 2015, a trough would occur in the 2,150 area, which is about 20 points above the current site of its 200-day moving average and a trendline connecting lower highs in August through October. A decline of this magnitude would likely result in a Dow retest of 19,000.

spx returns after vix extreme 1223


Continue reading:


Sign up now for a trial subscription to Schaeffer's Expiration Week Countdown! We'll send you 6 trades for expiration week, each targeting double- or triple-your-money gains in less than 5 days.

 

What This Election Year Means for Stocks

Ipad with I voted sticker

  


 
Special Offers from Schaeffer's Trading Partners