Here's Why It May Be Time for a Volatility Trade

Weighing the implications of the drop in energy prices

Senior Vice President of Research
Dec 6, 2014 at 9:15 AM
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The Dow Jones Industrial Average (DJIA) and S&P 500 Index (SPX) raced to even higher highs on Friday, helped by the Labor Department's stellar payrolls report. In fact, for the seventh consecutive week, both indexes finished higher, even as commodity prices continued to sag. That said, this week, Schaeffer's Senior VP of Research Todd Salamone will look at the implications of crude's decline, and explain why the time may be right for a volatility play.

  • The new macro risk that has emerged
  • Why now may be a good time for a volatility trade
  • Rocky White discovers whether high levels of bullish sentiment will play havoc with December's historically strong returns

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: Reasons to Reconsider a Volatility Trade
By Todd Salamone, Senior VP of Research

"... hedging activity has dried up in the past few weeks as the market has advanced. This suggests that there are a lot of un-hedged longs, which makes the market more vulnerable to bad news. Before the last correction, hedging activity dried up as well, but negative news caused a stampede into index put buying and volatility call buying, contributing to an accelerated decline as sellers of the portfolio protection had to short S&P futures to remain hedged."

- Monday Morning Outlook, Nov. 22, 2014

"... we have indeed seen evidence of short covering, with a slight decline in SPX component short interest in the most recent report, which is data as of mid-November ... short interest on SPX component names is still relatively high, nearer the top of its range during the past couple of years ... after reducing equity exposure two weeks ago -- a potential headwind if this were to continue -- active investment managers again increased their exposure to equities ... However, in the options market, equity option buyers have slightly soured on the market, with the customer-only, equity-only, 10-day moving average of the buy (to open) put/call volume ratio turning higher once again. Ideally, bulls would like to see this ratio continue lower from the climactic peak that occurred at the recent bottom."

- Monday Morning Outlook, Nov. 29, 2014

"None of the red flags -- not tumbling oil prices, not slowing growth in China, not stagnation in Europe -- are getting a rise out of U.S. investors. Indeed, plenty of folks think U.S. stocks are benefiting, playing the role of the safe harbor in the storm."

-The Wall Street Journal, Dec. 4, 2014

"Speculators hold around the fewest options on the Chicago Board Options Exchange Volatility Index in more than two years, while trading in the contracts is the slowest since 2012, according to data compiled by Bloomberg. The Standard & Poor's 500 Index has gained 12 percent this year."

-Bloomberg, Dec. 4, 2014

"Round millennium #'s in play around world: $DJIA 18K, $NYA 11K, $DAX 10K, $NIKKEI 18K, $SHGIDX 3K"

"$VIX decent collapse this morning - suggests elevated reading ahead of employment number"

"$QQQ 20% YTD return at $105.50- this week's resistance"


-@ToddSalamone on Twitter, Dec. 5, 2014

Not a lot has changed since our discussion last week, with large caps -- as measured by the Dow Jones Industrial Average (DJI - 17,958.79) and S&P 500 Index (SPX - 2,075.37) -- continuing to carve out all-time highs (albeit barely) in an advance that has clearly lost the impressive momentum that we observed off the mid-October bottom into mid-November. Meanwhile, smaller-capitalization stocks, such as the Russell 2000 Index (RUT - 1,182.43) and S&P MidCap 400 (MID - 1,444.31), continue to chop around 2014 resistance levels in the 1,180 and 1,450 zones -- although this might be interpreted as bullish, since we have not yet observed violent rejections from this obvious chart resistance, which occurred in early September.

Daily chart of SPX since April 2014 with 30-day moving average, site of 10% YTD return, and potential short-term support if we experience a pullback

Daily Chart of SPX since April 2014 with 30-Day Moving Average and 10 Percent YTD Return

Meanwhile, an additional macro risk has emerged, along with several others that have already surfaced this year, including the Fed hinting at raising interest rates, slowing economic growth in China, the Russia/Ukraine conflict, and one that has been brewing for a long time -- Europe's economy. The "newest" macro risk on many radar screens is the huge descent in oil prices, especially last week, following news that the Organization of Petroleum Exporting Countries (OPEC) would keep its production quotas intact.

But so far, the only visible damage that has occurred has been confined to the energy sector, as the Energy Select Sector SPDR ETF (XLE - 80.28) is off 20% from its 2014 highs. Nonetheless, concerns range that the drop in oil prices is foreshadowing slowing economic growth, to another financial crisis.

As a side note, in 2007-2008, when oil prices were surging amid strong demand, the conventional wisdom was that the economy was vulnerable to higher oil prices, and thus lower oil prices would be necessary to sustain economic growth. However, as oil prices declined sharply amid slowing demand, the economy and the stock market suffered.

Now, some market participants view lower oil prices as a threat to economic growth, even though the retreat in oil prices is in part being driven by new and improved methods of drilling for oil, creating additional supply. That brings up an important question to ponder: Will market participants again misjudge the implications of lower oil prices?

Weekly chart of XLE since January 2010 with key $80 area -- site of a major 2011 peak and roughly 20% below 2014 peak

Weekly Chart of XLE since January 2010 with Key $80 Area

The financial crisis concern is driven by the fact that energy junk-bond debt represents 16% of the $1.3 trillion junk-bond market, leaving banks exposed to those energy companies that lose money as a result of declining oil prices. That said, the Financial Select Sector SPDR ETF (XLF - 24.82) achieved a six-year high this past week, and the SPDR S&P Regional Banking ETF (KRE - 40.57) rallied strongly off a key longer-term moving average and its year-over-year breakeven level. However, the latter is currently trading just below multi-year highs and its year-to-date breakeven level of $40.61.

Daily Chart of KRE since March 2012 with 320-Day Moving Average and 2014 YTD Breakeven

Strong price action, positive December seasonality, and recent evidence of short covering and buyback activity that is usually robust at this time of year, are reasons not to disturb long positions. That said, we still have not lost sight of the fact that the "higher volatility ahead" trade -- via the purchase of CBOE Volatility Index (VIX - 11.82) calls -- has deteriorated significantly in recent weeks. This trade has been extremely popular for the past couple of years, and the fact that many have given up on it may not be a huge surprise, as 90-99% of VIX calls have expired worthless month after month.

But we know the market could succumb at any moment to "known" or "unknown" issues or events (the Federal Open Market Committee meeting later this month, for example). Nonetheless, volatility players and/or those that typically buy portfolio insurance through the purchase of VIX calls have essentially left the building.

Therefore, with VIX futures relatively low -- plus major equity benchmarks around the world trading near potential millennium resistance levels -- it might be prudent to add VIX calls as a portfolio hedge before something emerges that sparks renewed interest in the once-popular volatility trade.

I will end with this thought-provoking question: Despite almost daily reminders that China's economy is slowing and that this is a risk to our market, what does it mean that the Shanghai Composite (SHGIDX) is up almost 40% year-to-date?

Indicator of the Week: December Seasonality
By Rocky White, Senior Quantitative Analyst

Foreword: Seasonality data for December seems especially interesting, what with it being the final month of the year and the holiday season. Simply looking at monthly data over the past 50 years on the S&P 500 Index (SPX), we see December has been a very good month for stocks.

Specifically, it's the second best month (April is first) in terms of the typical return, with an average gain of 1.51%, and it has been positive more often than any other month, at 74%. Furthermore, the standard deviation of returns is the lowest, indicating less variation in the returns. Let's break down this data even further to see when the best time to buy has been, and add in some sentiment data to make it a little more relevant to the current environment.

SPX Monthly Performance - Past 50 Years

Wait Until Mid-Month: Don't be worried that we're already a week into the month. Historically speaking, all the gains in December happen in the second half of the month. Below is a chart that shows, on average, how December has played out. There have typically been gains in the first 10 days, but by the middle of the month, December is back at breakeven. The SPX has then spiked higher over the last part of the month.

SPX Average December Performance

Below, I have a table quantifying the data above. I summarize the returns from the beginning of December through the 14th, and then compare that to the rest of the year. The first half of the month has averaged a slight loss, and was positive 54% of the time. The second half has averaged an impressive gain of 1.56%, and has been positive 80% of the time.

SPX Last 50 Years December Returns

Investors Intelligence: The Investors Intelligence (II) sentiment poll shows investors to be very bullish right now. With the market hitting all-time highs, that's not completely unexpected -- but when investors are extremely bullish, it tends to have negative implications for the market. So right now, we're at a point that is historically very bullish, but expectations are very high. Does the market tend to struggle in these scenarios, or does one factor tend to prevail over the other?

The average percentage of II bulls over the past month is about 55%. There have been 18 occurrences when the reading was above 50% heading into the last half of December. In those 18 times, the average return for the rest of the year was 1.77%, with 83% of those returns positive. In other words, the late-December seasonality is just too strong. The SPX's returns have been pretty good, no matter what the Investors Intelligence poll has showed.

SPX Second-Half December Returns

This Week's Key Events: Retail Sales, Inflation Data Due Out
Schaeffer's Editorial Staff

Here is a brief list of some key market events scheduled for the upcoming 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

  • There are no notable economic reports on Monday. Diamond Foods (DMND), H & R Block (HRB), and Vail Resorts (MTN) will release earnings.

Tuesday

  • The Labor Department's Job Openings and Labor Turnover Survey (JOLTS) hits the Street on Tuesday, along with wholesale inventories. AutoZone (AZO), Conn's (CONN), Krispy Kreme Doughnuts (KKD), Pep Boys (PBY), and UTI Worldwide (UTIW) will step into the earnings spotlight.

Wednesday

  • The Treasury budget and weekly crude inventories make up Wednesday's docket. Costco (COST), Avanir Pharmaceuticals (AVNR), Hovnanian (HOV), Lands' End (LE), and Toll Brothers (TOL) will report earnings.

Thursday

  • Weekly jobless claims will come out on Thursday, along with retail sales figures, import and export prices, and business inventories. On the earnings front, Adobe Systems (ADBE), Ciena (CIEN), and Lululemon Athletica (LULU) will report.

Friday

  • The Thomson Reuters/University of Michigan consumer sentiment index and producer price index (PPI) come out on Friday. There are no major earnings reports on the day's schedule.

And now a sector of note...

Semiconductors
Bullish

Since gapping above the round $50 area in late October, the Market Vectors Semiconductor ETF (SMH) has continued its impressive uptrend. On Friday, in fact, the ETF rallied to a new 13-year high above $56, with its year-to-date gain of about 33% easily surpassing a roughly 20% advance in the broader PowerShares QQQ Trust (QQQ). Despite this strong technical backdrop, the average short interest-to-float ratio for the 48 names we track in the sector is a steep 8.0% -- accounting for more than a week's worth of pent-up buying demand, at typical daily trading volumes. Should the sector continue to outperform, a mass exodus of these bears could translate into additional upside for the semiconductor group. That said, with SMH exploring new multi-year highs, potential speed bumps are in the $58 area (representing a 50% retracement of the 2000 high and 2008 low) and at the $60 level (representing four times the SMH's 2008 low, and 50% above the historically significant $40 area).

Weekly Chart of SMH since May 2013

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