The bulls are still in charge

By Lawrence G. McMillan

MORRISTOWN, N.J. (MarketWatch) — Despite the occasional overbought condition, the stock market – as measured by the Standard & Poors 500 Index — continues to plow higher. Considering that support levels keep building up below the market, and that overbought conditions rotate out without any major damage to the bullish market, it is clear that the bulls are still in charge.

The S&P 500 pulled back for a few days last week, before rallying sharply Monday. Last week’s lows near 1,390 therefore once again become a support area. The 20-day moving average of SPX is nearing that 1,390 area as well, providing further support. The other rather meager pullbacks that have occurred this year, have all resulted in similar support areas. The most significant of these is the support at the 1,340 area, which was tested several times in the first half of February, and again in early March. Finally, the long-term trend line that defines this bullish phase (the one that connects the October and November lows) is rising toward the 1,340 level as well.

In fact, that pullback in early March was the only time that SPX has dipped below its 20-day moving average since last December. When that happened, we noted that it usually ushers in an era of more volatility (actual volatility, not necessarily option implied volatility). Moreover, at the time it is happening, one cannot be certain in which direction the volatility will occur; about half the time SPX follows with an upward move, and the other half, a downward move. In this case, the move since then has clearly been upward, and if the past is any guide, there should be more to come.

Equity-only put-call ratios have struggled to remain on buy signals. These ratios are bullish when they are declining. Lately, they have been moving sideways as there has been a relatively equal balance between call buyers and put buyers. Call buyers, of course, are chasing the rising market. The put buyers are those who are buying protection because they are worried about a potential market decline. It seems to me that as long as there is a relatively large number of people still wanting to buy puts, then the market has more room to run on the upside (i.e., it’s a contrarian view).

Market breadth has not been spectacular for quite some time, and that remains the case. Ordinarily this might be a “crack in the dam,” but so far the market has ignored the fact that there isn’t widespread participation at all times. Our breadth indicators have just now moved back to buy signals, but are only modestly overbought. We would expect that this is not a major impediment to the bulls.

Perhaps the most interesting area of this market is volatility — particularly as shown by the VIX & VXO and their accompanying derivatives. Before discussing VIX, though, I would like to point out that the average stock’s Composite Implied Volatility (CIV) is in the 8th percentile. This is “too low” and is thus an overbought condition. Eventually it will generate a sell signal when it rises above the 15th percentile, but that can sometimes take a while.

VIX itself broke below 17 last week and immediately plummeted to 14. A declining VIX, in general, is bullish for stocks. In addition, the accompanying moves in the VIX futures have continued to feed the bullish construct: 1) the VIX futures traded at a large premium to VIX for quite some time (that is now diminishing, though), and 2) the term structure of the futures slopes steeply upward (i.e., each futures contract is more expensive than its predecessor in time). Those are bullish indications as well.

The fact that the term structure continues to rise all the way out into the later months is fairly unusual. One interesting fact concerning 7-month futures illustrates the expensiveness of the current situation. In August, 2011, when VIX was 41, the 7-month futures contract (which was March 2012 at the time) traded at 30. Recently, with VIX at 20, the 7-month futures contract (September 2012) also traded near 30. That is, VIX had fallen by 50%, but the seventh month futures were trading at the same price! This is unusual, to be sure, and it certainly demonstrates the fact that longer-term contracts are not good proxies for VIX movement.

It also demonstrates just how crazy the current environment has become. Are we to believe that people are so worried about the market six months from now that they are willing to pay the same volatility for protection that they paid last August when the market was in full-fledged panic mode? Something isn’t right here, and I’m certainly thinking it’s the current situation that is out of whack — not what happened last August.

This term structure is the result of two factors. One is the ongoing and rather powerful bull market that has been under way since last October. But the other is an almost buying mania in volatility exchange-traded notes and funds, such as Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures (VXX), ProShares VIX Short-Term Futures ETF (VIXY), VelocityShares Daily 2x VIX Short Term (TVIX)  , Barclays Bank PLC iPath S&P 500 VIX Mid-Term Futures (VXZ), and so forth. These monstrous VIX futures premiums and steep term structure are being caused by a voracious appetite for VIX ETNs and ETFs.

Many inexperienced traders (institutional and retail alike) are thinking they’re “smart” by buying VXX, VIXY, and TVIX. But they are overpaying so much that it will be hard to make money. For example, early last week, when the stock market finally backed off a little, SPX was down a bit, VIX was up a bit, and VXX was down 15%(!) because the term structure flattened and premium decreased. Not a very good volatility hedge, there!

Too many unsophisticated traders — and I mean unsophisticated in their understanding of volatility and volatility derivatives — are buying volatility. As evidence of their misunderstanding of volatility, they seem to be enamored with buying and paying up for protection in the later months in the term structure. Experienced volatility traders know that those longer-term months won’t respond well at all if volatility does explode.

Not all of these volatility buyers are purely small retail investors, either. Plenty of them are large fund managers — some even at hedge funds (supposedly the smartest guys in the “room”). Their demand for protection is a contrary indicator, in my opinion. Once they lose enough money on this “strategy,” they will abandon it. It’s entirely possible that the market won’t decline substantially until they give up on the volatility protection schemes.

In summary, the bulls remain in charge. There are no sell signals in place from our indicators now, and the overbought conditions continue to seem manageable.

Source:  Marketwatch - 3/27/2012 This market is headed higher