Technical Analysis 101: Adam and Eve

I got bullish a bit early on equities last week as the Euro bounced and it felt like panic was in the air on the day of the German trading bans.  Still the pattern in stocks looks constructive for the short-term with a target above S&P 1150 (SPY 115).

The chart for SPY bears a striking resemblance to a double bottom pattern with momentum ebbing as the panic low from two weeks back gets retested.   Also, as Bill Luby points out options traders seem to be getting ahead of themselves pricing implied volatility trading above what is being observed.

I am only playing through upstrike call options (where implied vol is less dear), so my downside is limited.  Momentum players may still have stocks to dump so I have positioned for a bounce but kept the risk low.

If we do manage a rally here it is easy to imagine the news coverage shifting to discussing the liquidity enema eminating from central banks as equity positive.

Stock market stunned by its own fragility

The price action this week in equities was a change of pace.

I included the chart above to show just how low the short term volatility of SPY had fallen before the recent pull back.  As much as much as the Greek debacle may be the proximate cause of the stock drop, the steady grind higher over the last two months had left the market ripe for a pull back. The price drop is severe enough that momentum traders will be throwing out positions while value investors will still be on the sidelines for a few hundred more S&P points.  

US stocks continued lower on Friday, but the long bond and the Euro changed direction.  The long bond has been on a strong two week run up that was goosed higher by yesterday's late afternoon panic, while the Euro had been weakening in response to Europe's sovereign debt woes. Both trends are stretched but seem well supported by the current fundamentals.  The reversals in these markets, though mild, makes me think equities will not start next week in free fall.

The Greek saga (which began in early December 2009) dominated the headlines with European policy as of last weekend looking to keep the monetary union intact at the cost of a steadily weakening Euro.   There is still a lot of skepticism whether the current bailout for Greece is enough and whether the same thing can be done for the other PIIGS but it seems to me that where there's a will there's a way.   This is the train of thought that is driving the weakening Euro.  It may still happen that Greece abandons the Euro (likely leading to a sharp recovery in the currency) but I think the policy response of last weekend postpones it by a year while the powers that be wait to see if the austerity package works its magic.

A Greek debt restructuring will also relieve some pressure on the Euro and provide a far better template for the other PIIGS (should their situations worsen) to follow.  For all the weekly on again off again bailout announcements regarding Greece it is still not clear the authorities have done their homework and come up with a plan for the Euro and European debt markets that won't need to be reevaluated in the near future.  This lack of credible long term goals is the key uncertainty spooking the markets.  This thought from 2004 still reflects my view on why attempts to use the bailout package to discipline the Greek government is misguided.  

Most of the economic news out of the US has been positive, though ignored.  It was capped off today by  the best jobs report in years.  The positive recent news is being ignored due to fears of slowing growth in the second half of the year. As the US fiscal package winds down there is no obvious candidate to replace it.

London Bombings and the Markets

I don't think the markets have ever seen a 15 pt gap in the S&P index with an 11 handle on the VIX. That will probably lead to a gap in volatility prices when option markets open. The heads on CNBC are reminding people of the fast recovery the markets had after 9/11 and the Madrid bombings but the 11 VIX makes today completely different. There is a much higher risk that the vol increases from such a low level will lead to a very deep and sharp pullback that accelerates over the next few days.

VXO and SPX Divergence

The VXO already took out its Feb low last week and looks like it will manage the same trick again today. The SPX still needs to take out 1229 to keep pace so the market's forward view of risk is leading the actual price action.

Between this and my estimate of where sentiment is at I am going to buy some puts for the Fall. I am looking at the 1140 and 1100 strikes because I like to have the gamma around inflection points.

I probably won't short anything in cash unless TOL slips back below 85. Looking at other things too for that judgement but the breakout in homebuilders in the face of a lot of bearish commentary sums up my defensiveness best.

A divergence the other way occurred on May 13th just for some perspective.

Volatily Spiking Again

The scariest part of today's action has to be the spike in the VIX back near 18. The VIX bounced its way down to the 12 level over the course of 2 years and this quick move up is going to cause a lot of pain for options sellers. Besides that the higher vol will require options hedgers to sell increasingly larger size into the market as it heads lower. Implied and actual vols are also used pretty heavily to measure the risk on trading books so this move really has the potential to pull liquidity from the market.

As I mentioned all the talk of hedge fund trouble this week I was a bit skeptical. A rising VIX makes me a lot less skeptical.