Wednesday, March 3, 2010

CAN THE "FEAR INDEX GUIDE US?" - VIX REVISITED

Just a quick note about our old friend the VIX. We've rallied back quite well and all still seems to be going according to the plan we've laid out where we see some strength in the market for the next 6 weeks or so. Now the jobs report could come out extremely weak since (and blame it on the snow of course!) but still there does seem to be strength in the market in a broad based rally that has included home builders, retailers, technology, metals, commodities, and energy.
Despite things going as planned, I am still cautious and looking for indicators in the market that may give us a warning that the run is over done.


I have noticed that transports like KSU seemed to have hit the wall over the last two days, so that may be an indication of some weakness or some consolidation. As you know, the KSU trade in my opinion has past and I sold out of that earlier. Some might say too early, but 10% gains in little over a week are great and I didn't want to give them back. Having said that there has been some real stiff resistance right at the $35 area where I highlighted in the chart. By the way, don't over do your trade size. I received a comment from a visitor that told me that he had completed the KSU trade and it was HUGE. Do not purchase a particular stock in such a large portion that it becomes a significant or oversized holding in your portfolio. You must manage risk in many ways and the worst thing you can do is to take too large of a position.



Anyway, I mentioned that P/Es were way too high the other day and another item I'm watching is the VIX. The VIX is the fear index or really a measure of the volatility in the market. Since February 5th the market has pretty much rocketed in one direction and therefore fear has almost disappeared. As usual, my friend Guy Lerner at thetechnicaltake.com has highlighted that the smart money and insiders are beginning to sell and the dumb money is very bullish. These are the times we need to wake up! The VIX is now reading 18.83 and this is an indication of complacency in the market. I have mentioned a trade to buy VXX on a bet that the market will reverse and fear will flood back to the market. I think we are getting close to a good risk/reward area to put that trade back on, but I will hold off a bit as I've mentioned before in the comments section, I'd like to see it with a 17 handle. We won't need to go much higher in the market to get to that level.



I hope the attached chart is clear. Click on it to enlarge it, but this is a 3 year picture of the cash S&P 500 (SPX) against the VIX. I have marked each instance where the VIX traded lower than 19. I've also plotted points on the SPX so we could see where it was trading on that same day. (The tabletop line is the spot where showing the value of the SPX rather than the bold dot. The capture software I used moved the dots around, so please use the white line as a graphical indication of where the text values should be). I think the information is pretty compelling that it may make sense to bet that the market will reverse sooner rather than later. Yes, the market can continue higher, but again the VIX is warning us that EVERYONE thinks it is safe in the water, and that is usually when the sharks attack.

Finally, some will say that the last 3 years is not a great sample of to use, but I have two ideas that counter that notion. First, even the most recent correction on January 19th hit a level on the VIX around 17.50 and resulted in nearly a 100 point drop or 8.5% fall in the SPX or a purchase of VXX would have gone from around $27.00 a share to $33.50 in just a few days. So we have recent history that highlights just how actionable this trade can be. Second, the market in the last year has traded in a fashion that is absolutely not normal. The market typically doesn't move in one direction for 10 straight months. Therefore I would suggest that we need to be looking at recent evidence in "this" market rather than long dated historical examples that might not be relevant.
















Goatmug

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