On a day like this, you really need to start off any post with some good news.  Apparently, one of the greatest television shows of our time might be made into a movie: we’re talking about Arrested Development.  So you see, there is hope for this country after all.  (Nevermind that we’re all so scared of the boogeyman that the government will be warrantlessly watching the movie over our shoulders; that’s a matter for another day.)

Okay, now to the issue at hand.  Markets gapped down at the open and never looked back, closing at the lows on higher volume.  Severe technical damage has been done to the indexes on a short and long term basis.  Key support levels from March 07, January 08, and March 08 should have held the selling in check, but the bears blew right through those lows.  This was a high volume, high intensity day in which no buyers ever really stepped up.  We kept hearing things throughout the day like, “Where are all the value investors?”  Off acting like Milford men, that’s where.

Before the open this morning, we sent a note to subscribers describing why we were still in full bearish mode:

Our opinion is still that we are in the midst of a bear market and that any rallies will be short-lived and indecisive.  Some market commentators (especially in the rah-rah corporate media) have been calling for another rally like the one we saw off the March lows.  The primary reason we reject this view is that the sectors that provided leadership during the March rally (tech, transports, energy) now appear overextended - or at least weakened - and we haven’t seen any new leaders emerge…

More importantly, we said that this was as good a time as any to tighten up those allocations and double-check your risk tolerance:

One other important point here is that this is a good time to double-check the allocations you’re working with.  This applies not just to our newsletter trades, but to your whole portfolio.  Revisit each open position, and ask yourself whether you would be comfortable if you ended up exiting that individual position for a 50% or even a 100% loss.  If the answer is no, then dial down your allocation.

Today was a perfect example of why we prefer to trade spreads on ETF options instead of the traditional big index products.  SPY quoted contracts a few pennies apart today, which is typical, while you could catch similar SPX strikes at a dollar and a half wide or more.  Good luck getting a fast and fair exit in the SPX pit on a day like today.

Where do we go from here?

The first thing to say is that action like this is not to be blown off - even if we bounce up 200 Dow points over the next couple trading days, that wouldn’t negate the horrible market internals and total lack of support we’re seeing now.  That said, here are some factors that may favor a snapback sooner rather than later:

• $SPXA50R - the percentage of S&P 500 stocks above their 50 day moving average has been a helpful tool in the past for discerning market tops and bottoms.  Over the past four years, on the five occasions when this indicator has been at 20 or below, the S&P 500 has been significantly higher in the weeks following.  Now that it is fashionable once again to disparage technical analysis, we’ll note that this particular indicator is actually quasi-fundamental: when too many high quality stocks are irrationally sold off, value-chasing buyers invariably step in to snap them up, and that tide lifts even the less seaworthy boats.  Click on the chart for a full view.
• RSI(14) - this is the old standby, the 14 period Relative Strength Index.  Going back to 1999, there are only about 15 occasions when the RSI(14) has fallen to 30 on the SPX daily chart.  When that happens, the index is almost invariably higher the following week(s).  One interesting, if unsettling caveat is the fact even a slow-moving indicator like this can get oversold and stay oversold through a pretty nasty fall, as happened twice in 2001 and once in 2002.  Even so, unless we’re in the middle of a slow motion market crash, the odds still seem to favor some moderation in the near future.
• $VIX - normally, this is the part where we comment on some beautiful VIX spike and how investor fear has gotten really overblown. But the story here is actually the relative complacency in implied volatility.  Not sure exactly what’s going on there, expect that in all likelihood the smart money has been putting on robust hedges for weeks now.  This is also a data point in favor of not using VIX options as a proxy for regular index price movement - there’s absolutely no guarantee of any 1:1 relationship.  But anyway, what do we make of the conventional wisdom that you can’t get a market bottom without a VIX spike?  Who knows?  (Well, our future selves of 3-4 weeks from now know, that’s who.)

One last thing.  If your portfolio got hammered today and you’re looking to rebalance, don’t kill all of the positive theta trades you have going by throwing in the towel and loading up on expensive puts.  If you want to get in on this trend, sell some OTM index call spreads; if you’re an uber-contrarian, sell some not-so-OTM put spreads.

Back on June 4, we suggested some relatively conservative ways to play the potential downside in Lehman Brothers (LEH). Since we published that piece, the stock has dropped more than 13% to 27.20, and with earnings now behind us it’s time to revisit these positions.

• LEH July 40/42 call vertical - we initially sold this vertical for a credit of $0.34. You could buy it back right now for about $0.05, locking in a gain of 17.46% return on capital risked. Since these calls are now so far out of the money and so cheap, they’re not going to offer much added benefit if the stock resumes its decline, so it’s better to lock in profits here.  If you’
• LEH July 22.5/25/30 put butterfly - we bought this put butterfly for $1.05.  As of Monday’s close this spread is priced to sell at about $1.71, which represents a 62.85% return on capital risked.  There is plenty of time left in the July options, but if Lehman rallies up from here, the negative gamma this trade carries could erode those profits fairly quickly, so again we’d want to lock in these gains.

The interesting thing is that the implied volatility in Lehman options hasn’t declined, even though earnings are out and presumably the worst is (maybe?) behind them.  July options have a 111% IV, and that concern extends all the way out to the 2010 LEAPS, which are trading at 72%.  So if you think the stock still has further to fall, there’s still plenty of premium around to sell (or pay up for, as your tastes dictate).

Steven Sears in this weekend’s Striking Price is still on board the “Keep the VIX in perspective” train:

Stop obsessing about the VIX. The Chicago Board Options Exchange’s Market Volatility Index (VIX) is many things, just not all things. It can rise or fall for reasons that have more to do with trading type than market direction. During the week, some investors sold short-term hedges and bought long-term hedges. This exacerbated the VIX’s recent lows, and is one reason why the SPX skew — essentially the difference between put and call implied volatility — edged higher in thinly traded options that expire toward year’s end. [link]

We in the blogosphere covered this ground last week, and the general sentiment about not over-interpreting individual data points should only become more salient as we move into the summer months. There is some significant government data coming out this week, but earnings reports are drying up and this looks as good a week as any for the annual summer blandness to begin. It’s always fun to catch the Bubblevision staff pacing around the NSYE floor, dodging tumbleweed and wondering how many different ways they can rehash old stories.

We’re developing a market sentiment indicator that is testing pretty well so far and should prove helpful in checking our own biases from week to week. It isn’t ready for prime time yet, but the reading for this week is pretty close to neutral. We wouldn’t be surprised to see markets work off their short term oversold status by way of time rather than price - meaning that we could churn sideways here before resuming the selling or, by some miracle, finding new bullish leadership.

Now, to contravene our own injunction, let’s obsess just a little more. As of this morning, the short term volatility indexes (VIX, VXN, RVX, VXD) are all up 4-5%, and the VIX is teasing us with a move toward the broken trendline on the 2 year weekly chart. Markets are quietly and slightly up this morning, so this may well be institutions firming up their hedges in case oversold conditions persist this week. We suggest individual traders do the same.

Our VIX post from yesterday got picked up by two of the deans of options blogging, Adam Warner (shown) and Bill Luby:

The Big Question for the VIX
VIX Jumping the Shark?
VIX and VIX
(and thanks also to Abnormal Returns for the link)

Not much to add in response to all this, except to agree that the increased coverage of this one instrument doesn’t change the fact that it still definitely serves a purpose. When all you have is a hammer, every problem looks like a nail, right? But just because some people erroneously use the VIX as a catch-all proxy for fear doesn’t mean that that particular hammer doesn’t still have its purpose.

The idea of a VIX hiatus sounds about right - at least in terms of parsing and explaining it. Surely those who have ears to hear will have understood by now that statistical measurements do not exert causal force - that any cause-effect relationship between the S&P 500 and the VIX moves only from the former to the latter.

Finally, what about the other volatility products, you know? RVX, VXD, VXN, QQV - those guys deserve more love than they’re getting.

New complicated products

Two product launches of note:

1. Yesterday saw the announcement of the Merrill Lynch U.S. Forward Equity Variance Rolling (FEVR) Index, which “measures the performance of a long S&P 500 volatility strategy designed to be both tradable and efficient.” As to be expected from a press release, they don’t provide much insight as to what’s really under the hood, just the obvious remark that this index “efficiently tracks volatility using a strategy designed to minimize the carry cost associated with owning volatility” while still capturing the upside of being long vol. The claim is that being long 25% this FEVR and 75% the S&P 500 beats being long equities only. No mention of any retail-friendly implementation of this index, either now or forthcoming. But that’s Wall Street for you.
2. Felix Salmon notes the introduction of some index ETFs that handle your allocation adjustments for you. His concern is that paying 25bp for a quarterly rebalancing might not be a smart use of your money, and we have to agree. The sponsors (PowerShares) should set the rebalancing back to annual, and cut the fee to 5bp. We’d buy that, or at least might consider putting our cousins and neighbors in such a fund.

Portfolio Update

A quick note to our members: again today we didn’t get filled on the order we’ve been working this week. Premiums just fell off too sharply today, perhaps in advance of the long weekend, and we weren’t in the mood to give chase.

The good news is that the same premium suckage that kept us on the sidelines has been fantastic for our current newsletter positions. Our IWM trade for June expiration is currently up about 7% after just a week; our SPY position is up 10%, which is our upper target for these trades anyway.

Reversal Readings

DIA - 2.76
SPY - 4.51
XLY - Consumer Discretionary - 0.53
XLE - Energy - 8.53
EWZ - Brazil - 5.52
XLB - Materials - 5.25
IYR - Real Estate - 2.12

It’s significant that Steven Sears even felt the need to write this column in the first place; it’s even more significant that he actually published it, and said today:

[A]ll it took was some bad inflation data Tuesday, and a few crummy earnings report, for the Chicago Board Options Exchange’s Market Volatility Index (VIX) to jump up about 6%, to almost 18.

If this number seems random to you, guess what? It is. Investors need to fight the temptation to view VIX as the end all, be all, in the options market. [link; our emphasis]

Indeed. While the VIX isn’t actually a random number, it certainly is just a statistic, and that means many of the traditional tools of analysis simply won’t apply. And the VIX has definitely received too much attention of late, and is being asked to perform too many roles - market timer, sentiment indicator, and even trading vehicle.

The real question now is: has the VIX jumped the shark? Try as we might, it’s getting harder and harder to find a source whose daily market commentary doesn’t feature at least a casual nod to VIX action, and more importantly, those passing references almost always describe it one-dimensionally as “the fear index.” A Google Trends analysis suggests that the VIX has become a permanent fixture in both financial journalism and among the terms for which punters like us regularly search (the attached chart is US-only; there’s some unrelated Japanese term that skews the global results). The ubiquity of the VIX is as recent as early 2008: while spikes in searches and in news coverage matched spikes in the index itself during 2007, what we’re seeing now is a fairly steady stream of stories and searches even during a market rally. This may mark a fundamental shift, in that the story used to be, “market selloff = VIX spike = people are scared!” but is now “hey, look how low the VIX is going!”

Nous sommes tous VIX-watchers.