Stocks Tumble on Taper Talk
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The following is an excerpt from this week’s ‘Weekly Market Letter’ from Market Edge (www.marketedge.com).
The DJIA and S&P 500 were able to grind to new record highs to start the week but spiking coronavirus cases, sluggish economic data and the Federal Reserve signaling that they wanted to begin tapering asset purchases, tripped the bull’s run. A -1.1% drop in July Retail Sales and a cautious earnings forecast from Home Depot (HD) snapped the Dow and the S&P 500’s five-day win streak on Tuesday and the DJIA tumbled 731.28-points (-2.0%) over the next few days before bouncing back on Friday. Investors balked on Wednesday after the FOMC Meeting minutes signaled that the Federal Reserve wanted to taper bond purchases before the end of the year. Stocks slumped into the close but key moving average support levels were tested and held on Wednesday and Thursday. That led to investors buying the dip and Friday’s rebound saw every sector finish positive in a broad based rally. For the week the sectors were mixed as defensive groups and big cap technology found buyers. Utilities (XLU), Healthcare (XLV), REITs (XLRE), Technology (XLK) and Consumer Staples (XLP) outperformed as investors rotated out of cyclical sectors on growth concerns. Energy (XLE) was the weakest sector, down -7.14%, followed by Materials (XLB), Financials (XLF), Industrials (XLI) and Consumer Discretionary (XLY). Interest rates nudged lower and the yield on the 10-year Treasury fell as low as 1.22% before closing at 1.25%. The 30-year T-Bill yield landed at 1.87%. Signs of slowing global growth also weighed on crude oil prices. Crude fell to $62.10 a barrel as inventories grew, its lowest price since April. Once the dust settled, the major averages turned in their worst week since mid-June on choppy, low volume summer trading as the DJIA and S&P 500 snapped a two-week win streak, while the NASDAQ and small cap Russell 2000 were in the red for a second straight week.
For the period, the DJIA lost 395.30 points (-1.1%) and closed at 35120.08. The S&P 500 gave up 26.33 points (-0.6%) and settled at 4441.67. The NASDAQ slipped 108.24 points (-0.7%) to close at 14714.66, while the small cap Russell 2000 underperformed and dropped 55.51 points (-2.5%) finishing at 2167.60.
Market Outlook: The technical condition of the market deteriorated this week as the major averages pulled back and consolidated recent gains. The technical indicators finished mixed with MACD, which measures the short-term trend, bearish for the DJIA, S&P 500 and NASDAQ and Momentum, as measured by the 14-day RSI, neutral. The different indexes traded around technical support levels with the NASDAQ briefly falling below its 50-day moving average (MA), before closing back above it on Friday, and the DJIA bouncing off that support on Thursday. While the market sectors finished the week mixed, Technology (XLK), Healthcare (XLV), Consumer Staples (XLP) and Utilities (XLU) all hit new highs during the period. This points to money being repositioned in equities rather cashed out and according to Refinitiv Lipper, Equity Funds have seen net inflows over the last four weeks, including $13.9 billion this week which is a positive going forward. There was more technical damage in the secondary indexes as the small cap Russell 2000 dipped below its 200-day MA for the first time since September and had corrected 10% from its mid-March closing high to Thursday’s low. The DJ Transportation Index, as of last week, had corrected 11.6% off its early May closing high and the Philadelphia Semiconductor Index was down 7.8% from its August high. This shows that despite the Dow Jones, S&P 500 and NASDAQ not seeing a 5% correction since last October, there has been a revolving correction and rotation under the water line within the different indexes.
Internal breadth was negative as the NYSE and NASDAQ Advance/Decline lines both lost significant units showing most stocks were under distribution. New 52-week lows outdid the new highs during the week as investors rotated back into the safety of big cap technology shares and defensive sectors. Investor sentiment has been overly bullish for most of the year but has been reined in and fallen into a more neutral stance. That can lead to more cash on the sidelines that will eventually work its way back into the market. The National Association of Active Investment (NAAIM)Exposure Index fell to 70.6 this week, down from 97.5 previously, showing hedge funds were more cautious. Finally, FINRA’s Customer Margin Balance saw the first decline since March 2020.
Once again, the major averages bent but didn’t break as the rally hesitated on the Fed’s taper talk. However, with surging virus cases threatening the economic recovery, it’s doubtful that the Federal Reserve will be able to do much more than talk about stopping asset purchases over the near term keeping a floor under the market. In addition, Q3 earnings estimates are being raised and that should keep equities inching higher. Companies are heading into the fall flush with cash and we should start to see more share buybacks announced to help support prices. Look for dips to continue to be bought and the target for the DJIA remains 36229 and 4519 for the S&P 500.
A chart of these indicators can be found by going to the Market Edge Home page and clicking on Market Recap, which is on the right-hand side of the page just below the Second Opinion Status numbers.
Cyclical Trend Index (CTI): The underlying premise of the CTI is that the market, as measured by the Dow Jones Industrial Average (DJIA), tends to move in cycles that often resemble sine waves. There are five identifiable cycles, each with different time durations at work in the market at all times.
Currently, the CTI is Positive at +14, unchanged from the previous week. Cycles B, C, D and E are bullish, while Cycle A is bearish. The CTI is projected to remain in a positive configuration into the fall.
Momentum Index (MI): The market’s momentum is measured by comparing the strength or weakness of several broad market indexes to the DJIA. Readings of -4 and lower are regarded as bearish since it is an indication that a majority of the broader based market indexes are weaker than the DJIA on a percentage basis. Conversely, readings of +4 or higher are regarded as bullish.
The Momentum Index is Neutral at +0, unchanged from the previous week. Breadth was negative at the NYSE as the Advance/Decline line lost 3919 units while the number of new 52-week lows out did the new highs on three sessions. Breadth was also negative at the NASDAQ as the A/D line dropped 4548 units while the number of new lows beat the new highs on each day. Finally, the percentage of stocks above their 50-day moving average dropped to 36.1% vs. 53.1% the previous week, while those above their 200-day moving average fell to 60.1% vs. 70.9%. Readings above 70.0% denote an overbought condition, while below 20% is bullish.
Sentiment Index (SI): Measuring the markets Bullish or Bearish sentiment is important when attempting to determine the market’s future direction. Market Edge tracks thirteen technical indicators listed below that measure excessive bullish or bearish sentiment conditions prevalent in the market. In addition, we track money flows into and out of Equity Funds and ETFs which as of 8/18/21 shows inflows of $13.9 billion. Currently, the Sentiment Index is Negative at -3, down a notch from the previous week.
Market Posture: Based on the status of the Market Edge, market timing models, the Market Posture is Bullish as of the week ending 7/30/2021 (DJIA ñ 34935.47). For a closer look at the technical indicators and studies that make up the market timing models, check out the tables located below.
| Market Timing Models | Current Reading | Prior Week | Connotation | ||||||
| Cyclical Trend Index (CTI): | 14 | 14 | Positive | ||||||
| Momentum Index: | 0 | 0 | Neutral | ||||||
| Sentiment Index: | 0 | -3 | Neutral | ||||||
| Strength Index – DJIA (DIA): | 69.0 | 51.7 | Positive | ||||||
| Strength Index – NASDAQ 100 (QQQ): | 50.5 | 51.6 | Positive | ||||||
| Strength Index – S&P 100 (OEX): | 69.9 | 49.5 | Positive | ||||||
| Dow Jones Industrial Average (DJIA): | 35120.08 | 35515.38 | -1.1% | ||||||
| S&P 500 Index: | 4441.67 | 4468.00 | -0.6% | ||||||
| NASDAQ Composite Index: | 14714.66 | 14822.90 | -0.7% | ||||||
| *Connotation is Positive or Negative Divergence from the DJIA | |||||||||
| Momentum Index Components | Current Reading | Prior Week | Connotation | ||||||
| *Dow Jones Industrial Averages (DJIA): | 35120.08 | 35515.38 | |||||||
| *DJ Transportation Ave | 14554.71 | 14927.58 | Negative | ||||||
| *S&P 500 Index | 4441.67 | 4468.00 | Positive | ||||||
| *NYSE Composite Index | 16516.68 | 16868.11 | Negative | ||||||
| *NYSE Advance – Decline Line | 521977 | 525896 | Positive | ||||||
| *10 Day MA Advance – Decline Line | 0.80 | 1.08 | Negative | ||||||
| *NDX 100 Index | 15092.57 | 15136.68 | Positive | ||||||
| *NASDAQ Composite Index | 14714.66 | 14822.90 | Negative | ||||||
| *DJ Utilities Index | 950.75 | 938.29 | Positive | ||||||
| *Russell 2000 | 2167.60 | 2223.11 | Negative | ||||||
| Trin – 5 Day Average | 1.17 | 0.99 | Neutral | ||||||
| NYSE Weekly New Highs – New Lows | 376-128 | 446-119 | Positive | ||||||
| Zweig Breadth Indicator | 0.71 | 0.48 | Positive | ||||||
| McClellan Oscillator | 111 | -23 | Negative | ||||||
| McClellan Summation Index | 963 | 1592 | Positive | ||||||
| Unchanged Issue Index | 0.04 | 0.05 | Negative | ||||||
| Sentiment Index Components | Current Reading | Prior Week | Connotation | ||||||
| Fear-Greed Index – 5 Day Average | 35.20 | 37.80 | Neutral | ||||||
| Shares Sold Short NYSE – Monthly (000) | 14130969 | 13913298 | |||||||
| NYSE Short Interest Ratio – NYSE Only | 2.9 | 3.3 | Bullish | ||||||
| Shares Sold Short NASDAQ – Monthly (000) | 10907482 | 10993209 | |||||||
| NASDAQ Short Interest Ratio | 2.6 | 2.3 | Bullish | ||||||
| AAII Bull-Bear Ratio | 0.9 | 1.2 | Neutral | ||||||
| Put/Call Ratio – 5 Day Avg All Equity Options | 0.99 | 0.93 | Bearish | ||||||
| Dividend Yield Spread | 0.23 | -0.33 | Bullish | ||||||
| NAAIM Exposure Index | 70.6 | 97.5 | Neutral | ||||||
| Bullish Investment Advisors | 51.1 | 56.4 | Neutral | ||||||
| Bearish Investment Advisors | 18.5 | 15.9 | Bearish | ||||||
| Bullish – Bearish Investment Advisors Ratio | 2.8 | 3.5 | Neutral | ||||||
| VIX – CBOE Volatility Index | 18.56 | 15.45 | Neutral | ||||||
Ask Mr. Seifert
What is Implied Volatility?
Implied Volatility (IV) is the rate at which the price of a security increases or decreases for a given set of returns. It is derived by calculating the standard deviations from the current mean. To the average investor that definition doesn’t mean that much but if you watch your portfolio you should notice that when we are in a high volatility environment and when volatility is low. As a rule, volatility will go up when the market is breaking down and will be down when it is rallying.
Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts generally used to calculate IV. Once we know the price of the ATM options, we can use an options pricing model and a little algebra to solve for the IV. For those of you who snoozed through Statistics 101, a stock should end up within one standard deviation of its original price 68% of the time during the upcoming 12 months. It will end up within two standard deviations 95% of the time and within three standard deviations 99% of the time.
To option traders, implied volatility is more important than historical volatility because IV factors in all market expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these events will affect the implied volatility of options that expire that same month. Implied volatility helps you gauge how much of an impact news may have on the underlying stock. With an option’s IV, you can calculate a published range – the high and low of the stock by expiration. Implied volatility tells you whether the market agrees with your outlook, which helps you measure a trade’s risk and potential reward.
Let’s assume a stock trades at $50 with an IV of 20% for the at-the-money (ATM) options. If we assume a normal distribution of prices, we can calculate a one standard-deviation move for the stock by multiplying the stock’s price by the IV of the at-the-money options. For example, if the stock is trading at $50 with an IV of 20%, there’s a consensus in the market place that there is a probability of a one standard deviation move over the next 12 months which would be plus or minus $10 since 20% of the $50 stock price equals $10. Simply put, the market thinks there’s a 68% probability that at the end of one year, XYZ will wind up somewhere between $40 and $60. By extension, that also means there’s only a 32% chance the stock will be outside this range. In addition, 16% of the time it should be above $60, and 16% of the time it should be below $40.
All implied volatilities are quoted on an annualized basis, which means the market thinks the stock would most likely neither be below $40 or above $60 at the end of one year. Statistics also tell us the stock would remain between $30 and $70 (two standard deviations) 95% of the time and would trade between $20 and $80 (three standard deviations) 99% of the time. Another way to state this is there is a 5% chance that the stock price would be outside of the ranges for the second standard deviation and only a 1% chance of the same for the third standard deviation. Knowing the potential move of a stock which is implied by the option’s price is an important piece of information for all option traders.
Since we don’t trade one-year options contracts, we must break down the first standard deviation range so that it can fit our desired time period (e.g. the number of days left until expiration). As a short cut, divide the quoted IV by 19, which is a whole number when solving for the square root of 356 to get the weekly IV. It can’t be emphasized enough, however, that implied volatility is what the marketplace expects the stock to do in theory. And as you probably know, the real world doesn’t always operate in accordance with the theoretical world. In the stock market crash of 1987, the market made a 20 standard deviation move. In theory, the odds of such a move are positively astronomical: about 1 in a gazillion. But in reality, it did happen. Not many traders saw it coming.
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