Stocks Recoup Omicron Selloff
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The following is an excerpt from this week’s ‘Weekly Market Letter’ from Market Edge (www.marketedge.com).
Investors came to terms with the Omicron Covid variant this week and the major averages were able to snap back, turning in their best weekly percentage gains since February, with the S&P 500 sitting at a new closing record high. The DJIA ended a four-week losing streak and the different indexes were able to recoup all the losses and then some, since news broke on the new Coronavirus variant. Building on an oversold ‘relief rally’ on Monday, equities got another boost on Tuesday after China eased monetary policy to spur slowing growth. A broad based rally was led by a +3.51% spike in the Technology (XLK) sector that sent the Philadelphia Semiconductor Index (SOX) up +4.97% to an all-time high. News that a third dose of Pfizer’s (PFE) vaccine proved effective in offering protection form the Omicron variant on Wednesday nearly sent the S&P 500 to a new record high before the major averages ran out of steam on Thursday. Travel related stocks jumped on the report after coming close to 52-week lows the previous week. Despite a hotter than expected November CPI to close out the week stocks were able to nudge higher, ending on a high note. Economic data was solid with Initial Jobless Claims hitting their lowest mark since 1969 and US Exports expanding to a record high. Every sector was able to finish in the plus column led by strength in Technology (XLK), as Apple Co (AAPL) rose to a new record high, and the surge in semiconductors. Materials (XLB), Consumer Staples (XLP) and Industrials (XLI) were also sharply higher. Yields nudged higher during the week as investors expected the Federal Reserve to dial back stimulus faster to ward off inflation pressures at next week’s FOMC Meeting. The 30-year Treasury yield ended the week at 1.88% and the 10-year rate at 1.48%. A faster rise in the two-year T-Bill rate narrowed the yield curve which held financial shares back. Investors were cautious as the week came to a close despite the rally as they looked ahead to next Wednesday’s announcement on monetary policy from Fed Chair Jerome Powell. However, the major averages were able to snap their losing streak and finish the period once again at, or close, to new all-time highs.
For the period, the DJIA jumped 1390.91 points (+4.0%) and settled at 35970.99. The S&P 500 added 173.59 points (+3.8%) and closed at 4712.02. The NASDAQ picked up 545.13 points (+3.6%) finishing at 15630.60, while the small cap Russell 2000 lagged the broader market but added 52.49 points (+2.4%), finishing at 2211.80.
Market Outlook: The technical condition of the market was mixed this week as the major averages repaired the damage done to their charts over the last few weeks. The technical indicators are mostly positive for the DJIA and S&P 500 with MACD, a trend gauge, crossing into bullish ground, while Momentum, as measured by the 14-day RSI, positive and increasing. The technical indicators for the NASDAQ were mixed but were negative for the Russell 2000 which also fell back below its 200-day moving average (MA) during the week. The technical condition of the Philadelphia Semiconductor Index was also mixed despite hitting a new high on Tuesday. Momentum is positive for the semiconductors but slowing. Finally, except for the Russell 2000, the major averages were able to trade back above key moving average resistance levels which is a positive for the market going forward. The small cap Russell 2000 however, is once again showing negative divergence and could be a harbinger that stocks could continue to struggle over the next few weeks. Every sector showed gains this week and most sectors remain in decent shape. New highs were made in Consumer Staples (XLP), Technology (XLK) and REITs (XLRE), while Utilities (XLU), Consumer Discretionary (XLY), Industrials (XLI) and Materials (XLB) all were closing in on recent highs. Financials (XLF) however, slipped below its 50-day MA and Communication Services (XLC) remained below its 200-day MA.
Underlying breadth was also mixed as the NYSE and NASDAQ Advance/Decline lines, leading indicators of market direction, moved higher showing stocks were under accumulation, but new 52-week lows outpaced new highs for a third week. This shows negative divergence and narrowing leadership as the different indexes take aim at their old highs and points to a less than robust rally this week. Despite the S&P 500 making an all-time high, the NYSE only reported double-digit new highs on Friday. That negative divergence again shows weakness in the rally and bears watching. A healthy rally should be putting up 250+ new highs when an index is breaking out. Investor Sentiment is in the neutral camp as the recent pullback sent investors scrambling for the sidelines. Bullish retail investors remain below historical norms with this week’s American Association of Individual Investors (AAII) survey showing bears outnumber the bulls 29.7% to 30.5%. Furthermore, institutional investors are also getting nervous. According to Investors Intelligence, the Percentage of Bullish Investment Advisors, a contrarian indicator, dropped to 39.7% this week. That’s the least number of bulls since the first week of April 2020 and signals that a near-term bottom could be in. In addition, the National Association of Active Investment Managers (NAAIM) Exposure Index shows hedge funds are only 69.5% exposed to stocks. That compares to 103.1% and on margin just two-weeks ago.
Omicron and Fed speak have certainly spooked market participants and added to volatility over the last few weeks. The worst start to December in 20 years was followed by the best week since February. On Wednesday, we should get a clearer picture of the Federal Reserve’s game plan and timeline for fighting off inflation pressures and I expect another volatile week of trading. As of Friday, the CME Group Fed Watch gives the first rate hike only a 50/50 chance in May. While that should give the economy and investors plenty of time to adjust to a more aggressive shift in monetary policy, it also gives the Federal Reserve enough breathing room to allow inflation pressures due to supply chain issues perhaps time to prove ‘transitory’. That could mean lower rates for longer and keep equities moving higher.
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 +12, up 12 notches from the previous week. Cycles A, B, C, D and E are bullish. The CTI was reset to a positive configuration after last week’s low and is projected to remain positive the remainder of the year.
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 -2, down a notch from the previous week. Breadth was mixed at the NYSE as the Advance/Decline line gained 2592 units while the number of new 52-week lows exceeded the number of new highs on three of the five sessions. Breadth was also mixed at the NASDAQ as the A/D line added 2000 units while the number of new lows out did the new highs on four days. Finally, the percentage of stocks above their 50-day moving average jumped to 38.8% vs. 28.6% the previous week, while those above their 200-day moving average increased to 50.0% vs. 43.8%. 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 markets future direction. Market Edge tracks thirteen technical indicators listed below that measure excessive bullish or bearish sentiment conditions prevalent in the market. The Sentiment Index is Neutral at +2, down two notches from the previous week. In addition, we track money flows into and out of Equity Funds and ETFs which as of 12/08/21 shows outflows of $1.5 billion.
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 – 34935.47).
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Question: 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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