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Sell Signals for the Stock Market



Sell Signals – Fact or Fiction

Option-Based Indicator to Keep an Eye on – The Put/Call Skew



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March 19, 2012

Introduction

It was an unequivocal win for the bulls last week, as the major equity benchmarks finished with gains of more than 2% apiece. Nevertheless, after two-plus years of improving price action, naysayers continue to find reasons to doubt this rally.

Therefore, there are many alleged sell signals available to determine whether we should brace for an imminent pullback -- and an option-based indicator that needs to be kept an eye on -- discussed in this article.

Sifting Through the Various Sell Signals

“A risk to those waiting for a deeper pullback is that the early March decline might be all that will occur for now. It is interesting that Tuesday's low marked a 38-point decline from the SPX's intraday peak of 1,378.04 on Feb. 29, matching the 38-point decline from the intraday high to intraday low that occurred Jan. 26 through Jan. 30… Among the many concerns voiced by technicians in recent weeks is the divergence of the Russell 2000 Index… small-cap divergence fears could be misplaced… The scenario remains bullish, as the technical backdrop of the benchmark equity indexes still looks healthy… Sectors to consider are the homebuilders and retail/restaurants.”
- The SPX and the Latest Technical Sell Signal in the Week Ahead, March 12, 2012

"... the assets entrusted to the iPath S&P 500 VIX Short-Term Futures exchange-traded note (VXX) has increased by $746 million, or 94%, this year, to $1.54 billion. This is a fund that increases in value along with the price of implied market volatility, known more colloquially as disaster insurance. So, about three-quarters as much net cash has found its way to a fund that profits from spikes in U.S. market volatility as has been sent to funds that attempt to profit from rising equity-market values."
- Barron’s, March 10, 2012



3 Signs a Market Sell-Off Is Coming Soon
- Yahoo Finance, March 14, 2012



Small-Cap Divergence Bearish Argument for Sell Signals

Last week the significance of a noticeable small-cap decline simultaneous with the S&P 500 Index (SPX - 1,404.17) achieving a one-year high, and observed that those calling for a broader-market pullback based on this divergence had history against their side, was discussed. And after a roughly 30-point rally in the SPX last week, following four days of strong advances the week prior, those who bought into the "small-cap divergence" bearish argument felt the pain.

Reasons Technicians are Shorting the Market

In fact, a theme that has been discussed for the past few weeks has been the fact that many technicians seem to be short the market, for reasons ranging from:

1. divergence indicators;

2. the CBOE Market Volatility Index (VIX -14.47) futures term structure ;

3. the VIX falling below 15; and

4. Overbought indicators.

Research has proven that many of these concerns are misguided and, in fact, ranged between being spotty in their track record (the steep VIX futures curve) to having bullish implications (small-cap divergence when SPX hits new high).

There is still evidence, per the flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the bearish Yahoo Finance headline excerpted above, that short-term players are preparing for a correction, suggesting short covering and sideline money is still available to play the "trend is your friend" trade. In fact, one of the indicators discussed in "3 Signs a Market Sell-Off Is Coming Soon" was that more than 65% of stocks are trading above their 40-day moving averages, definitely not a sell signal.

The Influence of the VIX

When studying the historical implications of 85% of SPX components trading above their 40-day moving averages, there was no evidence that this indicator is anything to be alarmed about. The average return following a signal was flat going out to two months, but the percentage of positive returns was higher than the SPX's at-any-time expected returns since 2000.

sell-signals-2



sell-signals-3



Last week, some traders and investors were upset and disappointed about the CBOE Market Volatility Index’s drop below 15 as a sign that complacency had set into the market, leaving stocks vulnerable. However, looking closely at this situation, that even with the VIX below 15, it was still significantly above actual SPX volatility, which is around 10. And, upon further examination into VIX declines below 15 after spending a long time above this level, once again, it is to be found that nothing particularly alarming is in the historical data.

Expensive Options on SPY

So, while some technical indicators being bandied about among cautious traders suggest a pause could be imminent -- not a sell-off, as advertised – with further investigation it is evident how expensive 10% out-of-the-money puts on the SPDR S&P 500 ETF (SPY) have become relative to 10% out-of-the-money calls recently. The chart below shows the percentage by which the put is above the call implied volatility for 10% out-of-the-money options expiring in April. The last time out-of-the-money puts were priced this high relative to calls was early March 2011, and a correction of less than 10% occurred before the market quickly recovered. Bulls can take comfort that this skew has rolled over significantly in recent days, but the market hasn't sold off like it did in early 2011.

sell-signals-4



Conclusion

Therefore, even though some technical indications are being thrown around as corrective warnings - sell signals, yet with deeper research and practical understanding on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID - 1,000.73) making its second run in as many years at the 1,000 millennium mark. Overall, this appears to be still a favorable environment for the bulls.

Daily Chart of MID since February 2011

sell-signals-5

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