Friday, July 31, 2009
Quick peak under the hood
Following the SPX strength yesterday, a scan of the Russell 3000 universe of stocks shows that only 149 of them (5%) participated in making their own new highs since the broad market bottomed on Mar. 6. The chart below shows that the 5 day avg of the number of stocks making new cycle highs since that day (using the weekly avg to smooth daily fluctuations). It is evident that participation is thinning each time the SPX swung to new highs in May, June and July. By itself it does not mean that we are looking at an immediate drop, as the divergence can also be resolved with a broadening of breadth, it is something worth keeping an eye on.
Thursday, July 30, 2009
Island Reversal ?
Today's action in US equities started strongly with a >1% gap in the SPY, and looked set for a trend day until sellers came in near the close and drove it to close within the bottom 10% of the day's range. Bearish chartists are certainly rubbing their hands with glee with thoughts of island reversals in their minds, especially after the vertical run up that we have experienced in the past weeks. Let see if we can gain some clue from the past action on days that start with an open gap of >1%.
Using data going back to 1993, we had163 instances of days with a SPY open gap of >1%, 53 of which (35.5%) were immediately closed on the same day (price trading below the previous close or pre-opening gap price). As we now know that was not the case today, we can narrow our focus on the rest of the sample and see what tomorrow may bring. As it turns out, the probability of the gap being closed on the second day is only about 11% (12 of 105 cases, with the average loss being 1.7%), so the odds of the formation of an 'island reversal' signaling buying exhaustion just does not seem high. If we further narrow the sample down to those appearing after a period of strength, as was the case today which marked a monthly high, we find that the bearish case diminishes even more. Within our sample, 22 of those days also marked monthly highs, out of which only 1 experienced a gap fill on the second day. In summary, historical evidence makes a bear case very hard to build, at least for the immediate trade going into Friday.
Having said that, one should also keep an eye on the breadth of the market, which might be showing signs of tiredness as evidenced by only 4 sectors managing to close above the monthly range despite the broader index managing to do so.
Using data going back to 1993, we had163 instances of days with a SPY open gap of >1%, 53 of which (35.5%) were immediately closed on the same day (price trading below the previous close or pre-opening gap price). As we now know that was not the case today, we can narrow our focus on the rest of the sample and see what tomorrow may bring. As it turns out, the probability of the gap being closed on the second day is only about 11% (12 of 105 cases, with the average loss being 1.7%), so the odds of the formation of an 'island reversal' signaling buying exhaustion just does not seem high. If we further narrow the sample down to those appearing after a period of strength, as was the case today which marked a monthly high, we find that the bearish case diminishes even more. Within our sample, 22 of those days also marked monthly highs, out of which only 1 experienced a gap fill on the second day. In summary, historical evidence makes a bear case very hard to build, at least for the immediate trade going into Friday.
Having said that, one should also keep an eye on the breadth of the market, which might be showing signs of tiredness as evidenced by only 4 sectors managing to close above the monthly range despite the broader index managing to do so.
Low VIX ?
A common theme that has been much discussed is the persistent decline in the commonly referred to fear gauge in the market the VIX and whether it is too low and artificially manipulated given its relentless decline from the peak level of over 80 during the height of the crunch in 2008 to a current level of about 25. To recap, VIX is a measure of the implied volatility for a constant 30-day to maturity option chain based on the S&P500. If we accept that volatility is a mean reverting process, then the VIX level should be related to the realized volatility of the SPX plus some value of risk premium. As a fear gauge, the premium should also intuitively be higher in times of market stress. To test out this hypothesis, we shall take a look at a simple regression between the VIX premium (VIX - 1m realized SPX vol) vs. the 1m SPX realized vol and the weekly % change of the SPX level since 1990 with the following results:
The regression on these 2 variables alone explains 63% of the variation in the VIX premium, and both are statistically significant. The signs of the coefficients also corresponds to intuition. A higher level of realized volatility shrinks the premium (vol mean reverts), as does a positive return on the SPX. Applied to the current realized volatility of 21.3% and -0.1% SPX return (as of close 7/29) gives us a predicted VIX of 24.6% compared to the current spot reading of about 25%. Therefore, it looks like the VIX is fairly priced and not artificially depressed.
The regression on these 2 variables alone explains 63% of the variation in the VIX premium, and both are statistically significant. The signs of the coefficients also corresponds to intuition. A higher level of realized volatility shrinks the premium (vol mean reverts), as does a positive return on the SPX. Applied to the current realized volatility of 21.3% and -0.1% SPX return (as of close 7/29) gives us a predicted VIX of 24.6% compared to the current spot reading of about 25%. Therefore, it looks like the VIX is fairly priced and not artificially depressed.
Welcome!
Welcome to my first attempt at blogging. My intention of this blog is to share my market analysis and insights, rather than directly providing buy or sell signals and hopefully build a community dedicated to sharing their ideas and studies. The focus will be macro and cross market: including major indexes, volatility and credit. My main approach to trading is to use statistics to prove - or disprove - the validity of historical patterns and setups to hopefully gain a glimpse into which side the edge is on going ahead.
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