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Markets Struggle with Crude Oil Drop, But There is a Silver Lining

The action in the markets since Thanksgiving have been amazing, there is so much to cover after the past week so let’s get into it.

The last five days saw the worst price action for markets in a few years, the Industrials dropping nearly 800 points from the high set on Monday morning.  The SPX 500 fell a staggering 3.7% but that was also off of an all time high, while the Russell 2K was down but not nearly as much.  We can point to one culprit of the poor action – crude oil.  Since Thanksgiving crude has cascaded lower and has reached 5 yr lows.  Unless some intervention occurs it appears oil prices could continue to slide.

For it’s part, crude fell about 12% on the week, and we have seen many try to catch the falling knife, but with oil volatility (OVX chart below) so high it makes little sense to try and call a bottom.  For one reason, with volatility at these high levels option prices are juiced up, there is no advantage in buying, and selling premium – normally a great strategy with the volatility spiking – is not clear until the price has surely bottomed.

The VIX moved nearly 100% over the past five days, and it was this action that caused a major concern.  The previous Friday saw volatility at/near the lows of the year, the VIX clocking in under 12%.  That’s a dangerously complacent level, I spoke about the caution here<>.  Recent spikes in VIX have been great areas for reversals WHEN THEY HAPPEN, NOT BEFORE, but this time around everyone buying protection is getting on board early, looking to cash in on the big spikes lower (this is a change in the pattern of buying protection, which usually seems to occur at the end of a big run).  We’ll have to see if a spike high occurs quickly this time around.

One of the most reliable reversal tools has been the VIX/VXV ratio.  Simply put, this is 30 days volatility/90 days volatility.  In a bull market this ratio over 1 is not sustainable for long.  It is as my friend Steven Place of Investing With Options <> calls the ‘place to buy the blood’ (see chart below).  We chatted in mid October about this when the ratio spiked over 1, and while the condition lasted for about 5 days, it triggered a very powerful SPX 500 run, more than 190 handles up!

I would say the odds favor a turn HIGHER in the markets in the next couple of days.  We’ll play it that way.

The VIX term structure is something I watch closely, and my friend Jay Wolberg has some great charts and statistics each day on Trading Volatility<>.  Currently, the VIX cash is above many of the futures, as the reach for protection is extremely short term.  However, the curve has flattened significantly, much like the last time, when in mid October the term structure actually inverted for several days.  That was a temporary condition and the curve soon ‘normalized’ and morphed back into a bullish construct.  I suspect this time around the worry is short-lived.

Breadth has been worrisome of late, given the amount of selling and the shock from dropping crude, those who have been long stocks and are forced to sell (as we saw this happen late Friday) are getting out of the way.  Buyers have stepped aside, too.  The MC oscillators are well oversold, the NYSE coming in Friday at a ridiculously low -201 while the Nasdaq clocked in at -96.  These are extreme oversold readings.

Next week brings a big convergence of data and events that may swing the markets.  We are entering a seasonally strong period for stocks, and while that is not the case this month we could see the tide turn with all of the bearish sentiment stacked high.  The Fed will have their last meeting of 2014 and I suspect no change.  They will bring us a revised forecast and Janet Yellen will hold a press conference.  A slew of important economic data is forthcoming and some key earnings will be released by NKE, ORCL, FDX, ACN, GIS and KMX (among others).  This week is also a big options expiration, and that’ll have a major effect on price action as we end the week.

The speed of these moves down brings us worry, doubt and uneasiness.  We’ve been saying it for awhile, the market is need of a bigger correction, but we won’t make the timing call.  Why is that?  Simply put, the market will ‘see’ the reason for a correction and perhaps a bear market and will TELL US before hand.  The stock market is a great discounting mechanism that never fails, so there is really no sense in trying to front-run a move.

Santa Claus comes to town for the ‘rally’ on Dec 24, which lasts until Jan 5.  We’ll have to see if he’s bringing presents to Wall Street or lumps of coal.


Filed in: Commodities, Trading

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