To Buy or Not to Buy

This week we have watched the S&P 500 price (SPX) churn itself sideways spending most of its time in a 5 point trading range between 1445 and 1450.  Price moves above and below those levels have been abrupt and short lived.  Coming on the heels of a sharp 4 day 35 point rally in the SPX, conditions like this typically suggest that the move which is being consolidated will eventually resume.  In other words, when we see the market rally like it did off of the FOMC’s relatively upbeat outlook on the economy on Jan. 31 and then stall for a few days without any major retracement of the rally, we have to lean in favor of believing that the initial move was legitimate, and new buyers will begin to take the market higher again following the consolidation.  This is what is referred to as a consolidation by time but not by price.  So, taking this by itself, we may have a case for the bulls.  One thing which seems certain is that low volatility leads to high volatility.  Regardless of which way this consolidation resolves, it should be swift and somewhat explosive.

However, there are a couple of other factors to consider.  Firstly, we have the low levels of VIX, which is a measure of implied volatility in the S&P 500.  One common use of VIX is as a fear indicator.  High levels of VIX indicate high levels of fear in the marketplace.  High VIX tends to accompany a bearish market environment.  Low levels of VIX indicate high levels of complacency on the part of investors.  Investors are generally fearless as the market is steadily advancing as it has been.  This is related to the nature of the way price generally moves up vs. the way price generally moves down.  We tend to view low volatility conditions such as we have been experiencing as the market lulling the herd of investors to sleep before it corrects.  The correction may be short lived, but we suspect it would be sharp.

Secondly, we are in a market which is rather overextended.  We are not just talking overextended over the last 2-3 weeks, but overextended over the last 8 months.  The SPX has had 8 straight calendar months of positive performance.  When did that last happen?  How about 1996 - over 10 years ago.  That 8 month run was followed by a single month correction of over 10%.  Does that mean the same thing must happen to this 8 month rally?  Of course not, but we do have a rather intimidating precedent to look to for some guidance on whether or not to follow the herd and jump on board this rally.

One other piece of evidence we see which leads us to cautiously question the bullish case is the increase in NYSE volume we witnessed yesterday (Feb. 8) during this consolidation.  NYSE volume increased by about 8.5% over the previous day’s tally, but the S&P 500 closed only slightly lower.  Could this be institutional selling into strength to the “late to the party Charlies”?  The institutions love to attempt to conceal their selling, and for good reason of course.  As soon as the retail investor perceives that the “big boys” are sellers, guess who else becomes a seller?  Yup, the retail investor.  Once the retail investor starts selling, who’s going to buy the institutions’ shares?  Well, no one, unless it’s at a discount to where price is currently.

Considering all of this, we are leaning in the short term to expecting some type of a correction to the downside.  When it will ensue, and how painful will it be, we do not know.  Our clients’ portfolios are currently positioned slightly delta negative to take advantage of any movement to the downside, and slighly theta positive to capitalize on time decay.