foxex: Green Across the Board

Focus on the Price

Wednesday, December 26, 2018

1. Stocks rally on energy prices and holiday sales

2. An important risk indicator pointed towards today's rally

3. Volume likely to fall through the end of the week

Major Moves

Following an announcement that Amazon (AMZN) experienced record holiday sales, the S&P 500 erased all of Monday's losses and some of Friday's. The retail and technology sectors led the rally, and the gains in small-cap stocks helped confirm the shift in investor sentiment.

Oil prices outpaced stocks with a gain of more than 4.5%, which has been a nice breather from its 45% drop since the beginning of October. The $40-$42 per barrel price range has been an important pivot for oil since 2015, so if there were a price where investors might be looking for rally, this is it. Gains in energy prices tends to provide a halo effect on other sectors, like industrials and banking, which helped accelerate the rally today.

Yields Could Lend Support

Before getting too excited about today's bullish spike, investors should keep in mind that European markets are closed for the holiday. That doesn't invalidate today's gains, but it does mean market breadth is relatively narrow. Once global investors are back in the new year, we will have a better idea about the momentum behind the rally.

From a technical perspective, it's difficult to identify a clear level of support for the S&P 500. That's not to say that the market couldn't form a base here, only that we can't show that investors have been willing to buy at this price level after declines in the recent past. However, what is a little more clear is that long-term interest rates are at a historical pivot level, which means that investment-grade bonds are at resistance.

In the following chart I have compared the yield on 10-year Treasury bonds with the S&P 500. As you can see, 2.7% to 2.8% has been a reliable bullish pivot since beginning of 2018. Each time yields have reached this level, investors have been willing to favor stocks over bonds. If yields continue to rise, investors should become a lot more confident about profit opportunities in the first quarter 2019.

Read more:
Mastercard Crushes Holiday Sales

Market Near a Bottom
Disney is Oversold

Risk Indicators

Although most of the market indicators have been uniformly bearish over the last two weeks (at least through Christmas Eve) the risk indicator that has been most contrary is the SKEW. The SKEW index is produced by the CBOE (Chicago Board Options Exchange) like the so-called "fear index" or VIX. To understand why the SKEW index has been such a standout, and what it means, a little background information is necessary.

If investors are speculating that the market will rise, they may buy call options; if they fear the market will fall, they could buy put options. Call options rise in value in the market rises, and put options rise in value when the market falls. Therefore, if market returns are random, calls should be just as valuable as puts. That's true even if they are far out of the money.

However, since the market crash of 1987, the market has valued out of the money puts (those with a strike price below the market price) more highly than it has out of the money calls. The SKEW index measures how much more the market values out of the money puts than out of the money calls. If investors are very fearful of a market decline, the relative price of the puts (and the SKEW) will rise.

Despite the S&P 500 completing a drop of nearly 20% from the market highs on Christmas Eve, the SKEW index actually dropped back towards its lows. As you can see in the following chart, the SKEW approached its long-term lows during Monday's half-session.

Historically speaking, the SKEW index is not very precise timing indicator. However historical studies have shown that surprise rallies are much more common when the SKEW is low. The inverse is also true, when prices are rising but the SKEW is also very high, investors are pricing in a lot of downside risk and negative price shocks are more common. You can see example of that scenario in late September when the market was reaching its highs.

The SKEW is a short-term indicator, and its recent "bullishness" should not be interpreted as a signal that the decline has ended all by itself. However, if the S&P 500 starts to form a bottom over the next week or two, historical studies have shown that a bullish breakout is more likely if the SKEW continues this pattern of forming lows with the market price, which is what happened earlier this year when the market rallied in April.

Read more:
What is the SKEW Index?

The Options Volatility Smile
The Stock Market Crash of 1987

Bottom line: Low Volume Next Week

Today was an exception to the general rule that volume is very low during the holiday week between Christmas and New Year's. If volume returns to its historical norm the rest this week, we probably won't see much follow-through from today's rally. An important caveat to that estimate is the potential for a short-term resolution to the government shutdown before the weekend. In my view, a detente in the budget fight is the most likely catalyst for a continuation of today's rally.

Predictions for the Top Investing Terms of 2019